Evolution of Paper money

In earlier times, anything ranging from rice to cotton to food products like honey could serve as a medium of exchange

Over time, the economies, that survived on the barter system or in-kind transactions-systems became lesser and lesser in number, and slowly and steadily the medium of exchange kept evolving, from day to day goods like rice and crops, to cattle, to precious metals

Precious metals such as gold and silver hen became the commonly used medium of exchange and they continue to inspire confidence even now, in some form or the other.

Today, we use only paper currencies as money and therefore it’s interesting to see how this evolution happened continuously over time.

What should an Acceptable ‘Medium of Exchange’ Be Like?

It should be durable
Should be easily divisible into larger or smaller amounts
Should be comparatively scarce; procuring it should require some effort
Should be “homogeneous”: every item of the commodity should be exactly like every other item.
Should be convenient: it should be easy to carry enough around to make trades for other commodities
Should ‘store’ value: should have some perceived intrinsic value of its own

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What is ‘money’?

What is ‘money’?
Money is anything that is generally accepted as payment for goods and services and repayment of debts.  The main uses of money are as a medium of exchange, a unit of account, and store of value.

Evolution of Money: ‘Double Coincidence of Wants’
There was a time when money did not exist.  If ‘A’ wanted to buy something but ‘B’ did not have it, but ‘C’ wanted ‘A’’s goods while ‘B’ needed ‘C’’s produce (and so on) then through a complicated series of exchanges over time, everyone could get what they wanted.  However, this was dependent on too many factors and took a lot of time.

This sort of problem is prevalent in any society that relies on barter, and is referred to as the problem of a “double coincidence of wants” – situation where 2 people each happen to want what the other person has.  ‘A’ solved the issue by indirect exchange – he had to trade with a 3rd party for an item he did not want, and then trade that item for the product he did want.

This process of indirect exchange can be very inconvenient.  In the course of his day-to-day bartering, ‘A’ may find one day that people tend to prefer ‘honey’ in trade to other items. He begins trading his own goods and services for honey.   ‘A’ does this, not because he likes honey, but because he knows that honey can be more readily traded for what he does want, than what he could obtain by directly bartering with his own goods and services.

This sets up a positive feedback loop. Increased use of honey in barter, causes ‘A’ and others to begin trading their goods and services for honey, not because they like honey, but because they know that the honey can be readily traded for what they do want.

This causes even more people still to being trading and bartering for honey, until finally ‘A’s whole community is bartering and trading, not for what they do want, but for honey.  They then take the honey and trade for what they do want.
This problem overall is caused by the improbability of the wants, needs or events that cause or motivate a transaction occurring at the same time and the same place.

In-kind transactions have several problems, most notably timing constraints.  If you wish to trade fruit for what, you an only do this when the fruit and wheat are both available at the same time and place (and only if someone wishes to trade wheat for fruit).  That may be a very brief time, or never.  With money, you can sell your fruit when it is ripe and take the money. You can then use the money to buy wheat when the wheat harvest comes in.  Thus the use of money makes all commodities more liquid.

Because of the severe cost imposed by the coincidence of wants in an in-kind economy, money tends to emerge naturally as some form of commodity money.

Earlier times, anything ranging from rice to cotton to food products like honey could serve as a medium of exchange.

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From Gold To Paper

Evolution of Money: From Gold To Paper

In the recent past, gold and silver coins were used as a medium of exchange because they were more durable and universally accepted as a medium of exchange.  But they also had posed their own set of difficulties.  For instances one could never be sure of the purity and the quality of the metal being offered in exchange.

This led to the use of metal coins of gold and silver being issued by the king.  All coins carrying the seal of the king carried assurance of quality and weight were universally accepted as a medium of exchange.

But with the development of the printing press, this form of currencies evolved into paper currencies convertible into a previously fixed amount of gold at any time on demand. This worked well for both the people and the king.  People were happy because carrying paper currency was more convenient and the king was happy because it did away with the trouble of minting fresh coins to meet rising demand.

In case of gold coins, gold supply could be increased either by procuring more gold or by lowering the quantity of gold in existing coins and by using the extra gold for minting more coins.

