9 Important Terms you Should know before investing in stock market
Here are 9 important terms you should be aware of before you start investing in stock market:
“Risk comes from not knowing what you are doing”- Warren Buffet
Investing in stock market is often perceived as a risky proposition by investors. But, at the same time, the fact cannot be overlooked that the stock market offers the best opportunity for wealth accumulation. Anxiety and nervousness to venture into equity investing emerge due to lack of knowledge and awareness of the nitty-gritty of the stock market. So, if you spend some time in developing your investing skills and come up with a strategy, it will help you to stay afloat in the turbulent market.
The article throws light on some of the commonly used terms in the stock market which would enable you to ward off the fear of equity investing:
It is about understanding the macroeconomic scenario before arriving at the particular stocks to add to the portfolio. The underlying belief is that if the economic conditions are favourable, and industry has a growth potential, then stock prices of that industry are bound to grow and investing would be profitable in such situation. Here, the stock-picking process begins with initially scanning the dynamics of the economy as in whether the prevailing conditions are favourable or not. Then, you may select the industry that is at the most advantageous position at present. Within the particular industry, choose stocks of the company which has a higher growth potential and earning capacity as compared to other businesses.
It is about understanding the company-specific fundamentals before arriving at the particular stocks to add to the portfolio. The underlying belief is that if the company has strong fundamentals, then stock prices of that company are bound to rise irrespective of adverse economic conditions and business cycles. Here, the stock-picking involves analysis of the metrics of the company namely growth potential, earning potential, P/E Ratio, RoE, cost, etc. If you follow a bottom-up strategy to pick stocks, then you need to examine company attributes like its management, financial health, products and stock performance.
Fundamental Analysis involves estimation of the value of a company with the help of company attributes. It is concerned about determining the overall well-being of the company instead of only tracking the price movements. It includes both quantitative as well as qualitative factors. Quantitative factors consist of revenue, profits, and assets of the company. Qualitative factors include top management quality, patents, brand-name, etc. It assumes that if the company has a competitive advantage, viable business model, industry has growth potential, a large number of customers, etc., then the market prices of the shares are bound to rise.
Market Capitalisation refers to the total value of the company arrived at after considering the market price of each share and its total number of outstanding shares in the secondary market.
Market Capitalisation = Current Market price per share * No. of outstanding shares
In India, there are three types of stocks based on market capitalisation namely Large Cap Stocks (Mkt cap>Rs. 10 crores), Mid Cap Stocks (Rs 10 crore>mkt cap>Rs 2 crore) and Small Cap Stocks (Mkt cap<Rs. 2 crores). The prices of large-cap stocks are stable as compared to mid-cap and small-cap stocks. Before investing in equity, you need to pick stocks that match your risk appetite.
Stock Market Index
A stock market index represents an aggregate value that is obtained by combining a group of stocks and expressing their value against a base value on a particular date. The aggregate value of the index changes due a change in the value of underlying shares. Usually, large cap companies with a higher number of outstanding shares have a greater influence on the aggregate values as compared to smaller companies. This value is used as a benchmark to evaluate the performance of a particular sector or investments made by an individual. Two major indices in India are BSE Sensex and NSE Nifty.
Bonus Issue & Record Date
Bonus issues are when the company allots shares to the investors instead of cash dividends. The bonus shares are allocated in a certain proportion to existing shareholding of the investor. Suppose the company announces a bonus issue in the ratio of 1:1 then it means for every share that the investor holds, he would get one extra share. If an investor owns six shares of the company, then he would get six bonus shares thereby increasing his shareholding from 6 to 12. It is crucial to state the impact of bonus issue on the stock price of a company. If the company thinks that its shares are trading above the reasonable price level, then it may issue bonus shares. Bonus issue leads to a fall in the market price of the share and increases the supply of shares in the market. On one hand, it makes the company’s stocks affordable for the small investor and on the other; it increases liquidity in the market.
When the management declares a bonus issue, they specify a Record date. It is the day which is used to ascertain the shareholders who would be entitled to receive the bonus shares. If your name appears in the Shareholders’ Register, only then you would be eligible to receive bonus shares of the company.
Stock Split & Reverse Split
Stock Split results in an increase in the number of outstanding shares in the market. Consequently, every investor gets more shares in direct proportion to the number of shares owned by them on the date of issue. However, the company does not receive any consideration for the issue. The shares thus issued will have not only a lower market price but also less par value. Suppose BCD Company has 4 million outstanding shares, wherein the par value is Rs.10, and the current market price is Rs.2000 per share. If the management goes for a stock split in the ratio of 1:1, then after a split there will be 8 million outstanding shares with a par value of Rs.5 and a theoretical market price of Rs.1000 per share. Sometimes when the market price is very high, the company announces a stock split to bring the share price within reach of small investors.
“Reverse Split” has an opposite effect of the stock split. In this, the company reduces the number of outstanding shares by combining the available shares into fewer shares. It not only increases the stock’s par value but also increases the market price of the shares. It is often used by companies when the shares are trading at lower prices in the market.
Blue Chip Stocks
Blue Chip Stocks refers to shares of well-established companies that have a long history of sound performance and financial health. These stocks have faced all kinds of business cycles and can contain losses during bear runs and give good returns during bull runs. These are high-priced stocks, known to pay regular dividends and are recognised as market leaders in their respective business territory.
A company generally may pick any one of the two options with regards to disposal of profits remaining after payment of taxes. If it decides to reinvest the residual profits in the business, it’s called as Retained Earnings. If it plans to distribute the profits to the shareholders, then it’s called as Dividend. To pay or not to pay dividends is a company’s discretion. It is not mandatory to pay dividends regularly as these are paid only out of profits. However, investors perceive those stocks as favourable which declare a dividend on a regular fashion.
Remember that when you invest, you buy a company and hence you need to make sure that the company generates profits good enough to keep its share prices buoyant in the market. Develop a habit of assigning reasons while you pick stocks because it’s very easy to go from riches to rags in equity investing. Numbers matters but you need to be equally sound in the fundamental analysis as well.