The Pricing of Shares

Most people tend to think that a share quoting at Rs 1000/- is more expensive than a share quoting at Rs 10/-. I’ve seen many people looking to invest only in shares quoting at very low prices (what in the trade are known as ‘penny stocks’) believing them to be cheap. While this is true speaking in ‘per share’ terms, it’s not correct to go about valuing shares as such. In this post I will proceed to explain why.

If you own a share certificate- it implies that you own a part of the underlying company. So assume we have 2 companies A & B both valued at 10 lacs each. Both decide to go for an Initial Public Offer (IPO). ‘A’ decides to price its shares aggressively and quotes its share at Rs 1000/-. That means you will have 1000 shares of company A (10,00,000/1000) in total. B decides that it wants to price its shares at Rs 10/-. So you will have 1,00,000 (10,00,000/10) shares of B in total. In both the cases the total valuation of the companies remains the same, i.e. 10 lacs.

I’ll explain this with an example. Suppose you own a fairly large plot of land and decide that you want it sell it off in small equal plots. Now the size of the small plots is completely up to you. You can sell it in square feet, cents, grounds, acres, bighas- whatever, in any measure you want. The choice is completely yours as it’s your property. It’s a similar thing with shares. A business is free to price its shares initially in whichever way it wants. Understanding this is very important. 

Now suppose I’d invested 1 lac in both companies A & B. For A I’ll get 100 shares and for B I’ll get 10,000 shares. Suppose both companies are doing well and the valuation of the companies goes up to 12 lacs each. Then my initial 1 lac investment becomes 1.2 lacs in both cases. In per share terms - A’s price would have moved up from Rs 1000/- to Rs 1200/-, whereas B’s price would have moved up from Rs 10/- to Rs 12/-. In both cases my return on investment is the same.

Savvy investors should focus more on the return of a share than its price.  In the above example, if after your analysis you feel company A is a better prospect than B then you should buy A’s shares. The only advantage with shares quoting at relatively lower prices is that you can allocate small amounts of capital more effectively, i.e. if you have only 1000 bucks to invest then you could buy 50 shares of B and use the remaining 500 to invest elsewhere and diversify. 

Thinking that having more quantity of shares makes you a better investor is foolish. Quantity is immaterial- it’s quality that matters. As an investor, your focus should always be on return.

Understanding Shares

The stock markets arouse a great deal of curiosity amongst the public. People quote the stock market index points and share prices in general conversations a lot. However, a lot of people still don’t seem to understand what a share exactly is. This post is intended to explain the same.

A share is, just as the name suggests, a part owner-ship of a company. So if I own a Reliance share then I actually own a small part of everything that Reliance owns- its buildings, machinery, offices, logos and patents, etc. Even its employees work for me. So technically speaking- if I own a Reliance share then Mukesh Ambani works for me!

But, one must remember- this ownership is being shared between all the shareholders of Reliance. So your ownership or claim to all the property that Reliance owns depends proportionally on the number of shares of Reliance that you own. So if I own one share and you own 2 shares of Reliance, your claim is double that of mine (a very crude example- but just for your understanding).

If you’ve got the gist of things above then a question that comes to mind is- why do companies go in for shares at all. What purpose does it achieve? To answer this we will have to touch up on the concept of business just a bit.

A business is run so that it can generate profits. It does this by selling a product or service to its customers and keeping an adequate margin on the cost price vis-à-vis the selling price (simply put: the selling price-cost price= margin). Most of us fail to look beyond this but there are 2 very important parts to the above equation. One of course the sales- you sell your product at a high enough price and you will have a very generous margin. But, we know that the market place is a very competitive arena, and it’s just a matter of time before someone comes along and offers the same product/service at a lesser price.

It’s the second part of the equation that is usually of more concern to the business man. How do I bring down my cost price? (i.e. How do I manage my costs?) You can tell a good business from a bad one by finding out how it manages its costs.

One of the most expensive inputs for a business is money. All businesses will require money/credit for expansion. Most businesses arrange for their credit from a bank, which charges an interest on the amount lent. The bigger the amount required the more you’ll have to pay as interest.

Shares provide an alternative to the enterprising businessman. Let’s say you have a business and you’ve been borrowing from a bank. You come to me and say- “Buddy, why don’t you invest with me- become a partner in my business.” I agree and I put some money in your business. You acknowledge this by issuing me shares.

Now your business is doing well. Unlike the bank, I’m a part owner of the company. So when your business is doing well my shares are automatically going become more valuable. If I sell my shares (and the beauty of shares is you can do this!) right now I should be able to claim a handsome profit.

But things need not always be so hunky dory. There is a chance that your business may fail. Then the value of my shares will be less than what I paid for them. In this case- I make a loss! And this is exactly what the risk is!

For small amounts you could raise money through your family, friends and other immediate networks. But if you are in need of lots and lots of money then that won’t always suffice. When your business is in need of a lot of money, you are allowed to issue shares to the general public (what is known as an Initial Public Offering or an IPO!). So whoever in the country wants to invest with your company can do so here.

The place where these shares (after the IPO) are traded is the stock market.
Remember people buy shares in a company in the hope of making a profit. So in the ideal world the share price should reflect the value of the company. But, being humans we’re prone to moments of extreme emotion (herd mentality!). So if there’s a bit of bad news about a company then you’ll immediately see people dumping that stock. Sometimes the opposite also happens on good news and the people become exuberant and the share prices shoot up. It’s basically this interplay that we see happening in the markets every day.

So this is a very simple definition of shares and the stock market. I hope I’ve been able to give you a bit of clarity regarding shares.:-). Please do leave your feedback.