Gold/Silver coins etc were a natural precursor to the use of paper currency, as the value printed on it would be easily convertible to the underlying precious metal.

The second practice of lowering the quantity of gold for minting more coins is called “debasement” and one can simply print more paper currency by reducing the pre fixed amount of gold repayable against each currency.  This led to era of convertible currencies, where you can convert your paper currency at any time with a previously fixed amount of another commodity such as gold.

But as you keep on reducing the pre-fixed amount of gold payable against paper currency, you reach a point when the actual gold repayable is almost negligible.  They you may wonder why you should bother about keeping a paper currency that can be physically converted into gold.  But people wanted to use paper currency only as a medium of exchange for other goods and services and would not have minded losing gold if they were given an assurance that paper currency would not lose its status as a medium of exchange.

It was then decided to make paper currency compulsory for all to accept the paper currency as a medium of exchange.  Paper currency became a legal tender, which means that you had the right to offer the paper currency as a settlement of your debts and others are bound to accept the same.  This is what led to the birth of “fiat currency”.

Gold/Silver coins etc were a naturally precursor to the use of paper currency, as the value printed on it would be easily convertible to the underlying precious metal.

Fiat currencies are worth the paper securities backing them.  To print “fiat currency” it is not compulsory to have the backing of gold, it can be printed simply on the backing of government securities.  So the paper currency you hold loses physical convertibility with gold, however it retains financial convertibility with government securities backing it.  So you can convert you money into government securities and vice versa.  But many also criticize the era of fiat currency for the unbridled increase in money supply.

Recap: Why move from Barter to ‘Money’
The process of evolution of a commodity into a money is general and universal.  It occurs anytime a large group of people, trade goods and services under the barter.  This process can be broken down into simpler parts:

‘Selection pressure’, the force driving the natural selection process, is the problem of a double coincidence of wants.

‘Selectors’ are the intelligent decision makers trading goods and services via a process of indirect exchange.

The selectors, guided only by experience from past transactions, will select from among competing methods of payment, those commodities that can be most easily traded for other commodities and services.

An understanding of the fundamental concepts of money i.e. medium of exchange, measure of value, and store of value etc is not required at at for this process of selection to occur.  The selectors are driven only by their desire to make life easier on themselves more than anything else.

Increased selection of one commodity as a method of payment will only increases its “Preferability” as a method of payment in the eyes of the selectors.  This causes a positive feedback loop to occur, causing even more selectors to select this commodity as a method of payment.

The end result of this process is that over time, an entire population of people are now buying and selling their goods and services in exchange for that single commodity only.  By definition, this commodity is money, whether the selectors are aware of it or not.  When a commodity is used as money, the money is called “commodity money”.  Among primitive tribes, everything from shells, to cattle, to cocoa beans have been used as commodity money.  Gold and silver were used as commodity money right up to the beginning of the 20th century.

Price Shocks?
Fiscal measure?
Declining output?
Excess money supply?
Monetary tightening?

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What is inflation?

Introduction to Inflation

Inflation is defined as the increase in the general level of prices of goods and services from one period to another (generally one year).

It is measured in terms of percent change in the value of price index consisting of a basket of goods of services.

An inflation rate of 10% means that the general level of prices of goods and services has increased by 10% over the previous period.

In other words purchasing the same amount of goods and services will cost you 10% more than what it would have cost you in the previous period.

Hence Inflation can also be described as a decline in the real value of money- a loss of purchasing power in the medium of exchange which is also the monetary unit of account.

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Why do prices rise and fall?

Prices of goods and services in a free market are determined by the forces of demand and supply. Thus you cannot have constant prices unless and until you have a constant demand for these good as and services along with a constant rate of supply
In general it is observed that demand increases faster than the supply which leads to an increases in prices over a period
However in unusal times, when demand falls you may actually see a fall in the general level of prices, which in technical terms is called “Deflation”
An increase in the general level of prices implies a decrease in the purchasing power of the currency.  That is, when the general level of prices rises, each monetary unit buys fewer goods and services.

Is deflation healthy?
Both, a high level of inflation and deflation impact the economy adversely

It is believed that moderate inflation over a period of time is good for the economy because it encourages producers to increase output

However, a high level of inflation or deflation has the opposite effect.

