What is the Stock Market? How Does it Work?
Have you ever wondered what the stock market is and how it works? If yes, you’re not alone. The stock market can seem confusing and intimidating for people who don’t know how it works. But don’t worry! In this article, we shall learn what the stock market is, how it works, and who market participants are.
Given below are the different participants in the stock market. We’ll understand more about them through a story.
Let’s Look at a Story!
Mr. Jignesh, an owner of a renowned supermarket in Bengaluru, has been successfully running his business for the past ten years. The supermarket has been generating decent revenue and is highly profitable. His business also has goodwill (proprietary or intellectual property and brand recognition). When it comes to business, there are two things you must understand:
- Ownership of a Business
Jignesh completely owns and runs the supermarket, and the profit is not shared with anyone else.
- Valuation of a Business
Anything and everything has a value attached to it, even a business. The business has been generating income for Jignesh for the past ten years, so it is valuable. The valuation of a business is the economic value of how much a person has to pay to acquire 100% of the business from him. Let’s assume that the supermarket is valued at ₹1 crore.
Since Jignesh is growing old, he feels he doesn’t want to work as much as he did and is looking for a partner to operate the business in return for 50% of the ownership of his business. He decided to share his business with a partner, Ms. Riya.
What are Shares?
Shares represent units of ownership of a company. A shareholder is entitled to a part of the profit that the company generates.
The ownership of Jignesh’s supermarket was divided into 1000 equal shares. The value of each share can be mathematically expressed as:
Value of 1 Share = Total Valuation / Total Number of Shares
= 1,00,00,000 / 1000
= ₹10,000 per share.
Riya agreed to acquire 500 shares (50%) of the supermarket in consideration of the value of those shares in Cash.
Valuation = Total Number of Shares x Value of Each Share
Riya paid ₹50,00,000 to Jignesh, and they both became partners in the supermarket business.
A few years later, the business expanded with several profitable outlets across Bengaluru. Now, Jignesh and Riya want to open 200 more stores nationwide, for which they need a large amount of capital. The easiest way to get funding or capital is by taking out a loan from a bank and using the business’ assets as collateral. However, this carries the risk of falling into a debt trap. If they are unable to repay the loan for some reason, the assets will be seized by the bank to recover the loan. Jignesh and Rita did not want to deal with these issues.
An alternative would be to find more people who are interested in becoming part-owners of the business across Bengaluru. Even then, they may not be able to find enough people to do so. At this point, Jignesh becomes aware of the stock market. If they convert their company into a Public Limited company, they can raise capital from thousands of investors across India and other countries. The process of issuing shares to the public to raise capital for a business is known as an Initial Public Offering (IPO).
What is the Stock Market?
A stock market is a place where shares of publicly listed companies are traded. It is a physical place or institution where shares are bought and sold.
So Why Do Companies Go Public?
- To Raise Capital: The company can gather funds for many objectives, such as paying liabilities (loans) and funding its future expansion projects.
- Reward Founders & Early Investors: The founders and early investors of a company hold a good portion of the shares in their entity. They can sell these shares to the public and the proceeds go directly to them rather than to the company. It can be considered as a reward for all the time and effort they put in to build the company from the ground up. So going public can give them an early exit.
What are Stock Exchanges?
A stock exchange is a financial institution where different participants come together to buy and sell securities (shares). It provides the infrastructure for these activities. The term Stock Market is an umbrella term for a collection of Stock Exchanges.
The two major Stock Exchanges in India are:
- Bombay Stock Exchange (BSE)
- National Stock Exchange (NSE)
BSE is older than NSE, which explains why more companies are listed on the BSE than NSE.
Coming back to the story, Jignesh’s company had a total of 1000 shares, out of which they decided to issue 15% of the shares to the public. Thus, 150 shares are being offered to the public.
1000 x 15% = 150
How Many Shares Will a Company Have? Who Decides That?
