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Stock Market Investment 101

Sarmaaya Desk
Sarmaaya Content Team

What Is Stock Market, What Are Stocks, And Why Do Companies Go Public?

If you’re reading this article, you’re either curious about how stocks work or you want to invest in the stock market. Of late, a clear surge has been seen in Pakistani people’s interest in understanding the stock market and investing in it to create wealth and gain financial independence.

 

But what is the stock market and how do stocks work?

By a simple definition, the stock market is a global network of exchange where large sums of money move on a daily basis. A stock market doesn’t trade goods or services; instead, it trades securities.

And what are securities? Well, securities are rights to financial assets like a business share. A business share is a portion of ownership in a company; when a person buys a share of a company they are buying small ownership in this company.

 

But why are shares traded at all?

Founders need capital or financial resources to build a large business. Imagine a company being a pie that is divided into slices. And these small slices of the pie are shares of the company.

Selling its shares is a typical way for a company to raise capital to grow and expand its business. A common way to do it is through Initial Public Offering (IPO). This is when a company begins selling a portion of its shares to public investors.

 

In simpler words, the company goes public and anyone can buy these small parts of the company. But where would the trade of these business shares take place? The companies need a particular marketplace to facilitate the trade of securities to the public.

 

This is where the stock market comes into play.

There are countless stock markets – or stock exchanges as they’re alternatively called – around the world. Each country has more than one stock market.

In the US, they have the New York Stock Exchange (NYSE), Nasdaq, and a few others. In Canada, they have the TSX. India has NSE and Japan has the JPX. Similarly, in Pakistan, we have the Pakistan Stock Exchange (PSX) that has trading floors in Karachi, Islamabad, and Lahore.

 

Together, these stock markets make a global exchange system where shares can be traded all over the world. This expansive ecosystem allows businesses to raise money to continue the growth and expansion of their companies.

 

Here are some examples of IPOs and stocks.

In its Initial Public Offering (IPO), Facebook sold over 421 million shares at $38 per share. The company earned over $16 billion from investors through the IPO.

Share values usually reflect how well a company is performing business-wise. So, the individual slices of the pie (business shares) also grow in value as the company’s business expands. It turns out to be great for investors because their original investment also grows parallel to the company’s rise in value.

 

But with constant growth, the ‘pie’ gets so big that individual ‘slices’ also become too expensive for the average investor to buy.

 

This is when a stock split occurs.

A simple example here is that if you had bought 10 shares of Apple right after its IPO in 1980, you would now own 560 shares without any further investment.

Let’s try to grasp it from a different angle. Suppose you own a company and took it public a few years ago with 100 shares. You decided to sell 50 of these shares for $100 each as your IPO.

 

But today, after years of constant expansion, your company has grown significantly and your shares are now worth $500 each. Impressive, but not so great for the average investor who is no longer able to afford to buy your stock.

 

So to make sure your shares are easier for the public to buy, you do a two-for-one split, which means that each share splits into two shares. Now, instead of having 100 shares in your company, your company now has 200 total shares.

 

Naturally, splitting shares also means that you split the value of the original share by two. So after a two-to-one split, your $500 share is now two shares worth $250 each.

 

These stock splits encourage more investors to buy your stock and continue investing in your company. This also means that investors who initially bought 10 stocks of your company now own 20 stocks while the value of their investment remains the same.

A real-world example here is Apple.

The tech giant went public On December 12, 1980, selling its shares at $22 per share. The company had its first two-to-one split in 1987 when the stock hit $79 per share, reducing the share price to $39.50 per share.

But the company kept growing to mammoth proportions and had to split shares multiple times to encourage easy public investment. Apple had a seven-to-one split in 2014 when its stock hit $656 per share making your original 10 shares become 560 shares at the value of $93.71 each.

 

As of February 2020, Apple stock was worth $327 per share, making the value of your initial 10 shares you bought for $220 to be $183,120. This means that if Apple didn’t split their stock today, each original share that sold for $22 in 1980 would be worth around $18,312.

 

Interestingly, stock prices don’t always reflect the state of the company.

Yes, you read that right. Sometimes, a bad rumor about a financially stable business would send its stock value plummeting regardless of its actual business performance. Similarly, good words spreading about a company that’s not truly making considerable progress can spike its stock value.

Many investors tend to buy shares of a company if they see the great potential behind an idea. This is good for new companies because they can raise capital for their business even if they’re currently losing money. A great example of this is Snapchat – the social media platform was actually not profitable before it went public, yet it earned over $3 billion in its IPO.

 

Speculations can cause a company to be worth billions on the paper creating a financial bubble where the stock price is much higher than the practical value of the company. In case of a false hype, a company may run out of money before it can make any profits in the worst-case scenario.

 

And that means bad news for the investors who will lose their money. This is exactly what happened in the US in 2001. It was the heyday of new internet companies and investors poured money into them. They bought shares at a high price expecting companies to grow in value and had to sell their stocks when it didn’t happen.

 

The bubble burst giving way to the 2001 economic recession.

 

Several other factors influence share prices.

Stocks see the usual daily fluctuation in value. This is commonly influenced by a number of factors that include the company’s image to investors, supply and demand of the company shares, and more.

 

These often surprising and ill-founded fluctuations are one of the key reasons why investment experts recommend diversifying your investment portfolio. If you’re investing in stocks, it’s also recommended that you do it for the long term, rather than the short term.

 

Expansions and recessions are a common occurrence at stock markets of the world. But historically, nearly all stock markets tend to trend up making stocks one of the most sought-after and lucrative investment options out there.

 




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