A capital market is a type of market that serves the demand and supply of capital. Millions of currencies are traded here every day. Hundreds of organizations are invested in this market functioning to make the rapport between the companies and investors, between investors and investors. The capital is bought and sold through a small fragment of different types such as share, bond, etc. Firms sell shares and investors buy shares to earn money. But how they both get their purpose served in the stock market and how the share price is fixed are matters of interest to many. Let’s have a look at that.
Why should you buy shares?
Source of income
Usually, the prime reason is to earn a return. Profit from share trading is one of the main sources of income for many small investors in our country. Two types of financial benefits are available to the investors; profit from selling shares and dividend income.
Investors tend to buy shares when the stock price decreases and sell those at a higher price to make a profit. Let’s say, the price of the share of ABC Ltd, a listed company, today is Tk. 350 and Mr. Rahim buys it. To make a profit, he has to sell it at a price higher than 350. For example, if the price becomes Tk. 355 on 27th December, he can choose to sell the shares to make a profit of Tk. 5 per share.
Listed public companies whose shares are traded in the share markets may also declare dividends per share at the end of a fiscal year. The investors holding the shares at that declaration date receive that dividend in cash or stock.
Shareholders get voting rights in the Annual General Meeting of the company they buy the shares of. Investors cannot take a direct part in the management of the company. Through this right, they can express their say in the election of the Board of Directors and many other significant decisions regarding the management of their owned organization.
An asset is called liquid when it’s easy to buy or sell it anytime. People want to invest in liquid assets to be assured of the availability of cash whenever needed. Stocks are easier to buy and sell than any other long-term investment, which also with a good return. Examples of less liquid assets for individuals can be gold, building, vehicles, business project, etc.
Why do firms sell shares?
The primary objective of selling shares for companies is to raise cash to fund their business operation or expansion. When a private company goes public by offering shares for IPO, they usually look for additional capital to bear the expenses. This situation may arise for several reasons one of which can be the existence of high debt leverage and for which the company cannot go for more loans from banks. One important thing to note here is, the corporation whose shares are traded in the secondary share market doesn’t get any return for such trade. In addition to IPO, a firm can also buy its share at a lower price if it sees itself less valued in the market than books and sells those shares at a higher price. This also gives the company a little profit.
Acquisition of another firm
If a company decides to take over another firm for expansion or any other purpose they may choose to do it through issuing shares. This is the process of issuing shares in favor of the shareholders of the company to be acquired. Companies prefer this easier, efficient, and less costly option in case of an acquisition.
Some other minor reasons work too-
- Giving the public some stake in the company to connect better.
- Bring more expertise to a heterogeneous group of owners.
- Establish credibility for the customers, suppliers, and other stakeholders.
- Earn more publicity and attention to analyze.
Do you need to monitor a firm once you did invest?
As we are already informed, companies don’t get anything from the trading of shares in the secondary market. But do the shareholders get anything from the company while trading? Yes, they do. Let’s see how the shareholders can be monetarily affected by the firm, even though the firm doesn’t get involved in share trading.
To see the connection between firm performance, stock price, and investors in the secondary share market, we have to understand how the performance of a firm is measured. Firm performance is basically measured by ratio analysis. Two types of measurement are conventional- Book-based measurement and Market-based measurements.
Ratio analyses done with the numbers from financial reports or accounts are called Book-based ratios or Accounts-based ratios. Ratios are compared horizontally with other segments or other firms operating within the same industry and also compared vertically with the previous years’ performances to find a trend. Accounting ratios are further categorized into the following ratios-
- Liquidity ratios
- Current ratio
- Quick ratio etc.
- Profitability ratios
- Return on Assets ratio
- Return on Equity ratio
- Profit Margin ratio etc.
- Leverage Ratios
- Debt-to-Equity ratio etc.
- Turnover Ratios
- Inventory Turnover
- Accounts Receivable Turnover etc.
Let’s look at how these ratios are used to measure to decide how a certain firm is performing. Let’s take a random public limited company from SEC as our example and calculate some ratios from its annual report 2018-19.
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These financial ratios aren’t that meaningful on a standalone basis as there is no specific range defined to categorize as good or bad performance. These ratios need to be compared with those of years 2017-18 to see whether the company has better performed this year or not. Also, the analysts will be comparing these performance ratios with the industry average to find out whether our company is performing better or worse than the average companies in the industry.
Market value ratios are the ratios where the market-determined value of a firm is compared with the book value. The market valuation of a firm can be (you guessed it right!) different from the book value because of the information gap. Such differences are measured by-
- Price-to-Earnings ratio
- Mark-to-Book ratio etc.
The connection between firm performance, share price, and investors
Now that we know how to measure the firm’s performance, we can try to understand how this performance is reflected in the share price and how the investors trade on that quoted market price. Let’s say, our selected company (discussed before) performed better this year than the previous year according to the ratio analysis. Also, the performance is better than the industry average. Based on this information, investors will try to retain the shares considering a better future and better return. And those who will decide to sell will be looking for a higher price given that buyers will be willing to pay more for a better performing firm.
The case will be exactly the opposite if the ratios calculated indicate performance deterioration. It means, in general, the investors holding the shares of such a company may decide to sell those off because of the uncertain future. This will cause a fall in share price because of the increase in supply and also due to the less demand of the risk-averse investors.
In the worst-case scenario, if the investors find that the market value of the firm is higher than its book value, calculated by the Market ratios, they will be willing to pay less and this will eventually bring down the average share price of that firm.
In addition to these financial ratios, share market analysts and informed investors also take non-financial information into consideration while deciding the value of a firm’s share. Some of this non-financial information can be the performance of CSR by the company, selection of the board members and managers, pending litigations, expansion possibilities, employee satisfaction, etc. This information is usually publicly available through annual reports, magazines, press releases, etc.
A wise and informed investor can make a fortune out of the share market, while some consecutive bad decisions may lead to a burst of the bubble created by dishonest leaders of the market and loss of millions of small investors’ money. That is why it’s important for an investor to know ins and outs of the whole capital market before making an investment decision. But an ironic fact is that shareholders or investors don’t get the whole picture of the firm because of the information gap, so they have to be careful about which information to use and which to not in case of an investment decision. The collective behavior of the investors based on the firm performance is the determinant of the share price of that firm. Firms prefer to be highly valued. This depicts the reciprocal relationship in the market place.