Post No.-1
So yeah, let’s start right from the basics. The reason for starting from the underground level is so that you can relate to everything we discuss in any stage of this blog. I don’t want anyone of you to be lost in the complexities of the markets which are quite common to be encountered.
Okay, now tell me what comes to your mind when you think of the word “market”? Most probably, you will visualize a place where there are lots of pairs of buyers and sellers negotiating and bargaining the prices of the goods which are to be exchanged from one hand to the other. Stock market works the same way. By the way, here stock means tiniest parts of valuation of any company which are being traded electronically and not physical goods. Here the buyer of the stock aims to buy it with as low price as he can and the seller of the stock aims to sell it with as high price as he can. What price is low and what is high totally depends on the viewpoints of both the market participants regarding the underlying value of the stock also known as “intrinsic” value. When both the prices match, trade occurs. Let’s elaborate it further. When a company gets listed on the market, it’s current value is being divided into slices and a considerable number of these slices are made available to be bought by the non-promoter investors, be it retail investors(common public) or institutional investors(asset management companies, insurance companies, banks,etc). In India, the total amount of the slices(price of 1 slice × number of slices) which is put out for the non-promoter investors needs to be atleast 25% of the valuation of the company during the initial public offering or IPO. After the company gets listed, it’s valuation does not remain fixed for a long time as it used to be pre IPO. Post IPO the company gets entered into an auction driven market where fluctuations in the price of one slice aka stock aka share decides the total valuation of the company and is totally dynamic from thereon.
Let me share two examples with you so that you get it more clearly. Suppose there is a person Mr.X who owns a company ABC Pvt. Ltd. pre IPO. Let’s say he didn’t seek any investment from any investor before the IPO. He started the company with his own money. Now, the value of such company would be equal to its net worth i.e. the total cash the company has. Here cash refers to everything the company owns and not just liquid cash. Let’s assume the net worth of the company to be 75 Cr. Mr.X now decides to convert ABC Pvt. Ltd to ABC Ltd by listing it on any of the stock exchanges(NSE aka National Stock Exchange or BSE aka Bombay Stock Exchange). As mandated by SEBI(Securities and Exchange Board of India), Mr. X keeps 75%(threshold limit) of the company with himself and the rest is sold to the retail and institutional investors. And by doing so he raises fresh 25 Cr of cash from the market. Thus the total cash or net worth of the company raises from 75 Cr to 100Cr. And the latest valuation of the company just after the IPO is also 100 Cr.
Now suppose there is another company DEF Pvt. Ltd. whose founder and promoter(one who controls the company) Mr. Y has collected investment from an outsider. Let’s say the company was started by Mr. Y with 18.75 Cr(I deliberately chose this number for easy calculation) of his own capital. As of now, the company’s valuation and net worth are the same. Since the company looks promising, an investor approaches Mr. Y with an investment of 18.75 Cr for an equity of 35%. After a lot of negotiations, both the parties close the deal at 75-25 ratio(75% with Mr. Y and 25% to the investor). Therefore, the networth of the company increases to 37.5 Cr and the valuation becomes 75 Cr since in the latest round of founding the investor is happy with 25% for 18.75 Cr or 100% with 75 Cr if he where to buy the whole company. After sometime Mr. Y decides to list the company in the stock exchange. He demands 25 Cr for selling 25% of the company. As a result the networth of the company is now equal to 62.5 Cr and the valuation is 100 Cr. So these are the two ways any company gets listed in the stock market. The main purpose for listing it on the market is to raise money to fund it’s cost of doing the business. And this way of raising money doesn’t require the company to pay any interest on the fund it has raised. However, the company is given a choice to pay a percentage of the profit in the form of dividends to the existing investors. But it’s not mandated to do so atleast in the short term. Another way the company raises money after it gets listed is by pledging of shares. It means to raise money from the banks by providing a percentage of the shares owned by the promoters as collateral. Though it has a negative image in the investing community, but a little bit of pledging can be beneficial for the company to scale it faster.
And after the company raises fresh fund from the non-promoters during the IPO, it’s actually half done with it’s purpose of listing on the stock market. The other half consists of some other fund raising processes such as FPO(Further Public Offering), rights issue, bonds, pledging, etc. All the deals after the IPO are normally among the non-promoter investors. The investors who think keeping the stock in their portfolio makes sense, keeps it from those who think it doesn’t make any sense.
Now let us come to the most important part of this post, the price of the stock. What determines it after the IPO? But before that I want to shed some light on the concept of oversubscription, full subscription and undersubscription of the stock at the IPO. Suppose Mr. X’s company ABC Pvt. Ltd issued 25 lakh shares at the price of ₹100/- each to the non-promoter investors. If these investors have very high conviction about the business doing well in the future, they may oversubscribe it by demanding more than 25 lakh shares collectively. Now what happens when demand exceeds supply? The price of the stock increases from ₹100/- to let’s say ₹150/-(just an example). And in the case of full subscription, there is conviction among the investors but not of such magnitude and thus all of the 25 lakh shares get bought out and there is no further demand during the IPO. And lastly, in the case of undersubscription, investors don’t find the business to be that promising and hence demanding less than 25 lakh shares resulting in a free float of a considerable number of outstanding shares. So by now you must have an idea about what drives the price of a stock after its IPO. It’s the perception of the underlying business quality among the investors. A good perception will demand a more number of shares resulting in the existing stockowners to raise the price of the stock and vice-versa. Because if the business does well then it’s net worth would grow and more dividends can be paid to the investors which in turn encourages the investors to value the business highly.
As a whole, there are two kinds of participants in the market, long term investors and short term speculators. The first one is ready to devote enough time to let the plant grow into a tree whereas the other one is interested in capturing small price movements in the stock. I don’t want to go into which one is right and which one is wrong in its approach. It’s totally upto you and your interest. But this blog is specifically for the long term participants.
One thing I am sure many of you will be scratching your head for is a doubt whether the promoters and non-promoters get rich twice after the IPO. One through valuation and the other through net worth or cash. For simplicity purpose let us take the example of ABC Ltd. rather than DEF Ltd. The simple explanation of this would be to ask yourself another question. What would happen to the stock price if the management of the company ABC Ltd. made some poor business decisions which resulted in the networth of the company to be reduced by 50%? The answer is simple. The stock price would also crash drastically. We don’t know by how much percent but there will be a great fall. Therefore the stock price and the shareholder’s equity or the net worth of the company move in sync with each other. The important thing to notice here is that the shareholder’s equity makes the first move.