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Introduction to the Stock market: The guide to the basic knowledge of the stock market

A detailed guide of basics of the stock market

By Mv AjayPublished 2 years ago 9 min read
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It is crucial to understand the stock market in order to make informed trading decisions. Making informed trading decisions requires knowledge of how to select the right stocks.

This requires a thorough understanding of financial statements and an annual report. You will learn how to identify the stock in a company's stock and determine its true value. This will allow you to make better investment decisions and avoid the costly mistake of buying stock in a company when its share value is too high.

Stock Market Terms

Knowing the lingo is the first step in understanding the stock market. These are some of the most commonly used phrases and words.

  • Earnings Per Share (EPS): The total profit of the company divided by the number of outstanding stock shares.
  • Going Public: The slang term for when a company plans an IPO.
  • IPO: An initial public offering is when a company's stock shares are sold for the first time.
  • Market Capitalization: This is the value of every share of stock you own in a company. Multiply the number of shares with the price per share to calculate market capital.
  • Share: A share is a unit of ownership that represents one share of the company's profits, losses, and assets. When a company cuts itself into pieces, it creates shares and then sells them to investors for cash.
  • Ticker symbol: This is a shortlist of letters that represent a stock listed on the stock exchange. Johnson & Johnson, for example, has a ticker symbol JNJ and the Coca-Cola Company has a ticker symbol KO.
  • Underwriter: This is the financial institution or investment bank that handles all paperwork and organizes an IPO.
  • An Introduction to the Stock Market

    It can be difficult to understand the workings of a stock market. Some investors believe that investing is gambling. They feel that if they invest, they will most likely lose their money.

    These fears may be rooted in the experiences of friends and family who have experienced similar circumstances or were affected by the Great Depression. Although these feelings can be understood, they are not supported by facts. This type of thinking is not necessarily rooted in facts.

    Follow the crowd to invest

    Others believe they should invest long-term but don't know how to start. They view investing as a magic trick that only a few people can use. They leave financial decisions to professionals and can't tell you why they have a particular stock or mutual fund.

    This type of investment could be called "blind faith." Or perhaps it is limited to a feeling like, "This stock will go up. We should buy it." This group is more at risk than the first, even though it might not appear so. They follow the crowd and wonder why they don't achieve great results.

    Learn how to invest.

    An average investor can learn a few techniques to evaluate the balance sheet of a business and then, using a few simple calculations, determine the true value of a company or its stock.

    Investors can look at stocks and determine their value, such as $40 per share. Each investor can decide when stocks are undervalued, increasing their long-term return substantially, or overvalued, making their poor investment choices.

    Why do the companies sell stock?

    Before you can value a company, it is important to understand the business's nature and how it trades in the stock market. Nearly every major corporation began as a small mom-and-pop business and grew into a financially successful enterprise.

    Take Walmart, Amazon, and McDonald's. Walmart started as a single-store business in Arkansas as well. Amazon.com was founded in 2001 as an online bookstore from a garage. At that time, McDonald's was a small, unrecognized restaurant in San Bernardino, California. How did these small businesses grow from being tiny, local enterprises to become three of America's largest companies? They sold stocks to raise capital.

    Funding is essential.

    Growing a company means that it must continue to raise enough money to support its expansion. The owners have two options: either they can borrow money from a bank or venture capitalist, or sell a portion of their business to investors to raise funds for growth. Bank loans are often taken out by companies because they're easy to obtain and extremely useful up to a certain point.

    Banks are not always willing to lend money to companies. Over-ambitious managers might try to borrow too much, which can add to the company's debt and negatively impact its performance metrics. These factors can often be used to motivate small, growing companies to issue stock. They receive cash to grow the business in return for a small amount of ownership.

    The publication gives the company money that doesn’t need to be repaid. The public offering gives owners and business managers a new tool. They can now use their stock instead of having to pay cash for transactions such as the acquisition or expansion of a company or business line.

    What are stocks?

    At its most basic, the stock is simply an ownership share in a corporation or company. There are two types: public and private stock.

     Public Stocks

    A public corporation is one that issues stock that the public can trade on stock exchanges. These public stocks are not stocks that are held by employees of the company. Instead, they are owned by shareholders who are members of the general public.

