Important terms (shares and trading): Part 2

In this post, some of the other important terms related to shares and the stock exchange have been taken up for discussion.

Derivatives

A derivative is a contract whose value depends on the underlying asset. Futures, forwards and options are all of derivatives. Now, let us briefly understand them

Forwards and futures

A forward contract is a customised agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. For example, A and B enter into an agreement on 1/06/2011 under which A will buy from B 12 mangoes on 1/07/2011 at Rs. 5 each.

Futures are nothing but a special type of forward contracts because they are standardised in nature and are traded in stock exchanges.

Options

An Option is a contract which gives the buyer the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price (also called Strike Price). The buyer of an option pays the “option premium” to the seller of the option to get the right to exercise his option. The writer of an option is obliged to sell/buy the asset if the buyer exercises it on him. It should be noted that the option premium is forfeited in case the option is not exercised and is adjusted in the price initially decided if the option is exercised.

Options can be classified as American options and European options. In the former case the option can be exercised on any day up to the expiry date, whereas in the latter case it can be exercised only on the expiry date. The options traded in India are all American options.

Options are of two types - Calls and Puts options:

‘Calls’ give the buyer the right to buy a given quantity of the underlying asset; and ‘Puts’ give the buyer the right to sell a given quantity of underlying asset (at a given price on or before a given future date).

A call option is exercised if the market value of the asset is more than the price agreed upon. On the other hand a put option is exercised if the market value of the asset is less that the price agreed upon (adjusted for the premium in both cases).

The concept of leverage

Time and again we come across the term leverage in newspapers and magazines (with respect to shareholders). Leverage is the benefit that the shareholders get due to the loan taken by the company in the form of debentures, bonds, etc.

We shall understand the concept of leverage with the help of the following example:

There are two companies A and B, which have a profit of Rs 100,000 each. Both the companies required Rs 100000 for expansion. Company A raises the required amount by issuing 10000 shares worth Rs 10 each. Company B on the other hand issues 5000 shares worth Rs 10 each and issued 5000 10% debentures worth Rs 10 Each . Now, let us compare the Earnings per share (EPS) of the two companies:

COMPANY A	COMPANY B
Profit  before interest     Rs 100000	Profit before interest     Rs 100000
Interest                        (Rs 0)	Interest                 (Rs 5000)
PBT                              Rs100000	PBT                       Rs 95000
Tax                              (Rs 50000)	Tax                       (Rs 47500)
PAT                              Rs 50000	PAT                       Rs 47500
EPS                              Rs 5	EPS                       Rs 9.5

 (PBT= Profit before Tax, PAT= Profit after Tax, EPS= PAT/(number of shares) Figures in brackets mean an expense and the tax rate is 50%)

From the above example it is clear that the EPS is higher in case of the company that has taken a loan.

With this post, I come to an end of the series of articles pertaining to the stock exchange and shares. I have purposefully kept mutual funds out of the discussion because I would later come up with an entire post related to mutual funds. I hope that the readers found the posts useful. Feedback, suggestions and comments are welcome.

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Important terms (shares and trading): Part 1

In the last few posts I had attempted to introduce to my readers the basic concepts of shares and the stock exchange. In this post, some more commonly used terms– Book Building, Dual Listing and Preferential issue have been taken up for discussion.

Book Building

According to SEBI Guidelines 2000, Book Building means a process undertaken by which demand for the securities proposed to be issued by a body corporate is elicited and built up, and the price for such securities assessed, for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memorandum or offer document.

In case of book building, the investors place their bids at different prices and finally the price at which there is maximum demand is selected. The prospectus generally contains a base price and a maximum price between which the bids are made for the securities. The spread between the base price and the maximum price cannot be more than 20%. For example, of a company issues n number of securities with a base price of Rs 100, the maximum price cannot exceed Rs 120 (Rs 100 + 20% of Rs 100)

Difference between book building and fixed issue:

In case of a fixed issue, the price of the issue is fixed first and then the securities are offered to the investors. However, in case of book building, the price is determined on the basis of the demand.

The demand for securities in case of a fixed is known only at the close of the issue, whereas the demand is know on a regular basis in case of book building.

Dual listing

Dual listing is a process that allows a company to be listed on the stock exchanges of two different countries and hence the shares of the company are traded in both the stock exchanges. Dual listing generally takes place when companies belonging to two different companies enter into an equity alliance. Royal Dutch Shell (UK/ Netherlands) and Unilever (UK / Netherlands) are examples of companies which have their shares .

Dual listing is not allowed in India and it will need major amendments to key corporate laws of the country to allow dual listing. The Foreign Exchange Management Act (FEMA) too would need to be amended because case of a dual listed company, an investor can buy shares in one country and sell it in an overseas market and this would require the Indian rupee to be fully convertible. Also, it should be noted that domestic trading in shares denominated in foreign currency cannot take place without the permission of the Reserve Bank of India. It should be noted that the dual listing was one of the prime reasons for failure of the Bharti-MTN deal in the year 2009.