If inflation rises to very high levels then…

It reduces the purchasing power of the money in the hands of the people….

Resulting in a slowing down of demand for the goods and services produced….

Which in turn compels providers of these goods and services to reduce output

On the other hand, a deflationary scenario makes the production of these goods or services less lucrative and so encourages producers to reduce output.

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Type of Inflation

Demand Pull Inflation is caused by the presence of excess money in the system which leads to increase in aggregate demand in the system.  It’s a classic case of “Too much Money chasing Too Few Goods”

This kind of inflation can be controlled by monetary measures such as high interest rates and by asking banks to maintain high case reserves.  These measures act as breaks on money supply.

Cost Push Inflation on the other hand has been caused by supply side constraints.  The high cost of labor or raw materials may force producers to increase the prices of their goods and services.  High crude oil and food prices are examples of supply shocks leading to unexpected increases in prices of their goods and services.

This kind of inflation requires a more careful use of monetary and fiscal measures

Built in inflation is a type of inflation that resulted from past events and persists in the present.  It thus might be called hangover inflation.

Often linked to the “price/wage spiral”, as it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumer as higher prices as part of a “vicious circle.”

In this case, inflation encourages inflation to persist, which means that the standard methods of fighting inflation using either monetary policy or fiscal policy to induce a recession are extremely expensive, i.e., meaning increase in unemployment and fall in real GDP.  Hence, alternative methods such as wage and price controls may be needed as complementary to recessions in the fight against inflation.

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“Core Inflation” and “Headline Inflation”

Difference between “Core Inflation” and “Headline Inflation”.

We hear economist use the terms “Core Inflation and “Headline Inflation”.  What are these?

“Headline Inflation” is most commonly represented by a price index consisting of a basket of different goods and services

“Core Inflation” is what we get after removing volatile elements such as oil and food from the basket of goods and services.

Headline inflation is generally higher then core inflation.

How does inflation affect us?
Inflation will affect you depending up0on where you are place financially

People living on fixed sources of income such as retirees will feel the pinch more, as inflation eats away the value of their income day by day.

In an inflationary scenario, a person living on borrowed money is better off as the rate of interest that he would have paid for his borrowed money would be less than the rate of inflation.  Therefore inflation decreases the real value of debt.

But when you pay back your loan in an inflationary environment your lender realizes that now he can buy a little less than what he could have bought earlier with the he lent to you.

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What is GDP?

Gross Domestic Product (GDP) is one of the measures of economic growth for a country’s economy

It is measured in terms of the monetary value of all goods and services produced within the borders of a country during a year.

GDP (for any year) can be defined in three ways, all of which are conceptually identical

1.    It is equal to the sum of the value added at every stage of production (any intermediate stages) by all the industries within a country, plus taxes subsidies on products
2.    It is equal to the total expenditures for all final goods and services produced within the country
3.    It is equal to the sum of the income generated by production in the country.

GDP refers to the final value of all goods and services produced in an economy.

How is the GDP of an Economy Measured?

There are three official methods to measure GDP
1.    Output Method
2.    Income Method
3.    Expenditure Method

Output of goods and services leads to income for those who are producing, as well as expenditure for those who are consuming the items.  Hence, the value of GDP measured by any of the three methods is exactly the same.  (However, this is not always the case due to discrepancies, errors and omissions in the counting)

Measurement of GDP using any of the three methods yields the same value

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Calculation of GDP

Calculation of GDP: Output Method
GDP = Monetary (market) Value of all goods and services produced during an year
    Nominal GDP (or GDP calculated ignoring effects of inflation) leads to incorrect measurement.  Hence, an adjustment for inflation is required against the current market value, to arrive at the ‘real’ GDP

