Part 1: Basics of A Stock Market

TL;DR: "In the short term, the market is a voting machine.
But, in the long term, the

market is a weighing machine". -- Ben Graham[1]
Part 1: How the stock market works
Part 2: How does one evaluate Stocks
Part 1: Basics of a Stock Market

History: A long time ago, humans ran businesses with just their money. The businesses
they ran were small and they grew the businesses only with their own profits. However, not
all businesses can be built with your own money. What if you wanted to build a new factory
that costs more than a million dollars? Banks won't lend money for young companies and
your friends won't have that much.
In the 15th-16th century as the Europeans started exploring Asia and Americas, the big
explorers felt they needed a lot of money and their kings were not providing them anymore.
The wealthy guys demanded a lot of interest. Thus, they felt they need to raise money from a
bunch of common people. Thus, in 1602, the Dutch East Indian company became the first
company to issue shares of its company in the Amsterdam Stock Exchange and get traded
on a continuous basis.
What is a Stock? Stocks in a company provide you a share of the company's future profits
in return for the capital invested. For instance, if you buy 1 stock of Apple now, you will be
assured one-billionth of Apple's profits in the future (as there are almost a billion such
stocks that Apple has issued now).
Listing: In a stock market, 1000s of companies are listed and these companies (called
public companies - as they have given out their shares to common public) pay a fee to the
exchanges, along with a promise to provide all important info to the markets. In return they
get an opportunity to put their company in the stock market's board & have the ability to
get money from people visiting the market. The first time a company's stock appears on the
stock market's board is called an IPO (Initial Public Offer).
Brokers: Conceptually, a stock exchange is similar to eBay. These guys allow companies
to be listed and connect the buyers & sellers. Since millions of people trade in the market
and it is practically impossible for these exchanges to deal with all the individuals, they
have assigned brokers who act between the exchanges and the individuals.
Part 2: How does one value a stock
Basic Terminology:
We will use a term EPS (Earnings per share) that is exactly as it sounds. It is the profits
of the company divided by number of shares. For instance, Apple has $41 billion in profits
and about 950 million shares, giving an EPS of about 41000/950 = $44/share. Thus, if you
own a share of Apple, you are entitled to 44 bucks of Apple's profits this year.
Calculating Share price:
To evaluate how much you need to pay for that 1 Apple stock you need to do a simple
addition of all the earnings you will get
Stock Price = EPS in Year 1 + EPS in Year 2 +...
Now, you know that a dollar earned 10 years from now is not the same as a dollar earned
now. Because, there is an interest rate i involved and money you get in 10 years is less
worthy than the money you have now. Thus, you need to adjust that formulae.
Stock Price = ((EPS in Year 1)/(1+i))+ (EPS in Year 2/(1+i)^2) +...
Now, there is a whole bunch of math involved (starting from the compound interest
formula) and for the sake of simplicity, I will get you to the final results and reduce the stock
price to two cases:
1. In case of a mature company that doesn't grow:
Stock price = EPS/Interest rate
The expected Interest rate is relatively easy to calculate and depends on how risky the
company is, how risky the market is and the current long term interest rate of government
bonds. For many mature utility companies this interest rate comes to about 10%. Thus,
utility companies that doesn't grow much is generally traded at about 10-15 times the EPS.
(insert in the formula above).
The stock prices of these companies are very smooth and change only when there is a
change in long term interest rates, the risk profile of the company (can change when
hurricanes such as Sandy hits) or when market risk changes (for instance 2008 financial
crisis). But on a regular day, not much action here. Let us move to the second category of
shares:
2. For a growing company:
Stock price = EPS of next year / (interest rate - expected growth rate of the
company)
Let us use a simple example. If you assume Apple's next year EPS will be $48, the expected
interest rate for such a risky company at 15% and an expected annual growth rate at 5%, you
will get:
$48/(15%-5%) or $48/10% or $480 as the ideal stock price for the company. Where did I
get this magical 5% number?
Getting the growth inputs:
Now, we need to find the growth rate of the company and figure out what the company will
earn in the next year, the following year and so on. This is not an exact science and no one
has a perfect answer to this question. This is why we need stock markets. Collectively, we all
pool our intelligence to figure out the future growth of the company and thereby its current
price.
To do this collective prediction, we constantly get new inputs and project that to future. For
instance, if the company management gets hotshot new engineers, then we predict the
future will be bright. What are the other news that investors typically use:
1. Periodic financial results of the company that gives us a view into the company;s
workings and its financial position
2. Periodic results of similar companies that helps us guess this company;s results.
Thus, when Apple sneezes everyone else catches a cold.
3. Changes in the sector. If a new report comes that people are more inclined to
using mobile phones, we predict growth of these companies will be high.
4. Changes in the broader market.
5. Changes in the international economy
Market Estimation:
In short, we try to use every possible information to guess the future growth of the company,
plug that into our formula and find out the stock price. For instance, if Apple comes out a
report saying people are buying less of iPads, we might ding Samsung too as we believe their
Galaxy Tabs will sell less too.
Estimating growth rate is an art rather than a science, and is collectively done by millions of
humans in a place called the stock market. Since, we need to constantly adjust the growth
rate based on new information, stock prices constantly fluctuate.
Main advantages of a stock market:
1. Starting/building a business: The market lets companies get money from a large
number of people. That means there are more options to get money to build a business.
2. Spreading risk: It lets you spread the risk of a business into a large number of people.
Since, each person is investing only a small portion of their income in the stock of a
particular company, the risk of a single company collapsing doesn't significantly affect
investors.
3. Collective estimation of value.

