Understanding the stock market will help you in picking the right stocks at the right time. It also helps you to make informed trading decisions.
As a beginner you must try to understand:
- what stock represents in a company,
- how the stock market works,
- why stock market moves up and down,
- your long-term financial goals,
- the difference between investing, saving, speculating and trading,
- your risk tolerance level,
- all the financial jargons used by the market, and
- how the value is determined.
In this article, we will tell you all the stock market basics that can help you to start your investing journey.
What stock represents in a company and why do they sell
The most common question for beginners is: what is stock and why should I buy them?
To know the answer you have to read the following basics of the stock market.
Almost every large corporation in India and abroad started as a small enterprise. Due to their growth in business, these small corporations became giant companies.
As the company grows in size it inherits so many problems. Here are few important problems;
- Requirement of fund for ongoing expansion
To take care of these issues company’s owners have following two options;
- Approach a venture capitalists or angel investors or institutional investors, or
- Take debt to balance sheet, or
- Go for initial public offerings or IPO
If you find a company trading in stock exchanges such as BSE, NSE, NASDAQ and NYSE, then blindly you can say that the company has chosen the IPO route to raise money by selling shares of the company.
Corporations issue stocks to raise money. These stocks entitle the holders to a proportionate share in company’s earnings or losses. The main reason why companies raise money by selling shares is to avoid debt and interest payments.
You have two ways to make money by owning stocks: capital appreciation due to increase in share price and regular dividend payments.
Some investors have the misconception that investing in the stock market is a form of gambling. They believe that investing in stocks will likely end up losing money. Let me tell you these are not grounded facts. If it’s true, how many great investors are making money by investing in the stock market. The first and foremost thing needed before starting your investment career is to have an in-depth understanding of the stock market. Learn why it exists and how the market works.
Remember, investing is for the long term, which is more than 5 year. Whereas, trading is for short term, which can be holding the stock for months, days, hours or even for a few minutes.
How the stock market works
Stock market is an auction market where buyers and sellers place their bid and offer in order to buy and sell shares of a publicly listed company. Which means its a place where you can buy, sell, and trade stocks on any business days. The product being sold are shares of companies.
Just like the way we go to the super market to shop for our daily needs, similarly we go to the stock market to shop for equity investments. The main purpose of the stock market is to help you faciliate in buying and selling of stocks/equity. For example, if you want to buy shares of a company, the stock market helps you meet the seller and vice versa.
These stocks are bought and sold on a stock exchange where it’s listed, such as Bombay stock exchange (BSE), national stock exchange (NSE), NASDAQ and new york stock exchange (NYSE). You access the market electronically from their computer via a registered intermedicary called stock broker.
People bid for the stock when they think that the company will do well. Likewise, they bid the price down when they think the company will not perform well in future.
Buyers always try to buy their stocks at the lowest price available in the market. Sellers always try to get as much as possible for each share to make profit by selling at a price which is more than they paid for. The ultimate goal of market participants is to buy shares of stock, then sell them at a later point of time for profit as the value of the company appreciates or goes up.
As an individual, to buy and sell stocks you need a trading account with a stockbroker and a DEMAT account to hold your share certificates in digital format. You get connected to stock exchanges through a stock broker.
Financial jargons used in stock market
The first point to start is to understand the stock market basics by knowing all the financial jargons used by the market, investors, traders and other people.
Here are the most important financial jargons used in stock market;
- Earnings per share or EPS
- P/E ratio
- Dividend yield
- ROE – Return on equity
- ROI – Return on investment
- Top Line
- Bottom Line
- Profit Margin
- Company’s Payout
- Dividend dates
- Ex-dividend date
- Annual general meeting – AGM
- Initial public offering or IPO
- Market cap, also referred to as market capitalization
- 52 week high – low
- Fundamental analysis
- Technical analysis
- Financial statements
- Bid, Ask and Bid-ask spread
- Bull and bear market
- Limit order
- Market order
- Stop order
- Cash and margin trading
- Short selling
- Market capitalization
You need to understand these important terms to track the market better. Many beginners and amature investors fall into the trap of stock market fraud due to lack of knowledge and understanding on the stock market. Knowing fundamentals can help you avoid these kinds of scams in the stock market.
