# How Does The Stock Market Work? – Part 2

In the first part we saw how two entrepreneurs Billu and Tillu started a company B&T Private Limited and grew it in the first five years before approaching an investor, who put in ₹20 lakh into the company in an exchange of 20% stake.

At the end of first part I had asked you these two questions:

- Where does the investor’s remaining ₹17.5 lakh go?
- Where does all the profit which the company has earned during the first five years go?

For this, we must first understand the basics of financial statements. Let’s come to the Profit & Loss Statement first. I’m simplifying this for you to understand.

Expenses means all the expenses like raw material, staff salaries, rent, taxes etc. Below is the Profit & Loss statement of Hindustan Unilever. (Source: Hindustan Unilever 2020 Annual Report)

As you can see from the above profit & loss statement, there is revenue which the company earned during the financial year 2019-20, then there are expenses like raw material cost, employee salary, depreciation, taxes etc.

*(Financial Year starts from 01 April and ends on 31 March of the next year)*

Now what happens with all the profits which the company earns? The promoters have two choices: either distribute these to the shareholders or reinvest back into the company. As this is an early stage startup, which is in the growth phase, they decide to put all the profits back into the company for future growth.

This is the basic equation of the balance sheet.

And this is how a balance sheet of a real company looks like (Source: Hindustan Unilever 2020 Annual Report)

*Don’t worry even if you don’t understand anything. We will get into details of reading financial statements in a different article.*

As you can see, there is a reserves part in shareholder’s equity. Whatever part of profits the promoter puts back into the company for future growth goes into reserves. Also for any capital raised, the premium paid to the face value goes into reserves.

As is our case, the investor is also paying a premium to the face value, so the balance ₹17.5 lakh goes directly in reserves. Also the profits earned goes back in reserves.

It’s been ten years since inception and B&T Private Limited has expanded their operations all across New Delhi, and has now become the preferred choice for customers there. It now earns an annual profit of ₹1 crore. Now the promoters decide to expand in nearby areas. For this they decide to approach a venture capital firm (Venture Capitalists have a large pool of funds to invest in early stage, high growth companies).

For this expansion, the promoters need ₹10 crores. After a long discussion with the VC firm, they agree to get ₹10 crore in exchange of one third of the company, valuing the company at ₹30 crore (₹30 crores / 33.33%). This means they have to issue additional shares (as they want to put that into the company), so as the VC firm gets one third of the total. To achieve this, they issue fresh 625 shares, taking the total number of shares to 1875 (existing 1250 + newly issued 625). The per share price which the VC firm pays for the company comes out to be ₹1,60,000, which is 20 times what the previous investor paid. Remember that this fresh issue is also done at a face value of ₹1000.

If you look at it, the promoters Billu and Tillu will still be owning 500 shares each and our first investor will be owning 250 shares and the VC firm will be owing 625 shares. The shares owned will still be the same, but the total stake (in %) will be changed after each round.

Investor |
Shares |
Stake (in %) |

Billu (Promoter) | 500 | 26.67% |

Tillu (Promoter) | 500 | 26.67% |

Investor | 250 | 13.33% |

VC Firm | 625 | 33.33% |

Total |
1875 |
100% |

**Understanding the P/E ratio**

If you look at what our investor paid and what our VC firm paid for the company, you’ll start understanding better. Let’s start with our investor first. He received 250 shares, at a price of ₹8000 per share when the company was valued at ₹1 crore at a time when the total profit of the company was ₹5 lakh. This means the company at that time was worth (if the company were listed, it would be called as **market capitalization**) ₹1 crore.

So, the per share value of the company was ₹8000 (₹1 crore / 1250).

Similarly, we can calculate Earnings Per Share (EPS), which means the profits earned per share. The total profits per share were ₹400 (₹5 lakh / 1250).

Now let us understand what the famous P/E multiple is. The price-earnings ratio, also known as P/E ratio, P/E, is the ratio of a company’s share price to the company’s earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

In other words, the P/E ratio is the number of years it would take to recover your investment if the earnings of the company were to stay the same.

Our investor paid a price to earnings (P/E) multiple of 20 (₹1 crore / ₹5 lakh). Fast forward five years, the company was earning ₹1 crore profits, at the time when the promoters decided to go for another fundraising with our VC firm. The VC firm received 625 shares of the company and the value of the company was ₹30 crores when the transaction took place. The per share value of the company, as seen above, comes out to be ₹16,000. Also the company earned a profit of ₹1 crore during that year. That puts the earnings per share (EPS) at ₹5333.33 (₹1 crore / 1875).

Based on the price per share and the earnings per share, our VC firm paid a P/E multiple of 30 (₹1,60,000 / ₹5333.33), which turns out to be higher than what the previous investor paid. The P/E multiple had expanded from 20 to 30 in five years. This expansion of P/E multiple is called as** P/E multiple expansion**, a phenomenon which is seen in case of high quality and growing businesses.

In this article, you have learned about how fundraising takes place in a company, and understood about some basic terminologies of the stock market, such as market capitalization, earnings per share (EPS), price to earnings (P/E) ratio. In the next article, we’ll see how B&T Private Limited grows in future.