    If a company goes public, it means that it is listed on the stock exchange. It's known as an "initial public offer" (IPO).

    Along with an investment bank underwriter, the company going public will offer a limited number of shares at a given price. Beyond Meat (stock symbol: BYND) went public in May 2019 at $25 per share, with an implied market value of $1.46 trillion.

    Private Stocks

    Private stocks are not available to the general public. These shares are usually limited in number. These shares are usually owned by a few people and are not publicly traded on any exchange.

    Employees and managers may only be allowed to own shares. Publix is a grocery store chain that is privately owned. Only its store associates, as well as the board of directors, have access to shares.

    How is the stock issued?

    Take the hypothetical company ABC Furniture, Inc. to see how the stock is issued. A young couple got married and decided to start their own business. They can work from home and adjust their work hours to accommodate their families. They decided to open their own furniture store in their hometown because both the husband and wife have always been passionate about furniture.

    They borrow money from the bank to name their company ABC Furniture, Inc., and they go into business. The company does not make much profit in the initial years. Instead, the owners invest their earnings in the store by buying more inventory, remodeling the building, and expanding it to meet the growing demand for merchandise.

    Deciding to sell shares

    The business has seen rapid growth ten years later. The couple has been able to pay off their company's debt and now make more than $500,000 per annum. The couple opened two new branches after being convinced that ABC Furniture could succeed in larger cities nearby.

    They do extensive research and discover that they require more than $4 million to expand. They decide not to borrow money or make interest and debt payments again and instead offer equity to potential shareholders to raise funds.

    Locating an Underwriter

    The company contacts an underwriter, such as JP Morgan or Goldman Sachs, to offer the stock. They review their financial statements and determine the business's value. As we have already mentioned, ABC Furniture makes $500,000 in annual after-tax profits. After paying off its debt, it also has a value of $3 million. This includes the value of land, buildings, inventory, and any other assets. According to the underwriter, the average furniture stock trades at 20 times the company's earnings.

    What does this all mean? This means that you multiply the $500,000 earnings of the company by 20. That would give ABC a market-value estimate of $10 million. Add the company's book value, and you get $13 million. According to the underwriter, ABC Furniture's total value is $13 million.

    Choosing how much of their business to sell

    In their 30s, the young couple must decide how much company they want to sell. They currently own 100% of the company. They will raise more money if they sell more shares of the company. But they should remember that they will lose a greater percentage of their own if they sell more shares. The company's ownership will increase in value as it grows. A wise entrepreneur wouldn't sell more shares than they needed to.

    The couple discusses the matter and decides to keep 60% of the company stock and sell the remaining 40% to the public. This means they will retain $7.8 million of the business (or 60% of its $13 million value). They will retain control of the store because they hold a greater share of the stock than 50%.

    They want to sell the remaining 40% of their stock to the public for $5.2 million. The underwriter searches for investors interested in the stock and sends a check for $5.2 million to the couple.

    Although they hold less, their stake in the company will likely grow faster as they can expand quickly. ABC Furniture opened two stores using the proceeds from its public offering. They have $1.2 million left after raising $5.2 million, but only $4 million.

    Use the income to expand and grow.

    The new branches have better performance. Each of the new stores makes around $800,000. The old store still makes $500,000. ABC is now the largest store, with a profit of $2.1 million.

    Their company is valued at $51 million, even though it doesn't have the flexibility or freedom of a small business. This figure would be reached by multiplying $2.1 million in new earnings per year by 20 (the average furniture stock multiple) and adding $9 million to the latest book value. Each store has a book value of $3 million. The total value of the 60% ownership by the couple is now $30.6 million.

    The benefits of owning and selling shares

    This example shows how small businesses can explode in value once they are listed. In a way, the original owners of this company became wealthier overnight. The amount they could withdraw from the company was limited by the profits generated. They can now sell their shares in the company at any moment, allowing them to quickly raise cash.

    This is the foundation of Wall Street. The stock market is a huge auction in which ownership of companies such as ABC Furniture is sold each day to the highest bidder. 

    A company's intrinsic value can be sold for much more or less due to human nature and emotions like fear and greed. An investor who is savvy at identifying companies selling below their true value so they can purchase as many shares as possible will be a good one.

    advicecareereconomypersonal financestocksinvesting
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