What is the logic behind the valuation of stocks?

What is the logic behind the valuation of stocks?

Before proceeding with the answer, I would like to share some fun facts about share market of India.

1. Bombay Stock Exchange (BSE) is the biggest stock exchange in the world in terms of the number of listed companies on an exchange. BSE has over 5,500 listed companies.

2. BSE is also the oldest stock exchange in Asia. It was established in 1875.

3. When master blaster used to play international cricket, his dismissal adversely affected the Indian stock market.

4. The costliest share in the Indian share market is MRF. Its current price is around 59000. Berkshire Hathaway is the worlds costliest stock. One share of the company costs you over Rs 2 crore.

5. In addition to BSE, there are over 23 more exchanges in the country.

6. In India, out of 22124.14 INR billion household savings, only 2% goes as investment into equities. People in India are more inclined to invest their money in gold, banks and in real estate.

How does the stock market work?

Let me explain the concept of stock market with the simplest example. We all have been to vegetable market (sabji mandi) once in our life. Stock market is just like this market, the difference is people do buying and selling of stocks in former.

Operating much like an auction house, the stock market enables buyers and sellers to negotiate prices and make trades. We too can bargain with the seller for the price of a particular stock.

Now suppose a vendor of vegetable market named Bhola wants to expand his business of selling vegetable and he wants to start growing vegetables on land owned by him. He requires huge capital for purchasing land, tractors, seeds, fertilizers and for employment of labour force.

1. Family and Friends

2. Banks

3. Public

He can borrow from his friends, family or banks up to a certain limit as the rate of interest rate would be high and he would be bound by instalment payment every month. So what is other viable option with him?

He can raise the capital with the help of public. Now there comes the concept of IPO.

An IPO, or Initial Public Offering, is a company’s first introduction to the public market. An IPO is the process by which a private company issues its first shares of stock for public sale. This is also known as “going public.”

Companies do not begin with an IPO upon launch. While successful start-ups may go public eventually, it takes a firm time to establish the necessary business plan and market position. This is, in part, so that the firm can attract investors and in part so that it can meet many of the SEC’s qualifications for an IPO.

Prior to launching an IPO a company may be held entirely by its founders or by a combination of promoters (mainly owner of the company) and private shareholders. At this point the firm entirely controls its ownership structure. If it has shares, the firm’s principals can restrict those shares to purchasers or investors of their choosing.

Now what all options are available with the Bhola to raise his capital? He can borrow from-

A company that issues stocks is selling partial ownership in the company. Instead of getting repaid, like a loan, the investor will instead sell that partial ownership at a later date—hopefully after the company has grown and increased its value.

Upon launching an IPO the firm takes a portion of its ownership shares and makes them publicly accessible. After you apply in IPO through your demat account, you get shares or say ownership in that particular company on the day the company gets listed on the stock exchange.

Investors can then buy and sell these stocks among themselves, and the exchange tracks the supply and demand of each listed stock. After the company is listed on the stock exchange, buying and selling of stocks can be done by them in the secondary market.

How the price of the stock is determined?

Generally speaking, the stock market is driven by supply and demand, much like any market. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.

The more demand for a stock, the higher it drives the price and vice versa. The more supply of a stock, the lower it drives the price and vice versa.

Understanding the law of supply and demand is easy; understanding demand can be hard. The price movement of a stock indicates what investors feel a company is worth—but how do they determine what it’s worth? One factor, certainly, is its current earnings: how much profit it makes. But investors often look beyond the numbers. That is to say, the price of a stock doesn’t only reflect a company’s current value—it also reflects the prospects for a company, the growth that investors expect of it in the future.

The potential buyers announce a price at which they would be willing to pay, known as the “bid.” The potential sellers announce a price at which they would be willing to sell, known as the “ask.” A market maker in the middle works to create liquidity by facilitating trades between the two parties.

Put simply, the ask and bid determine stock price. When a buyer and seller come together, a trade is executed, and the price at which the trade occurred becomes the quoted market value. That’s the number you see splashed across television ticker tapes, internet financial portals, and brokerage account pages.

First, realize that the stock market is basically an auction, with one party wanting to sell its ownership, and one party wanting to buy ownership. When the two agree upon a price, the trade is matched and that becomes the new market quotation. These buyers and sellers can be individuals, corporations, institutions, governments, or asset management companies that are managing money for private clients, mutual funds, index funds, or pension plans. In many cases, you won’t have any idea who is on the other side of the trade.

Because the stock market functions like an auction, when there are more buyers than there are sellers, the price has to adapt or no trades are made. This tends to drive the price upwards, increasing the market quotation at which investors can sell their shares, enticing investors who had previously not been interested in selling to sell. On the other hand, when sellers outnumber buyers, there is a rush to dump stock and whoever is willing to take the lowest bid sets the price resulting in a race-to-the-bottom.

If you are beginner in stock market, I would suggest you some basic rules to follow-

• Never buy on rumours

• Stick to blue chip companies

• Always seek expert advice before indulging in trading or investing activity

• Spend time learning the fundamental and technical analysis of every company

• Dont jump into intraday trading and think of investing for long term in initial years of learning.

Happy reading and investing!!

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