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Buying stocks? Know your basics first

Last updated on: April 1, 2010 18:54 IST

Image: Illustration by Uttam Ghosh

What is equity? You hear this word every day. When you watch business news channels, when you travel in local trains or when you talk to your friends. But what is it exactly?

Equity is defined as stock or any other security representing an ownership interest in a company listed on a stock exchange.

An equity share is a right to a share in the profits of a company (in the form of dividends that companies distribute among its shareholders). If you want a share in a company's profits, you can do so by buying equity shares of that particular company.

Perhaps, the best way to create wealth, equity is a means to achieve returns that beats inflation by a wide margin.

Basic information on equity investing

Equity investment refers to buying a piece of a company. You do this by buying shares in that company. There are two ways to acquire shares in a company:

From the primary market where you can buy shares when a company first issues shares to the public. This first share offering is called an initial public offering, IPO


You can buy equity in the secondary market, which is the stock exchange

When you buy or sell equity on a stock exchange, you have to do the transaction through an exchange-certified broker/brokerage firm, who will act as your agent whenever you want to buy or sell equity.

Equity investments are high-risk high-return propositions. There is scope for serious erosion of capital (losses) as well as considerable appreciation (profits). This depends on many factors such as performance of the company, general market conditions, state of the economy and so on...

In an investment portfolio, the equity portion represents one end of the risk-return spectrum, the high end. No other investment tool gives you this much scope for capital appreciation. 

Fundamental research before equity investment

Image: Illustration by Uttam Ghiosh

You should be aware of the company in which you are investing. Some basic ratio like PE (price to earnings) and EPS (earnings per share) -- both of which give you a signal as to the profitability and future growth of a company -- should be known.

You must have a clear idea of the shares you want to purchase, based on your investment objective, risk appetite, and the fundamental parameters of the share (stock).

Some fundamental parameters are the EPS and the price to PE.

The EPS is found by dividing the profit after tax by the outstanding number of shares in the market. Basically, do not just rely on recommendations received from your broker, friend, lover or anyone else. You can use these as starting points, but ensure that you do your own independent bit of digging before you invest.

Another tip is if you feel a stock price is high, do not buy it. Only buy stocks that have scope for appreciation.

Yet another tip is not to try to time purchases, as a matter of strategy. While seismic upheavals in the stock market will give you obvious signs to either buy or sell, do not rely only on timing the markets. This will turn you into a speculator rather than an investor.

And lastly, if your research shows that the prospects of the company you own do not look rosy in the long term, get rid of the stock. Do not hesitate to liquidate (sell) your portfolio even before your targeted time horizon if you think that it isn't worth it. In the end, it is your money, and above all, you must be comfortable in keeping it invested.

Risks inherent in equity investing

Image: Illustration by Uttam Ghosh

The risk factor in equity investments is appreciably higher than fixed income securities such as fixed deposits or National Saving Certificates, or post office monthly income schemes.

Like any avenue of investment (except those whose returns are guaranteed by the government, like the PPF), equity investing comes with risk. In fact, the risk factor in equity investments is appreciably higher than fixed income securities such as fixed deposits or National Saving Certificates (NSC), or post office monthly income schemes.

Company stocks are susceptible to risks, and these risks are carried forward to your investments as well. Here are a few:

Business risks: The risks associated with the prosperity of a business and the demand for its products. There is always a risk that buyer profile or habits might change suddenly and a company's product goes from being the rage to become an also-ran.

Financial risks: The skill with which a company's finances are managed to ensure that it has an optimum level of debt, equity, reserves, etc. If a company's financials are ineptly handled, even in the short term, chances are that the ineptness will show up as a run on (decrease in value of) the stock in the future.

Industry risk: Changes in technology, regulations, vogue, etc can affect the performance of an industry sector as a whole, and a company stock of that sector might take the hit along with all its other competitors in that sector.

Management risks: The level of corporate governance, management skills and vision determines the long term health of a company. Short term, ad hoc management decisions to ramp up profit sheets invariably leads to long-term grief for that company (case in example, the erstwhile Satyam Computers).

Exchange rate risks: These factors affect a company but are outside its control, such as a sudden strengthening of the rupee that might affect exports, having adverse effect on an export-oriented company's stock.

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