How does the stock market work?
"In the short
term, the market is a voting machine. But, in the long term, the market is a
weighing machine". "-- Ben Graham[1]"
Part 1: How the
stock market works .
Part 2: How does one
evaluate Stocks.
Part 1: Basics of a Stock Market
History: A long time ago, humans ran businesses with
just their money. The businesses they ran were small and they grew the
businesses only with their own profits. However, not all businesses can
be built with your own money. What if you wanted to build a new factory
that costs more than a million dollars? Banks won't lend money for young
companies and your friends won't have that much.
In the 15th-16th
century as the Europeans started exploring Asia and Americas, the big explorers
felt they needed a lot of money and their kings were not providing them
anymore. The wealthy guys demanded a lot of interest. Thus, they felt they need
to raise money from a bunch of common people. Thus, in 1602, the Dutch East
Indian company became the first company to issue shares of its company in the
Amsterdam Stock Exchange and get traded on a continuous basis.
What is a Stock? Stocks in a company provide
you a share of the company's future profits in return for the capital
invested. For instance, if you buy 1 stock of Apple now, you will be
assured one-billionth of Apple's profits in the future (as there
are almost a billion such stocks that Apple has issued now).
Listing: In a stock market, 1000s of companies are
listed and these companies (called public companies - as they have given
out their shares to common public) pay a fee to the exchanges, along with
a promise to provide all important info to the markets. In return they
get an opportunity to put their company in the stock market's board &
have the ability to get money from people visiting the market. The first
time a company's stock appears on the stock market's board is called
an IPO (Initial Public Offer).
Brokers: Conceptually, a stock exchange is similar to
eBay. These guys allow companies to be listed and connect the buyers
& sellers. Since millions of people trade in the market and it is
practically impossible for these exchanges to deal with all the
individuals, they have assigned brokers who act between the exchanges and the
individuals.
Part 2: How does one value a stock
Basic Terminology:
We
will use a term EPS (Earnings per share) that is exactly as it sounds. It
is the profits of the company divided by number of shares. For instance, Apple
has $41 billion in profits and about 950 million shares, giving an EPS of about
41000/950 = $44/share. Thus, if you own a share of Apple, you are entitled to
44 bucks of Apple's profits this year.
Calculating Share price:
To evaluate how much
you need to pay for that 1 Apple stock you need to do a simple addition of all
the earnings you will get
Stock Price = EPS in Year 1 + EPS in Year 2 +...
Now,
you know that a dollar earned 10 years from now is not the same as a dollar
earned now. Because, there is an interest rate i involved
and money you get in 10 years is less worthy than the money you have now. Thus,
you need to adjust that formulae.
Stock Price = ((EPS
in Year 1)/(1+i))+ (EPS in Year 2/(1+i)^2) +...
Now, there is a
whole bunch of math involved (starting from the compound interest formula) and
for the sake of simplicity, I will get you to the final results and reduce the
stock price to two cases:
1. In case of a mature company that doesn't grow:
Stock
price = EPS/Interest rate
The expected
Interest rate is relatively easy to calculate and depends on how risky the
company is, how risky the market is and the current long term interest rate of
government bonds. For many mature utility companies this interest rate comes to
about 10%. Thus, utility companies that doesn't grow much is generally traded
at about 10-15 times the EPS. (insert in the formula above).
The stock prices of
these companies are very smooth and change only when there is a change in long
term interest rates, the risk profile of the company (can change when
hurricanes such as Sandy hits) or when market risk changes (for instance 2008
financial crisis). But on a regular day, not much action here. Let us move to
the second category of shares:
2. For a growing company:
Stock
price = EPS of next year / (interest rate - expected growth rate of the
company)
Let us use a simple
example. If you assume Apple's next year EPS will be $48, the expected interest
rate for such a risky company at 15% and an expected annual growth rate at 5%,
you will get:
$48/(15%-5%) or
$48/10% or $480 as the ideal stock price for the company. Where did I get this
magical 5% number?
Getting the growth inputs:
Now, we need to find
the growth rate of the company and figure out what the company will earn in the
next year, the following year and so on. This is not an exact science and no
one has a perfect answer to this question. This is why we need stock markets.
Collectively, we all pool our intelligence to figure out the future growth of
the company and thereby its current price.
To do this
collective prediction, we constantly get new inputs and project that to future.
For instance, if the company management gets hotshot new engineers, then we
predict the future will be bright. What are the other news that investors
typically use:
- Periodic financial results of the company that gives us a view into the company;s workings and its financial position
- Periodic results of similar companies that helps us guess this company;s results. Thus, when Apple sneezes everyone else catches a cold.
- Changes in the sector. If a new report comes that people are more inclined to using mobile phones, we predict growth of these companies will be high.
- Changes in the broader market.
- Changes in the international economy
Market Estimation:
In short, we try to
use every possible information to guess the future growth of the company, plug
that into our formula and find out the stock price. For instance, if Apple
comes out a report saying people are buying less of iPads, we might ding
Samsung too as we believe their Galaxy Tabs will sell less too.
Estimating growth
rate is an art rather than a science, and is collectively done by millions of
humans in a place called the stock market. Since, we need to constantly adjust
the growth rate based on new information, stock prices constantly fluctuate.
Main advantages of a stock market:
1. Starting/building
a business: The
market lets companies get money from a large number of people. That means there
are more options to get money to build a business.
2. Spreading
risk: It lets
you spread the risk of a business into a large number of people. Since,
each person is investing only a small portion of their income in the
stock of a particular company, the risk of a single company collapsing doesn't
significantly affect investors.
3. Collective
estimation of value.
Summary: Modern corporations require a lot of capital, which
is beyond the reaches of a few individuals. Markets help companies raise money
from a large number of people and together these investors value their
company. The theory is that when a large number of people do their
independent valuation, the company's price comes more closer to its ideal
worth.
"In the
short term, the market is a voting machine. But, in the long term, the market
is a weighing machine". -- Buffett
(Disclaimer: This is
an answer targeted at basic-intermediate level investor & not high
frequency traders or experts. I deliberately approximated a few things to
improve clarity).
