The Story Of Stocks
Raju was the smartest bloke you’d meet - he was fiercely independent, streetwise and had the people skills of a politician. Nobody asked him his grades because you would be busy being awed listening to the latest story of how he managed to convince Verma uncle to give him all the cricket balls that had gone into his house.
Raju lived in a township with his parents. His father, a retired army general, had had his share of noise and poor air quality, and preferred to spend his days in the clean and green townships that were a part of the latest urbanisation planning by the city council. Situated on Ahmedabad-Gandhinagar highway, the Godrej City Township was an hour away from civilisation.
Soon after the township was populated, it didn’t take very long for shops to start appearing in the vicinity. The shopkeepers made profits hand over fist - they could charge ridiculous amounts for things and get away with it. Nobody would want to drive all the way to the city to buy a pack of macaroni or get their phone repaired.
When the board exams of Class 10 approached, Raju and his friends found themselves swarmed with projects. These projects were a part of internal assessment, and they had to make projects for every subject, twice a year. Like any other normal teenager, Raju started calculating the cost of printouts he will have to incur for every project, and realised that he would have to give up on certain small luxuries to be able to afford these printouts within his pocket money. Among other things, he was most depressed about not being able to get a nice birthday present for his girlfriend, Priya.
That night, Raju’s dad was watching the Abhishek Bachchan starrer, Guru, on the TV. Raju had a moment of enlightenment, and he quickly devised a plan to solve the problem.
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A standard, good quality printer cost anywhere around 4000 rupees. There was no way Raju could afford that amount, but he realised that there were 10 odd people in the same township who needed printing services.
Raju called an informal gathering and made an offer to them - if they all shelled out 500 rupees per head, Raju would allow them to get 10 free printouts for the first month, and thereafter, at a minimum cost of 1 rupee per black-and-white printout as long as they brought their own paper.
The printer will belong to Raju on paper, but all of them will have a right to use it at minimum costs. Raju will keep the printer in his room, and all of them were free to come and get the printouts whenever they wanted.
Raju collected 500 rupees each from all 10 of them, and gave the remaining 1000 to his dad as electricity expense for the first two months.
Soon enough, the word spread and everyone praised Raju on his smart thinking. Lina, a fashion student, used to get a lot of printouts from the overcharging stationery shop down the lane. She had a higher budget than these teenagers, so she could afford it, but she found herself in a fix on a certain Sunday when the stationery shop was closed. She reluctantly went to Raju and asked him if she could use his printer. Raju smelled an opportunity.
He quickly called a meeting and told his friends that this was a business opportunity to earn extra money. They could charge a small margin from Lina and still earn a small amount of money. They can buy new cartridge and blank papers from this money. Everyone readily agreed to the proposal.
Lina used to pay 10 rupees per printout at the shop, and Raju offered her a discounted rate of 5 rupees per printout. She could simply walk in with blank papers and get the printouts whenever she wanted. Lina found this arrangement very convenient, since she could get printouts even in the wee hours of night. Hence, she started using Raju’s printer regularly. Soon enough, Raju and his friends weren’t paying for the cartridge or paper or electricity from their own pockets - the profit they made from Lina was enough to cover their costs. This essentially means that Raju and his friends were making a profit, earning a revenue, from their investment.
**************************************************
Raju and his 10 friends pooled in money to buy an entity, which they all owned equally. They were the equity shareholders of this money-producing entity.
Since they also used the printer, they were both owners and consumers of the final product.
After they made a profit from letting Lina use their printer, Raju’s dad had the first right to be paid because he paid for the electricity. He was not a shareholder. If they wouldn’t make a profit from Lina in a certain month, they would still have to pay electricity charged to Raju’s dad. If there was any profit leftover after paying Raju’s dad and buying cartridges, it could be distributed among Raju and his friends as profit.
This is quite similar to the concept of stocks.
Stocks are equity instruments and can be of different types. But their basic valuation remains the same and all the properties of equity instruments are applicable on them.
Holders of the equity capital are owners of the firm. In this case, it is Raju and his friends.
Shareholders are the residual claimants of the firm: the claims of the equity holders cannot be paid until the claims of all creditors, including both interest and principal payments on debt has been serviced. In our example, Raju’s dad is a kind of creditor in the sense that he provides electricity to them every month. He needs to be paid before Raju and his friends can take a piece of pie home.
Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear. If more people like Lina start using Raju’s printer, they will obviously make higher profits and after giving Raju’s father his cut, they can take home all the leftover profits. However, if the printer needs repairing or is spoiled, it is them who will incur the expenses.
Unlike debt, equity capital is a permanent form of financing.
Equity has no maturity date and never has to be repaid by the firm.
While interest paid to bondholders is tax-deductible to the issuing firm, dividends paid to preferred and common stockholders of the corporation is not.
If you buy a share of stock, you can receive cash in two ways
•The company pays dividends
•You sell your shares, either to another investor in the market or back to the company
Stock-valuation
Shyam, one of the ‘stock-holders’ of the printer, finishes Class 12 and plans to leave the city for higher studies. He can either..
Continue to reap profits from his investment in the printer, or,
Sell his stake in the printer to Lisa or somebody else.
Whoever buys Shyam’s stake will become an investor in the ‘business’.
The initial price of the ‘stock’ was 500 rupees, but Raju and his friends now earn at least a couple of thousand rupees per head every month from the profit made. Obviously, Shyam will not accept 500 rupees to sell his stake because it is not in keeping with the expected returns. Hence, this calls for valuation of Shyam’s stock.
There are 2 methods of stock valuation:
Dividend Discount Model
As with bonds or any asset, the price of the stock is the present value of the expected cash flows. This is called the Dividend Discount Model (DDM)
Today’s Stock Price = PV (all future dividends)
Now this formula can be changed on a case to case basis.
If the company maintains a constant dividend forever, it is just a like a perpetuity P = D/r
If the dividend is growing at a constant rate forever, it is just like a growing perpetuity.
P = D/r-g
If you know the amount of dividends until a certain point but not after that, then discount the dividends until that date and discount the future share price. It can be treated as an annuity.
P0 = D/r(1-(1/1+r)^n) + Pn/(1+r)^n
r = Cost of equity, g = dividend growth rate
g = Retention Ratio * ROE
Retention Ratio = Fraction of earnings retained by the firm = 1 – Payout Ratio
Payout Ratio = Fraction of earnings paid out as dividends = DPS/EPS
ROE = Return on Equity = PAT/Equity
In this case, the dividend that Raju and his friends earn is growing at a constant rate every month, and it is expected to do so. Hence, Shyam can calculate his stock price in the following manner.
P=D/r-g , where r = Cost of equity and g = Retention Ratio * Return on Equity.
The DDM model is ideal in this case because the dividends are paid on the stock, and the future expected cash flows are known. It is an accurate and easy method that takes into account the cash flows.
Shyam sells his stocks and leaves the city, satisfied at having made a profit from his investment.
*****************************************************************************************************
Rahul lived in the same township, and he also used Raju’s printer services from time to time. He didn’t join Raju and others when they first set up the printer, and hence, missed out on early investment. He regretted it till date.
However, he didn’t want to buy Shyam’s stock. He preferred starting something of his own. He realised that while Raju had tapped the black-and-white printouts market, the colour printout market was still up for grabs.
He wasn’t going to start the business without any drama - he made a big deal about how his set-up will definitely earn a lot of revenue since everyone needs nice colour printouts for school projects and regular work. Soon enough, many other kids were interested in joining Rahul in his endeavours.
Rahul took a ‘loan’ from his dad and set up his ‘business’ in his room. He then proceeded to sell the shares of his business to 9 other people, at a cost which was higher than their share of the cost of printer. He told everyone, “The printer cost me 7000 rupees, and with electricity and cartridge costs, it will have an initial maintenance charge of 3000 rupees. However, you need to pay 2000 rupees to buy share in the ‘business’, because you are sure to earn money more than the basic cost.
This method of valuation of stocks is called P/E Multiple Approach.
It is used to relate earnings per share to price. Calculated as current stock price divided by annual EPS. Firms whose shares are “in fashion” sell at high multiples - Growth stocks and those whose shares are out of favor sell at low multiples - Value stocks.
P/E multiple is usually calculated by calculating the median of the P/Es of all comparable firms (having same risks, financials, operations and growth) in the same industry.