Summary: Modern corporations require a lot of capital, which is beyond the reaches of a
few individuals. Markets help companies raise money from a large number of people and
together these investors value their company. The theory is that when a large number of
people do their independent valuation, the company's price comes more closer to its ideal
worth.
"In the short term, the market is a voting machine. But, in the long term, the market is a
weighing machine". -- Buffett
(Disclaimer: This is an answer targeted at basic-intermediate level investor & not high
frequency traders or experts. I deliberately approximated a few things to improve clarity).
[1] Buffett's metric says it's time to buy
Balaji Viswanathan's answer to What should everyone know about investing?
Balaji Viswanathan's answer to What should everyone know about economics?
The Six Success Rules

The rules for successful stock market investing are not complicated. However, one must
avoid the 'learning too much' syndrome. Learning too much is dangerous because in doing
so our future judgement is clouded
Rule of Expected Returns
investors need to be realistic about the sort of returns they can expect. the first
lesson to learn from market history is to be realistic
Rule of Staying Calm
all investing involves a degree of risk. Market volatility is inevitable, it goes with
the territory. History shows thats almost invariably prices eventually recover
Rule of Timing the Market
although its very tempting to try to time the market, in fact its virtually
impossible to do it successfully
Rule of Avoiding Complex Products
investors should try to keep things simple, and the simplest way to invest in
equities is via index funds
Rule of Diversification
the one lesson that screams from every page of market history is to diversify
'The Golden Rule'
Rule of Excessive Trading
despite the constant temptation to trade, the best thing that investors can do
once they've built a portfolio that matches their attitude to risk is nothing
Learn more about the Six Investing Principles by watching a few short videos which
describe each principal in detail. In the videos, leading academics and financial experts
explain Stock Market Principles.
Stock Market Principles 'A Crash Course'
Benefit the most from stock market investing & maximize your investment opportunities.
Note: the author has curated these videos

Part 1: Basics of A Stock Market

Uploaded by

Copyright:

Available Formats

Part 1: Basics of A Stock Market

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Part 1: Basics of A Stock Market

Uploaded by

Copyright:

Available Formats

TL;DR: "In the short term, the market is a voting machine.

But, in the long term, the

Part 1: Basics of a Stock Market

3. Collective estimation of value.

The Six Success Rules

Note: the author has curated these videos

You might also like