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What are the Sensex and the Nifty? 3 important things that every investor MUST remember!! How to decide which stocks to buy? Basics of fundamental analysis! Earnings per share (EPS) ratio and what it means? Price to earnings (P/E) ratio and what it means? PEG ratio and what it means? Inflation and how it silently eats your money! Brokerage and taxation
So what does ownership of a company give you? Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns. This means that technically you own a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well. These earnings will be given to you. These earnings are called dividends and are given to the shareholders from time to time. A stock is represented by a "stock certificate". This is a piece of paper that is proof of your ownership. However, now-a-days you could also have a demat account. This means that there will be no stock certificates. Everything will be done though the computer electronically. Selling and buying stocks can be done just by a few clicks. Being a shareholder of a public company does not mean you have a say in the dayto-day running of the business. Instead, one vote per share to elect the board of directors of the company at annual meetings is all you can do. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions. For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the companys profits and have a claim on assets. Profits are sometimes paid out in the form of dividends as mentioned earlier. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt.
In case of liquidation, you'll receive what's left after all the creditors have been paid. Another extremely important feature of stock is "limited liability", which means that, as an owner of a stock, you are "not personally liable" if the company is not able to pay its debts. In other legal structures such as partnerships, if the partnership firm goes bankrupt the creditors can come after the partners personally and sell off their house, car, furniture, etc. To understand all this in more detail you could read our How to incorporate? article. Owning stock means that, no matter what happens to the company, the maximum value you can lose is the value of your stocks. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets. Why would the founders share the profits with thousands of people when they could keep profits to themselves? This is the obvious question that comes up next. This what the next section is all about!
Why does a company issue stocks? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to "raise money". To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods come under "debt financing". On the other hand, issuing stock is called equity financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).
It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful. Its a tricky game! Note that: There are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends. Without dividends, an investor can make money on a stock only through its appreciation of the stock price in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing. Having understood this, we now want to know what makes stock prices rise and fall? If we know this, we will know which stocks to buy. In the next section we will try to understand what makes stock prices go up and down.
makes people like a particular stock and dislike another stock. If you understand this, you will know what people are buying and what people are selling. If you know this you will know what prices go up and what prices go down! To figure out the likes and dislikes of people, you have to figure out what news is positive for a company and what news is negative and how any news about a company will be interpreted by the people. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Dalal Street watches with great attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results are better than expected, the price jumps up. If a company's results disappoint and are worse than expected, then the price will fall. Of course, it's not just earnings that can change the feeling people have about a stock. It would be a rather simple world if this were the case! During the dotcom bubble, for example, the stock price of dozens of internet companies rose without ever making even the smallest profit. As we all know, these high stock prices did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, this fact demonstrates that there are factors other than current earnings that influence stocks. So, what are "all the factors" that affect the stocks price? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price very very rapidly. Just remember this: At the most fundamental level, supply and demand in the market determines stock price.
There are many types of techniques and methods that investors use to figure out whether a stock price will go up or down! We will try to give you an introduction to these techniques in this article. But before we go into the concepts of stocks picking, and the techiques of analysis, let us understand one last basic thing....
how the SENSEX is actually calculated...you must check-out our "How to calculate BSE SENSEX?" article! But, before we go ahead and try to understand "How to make money in the stock market?" you MUST read the next page....
But then again, nothing comes free. Everything has a price. You will have to loose some money, make some bad decisions and then only will you really understand the market. You cannot understand the market by just looking at it from far. By following these rules, you will basically not loose too much!