Stock Returns for Shareholders: Stock Returns are derived from both dividends and capital gains
Stock returns = Dividend Yield + Capital Appreciation (growth)
Raju lived in a township with his parents. His father, a retired army general, had had his share of noise and poor air quality, and preferred to spend his days in the clean and green townships that were a part of the latest urbanisation planning by the city council. Situated on Ahmedabad-Gandhinagar highway, the Godrej City Township was an hour away from civilisation.
Soon after the township was populated, it didn’t take very long for shops to start appearing in the vicinity. The shopkeepers made profits hand over fist - they could charge ridiculous amounts for things and get away with it. Nobody would want to drive all the way to the city to buy a pack of macaroni or get their phone repaired.
When the board exams of Class 10 approached, Raju and his friends found themselves swarmed with projects. These projects were a part of internal assessment, and they had to make projects for every subject, twice a year. Like any other normal teenager, Raju started calculating the cost of printouts he will have to incur for every project, and realised that he would have to give up on certain small luxuries to be able to afford these printouts within his pocket money. Among other things, he was most depressed about not being able to get a nice birthday present for his girlfriend, Priya.
That night, Raju’s dad was watching the Abhishek Bachchan starrer, Guru, on the TV. Raju had a moment of enlightenment, and he quickly devised a plan to solve the problem.
************************************************************
A standard, good quality printer cost anywhere around 4000 rupees. There was no way Raju could afford that amount, but he realised that there were 10 odd people in the same township who needed printing services.
Raju called an informal gathering and made an offer to them - if they all shelled out 500 rupees per head, Raju would allow them to get 10 free printouts for the first month, and thereafter, at a minimum cost of 1 rupee per black-and-white printout as long as they brought their own paper.
The printer will belong to Raju on paper, but all of them will have a right to use it at minimum costs. Raju will keep the printer in his room, and all of them were free to come and get the printouts whenever they wanted.
Raju collected 500 rupees each from all 10 of them, and gave the remaining 1000 to his dad as electricity expense for the first two months.
Soon enough, the word spread and everyone praised Raju on his smart thinking. Lina, a fashion student, used to get a lot of printouts from the overcharging stationery shop down the lane. She had a higher budget than these teenagers, so she could afford it, but she found herself in a fix on a certain Sunday when the stationery shop was closed. She reluctantly went to Raju and asked him if she could use his printer. Raju smelled an opportunity.
He quickly called a meeting and told his friends that this was a business opportunity to earn extra money. They could charge a small margin from Lina and still earn a small amount of money. They can buy new cartridge and blank papers from this money. Everyone readily agreed to the proposal.
Lina used to pay 10 rupees per printout at the shop, and Raju offered her a discounted rate of 5 rupees per printout. She could simply walk in with blank papers and get the printouts whenever she wanted. Lina found this arrangement very convenient, since she could get printouts even in the wee hours of night. Hence, she started using Raju’s printer regularly. Soon enough, Raju and his friends weren’t paying for the cartridge or paper or electricity from their own pockets - the profit they made from Lina was enough to cover their costs. This essentially means that Raju and his friends were making a profit, earning a revenue, from their investment.
**************************************************
Raju and his 10 friends pooled in money to buy an entity, which they all owned equally. They were the equity shareholders of this money-producing entity.
Since they also used the printer, they were both owners and consumers of the final product.
After they made a profit from letting Lina use their printer, Raju’s dad had the first right to be paid because he paid for the electricity. He was not a shareholder. If they wouldn’t make a profit from Lina in a certain month, they would still have to pay electricity charged to Raju’s dad. If there was any profit leftover after paying Raju’s dad and buying cartridges, it could be distributed among Raju and his friends as profit.
This is quite similar to the concept of stocks.
Stocks are equity instruments and can be of different types. But their basic valuation remains the same and all the properties of equity instruments are applicable on them.
Holders of the equity capital are owners of the firm. In this case, it is Raju and his friends.
Shareholders are the residual claimants of the firm: the claims of the equity holders cannot be paid until the claims of all creditors, including both interest and principal payments on debt has been serviced. In our example, Raju’s dad is a kind of creditor in the sense that he provides electricity to them every month. He needs to be paid before Raju and his friends can take a piece of pie home.
Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear. If more people like Lina start using Raju’s printer, they will obviously make higher profits and after giving Raju’s father his cut, they can take home all the leftover profits. However, if the printer needs repairing or is spoiled, it is them who will incur the expenses.
Unlike debt, equity capital is a permanent form of financing.
Equity has no maturity date and never has to be repaid by the firm.
While interest paid to bondholders is tax-deductible to the issuing firm, dividends paid to preferred and common stockholders of the corporation is not.
If you buy a share of stock, you can receive cash in two ways
•The company pays dividends
•You sell your shares, either to another investor in the market or back to the company
Stock-valuation
Shyam, one of the ‘stock-holders’ of the printer, finishes Class 12 and plans to leave the city for higher studies. He can either..
Continue to reap profits from his investment in the printer, or,
Sell his stake in the printer to Lisa or somebody else.
Whoever buys Shyam’s stake will become an investor in the ‘business’.
The initial price of the ‘stock’ was 500 rupees, but Raju and his friends now earn at least a couple of thousand rupees per head every month from the profit made. Obviously, Shyam will not accept 500 rupees to sell his stake because it is not in keeping with the expected returns. Hence, this calls for valuation of Shyam’s stock.
There are 2 methods of stock valuation:
Dividend Discount Model
As with bonds or any asset, the price of the stock is the present value of the expected cash flows. This is called the Dividend Discount Model (DDM)
Today’s Stock Price = PV (all future dividends)
Now this formula can be changed on a case to case basis.
If the company maintains a constant dividend forever, it is just a like a perpetuity P = D/r
If the dividend is growing at a constant rate forever, it is just like a growing perpetuity.
P = D/r-g
If you know the amount of dividends until a certain point but not after that, then discount the dividends until that date and discount the future share price. It can be treated as an annuity.
P0 = D/r(1-(1/1+r)^n) + Pn/(1+r)^n
r = Cost of equity, g = dividend growth rate
g = Retention Ratio * ROE
Retention Ratio = Fraction of earnings retained by the firm = 1 – Payout Ratio
Payout Ratio = Fraction of earnings paid out as dividends = DPS/EPS
ROE = Return on Equity = PAT/Equity
In this case, the dividend that Raju and his friends earn is growing at a constant rate every month, and it is expected to do so. Hence, Shyam can calculate his stock price in the following manner.
P=D/r-g , where r = Cost of equity and g = Retention Ratio * Return on Equity.
The DDM model is ideal in this case because the dividends are paid on the stock, and the future expected cash flows are known. It is an accurate and easy method that takes into account the cash flows.
Shyam sells his stocks and leaves the city, satisfied at having made a profit from his investment.
*****************************************************************************************************
Rahul lived in the same township, and he also used Raju’s printer services from time to time. He didn’t join Raju and others when they first set up the printer, and hence, missed out on early investment. He regretted it till date.
However, he didn’t want to buy Shyam’s stock. He preferred starting something of his own. He realised that while Raju had tapped the black-and-white printouts market, the colour printout market was still up for grabs.
He wasn’t going to start the business without any drama - he made a big deal about how his set-up will definitely earn a lot of revenue since everyone needs nice colour printouts for school projects and regular work. Soon enough, many other kids were interested in joining Rahul in his endeavours.
Rahul took a ‘loan’ from his dad and set up his ‘business’ in his room. He then proceeded to sell the shares of his business to 9 other people, at a cost which was higher than their share of the cost of printer. He told everyone, “The printer cost me 7000 rupees, and with electricity and cartridge costs, it will have an initial maintenance charge of 3000 rupees. However, you need to pay 2000 rupees to buy share in the ‘business’, because you are sure to earn money more than the basic cost.
This method of valuation of stocks is called P/E Multiple Approach.
It is used to relate earnings per share to price. Calculated as current stock price divided by annual EPS. Firms whose shares are “in fashion” sell at high multiples - Growth stocks and those whose shares are out of favor sell at low multiples - Value stocks.
P/E multiple is usually calculated by calculating the median of the P/Es of all comparable firms (having same risks, financials, operations and growth) in the same industry.
Stock Returns for Shareholders: Stock Returns are derived from both dividends and capital gains
Stock returns = Dividend Yield + Capital Appreciation (growth)
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