A beginner's guide to the stockmarket

Want to learn more about the stockmarket and how to go about buying and selling shares? Read our back-to-basics guide to get you started.

What's the point of stockmarkets?

Stockmarkets have a much higher purpose than events such as the dotcom bubble of the late 1990s would suggest. For centuries, they have been vital in facilitating the transfer of capital from individuals who don't need it immediately to companies that do.

The concept behind exchanges goes back to the 16th century. Until then, firms had generally been owned by small groups of private individuals. But then came the huge opportunities offered by foreign exploration the voyages to the East Indies, to India and Africa. These endeavours were far too expensive and indeed far too risky for the cost to be borne by one man or partnership alone. The answer? Limited liability and the first real joint-stock companies.

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The East India Company, launched on 31 December 1600, was a classic case in point. It needed vast amounts of money for voyages from which there was no guarantee of return. So it offered shares to individuals in return for cash, the idea being that the risk would be spread among all the investors; there would be no set return on the shares, but if the company did well its proceeds would be divvied up between all the shareholders.

This worked a treat. As trade developed, the investors did extremely well: the tenth voyage (in 1611), for example, returned investors 148%. By the end of the 17th century, many more were getting in on the game there were more than 100 joint-stock companies with tradable shares, and merchants and traders had started to gather in London coffee shops.

This system was formalised in 1801 with the creation of the London Stock Exchange and since then barring a few hiccups, such as the South Sea Bubble and the collapse of the railway boom, for example it has barely looked back.

Today, the London Stock Exchange (LSE) runs Britain's biggest exchange with 1,800 companies making up what is referred to as the main market'. In addition, the LSE runs the Alternative Investment Market (Aim), which is a starter market' for young companies that offers trading in another 1,040 firms.

Why do companies list on a stock exchange today?

For two main reasons. The first is to enable the current private shareholders to sell some of their stake to realise gains. When online poker company PartyGaming floated in June, its founders made £797m by selling just 20.6% of the company to investors.

Alternatively, the aim of a new listing may be to raise money to expand the company (as it was back in the days of the East India Company). In this case, rather than selling their own shares, the owners will issue new ones to the public: they will then own less of the company, but the company as a whole should be worth more due to the new injection of cash that can then be invested.

Companies are not restricted simply to raising money on the stockmarket once the East India Company came back to investors time after time; it raised £1.6m between 1617 and 1622, for example. But firms don't always come to market for cash just to fund expansion or acquisitions: they may also need the cash to prop up their finances in the wake of business failures.

How do I buy and sell shares?

Historically, trading shares was considered to be another perk of the rich: you had to buy and sell through certain stockbrokers and it was extremely expensive. There was little free flow of corporate information, so it was those with the inside information that made most money.

The latter may still be true (if illegal), but the stockmarket is at least now open to all. The 1990s ushered in an era of freedom of information anyone can find out pretty much anything on the internet forcing brokers to offer a no-frills execution-only' service (this means that they don't bother you with their opinions on what you should buy or sell, but just do what you ask them to).

The likes of Hoodless Brennan does this for a mere £7 a trade, whether it is over the phone or online (https://www.hoodlessbrennan.com/). Square Gain (https://www.squaregain.co.uk/) offers execution-only for £12.50 for each trade, as does Share Call (https://www.share.com/0800/default.htm).

If you want advice, Hoodless Brennan also offers an advisory service for £7-£15 per trade, as does Barclays although its service is more suited to bigger investors, as commission is a minimum of 1.25% of each deal, or £1,000 in a year. Bear in mind, however, that commission is not the only cost. Many brokers will charge you an annual or quarterly fee to keep your account open and UK investors also have to pay stamp duty of 0.5% of the value of their purchases. You can find more stockbrokers and their charges at https://www.find.co.uk/ or https://www.fool.co.uk/.

How do I make money from shares?

Some investors buy shares purely to get a regular dividend income. Right now, you can buy shares in HSBC and get a yield of 3.5%. United Utilities yields a hefty 6.7% and other relatively solid shares, such as BT, yield more than 4%.