What advantage do they have over their competing firms? Do they have a strong market presence and market share? Or do they constantly have to employ a large part of their profits and resources in marketing and finding new customers and fighting for market share? After you understand the company & what they do, how they relate to the market and their customers, you will be in a much better position to decide whether the price of the companies stock is going to go up or down. Having understood the basics of fundamental analysis, let us go into some more details. When investing in the stocks, we want the price of our stock to rise. Not only do we want our stock price to rise, we want it to rise FAST! So the challenge is to figure out: which stock prices are going to rise fast? Some stocks are cheap and some are costly. Some are worth Rs.500 and some are even worth 50paise. But the price of the stock is not important. The price of the stock does not make a stock good to buy. What is important is how much the price of the stock is likely to rise. If you invest Rs.500 in one stock of Rs.500 and the price goes up to Rs.540 you will make Rs.40. However, if you invest Rs.500 in a 50paise stock, you will have 1000 stocks. If the price of the stock goes up from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You made a profit of Rs.500. If you understand this, you can see that the price of the stock is not important. What is important is the rise in the stocks price. More specifically the percentage rise in the stock price is important. If the Rs.500 stock becomes worth Rs.540, then that is a 8% rise. This 8% rise only makes us Rs.40. On the other hand when we invest the same Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it is a 100% rise as the stock price has doubled. This 100% rise makes us Rs.500. The point is that when picking a company, we are interested in a company whose stock price will rise by a large percentage.
Please note: Looking at the above paragraphs, it may seem like a good idea to buy all the really cheap 50paise and Rs.1 stocks hoping that their price will rise by 100% or more. This sounds good, but it can also be really really bad some times! These really small stocks are very volatile and unless you know what you are doing, do NOT get into them. However, the point to be noted is that we are interested in stocks that will have the highest % rise in the stock price. Now the question is, how do you compare stocks. How do you compare a stock worth Rs.500 to a stock worth 50paise and figure out which one will have a higher percentage rise. How do you compare two companies that are in different fields and different industries? How do you know which one is fundamentally strong and which one is week? If you try to compare two companies in different industries and different customers it is like comparing apples and elephants. There is no way to compare them! So fundamental analysts use different tools and ratios to compare all sorts of companies no matter what business they are in or what they do! Next let us get into the tools and ratios that tell us about the companies and their comparison....
earned Rs.100 then each shareholder has earned Rs.2. So you see it is important to know what is the total number of outstanding shares are as well as the earnings. Thus it makes more sense to look at earnings per share (EPS), as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares. EPS = Net Earnings / Outstanding Shares So looking at the EPS ratio, you should go buy Company A with an EPS of 10, right? EPS is not the only basis of comparing two companies, but it is one of the methods used. Note that there are three types of EPS numbers:
Trailing EPS last years numbers and the only actual EPS Current EPS this years numbers, which are still projections Forward EPS future numbers, which are obviously projections
EPS doesnt tell you whether its a good stock to buy or what the market thinks of it. For that information, we need to look at some other ratios next....
For example: A company with a share price of Rs.40 and an EPS of 8 would have a P/E of: (40 / 8) = 5 What does P/E tell you? Some investors read a high P/E as an overpriced stock. However, it can also indicate the market has high hopes for this stocks future and has bid up the price. Conversely, a low P/E may indicate a vote of no confidence by the market or it could mean that the market has just overlooked the stock. Many investors made their fortunes spotting these overlooked but fundamentally strong stocks before the rest of the market discovered their true worth. In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes or dislikes the stock. If things are vague and unclear to you, do not worry. The next ratio will make everything you read till now make sense..
What does the 2 mean? Technically speaking: The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value. So, to put it very simply, we are interested in stocks with a low PEG value. Just for the sake of understanding, consider this situation, you have a stock with a low P/E. Since the stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value? To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the projected growth earnings are low. This is the kind of stock that the stock market thinks is of not much value. On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason. Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Having understood these basic three ratios, you probably have started to understand how these ratios help you understand a stock and what is valuable and what is not. In the next section we shall look at some of the things that every investor must know about. Something that SILENTLY eats into the profits of each and every investor and how to beat it...
"Inflation" & how it eats your money silently & affects your investments!
Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of everything going up over the years. A movie ticket was for a few paise in my dads time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up. If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dads time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!) Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a paan with the 50paise!! The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things. Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe. Always invest money.
If you cant think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing. Secondly: When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation. What is the rate of inflation? As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up? The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2 So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.