For eg:
-    Year 1 : 10 units of ‘X’ produced of Rs.10 each, Total value = Rs.100
-    Year 2 : 9 units of ‘X’ produced at Rs.12 each, Total value = Rs.108
o    Increment in total value of output at market value = (108-100)/100, or 8% ­
o    Increment in total value of output at constant price=((9 units x Rs.10 each)-100)/100, or 10%¯
o    Prices rise (from Rs.10 to Rs.12) due to inflation makes it seem as if output has increased by 8%, whereas in reality it decreased by 10%
-    Taxes destroy (­) the cost of production, hence they need to be subtracted from the cost
-    Subsidies also distort (¯) the cost of production, hence they need to be added back to the cost
-    Value of GDP measured at actual cost without taxes or subsidies is called GDP at factor cost.
-    It is important to avoid ‘double counting’ – counting the value of the same good twice.  For eg. If value of steel is counted as raw material cost, it should be deducted from value of cars that use steel as an input.


Final GDP = GDP constant prices – Taxes + Subsidies

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Calculation of GDP : Expenditure Method

GDP = Sum of expenditure from all firms and individuals on consumption of any goods or services

-    Output of goods and services that have a value in terms of money results in expenditure for the consumer.  GDP can hence be derived by measuring the overall expenditure in the market.
-    C + I + G +(X-M)
-    C…..Private consumption from households (for eg; goods and services such as food, clothes, laundry etc)
-    I…..Investment from firms to increase productive capacity (for eg; purchasing machines, office buildings etc) This also includes unsold goods in the inventory of firms.
-    G….. Spendin from Government (for eg; to build hospital, school, infrastructure etc)
-    (X-M)….. Spending from foreign consumer on goods and services produced within our country.  This is calculated by measuring net exports (subtracting the value of imports from the value of exports of goods and services)
-    This method works on the presumption that all the goods and services that the country is producing are consumed amongst these four groups of people.  So if one adds up the total expenses by each of these groups, the total GDP can be measured.


Final GDP = Private Consumption + Firms’ investment + Govt. Spending + Net Exports

Calculation of GDP: Income Method
GDP = Sum of income of all firms and individuals engaged in production of any goods or services
-    Economy is broadly divided into two groups of people
o    Those who contribute their labor
o    Those who contribute their capital
Cost or production leads to income for both these groups of people.  (for eg: a mechanic for cars earns a monthly salary, the shareholders of the car company earn money from dividends, owners of the manufacturing premises earn lease rent and so forth)

If we add income of all firms and individuals engaged in the production of any goods and services within the premises of a country, we can measure the GDP at Factor Cost (which does not reflect the impact of taxes or subsidies)

Taxes distort (¯) the income form production; hence they need to be added back into the income.
Subsidies also distort (­) the income from production, hence they need to be subtracted from the income.

Final GDP = GDP Factor cost + Taxes – Subsidies

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GNP NNP

What is GNP?

-    Gross National Product (GNP) is one of the measures of national income for a given country’s economy
-    It represents the income earned by the nationals of a country, irrespective of their physical residence
-    While GDP is the total value of goods and services produced in the country, GNP also takes into account the value of goods and services offered by Indian companies outside the boundaries of the country
-    Adding the income of a country’s nationals from abroad and subtracting the income of foreign nationals in that country results in ‘Net Income from Abroad’
-    Hence GNP = GDP ± Net Income from Abroad
o    If Net income from Abroad is +ve, then GNP > GDP (where profits earned by nationals of country ‘X’ are higher than the profits earned by foreign nationals residing in country ‘X’)
o    If Net income from Abroad is –ve, then GDP > GNP
o    Value of a product said in country ‘X’ produced by a firm from country ‘Y’ is included in GDP of country ‘X’, however, profits earned in the sale of the product (even if in country ‘X’) are included in GNP of country ‘Y’

GNP = GDP ± Net Income from Abroad











What is NNP?

-    Net National Product (NNP) represents income after taking into account any future needs
-    It is calculated by making adjustments in GNP for description
-    NNP = GNP – Depreciation (of plan and machinery)
-    Depreciation represents the reduction in value of plant and machinery over a period of time.  Every unit of a product which is produced today reduces the power of a machine to produce the same quantity of the product in the future.

NNP = GNP – Depreciation

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What is a Stock Market Index?

