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Stock Market Basics - Value vs Price


Dear investors & friends,

How are you all doing? Hope you had an awesome week and are enjoying reading my articles. I am trying to slowly and steadily take you through the world of Investing in the Stock Market

Now, let's try to understand some really basic stuff in a simple language. I hope this analogy helps beginners to understand some nice basic terms.

Let's say that you have started a business with a capital of Rs 10000. Your business has been doing well and you had a profit of Rs 10000 in the first year (after all payments, liabilities etc). In the second year, you decide to put all of the profit (Rs. 10000) to your working capital and now your capital becomes Rs 20000.

In this way, year after year, your business grows and in due time, let's say that your working capital has become Rs 100000 (1 lakh). Now, you have some expansion plans. Also, you have earned a great name in the industry. Lots of people have seen that your business, your management, your plans and visions are good.

For expansion (or maybe for settling loans as well), you want to raise some money. You make a nice document which states why you wish to raise further capital. This document is circulated to your close circles which gives them a good feel of your business. 

Let's say that you need Rs 2 Lakh totally as capital for your business. You already have 1 Lakh with you. How much do you need? You need 1 Lakh more.

Since you have a name in the industry, you decide to get more stake holders in your own business. You want to give others a share of your business. Now, if you want to allow others to invest in your business, you need to decide the number of shares for the capital of Rs 2 Lakh.

Here comes an important term - FACE VALUE (FV) of a business. In our Indian market scenario, we see Face Values of Rs 10, 5, 2, 1. Now, if you decide that your company should issue shares at a FV of Rs 10, you would have to give

Rs 2 Lakh / FV (Rs 10) = 20000 shares.

Now, you as an owner already have Rs 1 Lakh with you as capital. So you will automatically have 10000 shares (50% stake) in your business.

The rest 10000 shares are given to others to invest. 

So Face Value only decides the number of shares the business has. Also, Face Value is with respect to Capital and nothing else.

Now, after getting listed in an exchange, you need to decide the actual worth of your business. Now, apart from Capital, we need to get the NET WORTH of the company. The net worth of your business is the Total assets - Total liabilities. If your total assets (including reserves, trading gains, inventory worth etc.) is Rs 5 Lakh and your liabilities is Rs 1 Lakh, your net worth is Rs 4 Lakh.

Now, the BOOK VALUE of your business will be:

Rs 4 Lakh / 20000 shares = Rs 20.

So Book value is the value of your company as per the books, balance sheets etc. This deals with the net worth of the company based on the number of shares.

Ok. You got listed and loads of people are ready to buy the 10000 shares. What is the MARKET VALUE of the share? Market value of the share can be either less than, greater than or equal to the Book value of the share.

Market value purely shows how confident the investors are in the business, moving forward. If the market believes that the company has got amazing future earnings potential, the Market value will be much much higher than the Book Value. However, if the market feels that there is not enough future potential in the business, the Market Price can be lower or equal to the Book Value.

Market value is the price of the share in the market. It is not only based on the Book Value, but also on the Future potential of the business, its sector, market sentiments, punters, operators, insiders, analysts, news makers, news and so many many factors.. 

So Market Price need not necessarily be the Value of the Share :-) What this means is that due to sentiments and the principle of demand and supple, the Market Price might be way above or below the actual Value of the Share. This gives investors Entry and Exit points if they know how to Value a Share. 

Don't worry. We will slowly learn all these things in the course of time.

A few points to note:

MARKET CAPITAL = Total number of shares x Market Price of the share
Dividends are always calculated on the FV of the share (We will have a separate discussion on Dividends in the future)
We have many ratios like 
- Market price / Earnings of the company (P/E)
- Market price / Book value (P/B)

I hope you can understand some basic terminologies now. 

We have covered,
- How number of shares are calculated
- Face value
- Book value
- Market value
- Market capital

Please take this reading as a basic understanding of the terms. I have just touched the topic with a simple language. The book and market value calculation in itself, needs lots of parameters to be taken into consideration and can be read on your own interest.

We will slowly get into the flow :-) 

Fundamental Investor

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