Understanding of company’s annual report and financial statements
To know how to pick a stock, you must first understand the company’s annual report and financial statements. It will help you to determine the true worth of the company.
By knowing the true worth or intrinsic value of a company, you can easily find stocks which are trading at a price high relative to its value.
By learning some of the financial analysis techniques, you can evaluate the balance sheet of a company to find out the real value of a company and its stock. This helps you to determine when the stock is undervalued and overvalued.
Understand why stock prices move up and down
Stock market is considered as one of the biggest auction markets of the world. Buyers and sellers from different parts of the world buy and sell their shares based on the offers they get.
Price of the stock moves up when we have more buyers than sellers.
Likewise, the price will go down when there are more sellers than buyers.
Basically it’s based on the demand and supply mechanism. Demand and supply of a stock can be studied by looking at the ask and bid prices against the number of stocks on offer.
When the company and economy is expected to perform well, more number of people will be interested to own the stock, consequently more number of people take interest to buy the stock in comparison to sellers. Therefore, demand for the company’s stock goes up and supply comes down, resulting in driving the price up. The reverse is true when the company and economy underperforms.
Know what is stock’s market capitalisation
Market capitalization of a stock is calculated by multiplying the total number of shares outstanding by the market price of a share. For example, if the outstanding number of shares is 10,000 and the current price is Rs 100 per share, then market capitalisation of the company is Rs 10,00,000.
Based on market capitalization, a company is divided as large-cap, mid-cap or small-cap. It reflects the company’s size and business risk it has in comparison to its competitors.
Know the difference between stock value and market price
Market price of the stock is the amount at which a share of the company is currently trading in the stock exchange. It’s different from the true worth of the company.
Company’s true worth or intrinsic value is determined by using different tools of financial analysis.
As a value investor, you should always find out the intrinsic value and compare it with the current price to know whether the stock is undervalued or overvalued.
Price to earnings ratio is one of the factors which can instantly tell you the valuation at which the company’s stock is trading at present.
Know how much dividend the company has paid and expected to pay
Dividend is a regular payment from a company’s earnings to its shareholder in proportion to their holdings. If you are investing to get regular income, then this factor might help you to find out those companies that pay regular income to you.
You are also required to understand how the company is reinvesting the remaining portion of the earnings after paying dividend. It will define the growth of the company which will result in getting more dividend in future.
Understand different category of stocks
We have different types of stocks defined based on different factors. Fundamentally well established companies having a track record of number of years are considered as blue-chip stocks and income stocks. They always offer less risk, solid balance sheets and steady returns.
Companies falling into the small-cap and mid-cap category with a strong growth in earnings and sales are considered as growth stocks. These companies offer high return with high risk.
Based on your investment style you can choose stocks falling into these categories. It’s always important to consider diversifying your stocks into different sectors and companies.
Know when to sell your stocks
Knowing when to sell a stock is as important as buying stocks.
Don’t panic in the event of a correction or a crash in the stock market. Try to understand why it happened. These types of events don’t tend to last very long.
Bear and bull market
In bull markets everything in the economy goes well, therefore more number of market participants take interest, resulting in stock price rise. Which attracts more number of market participants to the market to buy stocks.
Market moves in cycles, eventually the bull market has an end point.
When the economy is not doing well, unemployment rises and corporate earnings decline, market participants take less interest in buying stocks, which is known as a bear market.
When a major stock index declines 20%-30%, it’s considered a bear market. It does not mean that you should wait for 20%-30% correction before selling your stocks, you have to foresee the future of the market with your understanding of the economy. Bear market also does not last for a long term, it has an end point from which the bull market starts.
We have listed all the basics you should know before getting into the stock market. Remember investing is a long term game. You need to sharpen your skills and style by reading various investment websites, books and journals.