-    Stock market indices basically convey the mood of the market and act as the market’s messengers
-    Indices represent different clusters of stocks/industries and the rise and fall in these indices’ values is a close representation of the market’s view on the stocks that make these indices.  Hence, stock market news is cumulatively reflected in the movement of the index
-    Simply put, an index represents the composite value of shares of different companies traded on a particular stock of exchange
-    Till late 1980s, there was no index for India’s stock markets, till the Bombay Stock Exchange (BSE) introduced the ‘Sensex’ in 1986 (which represents composite share value of 30 selected companies trading in BSE).
-    Later in the 1990s, the National Stock Exchange (NSE) introduced another index, popularly known as the Nifty (which represents composite share value of 50 selected companies trading on NSE)
Stock market indices provide us with a common measurement tool for the raise and fall in prices of shares that are traded on the index

First list of companies in BSE Sensex as on 01st January 1978

Companies in the BSE Sensex      
Asian Cables    Indian Organic      
Ballarpur Industries Limited    Indian Rayon      
Bombay Burmah    ITC      
Ceat Limited    Kirloskar Cummins      
Century Textiles    L&T      
Crompton Greaves    Mahindra & Mahindra      
Glaxo Smithkline Pharma    Mukand Iron      
Grasim    Nestle      
GSFC    RIL      
Hindalco    Scindia Shipping [4]      
Hindustan Motors    Siemens      
HLL    Tata Motors      
Indian Hotels Company    Tata Power      
Indian Organic    Tata Steel      
Indian Rayon    Zenith   

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Latest List* of companies in BSE sensex today

Latest List* of companies in BSE sensex today       

Company     Sector      
ACC*    Housing Related      
BHEL    Capital Goods      
Bharti Airel    Telecom      
DLF Universal Limited    Housing Related      
Grasim Industries*    Diversified      
HDFC    Finance      
HDFC Bank    Finance      
Hindalco Industries*    Metal, Metal Products & Mining      
Hindustan Lever Limited*    FMCG      
ICICI Bank    Finance      
Infosys    Information Technology      
ITC Limited    FMCG      
Jaiprakash Associates    Housing Related      
Larsen & Toubro    Capital Goods      
Mahindra & Mahindra Limited    Transport Equipments   
 
Maruti Suzki    Transport Equipments      
NTPC    Power      
ONGC    Oil & Gas      
Ranbaxy Laboratories    Healthcare      
Reliance Communications    Telecom      
Reliance Industries*    Oil & Gas      
Reliance Infrastructure    Power      
State Bank of India    Finance      
Sterlite Industries    Metal, Metal Products, and Mining      
Sun Pharmaceutical Industries    Healthcare      
Tata Consultancy Services    Information Technology      
Tata Motors*    Transport Equipments      
Tata Power    Power      
Tata Steel*    Metal, Metal Products, and Mining      
Wipro    Information Technology   

*ACC, Grasim, Hindalco, HLL, ITC, RIL, Tata Motors and Tata Steel are the only eight companies that have been a part of the Sensex since its inception

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How is an Index Constructed?

-Three basic ingredients have to be judged:
1.    Base year for measurement
2.    Number of companies to be included
3.    Base value (For eg: 10/100/1000)

-For BSE Sensex:
-    Base year: 1978-79
-    Number of companies: 30
-    Base value: 100
-    Date of launch: January 1, 1986 (baseline to 1978-79)
-    Index calculated every 15 seconds

No written rule which specifies number of companies to be included or base value to be consider (Sensex considered 100 as it was neither too large nor too small a value)


On what basis are companies chosen to be part of an Index?
-    Composition of the companies in an index can keep changing periodically
-    Some factors on which the decision to include a company depends on:
o    Size of free float market capitalization
o    Frequency of trading
o    Listed history and track record
o    Industry representation
-    When the BSE Sensex was originally formed, it used the weigh of market capitalization of companies, but from September 2003 onwards, it shifted to the free-float market capitalization method.

