Introduction to the Stock Market
Get the basics of the Equity Market in under 5 minutes
Background
The Equity Market, or the Stock Market as it is often known as is the market for buying and selling shares in public companies. Shares represent an ownership claim on the company, and consequently a claim on future earnings.
The stock market generally refers to the secondary market, and it is the place that buyers and sellers come together to trade. The organisations and venues which facilitate this market, are known as stock exchanges. Some of the biggest and most famous stock exchanges include the London Stock Exchange (LSE), New York Stock Exchange (NYSE) and Japan Exchange Group(JPX).
The main participants in the equity market include individual investors (like you and me), institutional investors (organisations that trade on behalf of their clients: think banks, hedge funds, etc.) and finally public companies (they could be trading on their own stock or other companies’).
Why would a company go public?
When a company gets listed on an exchange and investors can buy and sell their shares, then that company is said to be a public company. The process of taking a company public is known as an Initial Public Offering (IPO).
There are several reasons why a privately held company may decide to go through the IPO process. Going public essentially means that the existing shareholders will be selling some of their shares to the public. That can act as an exit strategy for the existing investors, while also allowing to diversify the investment risk to a more significant number of investors.
Moreover, going public is an excellent way for a company to raise funds and its profile. The higher profile, as well as the extra funds, will allow the company to expand faster and meet its goals.
How do investors make money in stocks?
Investors can gain exposure to a stock by purchasing some of its shares. The exchange will quote the price of a single share, and investors can choose to buy as many as they want depending on the capital they would like to allocate.
Once an investor has gained exposure to a stock, they can primarily make money one of two ways. Firstly, they can wait for the price of each share to rise and then sell it. The difference between the purchase and sell price, minus any expenses, is the investor’s profits. These profits are known as capital gains. The other way they can make money is through dividends.
As public companies make profits, they may decide to allocate some of those profits as dividends. That means that each outstanding share will receive a payment. Take, for example, that you own 100 shares of IBM and IBM declares a dividend of $1. That means that you will receive $100 in dividends. Not all companies offer dividends and the ones that do, are not always guaranteed to continue; though some companies take pride in paying dividends non stop of many decades.
As a closing note in this section, it is worth mentioning that investors can also make money through short positions and equity derivatives.
How is the price of a stock determined?
The price of a stock is determined through demand and supply. Each buy and sell order goes in an order book on the exchange, determining the bid and ask. Through the best bid and ask, the exchange works out the mid-price, which is then quoted as ‘the price’.
This does mean, however, that you are not guaranteed that you will actually get that exact price. It all depends on the availability of bids and asks; that is, if you are trying to buy a stock, there needs to be an investor trying to sell and vice versa.
Demand and supply of a stock can be affected by a number of factors. Short term fluctuations can be due to anything; from investor sentiment to rumours and newspaper articles. Over the long term, however, it is often said that the share price will gravitate over its long term averages; which is guided by the stock’s value.
‘Price is what you pay, value is what you get’ — Warren Buffet
The stock’s value is determined by the company’s intrinsic value as well as other external factors (e.g. being the market leader). That is, how much is the company worth today, taking into consideration todays and future profits. There is no ‘correct’ way of calculating the intrinsic value of a company, though there are a lot of different models. We will go through some of these in upcoming articles.
Risks Associated with Equities
Market Risk
Market Risk refers to events that cannot be diversified away and can have a negative effect on your portfolio. In this instance, prices can go up or down against you in the market at any time and cannot be diversified away. This is also often referred to as Equity risk.
Liquidity Risk
As with any market, there is inherent Liquidity Risk. For every buyer, there needs to be a seller and vice versa. This problem is more evident in thinly traded stocks with significant gaps between the bid and ask price as well as during times of panic.
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