What is the rate of return? The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%. If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with todays Rs.100, you will only be able to buy with Rs.104 a year from
now. But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect, you are loosing money! So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation. From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it an your money would sit loosing value for no fault of yours. But inflation is not the only thing you should be considering, there are other things too that eat into you money. The first thing is brokerage and the second thing is taxation.
brokerage and inflation. Important note about brokerage: Brokers make money on whatever transaction you make. Whether you buy or sell, brokers will make money. Because brokers basically make money on transactions. Because of this, brokers tend to encourage you to trade. They dont really care about whether you make a profit or loss. They just care about whether you are trading. The more money you are using for trading, the more they will make. Because of this, it would be wise to not blindly follow your brokers advise. The broker will give you hot tips etc. not because they are looking out for you and your profit, but because they are thinking about their own personal profit! There is even one more factor that eats into your money. Tax!!! Please note: We are not in any way encouraging you to not pay tax! We are just educating you about it. There is a short term capital gain tax in our country. For a short term (less than one year) you have to pay tax on any capital gain you make though the stock market trading. How much % tax you have to pay, depends on which "tax bracket" you fall in. Just to give you an idea. If I make Rs.100 though a transaction in the stock market, since I fall in the 33% tax bracket. It have to pay Rs.33 of that to the government!! Please note: The government encourages you to be a long term-investor by having no long term capital gain tax. If you make a capital gain by investing for a period greater than one year, the you do not have to pay any tax on the money you make. Now combine this short term capital gain tax with brokerage and inflation! Think about it for some time. You will almost make nothing on a small profit gains! If you want to make money out of the stock market, you must make large profit gains. Conclusion: As a general rule, just for the sake of simplicity, your investments must grow at a minimum rate of 15% per year to stay ahead of inflation, tax and brokerage!! Remember this when making all your investments. This concludes our basics of the stock market guide. There is lot more to learn! And the best way to do it is to start investing! (Dont invest too much in the
beginning but do start!) Once you have your money in the market, you will start to understand things a whole lot better! Best of luck!
the free-float shares. When we are calculating the Sensex, we are interested in these free-float shares! A particular company, may have certain shares in the open market and certain shares that are not available for trading in the open market. According the BSE, any shares that DO NOT fall under the following criteria, can be considered to be open market shares:
Holdings by founders/directors/ acquirers which has control element Holdings by persons/ bodies with "controlling interest" Government holding as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by employee welfare trusts Locked-in shares and shares which would not be sold in the open market in normal course.
A company has to submit a complete report about who has how many of the companys shares to the BSE. On the basis of this, the BSE will decide the freefloat factor of the company. The free-float factor is a very valuable number! If you multiply the "free-float factor" with the market cap of that company, you will get the free-float market cap which is the value of the shares of the company in the open market! A simple way to understand the free-float market cap would be, the total cost of buying all the shares in the open market! So, having understood what the free float market cap is, now what? How do you find out the value of the Sensex at a particular point? Well, its pretty simple. First: Find out the free-float market cap of all the 30 companies that make up the Sensex! Second: Add all the free-float market caps of all the 30 companies! Third: Make all this relative to the Sensex base. The value you get is the Sensex value!
The third step probably confused you. To understand it, you will need to understand ratios and proportions from 5th standard mathematics. Think of it this way: Suppose, for a free-float market cap of Rs.100,000 Cr... the Sensex value is 4000 Then, for a free-float market cap of Rs.150,000 Cr... the Sensex value will be..
So, the Sensex value will be 6000 if the free-float market cap comes to Rs.150,000 Cr! Please Note: Every time one of the 30 companies has a stock split or a "bonus" etc. appropriate changes are made in the market cap calculations. Now, there is only one question left to be answered, which 30 companies, why those 30 companies, why no other companies? The 30 companies that make up the Sensex are selected and reviewed from time to time by an index committee. This index committee is made up of academicians, mutual fund managers, finance journalists, independent governing board members and other participants in the financial markets. The main criteria for selecting the 30 stocks is as follows: Market capitalization: The company should have a market capitalization in the Top 100 market capitalizations of the BSE. Also the market capitalization of each company should be more than 0.5% of the total market capitalization of the Index. Trading frequency: The company to be included should have been traded on each and every trading day for the last one year. Exceptions can be made for extreme reasons like share suspension etc.
Number of trades: The scrip should be among the top 150 companies listed by average number of trades per day for the last one year. Industry representation: The companies should be leaders in their industry group. Listed history: The companies should have a listing history of at least one year on BSE. Track record: In the opinion of the index committee, the company should have an acceptable track record. Having understood all this, you now know how the Sensex is calculated. Jai Hind.