Other investors are less interested in income and more in capital growth. However, it is crucial to understand that capital growth is intimately connected to dividends: a share rises in price mainly as a consequence of the expectation that a firm's profits will rise and that, as a result, the dividend payout will also rise. Shares that offer no yield at all will nevertheless rise if the market believes the prospects for the company however long term are good. Not for nothing is the City called a great expectations machine'.

If you are investing for income, you buy shares that pay dividends. If you are investing for capital growth, you buy shares that you expect to be able to pay a massive dividend in the future, whether you intend to hold them for that long or not.

How is a share price determined?

In much the same way as the price of everything else in a free market: by supply and demand. Shares in companies that are judged to be unsound or overpriced will not attract investors and prices will fall. However, shares in firms that are successful or are perceived as being likely to be successful create demand and will rise.

In the short term, press releases, newspaper stock tips, reports from professional analysts and sentiment drive share prices. This is what happened in the 1990s euphoria pushed the prices of technology stocks to silly levels. However, in the long term, the truth always comes out in markets: shares that are too cheap rise in price and shares that are too expensive fall in price.

How do I work out if a share is good value?

Many refer to the dividend yield, which is the annual dividend paid to shareholders expressed as a percentage of the share price. You can find details of these in newspaper share listings, along with other key data, such as p/es but some you will have to calculate yourself.

The yield is the cash return on the share, so you can compare it with the returns on bonds, savings accounts and other stocks. A company with a yield higher than the interest on a savings account is worth a look for income investors.

However, a high reported yield is not in itself a reason to buy a share. Yields are worked out on the basis of what a firm paid out last time. But nobody knows what they will pay out next time. At present, companies are cash rich, so on top of dividends many are buying back shares (for example, BP) another indicator that a company's finances are solid.

A high yield can suggest a rising perception of risk: if investors think a firm is no longer financially stable, they will sell its shares, forcing the price down and its yield (remember, this is the dividend divided by the share price) up.

What about price/earnings ratios?

The price/earnings (p/e) ratio is another good indicator of value. A historic' p/e is the company's current share price divided by its last reported earnings-per-share (EPS). A prospective p/e is the share price divided by the forecast EPS. Both figures tell you how many years, at the given profit level, it will take the firm to make as much money as you are paying for each share.

The average p/e of shares listed on Western markets has hovered between ten and 14 times, but there is no correct' p/e. Shares in a company that is growing may trade on a very high p/e, but this merely reflects the fact that investors expect profits to rise fast.

Many investors look at the p/e in conjunction with the p/e to growth, or PEG, ratio. This divides the prospective p/e by the anticipated rate of earnings growth per share and indicates whether a firm is reasonably priced, given its growth potential. The lower the ratio, the better.

Most investors prefer PEGs closer to one or even better, closer to zero. Bear in mind, however, that just because a share looks cheap, that doesn't mean its price will rise: the numbers only tell you what should happen, not what will, or when it will.

If I buy, when should I sell?

During the 1990s, all shares appeared to be rising, and there rarely seemed to be a need to sell. But when the market collapsed, a lot of people were burnt. It is wise to be an active trader because you are likely to have both winners and losers. The best way to ensure that the losers do not overwhelm the winners is to listen to star fund manager Hugh Hendry and "only hold shares that are going up". Sell falling shares as soon as you realise you have made a mistake. Hold ones that are rising until the fundamentals change. The key is never to become emotionally attached to a share: if your shares are losers, dump them.

How many shares should I hold?

Only as many as you can follow, while being reasonably diversified. There is no way that you can single-handedly watch 100 companies. It is better to have 15-25 and know them well. Fewer than that and you may find yourself too exposed to one share.

How can I buy and sell my shares tax efficiently?

Inside a self-select Isa. Most brokers offer this facility: they provide you with an empty Isa wrapper. You are then allowed to fill it with £7,000 worth of shares a year and to trade them freely. Any capital gains you make will be tax-free.

Recommended further reading:

For more on the basics of of buying and selling shares, read: What you need to know about trading shares. Then see our section on share tips to get you started.