A company’s promoters can decide how many shares it should have. Some firms may have thousands of shares, while others may have lakhs or even crores of shares.
For example, the valuation of Jignesh’s company was ₹1 crore in the beginning. But the business has grown over the years, and now the valuation stands at ₹2 crores, bringing the value of each share to ₹20,000.
Why do Investors Exist? What are their Objectives?
The two main objectives of investors are:
1. Capital Appreciation - When a company grows, the price of its shares increases. If investors buy the shares of a company when the prices are low and sell them when the prices increase, they can make good profits via capital appreciation.
2. Earn Dividends - When a company makes profits every year from its operations, it distributes a portion of the profits to shareholders as dividends. However, it is not necessary for them to declare dividends every year. It’s the company’s choice whether to issue dividends or not. The company may fully retain its profits for future capital needs or may give out a part of the profit and retain the rest.
In short, the objective of a public limited company is to raise capital for its funding needs and the investors’ objective is to grow their money. But the real question is, how does the stock market fit into this?
Why do Stock Markets Exist?
The stock market provides an avenue for a public company to raise capital from investors in consideration of shares. Investors will be able to grow their savings and wealth through capital appreciation and dividends. The stock market is the facilitator for the two parties.
What are Primary Market and Secondary Market?
The stock market is divided into two:
1. Primary Markets
It is a market wherein a firm issues securities/shares to investors directly (via an initial public offering or IPO). These sale proceeds go directly to the issuer to finance their capital requirements.
2. Secondary Markets
It is the market where previously issued securities are bought and sold among investors. These sale proceeds go to the person who holds the securities.
In our story, many people wanted to buy shares of his company after the IPO. However, the company does not issue any more shares as the IPO is already done. So these new investors can only buy the shares from those already holding them.
When such transactions happen between investors in the secondary markets, the price of the share gets updated. If an existing shareholder sells the stock to another person for ₹20,100, the price of all the shares of the company gets updated to ₹20,100. Consequently, the net worth of the shareholders increases as the price of the shares they hold increases.
Who Decides the Price of a Stock?
The two reasons which decide the price of a stock are:
- Company’s Actual Valuation: A company’s value fluctuates as the revenue, profit, and goodwill change. The future prospects of the company also contribute to the valuation. If the revenue and profits go down, the valuation may also decrease, which causes the share price to drop. However, if the revenue and profit increase, the valuation could also rise.
- Demand & Supply: The market forces of supply and demand also play an important role in deciding the share price. If the demand for the stock increases, then its price also increases since supply is limited. If the demand for the stock decreases, then its price also decreases since the supply is the same. Demand for the stock depends upon market sentiments, which refers to the overall attitude of investors toward the company. If the market sentiment is positive, then the demand for the stock will be high, thus driving the stock price up. Demand for the stock will be less if the market sentiment is negative.
Why Do Stock Prices Fluctuate Every Second?
The Last Traded Price (LTP) refers to the price at which the previous share transaction took place. The stock market has lakhs of participants, and transactions happen every second. If a person sells a stock for ₹150, then the LTP at the time will be ₹150. The very next second, if a stock is sold for ₹149, then the LTP changes to ₹149. This is the reason why stock prices fluctuate every second.
Who are Brokers?
If you want to buy a stock, you cannot do it directly from the stock market. We have to approach a stockbroker, and the broker will transact on our behalf. A broker is an intermediary that facilitates transactions in the stock market. If you want to buy a stock, your broker will find a seller in the stock market on your instruction and facilitate the transaction between you and the seller.
Before technology evolved, an investor had to physically visit the broker’s office and instruct them to buy the stock. The broker would then physically go around the stock market, find a seller, and conduct the transaction. But now, technology has evolved, and transactions can be conducted via our phones. Brokers are accessible on computers and smartphones, and investing & trading are as easy as ever.