Preferential issue

A preferential issue is an issue of shares or of convertible securities by listed companies to a select group of persons under. The issuer company has to comply with Section 81 of the Companies Act, 1956 and to the guidelines laid down by SEBI. A preferential issue is neither a rights issue nor a public issue, and is a faster way to issue shares.

I hope that the readers will come up with questions and feedback. In the next post, some other important terms like futures, options and leverage would be taken up.

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The Stock Exchange: An Overview

The stock exchange is often termed as the barometer of the economy. In this post, an attempt has been made to briefly discuss some of the terms related to the stock exchange.

As per the definition given by The Securities Contract (Regulation) Act, 1956 a Stock Exchange is a body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.

The stock exchanges in India are under the overall supervision of the regulatory authority, the Securities and Exchange Board of India (SEBI). These exchanges provide a trading platform, where buyers and sellers can transact in securities. At present there are 21 recognised stock exchanges in India. To see the list of stock exchanges in India, click here.

Thus, to be precise, it is a regulated market for the buyers and sellers of securities.

Demutualised and mutual stock exchange

In a mutual exchange, the functions of ownership, management and trading are concentrated into a single Group. Here, the broker members of the exchange are both the owners and the traders on the exchange and they further manage the exchange as well. This at times can lead to conflicts of interest in decision making. A demutualised exchange, on the other hand, has all these three functions clearly segregated, i.e. the ownership, management and trading are in separate hands. NSE is an example of a demutualised stock exchange.

Listing of shares in a stock exchange

The shares of a company can be listed on a particular stock exchange (or exchanges) after fulfilling the conditions laid down by that particular stock exchange. It should be noted that all stock exchanges do not have a unique set of prerequisites for listing.

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BSE and the NSE

The history of the Bombay Stock Exchange (BSE) dates back to the year 1875, when 318 persons who had contributed a sum of Re. 1 each to become a member of the exchange. It is the oldest stock exchange in Asia. The BSE came up with the BSE SENSEX in the year 1986. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. In 1995, the BSE successfully moved to electronic trading from the open-cry system of trading. The BSE has the largest number of listed companies in the world. Please click here to know the listing criteria of listing requirements of the BSE. The BSE SENSEX is made up of 30 companies.

The National Stock Exchange (NSE) is a stock exchange located at Mumbai, India. It was incorporated in the year 1992. It is the 9th largest stock exchange in the world by market capitalization and largest in India by daily turnover and number of trades. The index S&P CNX Nifty was launched in the year 1995. The base period for the S&P CNX Nifty index is November 3, 1995. The base value of the index has been taken as 1000. In the year 2000, the NSE became the first exchange in India to started trading of stocks on the Internet. To know the listing criteria of the NSE, click here. The Nifty index is made up of 50 companies.

What is an Index?

An index is a basket of securities that is used to track the changes in the stock market. Securities from various sectors of the industry form a part of the index. Weights are assigned to the securities on parameters like market capitalisation, share price, etc. The securities that form a part of the index are from different sectors; hence they reflect the changes in the entire economy. For example, S&P CNX Nifty is an index that is composed of 50 stocks of various companies belonging to more than 20 different sectors of the economy. An index is revised regularly by varying the companies that form a part of the index. For e.g. if in a particular market scenario, assigning higher weights to petroleum companies can lead to distortion of figures, the weights will be adjusted to depict a more realistic figure.

To illustrate the working of an Index in a Stock exchange, suppose we have an Index named S&P ABC Swifty which indicates the performance of stocks at ABC Stock Exchange. ABC Exchange has in total 100 company’s shares listed on it (from varied sectors of the economy), out of which stocks (and not shares) of 5 companies have been chosen (assume the economy has only 3 notable sectors) to formulate the S&P ABC Swifty. These 5 company stocks are such that they provide an overview of the entire economy.

Now, let’s assume the weights are assigned on the market capitalization of the company.

Company	Market Capitalization (in Rs. Lakhs)	Weight
A	1	0.1%
B	2	0.2.%
C	3	0.3%
D	4	0.4%
E	5	0.5%

Thus total value of S&P ABC Swifty is 5500 points, as of the closing day for, say, 13.05.2011

If the same value falls to, say, 5450 as on the closing day 14.05.2011, we’ll say Swifty has fallen by 0.91% (Bad news for the economy and the investors).

Hope this gives you a rough idea of how the index works. Remember, the actuals are much complex and boggling but you may still draw some parlance with the example.

We hope that the readers were able to understand the basic terms related to the stock exchange. Suggestions, feedback and comments are welcome.

(Co-authored with Dola Halder, B. Com. (Honours), SRCC)

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Shares: An overview

In the last post, some common terms related to shares were discussed.  Now, we would get an overview of some common types of shares and differences between shares and debentures.

Shares: As mentioned in the previous post, a share represents a faction of an individual’s ownership in the company. For example, if the equity share capital of a company is Rs 500000, and it is divided into 5000 shares, the value of one share is Rs500000/Rs 5000 = Rs100. Thus, an individual holding 1000 shares has a 25% ownership in the company.

