THE STOCK MARKET

 In this second article of a regular feature, John Smith explains the fundamentals of investing in the stock market.

 When a new company is formed it issues “ordinary shares” and the price of a single “share” will be determined by two factors. First, how many shares it is decided to issue and secondly the “market value” that specialists place on the whole business. Normally, this value is fixed by applying a “multiple” to the current net profit of the business. Often, a big factor in setting a multiple is the “sector” that the business fits into. For example, Banks and Insurance companies tend to operate on fairly low multiples whereas Information Technology and Retail businesses are generally higher. Market sentiment plays a part in this. Banks may be seen as “old hat”, steady but boring whilst a new computer or technology business holds more excitement.

 A typical multiple in valuing a company would be 15. So, for example, if the business makes £1m profit a year and 15 million shares are issued then the price of each ordinary share will be set at £1.

 Ordinary shares are referred to as “equity” and because they are not backed by any assets or security of any kind, they represent the “risk capital” of the company. Going back to the brief history set out in the first article last month, many pioneering ventures over the years, such as the building of the railway system in the 1800’s, could not have occurred if ordinary people had not invested in the risk capital of the new railway companies. They risked their money in anticipation of the initial share price rising as operating profits grew. Equity in a company is the same as in the home you “own”. What you own is the market value of your property less the mortgage attached to it. That equity is always at risk, it could go up but also it could go down.

 Many people think they have no involvement in ordinary shares. This is unlikely to be so. Anyone who invests in a pension scheme, holds an ISA or has money in a Unit or Investment Trust for example is beholden to a greater or lesser degree to the performance of The Stock Market. It will be indirect, but it exists nevertheless.

 Next month, a direct investment in The Stock Market will be discussed.

Visit John's website www.jgwalkersmith.co.uk for details of his latest book "Violets"