What is a stock?
Why do we invest in them? How do they make money for us?
All these questions are very basic, but it’s really important to understand these basics as they act as building blocks to our approach to investing.
This post is written keeping absolute beginners in mind, those who do not understand the basics of stocks and stock market.
There are two popular perceptions about stocks and stock market.
First, Stocks are usually seen as an easy approach to make lots of money in a short span of time.
In other words, stocks are usually seen as some kind of lottery tickets that can make you rich overnight.
Second, those who have had a bitter experience with the market usually see it as a gamble where only lucky few get to make money successfully while majority of participants lose.
However, both the perceptions about stock and stock market are incorrect.
So, what is the right approach to investing in stocks? That is exactly what we are going to discuss in this post of what is a stock and How do they make money for you?
Before jumping in to invest in stocks, it important to understand what is a stock, the inner working on how they make money for their investors, and how you should approach them in order to make money successfully.
What is a stock? An Introduction:
Stocks (sometimes also called shares), by definition, are part ownership in a business. But how does owning a stock make money for you?
The answer is simple. The basic purpose of every business is to generate more profits and increase their business value (aka Net Worth)
When you buy a share, you own a small portion of that business, and as the business grows in value the small portion of the business held by you as an investor, grows proportionately.
Let us understand this in a much simpler manner with the help of an example.
How Do Stocks Make Money for Investors?
Let’s say you bought a flat in an apartment building which has 100 flats in it.
This simply means that you own 1% of the entire apartment building. 1/100=1%.
As the price of the entire building appreciates in value, your flat being a part of the building appreciates in value proportionately.
Similarly, when you buy a stock, you buy a part ownership in the business of the company.
As the company generates higher profits, it add value to its total Net Worth, and since you own a small portion of the business, the price of the part owned by you in the form of stocks/shares grows proportionally.
On the other hand, if the the price of the building goes down for some reason, the small portion owned by you will also lose its value.
Apart from this, there is another way stocks make money for their investors and that is by giving dividends.
Dividends are a part of company’s profit distributed to shareholders, although dividends form a very small portion of the overall returns, some companies provide decent dividend to their shareholders.
There are many investors that invest in stocks only to receive regular dividend income every year.
Does that sound too easy? trust me, it actually is.
Okay, if you’re not convinced, here is a real life example of two companies, Larsen and Toubro and Lanco Infratech, both working in the same sector(infrastructure).
While one of them(Larsen and Toubro) generated profit, adding value to its Net Worth, the other one,(Lanco Infratech) suffered continuous losses eroding Net Worth, destroying shareholder wealth.
Real Life Example: How Business Performance Affects Stock Price.
Larsen and Toubro, one of the leading Engineering and Infra Companies, created consistent profit every year for the business and its shareholders, resulting in increasing Net Worth.
Here is the Screenshot of five years of financial performance of Larsen and Toubro.
As a result, company was able to pay dividends to shareholders, even issued bonus shares, which lead to huge appreciation in its stock price.
Here is the screenshot of five years of stock price of Larsen and Toubro.
On the other hand, Lanco Infratech, another infra and engineering company, because of its poor profit generating ability and huge liabilities, destroyed the Net Worth of the company.
Here is the screenshot of Five years of financial performance of Lanco Infra.
As a result, because of erosion of wealth, the Net Worth of the company suffered badly, leading to steep decline in price over the years, destroying wealth of the shareholders.
Here is a screenshot of the five years of stock price of Lanco Infratech.
Is it Really That Easy?
The broader answer is yes, but if you dig deeper, there are some additional factors that you must consider before investing in a stock. What are those?
Future Growth Potential:
An investor today, cannot make money from yesterday’s growth.
No matter how great a business has performed in the past, there is no certainty that it will be able to repeat its past performance in the future.
Think about it, if a business reaches saturation after showing healthy growth, and is unable to generate wealth for shareholders, will it be a good investment?
In order to make sure that you chose the right stock to invest in, it is important to understand the future growth potential of the business.
Business that are relatively smaller in size but are in high growth sector usually have better growth potential.
An example that I can think of right now is Kajaria Ceramics. A market leader in the ceramic tiles segment, with pan India presence is trading at approx 8,000 crore market capitalization, much lower than total industry size and growth.
The second and even more effective way is to invest in stocks where the demand for products and services is consistent
For example FMCG sector is one of those sectors with consistent demand. Buying good stocks in this sector for long term will give consistent returns over a period of time.
Price Vs Value:
A great stock is not a great investment if you pay too much for it. What does that mean?
While good stocks are always good investments, the problem is that they are usually available at higher price.
This makes them less attractive as an investment, which means it is rare to find good stocks at a lower price.
The key to successful investing is to find quality stocks at a bargain. How?
Here is a simple example, let’s say you want to buy a shirt, based on the quality of fabric, its stitching etc, you assume a price you are willing to pay for it.
If the price of the shirt is higher than your assumption, you will decide not to buy it, but its lower, you have found a bargain.
Similarly, Every Stock has a value associated with it, which is derived by estimating how much Cash Flow the business will generate in its lifetime and how much are you paying for it today.
Although estimating future cash flow is very tricky and subjective, if your assumption is close enough, you can estimate the right price(intrinsic value) you’re willing to pay for the stock.
Companies with great future growth potential, available at lower valuation are the best long term bets you should play.
Finding such stocks is very rare, but if you successfully find just a handful of them, you will never have to worry about your financial future.
Some additional Points…
So does that mean that buying a great stock at a bargain will eventually make you rich effortlessly?
Well to a certain extent yes, but there are some important steps you must take after investing in stocks.
Keep an eye on growth:
A stock may have a promising future, but it won’t make money for you if it does not deliver as per your expectations.
In order to make sure that a stock is doing well, you have to keep tracking its financial performance frequently,
Keep tracking its profitability and compare its financial performance with your expectations.
There might be some variations between what you expect and what the company delivers(of course, nothing is perfect in this world)
If the variation is large, it is always intelligent to revisit your future growth assumptions and re- estimate the expected return.
If the new expected growth is does not make you happy, it’s time to get out of that stock and find the one that has good growth potential.
Having said all that, there are few key points you need to keep in mind about stocks:
Key Things to know about stocks:
Here are few important points you need to know before investing in stocks:
Investors who stay invested for long term get better returns:
Patience is the key:
Most investors want to make a lot of money in the short term as they do not have the patience and willingness to hold stocks for long term.
Such investors, being driven by greed, end up making irrational decisions, which results in loss of money and faith in the market.
Investing in stocks is a long term game. Thus, you have to be patient with your investments.
Apart from analyzing stocks and carefully choosing good quality businesses for your long term portfolio, you have to give your investment time to grow.
Learning to invest in stocks takes time:
Before making an investment decision, you should research the stocks properly, which means deep analysis of financial statements of the company and a thorough understanding of the company’s business and its future growth potential.
Many investors may find it very difficult to research stocks for themselves, as it involves a learning curve, in such case, it is advisable to stay invested in equity mutual funds, low cost index funds and ETF (Exchange Traded Funds).
An index fund or an ETF is an already diversified portfolio of fund that mimics the movement of a benchmark index.
Investing in stocks is one of the best ways to make money. All it takes is a detailed research, practical thinking, discipline, and patience to stay invested for long term.
However, market does not guarantee success. No matter how in-depth your research is, it will only minimize the risk factor, but does not eliminate it, still it is always better to take research about stocks before investing rather than simply shooting in the dark and hoping you will hit the bulls eye.
That is it on our blog post what is a stock and how does it make money for you. I hope you found this post useful.
Do let me know in the comments if there are other points you would like me to add.