How Stock Markets Work
A stock market is a place where shares and stocks of companies are bought and sold. Just like a "supermarket" that acts as the point for selling foods and stuffs, a stock exchange is the point where the companies sell their stock. And just like buyers visiting supermarkets to buy foods and other home stuffs, investors buy shares from the stock exchanges. However the only difference between normal buying and selling and the buying and selling of stocks is that a buyer of stocks or an investor cannot directly buy them from stock exchanges. Instead he has to place his orders with a broker/sub brokers who then buys the stocks on his behalf.
Now for a beginner the very first question relating to the stock exchanges is relating to the “stocks” itself. What are stocks and why would companies sell stock? The answer for the first question is : A share or stock is a document issued by a company, which entitles its holder to be one of the owners of the company. Now why shall a company want to issue all those documents that entitle somebody who is not concerned with its working in any way, of its ownership? Well the answer for it is that, a company; public limited companies in fact to be precise, are authorized by the government to raise money from the general public by issuing them with it’s ownership in the form of shares. As an owner of the company the shareholders have the right to earn dividends on their holdings and elect the “Board of Directors” who are responsible for the running of the company. And on its part, the Company by issuing the shares is able to raise valuable capital for funding its expansion.
When a business grows and need money for expansion it can raise the required capital by offering its share in the public. When a company first sells stock to the public, it has to get itself listed in the stock exchange and offer its share to the public. This is called the IPO (Initial Public Offering). The company might sell one lakh shares of stock at Rs10 a share to raise Rs10,00,000. People who are hopeful of a better prospect for the company would buy the shares by paying the requisite amount. The investors in the company would thus become the owners in the company and would get dividends. And with the money thus raised ,the company would invest in equipment and employees. After the IPO, once the stock is issued, its existence becomes somewhat independent of the company. It's now a commodity, a product, that someone owns, and the company won't make money off any further trades involving a particular stock. Now the stocks of the company starts getting traded in the market; people who bet on its better performance would buy its share while those who hold its share would sell it. The value of the share of the company depends on lots of things like the company’s over all performance, the general economic trend etc. Traders, & investors alike are always keen on an IPO because it is through an IPO that they can acquire the shares of a company at a less price.(Generally shares are offered at discount in an IPO).
Generally a company that is earning profits is faced with four alternatives on how to use the surplus.
- It could put it in the bank and save it for a rainy day.
- It could decide to give all of the profits to its shareholders, so it would declare a dividend of $1 per share.
- It could use the money to buy more equipment and hire more employees to expand the company.
- It could pick some combination of these three options.
If a company traditionally pays out most its profits to its shareholders, it is generally called an income stock. The shareholders get income from the company's profits. If the company puts most of the money back into the business, it is called a growth stock. The company is trying to grow larger by increasing the amount of equipment and the number of people who run it.
The price of an income stock tends to stay fairly flat. That is, from year to year, the price of the stock tends to remain about the same unless profits (and therefore dividends) go up. People are getting their money each year and the business is not growing. This would be the case for stock in a single restaurant that distributes all of its profits to the shareholders each year.
Let's say for example a software company decides to save its profits for years and then eventually opens a second branch. That is the behavior of a growth company. The value of the stock rises because, when the second branch opens, there is twice as much equipment and twice as much profit being earned by the company. In a growth stock, the shareholders do not get a yearly dividend, but they own a company whose value is increasing. Therefore, the shareholders can get more money when they sell their shares -- someone buying the stock would see the increasing book value of the company (the value of the buildings, equipment, etc.) and the increasing profit that the company is earning and, based on these factors, pay a higher price for the stock.