The Explainer: Stock Market - Part I
Last week, I started 'The Explainer' - a feature on explaining important political and economic issues. Initially I was skeptical of your response; however, your response to the first article on FDI was overwhelming and extremely positive. Thank you!
The Explainer this Friday will focus on 'Stock Markets'. In the space below, I have explained a lot of stock market terms, like dividend and demat accounts. I will try to explain these complicated terms in a layman's language.
What is the basic difference between a Private Company and Public Company?
In a private limited company, the minimum number of people required to start the business is two (2); in other words, you require a minimum of two people to contribute to the capital. In a public limited company, seven (7) people are required to start the business.
As for the maximum members who can contribute to the capital of a private company, it is 50. In the case of a public limited company, it is unlimited; in other words, a public company can have lakhs of people contributing to the capital base. For example, Reliance Industries, a public limited company, has more than two million shareholders.
In a very simple way, the people who start the company are called promoters.
What is a 'Share'?
The total capital of a company is divided into a large number of units. Each unit is given an equal value; such value is called par value (also called face value). Each such unit (with an equal value) is called a ‘share’. In short, a share is a unit of capital.
Example:
Let us say that you and six of your friends wish to start a public limited company, with Rs10,00,00,000 (Rs Ten Crore). Now you do not wish to invest a lot of your own money in the company because there is an inherent risk associated with it (like you may lose your entire investment if the company goes bankrupt!). So follow a simple principle of investment: use OPM – Other Peoples’ Money!
To make it easy for people to invest in small parts, you divide the total capital of Rs10 crore into 1 crore units, each with an equal value of Rs10. In this example, Rs10 crore is the total capital of the company, the total number of shares is 1 crore, and Rs10 is the par value (also called face value) of each share of the company.
The company now comes out with a prospectus, asking people to subscribe to the capital of the company. Let us say, I have bought 2000 shares of your company, at Rs10 each, for a total investment of Rs20,000. So now I have become a shareholder of your company; in other words, a co-owner of your company.
What is Dividend?
There are different names for the returns gained on various kinds of investments. For example, when you invest money in a Fixed Deposit, the return is called ‘interest’. Similarly when you invest in shares, the return on such investment is called dividend.
Let me open this up. A dividend is that part of the profit that is distributed among shareholders. Each share-holder will receive her share of the dividend in ‘proportion’ to her share holding (as a part of the total shares issued). In other words, dividend can be termed as distributed profit.
Recall that I had purchased 2000 shares. Now if the company declares a dividend of 20% on the face value of the share, then the dividend would be Rs2 per share. So, the total dividend I would receive would be Rs4000 (2000 shares x 2 per share).
What is a Stock Exchange?
A stock exchange is a marketplace where the shares of public limited companies are bought and sold. In India, the two main stock exchanges are the National Stock Exchange (NSE; India's largest) and the Bombay Stock Exchange (BSE; Asia's oldest, established 1875).
What comprises a Stock Market?
There are two major components in a stock market: primary market and secondary market.
What is a Primary Market?
The primary market can also be called capital market. It is a market in which newly issued shares are sold and purchased, via application. Hence, the primary market is also known as ‘new issues market’.
You must have seen ads of companies coming out with new issue of shares: in other words, these companies are raising fresh capital and are asking members of the public to buy shares (by subscribing to the capital) at the quoted par value and thus become shareholders.
What is a Secondary Market?
In this kind of a market, you deal in shares which already exist. In other words, it is a market in which previously issued shares are traded. Trading in such shares is done through a stock exchange.
Can you buy / sell shares on a stock exchange directly?
No. One needs membership of a stock exchange to be able to buy / sell shares on a stock exchange. The membership of a stock exchange comes with a very high price tag; hence it is difficult for common people like you and me to directly trade shares on a stock exchange.
So, how do you buy / sell shares?
We can buy / sell shares by approaching a stock broker, who is already a registered member of a stock exchange. There are a large number of stock brokers in the market (like Motilal Oswal and Anand Rathi) who can help us buy / sell shares.
Recall again that I had bought 2000 shares. Now if I wish to sell these shares, I need to have two things: (1) approach a stock broker to find a buyer and (2) own a demat account.
The easy part is that a stock broker can help me find a buyer on the stock market and help me dispose of my shares.
What is a demat account?
Demat stands for dematerialisation. In the past, when you purchased shares, you received hard / physical copies of certificates as proof of ownership of shares (just like a fee receipt or a fixed deposit receipt).
However, in order to avoid legal hassles like stealing of share certificates (and tax transparency) and administrative problems like crumpled share certificates, demat accounts were introduced.
A demat account can be opened with a bank or a stock broking house, for which the bank charges a fee. It works like a normal bank account or like your email account. In the most basic way, when you purchase shares, an electronic entry is entered in your demat account that mentions such a purchase. Similarly when you sell shares, another entry is made which reflects such a sale. In other words, a hard copy of your demat account will look like the passbook of your savings account.
Note: Whenever I write the next part of this article (if it is not on next Friday), I will focus on stock brokers, like bulls and bears and a few more stock market terms like wash sales.
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