Demystify the inner workings of the stock market via an easy to follow life-like example. Recommended reading for anyone new to the world of investing.

It is easiest to talk about these terms if we take a simple example. Let us say you are starting a lemonade company, which manufactures lemonade. You know that to manufacture a certain quantity of lemonade, you need supplies (lemon, sugar, water, ice). Then you need pitchers and glasses and maybe a table to serve your product. You may need some marketing material such as a cardboard and pens to write your name, and advertise your price.

To buy all of these items you need cash. This cash that you initially inject into your company is called as the starting capital for your lemonade company. You may choose to put in more than the required amount of capital so that you do not have to look for capital repeatedly.

Let us say you inject $100.00 into your lemonade company. This is the capital stock of your company at its inception. You could, if you so chose, divide this capital stock into a 100 shares, each with a value of $1.00. Thus you now have 100 shares, valued at $1.00 each, in your company.

100 shares for your company

Now you start your business, and purchase all the needed supplies and marketing materials. This would mean you would have, say, supplies worth $75 and $25 cash left in the bank. Your capital stock is still $100 (inventory, equipment and cash in the bank combined). Of course your supplies are perishable goods, and so if you do not use them quickly, your stock may erode in value.

You start your business immediately, and at the end of 3 weeks, you find that your supplies have been exhausted, but you now have $90 in your bank (due to $65 of sales). And you still have the marketing materials intact, and the pitchers and glasses and table are left over. In other words, if the remaining equipment left with you are worth $20 - that, combined with the $90 in the bank, makes the company's stock value worth $110! In other words, the value of each share is now $1.10.

 

Hard work pays off!

You get ambitious and decide to sell a part of your company to your friend Bob to raise cash. You wish to sell 30% of the company, this means you will have to sell 30 shares. The value of each share is $1.10 by your calculations. So you collect $33 from your friend, and write over 30 shares to his name. Now Bob owns 30% of the company, and you own 70% of it. Time passes, and the lemonade business is continuing to do well. By your calculations, per share value of the company is $1.50 now! This means your 70 shares are now worth $105 and Bob's share is worth $45. Bob, though happy to see his worth go up, wishes to convert his shares into cash and decides to hold an open auction of his 30 shares in the lemonade company. He hopes to raise more than $1.50/share in this process.

Bob starts preparing for the auction and does so by preparing a small write-up about the lemonade company,its history of operations, its revenues and profits, its business model, the prime location it has for selling lemonade and about the future plans of the lemonade company. Of course all this was made possible by your efforts, but Bob is within his rights to talk about the company because he is a 30% owner of it.

Bob also writes about you- its star manager! He talks about your strengths and capabilities. And finally, he talks about the pure asset value/share of the company (which is $1.50 at the moment), but also introduces the notion of intrinsic value: that is, the company's value based on the future profits it is likely to generate. He then makes copies of this write-up and gives it to all those who had shown an interest in bidding for these shares.

Auctioning his shares!

The write-up has the desired effect. Many folks come for the day of the auction, and Bob himself sets the floor of the bidding at $1.45 and says he will not sell for anything below that number. Fred from the audience immediately offers $1.50 for the shares; Mary jumps in and offers $1.55; Ken raises it to $1.58; Fred comes back with a $1.60/share offer! Julia, who had been watching all this quietly, now makes a large offer: she offers $1.65 for all the 30 shares. Silence descends on the crowd and Julia wins the auction. Bob thus manages to get $49.50 for his 30 shares!

You watch the auction with interest, and calculate that your shares are now worth $115.50! With no additional work on your part! But of course you know that the worth based on your calculations was $105. This additional $10.50 is based on an estimate of multiple interested buyers of the future worth of the company (and your share in it). In fact, the buyer is hoping that the future worth will be more than the $1.65/share than she paid for it.

Your worth has increased with no work on your part!

A second question for the buyer is how many years would it take for the company's value to reach $165 (or $1.65/share)? If it is 10 years, then the buyer has probably overpaid because 10 years is a very long time horizon to accurately guess the future of a small company such as the lemonade company. If it is only 1 year before the value of the company rises to $165, it may be a fair deal.

Thus there are many considerations that the buyer of the shares in this business must account for. And yet, you, as the manager and owner will almost always have the best knowledge of the inside workings of the company. The buyer will almost never have the same advantage.

The Buyer has now rolled the dice!

This buyer (Julia in our example) is what we are: buyers of stock in the stock market. The role that you played in the above example is the role played by those who take their company public, for example, the owners of Google sold a portion of the company to you and me; Bill Gates did the same with Microsoft in 1980s and so on.

The role of Bob is interesting - he played the role of a market maker (in a very loose sense) - he bought shares from you and sold it to the best bidder in the market. This would have been even more accurate if you had hired Bob to sell your 30 shares to someone, instead of selling to Bob directly. Folks like Bob act as brokers and bring together buyers and sellers; occasionally, the broker may himself purchase shares and keep them on hand, fairly confident of the demand for the shares and his ability to sell them.

Multiply the above example by several trillion dollars, and add 10,000 companies to the mix, and a billion participants, and you have the makings of a stock market. Multiply the lemonade company by a few billion dollars, and you have an example of companies like Cisco, Microsoft and IBM. But the basic concepts of the value of a company, its value per share, its future value and so on do not change.

We hope this brief introduction was helpful in getting the basic concept of stocks and shares clear.