Equity shares and Preference shares are the two most common types of shares. The primary difference between equity shares and preference shares is that in the latter case the shareholders are entitled to receive  a fixed rate of dividend which is to be paid before dividend can be paid in respect of equity shares. Another important difference is that the preference shareholders enjoy priority over the equity shareholders in payment of surplus and on liquidation of the company. There are several types of preference shares, two of the most common ones are:

·        Cumulative preference shares: In this case the accrued dividend keeps on accumulating till paid.

·        Convertible preference shares: Here the preference shares are converted to equity shares after a stipulated time period or after certain conditions are fulfilled.

Rights Shares: These are those shares that are issued to existing shareholders at a certain price in proportion to the shares held by them. For example, if a company comes up with a rights issue in the ratio of 1:5, each shareholder who currently has five shares is offered one share at a definite price. The shareholder is free to accept or reject the offer.

A rights issue should not be confused with a bonus issue. In the latter case, the shares are distributed in a particular ratio among the existing shareholders free of cost. The issue of bonus shares does not bring money into the company, whereas an issue of rights shares does.

Debentures: A debenture is a certificate of acknowledgement of debt. When a company issues debentures, it raises money in the form of loan, and hence the debenture holders are creditors to the company. Debenture holders are entitled to receive a fixed rate of interest, irrespective of the profit or loss of the company. Convertible debentures are the most common types of debentures. Here, the debentures are convertible to shares after a stipulated time period or after fulfilling certain conditions.

Difference between shares and debentures

The shareholders of a company are owners of the company, whereas the debenture holders are creditors of the company. The dividend payable to shareholders varies with profit (in most cases, when there is no profit, no dividend is paid). On the other hand, a fixed rate of interest is payable to the debenture holders irrespective of the profit or loss. Debenture holders are exposed to less risks as compared to the shareholders because in the former case, the income is regular in nature. It should be noted that at the time of liquidation of the company, the claims of the debenture holders are settled before the claims of the preference and equity shareholders.

In the next post, the basics of stock exchanges and trading would be taken up. I request the readers to come up with questions, comments and suggestions.

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Shares: Basic concepts and terminology

We often come across terms related to shares and stock markets in the newspapers, and many a times we are not very clear with the meanings of these terms. In this post, an attempt has been made to explain the basic terms related to shares. In some of the following posts; the types of shares, terms related to the stock exchange, derivatives and trading will be discussed.

Share: A share represents a faction of an individual’s ownership in the company. For example, if the equity share capital of a company is Rs 500000, and it is divided into 5000 shares, the value of one share is Rs500000/Rs 5000 = Rs100. Thus, an individual holding 1000 shares has a 20% ownership in the company. There are several types of shares, equity and preference shares being the most common ones.

Face value: The face value of a share means the price of the share. For example, if a company has total equity share capital of Rs 500,000, and the number of shares are 5000, then the face value of each share is Rs 500,000/5000=Rs100.

Issue price: Issue price refers to the price at which the shares are offered to the public. Issue price of a share may be more or less than the face value. If the shares are offered at a price that is greater than the face value, it is said to be issued at a premium. On the other hand, if a share is offered for share at a price less than its face value, it is said to be issued at a discount.

Market Price: Market Price of a share is the price at which the shares are being currently changes.

Now, a trick question: Which amongst the following will be WOW choice:

1. A Rs.9 of XYZ and Co. share with face value Rs.1; or
2. A Rs.99 of XYZ and Co. share with face value Rs.1?

Well, as long as you have the same amount of money to invest, it doesn’t make a pinch of difference. You will end up with the same amount of percentage holding with XYZ and Co. folks.

Market Capitalisation: The term Market Capitalisation refers to the total value of all shares of a company. For example, if the number of shares are 100 and the market price of each share is Rs 50, the market capitalisation is Rs50*100=Rs 50000. It should be noted that the market capitalisation is not calculated taking into account the face value of a share.

Stock: A stock refers to a bundle of shares. It should be noted that unlike a share, a stock can be expressed in fractional terms. For example, if 1 stock=100 shares, 25% of the stock would mean     (25 %)*(100 shares) = 25 shares

Dividend: Dividend refers to that portion of the earnings of the company that are distributed between the shareholders. The dividend is always calculated on the face value of a share.

Divided per share: It is calculated by the formula-(Face value)*(%age divided declared). For example, if a company has declared a dividend of 10%, and if the face value of one share is Rs10, the dividend a person who holds 10 shares of the company is (Rs10*10%)*10= Rs10.

Bonus shares: Bonus refers to those shares that are issued by companies free of cost to the existing shareholders, generally on a pro-rata basis. For example, if a company declares a bonus issue in the ratio of 1:5, each shareholder who has five shares is entitled to receive one bonus share.

Price-Earnings Ratio: It is the ratio of the Market price per share and the Earnings per share. For example, if the market price is Rs10, and the earnings per share is Rs2, the Price Earnings Ratio is    Rs 10/ Rs2 = 5. (Earnings per share is calculated by the formula- Profit/Number of shares)

We hope were able to explain clearly the meaning of some frequently used terms. Please feel free to revert back with queries and comments. That’s our dividend for this share of information investment.

(Co-authored with Dola Halder, B. Com. (Honours), SRCC)

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