Rahul, a recent engineering graduate, wants share trading but is not familiar with the stock market. Rahul consults Abhishek, a senior financial advisor.
"Abhishek. Can we start with the basics?"
Abhishek stated, "Ask Rahul to your heart's content, Rahul. It is part of my job teach people how to trade in the stock market." "It is also not recommended to invest in stock markets without having the right knowledge.
"Share prices often confuses me!" Rahul was curious to know why some stocks are priced in hundreds, while others in thousands.
Abhishek said, "Don't get it wrong, stock prices are important, but they don't have any meaning without context,"
Rahul looked confused on his face.
Let's take an example to illustrate. The stock can be thought of as a person. If I introduce you to someone new and tell you his name, can you understand what he is? It is not. You will understand why I introduced him if you tell you that he is a successful investor who is organizing a workshop.
"Similarly, while the price is the most easily identifiable aspect of stock, without additional information it may not be very useful."
"The stock price is constantly changing, and many people mistakenly believe that the stock price equals the stock's value. Abhishek said that nothing could be further from the truth.
The stock price is a reflection of current stock value, but it doesn't reflect the stock's intrinsic value.
Rahul asked, "So, the stock market price doesn't reflect the actual value of the company. Differences in prices don't mean anything when comparing companies."
When comparing the intrinsic value a company's stock price, "the difference in stock prices does not matter." Abhishek stated that although a company may have shares priced at Rs.7000, it may be much less valuable than one with Rs 100 shares.
"For clarity, let's take two companies ABC (XYZ) as an example. Each share of ABC is Rs 10,000 and there are 1 million shares in the market. The company's market capitalization is Rs 100 crores. The share price for XYZ is Rs 3000 but there are only 1 million shares on the market. A simple calculation will show that the market capitalization of XYZ stands at Rs 3000 crores. This is significantly higher than ABC's.
Market capitalization is not a way to determine the intrinsic value of a company. There are many fundamental factors that must be taken into account. It is however a useful tool for understanding the futility and volatility of stock prices.
"Abhishek can you please explain the factors that lead to the different share prices in different companies?"
When share trading takes place, there are many factors that can affect the stock price of a company's shares. The primary reason for differences in shares prices between companies is the supply-demand relationship.
Let's say that two companies are listed at the same prices. Abhishek stated that if the demand for shares of the first company is greater than that of the other company, and both companies have equal shares in the market the share price will automatically go up for the first company."
"Several major stocks traded on Indian bourses trade at higher prices due to low free floating, which refers to the number of shares that a company can be publicly traded."
Rahul exclaimed, "Oh, that's an interesting insight, Abhishek."
Stock prices are not determined solely by the demand-supply situation. Stock splits are a popular option for many companies to make their shares more affordable for retail investors.
"All the knowledge about investing in the stock exchange would have been a waste if it was not possible to reach a small investor. Rahul, isn't that it?
"Can you explain further?" Rahul asked.
"Consider MRF. Each share of MRF currently costs Rs 58.500. Abhishek asked, "Would you be able invest in MRF if you wanted to start trading shares with Rs 50,000?"
Rahul replied, "Obviously No!"
"If MRF decides that the stock should be divided in a 5-for-1 ratio, each share will be split into five shares. The price of each share would fall, and liquidity would increase."
Abhishek explained, "A lower price will allow smaller investors to invest in MRF."
Stock splits and demand-supply do not determine share prices. Stock prices are affected by many other factors, such as profit growth, revenue growth, and other developments. This is why some stocks appear expensive while others seem cheap.
"Thanks, Abhishek for your detailed explanation."