How the Market Works?

The common myth is market works based on demand & supply. It’s true to some extent but most part markets work based on manipulations. While most of you may think, this is some conspiracy theory, but it’s not. That’s a hard fact. Markets work based on manipulations & that’s true for every market including equities, commodities, currencies & crypto.

But before we go into that aspect let’s try to understand how do these assets derive a price or valuations as they call it. Well it’s complex, I will try my best to explain in a simplest possible way.

Chapter 1

How assets derive their valuations ?

Let’s divide the markets across different asset classes first:

• Equities (stocks)
• Commodities
• Currencies (forex)
• Bonds
• Real Estate
• Alternative Investment
• Crypto Currencies

For the purpose of understanding we will focus on equity valuations. Actually it’s a funny world and once you learn how it all works, you will really enjoy it.

So let’s assume you want to setup a business to sell cookies! The business requires 10,000$ investments. Assuming you have all the money & you are the sole investor. In this case the business will be called “proprietary” business. Assume business delivered 4000$ profits after tax. As a sole owner you get to keep the entire profits. Now assume you want to sell the cookie business after 2 years, at this stage your annual profit is 4000$ & your investment in the business was 10,000$. By this time you already received 8000$ profits out of the 10000 investments. And your assets have depreciated in value. However you can ask for something called Profit Multiple / Price Earning Multiple or in simple language premium. You may demand 20,000$ which is equivalent of next 5 years profit. The buyer may offer you 2–3 years equivalent of profit. Let’s assume buyer offered you 16000 & you sold your business.

Now let’s assume BUYER is not one person but 2 people who are business partners. Let’s assume one guy invested 6400 & the other one invested 9600. So they are 40:60 partners. Now the business is growing and makes 10,000$ annual profits after tax. They both decided to split the profits between as per their 40:60 ratio. That’s called Profits Distribution.

They run the business for 5 years & grow the business that now makes 100,000$ annual profits. They now want to setup their own cookie factory & few more outlets. They need around 1,000,000$ financing.

They go to investment bank & take their help to raise funds. The bank introduced them to Venture Capital Firms. Venture Capital firms are in the business of investing funds in early stage companies. The partners now want to raise 1 Million $ & want to offer 50% of their company’s shareholding to Venture Capital Firm.

So effectively they are valuing their company at 20 times of their annual profit of 100,000 x 20 = 2,000,000 & offer 50% at 1,000,000 to the new investor. This is called Pre Money Valuation.

Number of times is called Price Earning Multiple or PE Ratio. This is the single most important factor to decide if a stock is under valued or over valued in stock market.

Let’s get back to the transaction. So while 20 times pre money valuation may sound too much consider the annual profit is only 100,000 & the partners are expecting 2 million valuation, however if they indeed get this 1,000,000 investment, their annual profits are likely to jump to 400,000 after they setup their own cookie factory, so on a Post Money basis the valuation Multiple is now only 5 times & not 20 times. This is called post money valuation.

Now let’s assume the Venture Capital Firm invested 1 million than the business can be converted into a joint stock company. Instead of partners, there are now shareholders.

VC investor : 50%

Partner A : 20% (He was 40% But now reduced to 20)

Partner B : 30% (He was 60% But now reduces to 30%)

Let’s assume 5 years down the line, they want to build a larger factory & they now need 25 million dollars. By this time the existing business is generating 2,500,000 annual profits. Their advisors decided to raise the money through Initial Public Offering (IPO). IPO is basically same as ICO but here instead of coins the company will issue shares. The company, shareholders & advisors decided to value the company at 50 million $ & Sell 50% Shares in IPO to raise 25 million $.

At 2,500,000 profits the pre money valuation was 20 times PE Multiple. Their expected profits after the new money invested was 5 million so post money valuation was at 10 Multiple.

So the entire game is based on something called Price Earning Ratio or PE Multiple. How much an investor is willing to pay depends on the nature & type of industry.

For example a commodity business like still can command a Price Earning Multiple of 4 vs an Internet Company like FaceBook or Google which can command a PE Multiple of 100. A biotech company which is inventing new drugs may demand and command a price Earning Multiple of 60–100 vs a generic pharma cosmonaut which is producing bull drugs which may command 10–12

The price Earning Multiple ratio depends on the complexity and nature of the industry. How easy or how difficult is it to replicate that business is where the biggest valuation comes from.

Now you may ask what about those companies which never made any profits & still raised billions of dollars. How are they valued ? Well let’s take an example of UBER. UBER is yet to turn significant profits but is valued at 69 billion dollars. This is possible in emerging industries where the scale of the business is such that initial few years may be required to build the business and customer acquisition. There are complex valuation models (well jargons used by large private equity firms to justify those numbers).

All in all, either you need to be a profitable business to command a large PE Multiple or you need to So an exponential growth potential to deserve a large valuation. In both cases the investor is acquiring underlying shares of the company & becomes part owner / shareholder of the business. If the business is sold for a huge value, the shareholder gets the benefit and upside in the share valuation.

When an investor invest in stocks he gets share holder benefits which includes dividends from the profit of the company, upside in share price and all rights as a share holder.

Now let’s talk about Crypto. How crypto is valued ? Where do they get their value from ? What valuation matrix used ? Why some crypto is 100 Billion vs some at 1 million valuation. What does a coin holder get ? What rights a coin holder has ? More on the next chapter…….

(Pardon typos)