It is absolutely necessary to have an account with a broker to participate in the stock market. As intelligent stock market participants, we must have multiple broking accounts for different purposes. We can use one account for our long-term investing activities and another one for trading. Successful traders use multiple broking accounts for different trading strategies.
How Does a Broker Work?
There are two accounts that we open with a broker. Even though they are two separate accounts serving different purposes, both of them come in a bundle.
1. Demat Account
A Demat account or dematerialisation account allows you to hold your shares in an electronic format. It converts the physical shares into an electronic form, therefore dematerialising them. Demat accounts are maintained under depositories.
Earlier, the proof of ownership of shares, bonds, or debentures was in the form of physical share certificates. However, this system had many drawbacks, such as the risk of losing the certificate, fire hazards, getting wet, or even a mismatch in the signatures.
2. Trading Account
A trading account acts as an interface between the investor’s bank savings account and a broker. For the broker to conduct trading activities on our behalf, they need money. We transfer the money we have in our savings account to a trading account with which the broker then conducts trading activities. Money can be transferred using net banking or UPI.
If we want to buy a stock, we instruct the broker to buy the stock, and the broker uses the money we have in our trading account to conduct the transaction. Similarly, when we sell a stock, the proceeds of the sale come directly into the trading account.
An Illustration to Understand How Demat & Trading Account Works
- Arun wants to buy a share of Mahindra & Mahindra (M&M) from the stock market. The first step that Arun should take is to open a Demat and trading account. Arun opens a Demat & trading account with a leading broker and deposits money into his trading account by transferring from his bank savings account via UPI.
- When the market opened at 9:15 AM, Arun placed an order with his broker to buy 1 quantity of M&M stock. The market price of M&M at the time was ₹1000. His trading account was debited ₹1000 by the broker to finance the transaction. Apart from this, a small amount was deducted as taxes and charges.
- Even though the transaction was completed, the stock will only be transferred into his Demat account after T+1 days, which means he will receive the stock in his Demat account on the next working day.
While selecting brokers, we should choose the brokers that satisfy our various investing and trading needs. YOu can open a Demat and trading account using the links given below:
Fyers (FREE) - https://bit.ly/3tx3ZJx
Zerodha - https://bit.ly/3AlErmb
Upstox - https://bit.ly/3OUAJnR
(Full disclosure: These are affiliate links. Do use the links if you wish to support us at no extra cost. ❤️)
Click here for step-by-step instructions on how to open a Demat and trading account.
What are Depositories?
If your shares are held by the broker, there is a risk of the broker running away with the shares they have. As a remedy, all Demat accounts are maintained by depositories. A depository is an institution that acts as a custodian of Demat accounts and shares. A Demat account is opened by a depository participant, who acts as an intermediary between the depository and investors.
There are two depositories in India, which are governed by the Government of India:
1. CDSL - Central Depository Services Limited
2. NSDL - National Securities Depository Limited
Who are the Other Facilitators?
The other facilitators part from brokers, depositories, and depository participants are:
- Clearing Houses - It is an intermediary between buyers and sellers of financial instruments. It is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data.
- Transfer Agents - A transfer agent keeps records of who owns a publicly traded company's stocks and bonds. They also ensure investors receive dividends on time.
- Settlement Banks - It refers to a customer's bank where payments or transactions are finally settled and cleared for customer use.
What is a Market Regulator?
The Indian stock market is a place where transactions worth lakhs of crores of rupees take place. The Securities and Exchange Board of India (SEBI) is a regulatory authority established under the SEBI Act 1992. It’s the principal regulator for stock exchanges in India. SEBI's primary functions include protecting investor interests and promoting and regulating the Indian securities markets. It is a government organisation. SEBI exists as the watchdog to make sure nothing wrong is happening in such a massive money-involved ecosystem.
Throughout the article, we discussed the various participants in the stock market and how they all work together in the stock market. We've also understood the basics of what the stock market is, who its participants are, and how it works!