Thursday, May 23, 2013

It's about confidence

This article was originally published in Postnoon on May 23, 2013
Vishal was not ready to leave my office till his curious brain was satisfied. He wanted to start investing in stocks. In spite of my telling him to first get a demat account and then come back to me, he continued to ask questions.

Vishal: Professor, if I invest in a particular company, I would get dividends and/or capital appreciation. That's how I would get my returns. But how does my trading in the market have an impact on the company? Why should the company worry about the share prices? They don't get anything if I buy from trader A and sell to trader B!
Nicky: You are right. The company does not get any money out of your trade. But what if the company needed more money to expand and wants to raise that money through equity? Who will subscribe to the public offering of a company which has not been performing well? Ultimately, share prices are closest indication of the value of a company that the investors have.

Vishal: Could you explain it with an example please?
Nicky: Yes. Let us say we have only two companies in the market. One gives a return of 10% and the other gives a return of 5%. Every investor would want to invest in the first company. Increase in demand will lead to increase in prices of this company and the low demand for the shares of the other company will lead to fall in prices of that company.

Now let's say that both the companies want to raise money and come to the market with a public offering. Which company will you chose to invest your money in?
Vishal: Obviously the company which gives a 10% return, whose share prices are rising.

Nicky: Correct. Due to increased share prices, this company will be able to raise the same amount of money as the other company by issuing lesser number of shares. The earnings per share will not get as diluted as in the other company.
Vishal: Ah, got it. But what if the company does not want to raise money through the stock market and goes to a Bank for a loan?

Nicky: Higher stock prices indicate confidence of the investors in a company. Even if the company goes to a bank for loan or a financial institution for private placement of shares, the bank or the financial institution would prefer to give funds by way of equity or loan to companies which enjoy better goodwill and confidence in the market.
Vishal: Now I get the big picture. Thank you.
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