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Selection Criteria For BSE Sensex

-    Listed History: The scrip should have a listing history of at least 3 months at BSE. Exception may be considered if full market capitalization of a newly listed company ranks among top 10 in the list of BSE universe.  In case, a company is listed on account of merger / de-merger / amalgamation, minimum listing history would not be required.
-    Trading Frequency: The scrip should have been traded on each and every trading day in the last three months at BSE.  Exceptions can be made for extreme reasons like scrip suspension etc.
-    Final Rank: The scrip should figure in the top 100 companies listed by final rank.  The final rank is arrived by assigning 75% weight age to the rank on the basis of three-month average full market capitalization and 25% weight age to the liquidity rank based on three-month average daily turnover & three-month average impact cost.
-    Market Capitalization weight age: The weight age of each scrip in SENSEX based on three-month average free-float market capitalization should be least 0.5% of the Index.
-    Industry / Sector Representation: Scrip selection would generally take into account a balanced representation of the listed companies in the universal of BSE
-    Track Record: In the opinion of the BSE Index Committee, the company should have an acceptable track record.

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What is Free-Float Market Capitalization?

-    Free-float is defined as the total number of shares, which are actually available for day-to-day trading (hence this excludes shares locked with promoters, institutional investors, government etc)
-    Multiplying the number of free-float shares of a company with the current market price gives us the value of free-float market capitalization (FFMC)
-    How is this used?
o    Suppose in base year, FFMC of A: Rs.100,forB:  Rs.200 and so on, adding up to overall FFMC for all 30 companies in the index: Rs.1000
o    Base value of the index: Rs.100
o    Establish a proportional relationship between base value and FFMC (termed as index divisor) by equating the overall FFMC (Rs.1000) to value of the base (100 points)
o    Hence, each Rs.10 of FFMC is worth 1 point in terms of base value of the index
o    In other words, if market cap rises by Rs.100, index should rise by 10 points

Free-float market capitalization defines how much money will be required if one were to buy all the shares of a company that are available for trading

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What is the Index Divisor?

-    It is the proportional link between the base value of the index and the free float market capitalization
-    Dividing the FFMC (Rs.1000) with the index divisor (10 from the previous example), gives one the base value
-    If the FFMC increases next day by 30% (hence the value increasing to Rs.1300), then dividing this value by the index divisor will give the index value at that point in time
-    Hence, the index divisor acts as a link between the past and the present value of the index
-    It also helps in ensuring that corporate actions such as stock splits, bonus and rights issues, mergers etc don’t distort the value of the index

To calculate value of index at any point in time, one needs to divide the free-float market cap of all shares with the index divisor


Other Benefits of the “Index Divisor”
-    Apart from helping to derive the vale of the index, the index divisor also plays a great role in ‘maintenance of index’ (in technical terms)
-    This means making necessary modification in the value of index divisor to counterbalance the effects of corporate actions such as those mentioned in the previous section.
-    Suppossing that the number of free float shares of a company suddenly increases due to some reason, for eg because of a bonus issue
o    Even though the market price of stock doesn’t move at all, the free-float market cap shown as increase, hence increasing the value of index as well (which would be a misrepresentation)
o    In such a scenario, necessary adjustments are made in the index divisor so that the continuity of the index is not affected
The index divisor plays an important role in not only determining the value of the index, but also to ‘maintain the index’.  Hence choosing the right index divisor is always important.

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Advantages of Free-float Methodology

-    Reflects the market trends more rationally; takes into consideration only those shares that are available for trading in the market
-    Makes the index more broad-based by reducing concentration to top few companies in index
-    Aids both active and passive investing styles
o    Aids active managers by enabling them to benchmark fund returns vis-à-vis an investible index, enabling an apple-to-apple comparison thereby by facilitating better evaluation of performance of active managers
o    Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them t track the index with the least tracking error.
-    Improves index flexibility in terms of including any stock from the universe of listed stocks, improving market coverage and sector coverage of the index.
o    For eg, under a Full-market cap methodology, companies with large market cap and low free-float can’t generally be included in the Index because they tend to distort the index by having an undue influence on the index movement.
o    However, under the Free-float Methodology, since only the free-float market cap of each company is considered for index calculation, it becomes possible to include such closely-held companies in the index while at the same time preventing their undue influence on the index movement.
-    Globally, the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same
o    MSCI, a leading global index provider, shifted all its indices to the this methodology in 2002
o    The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FII) to track Indian equities, is also based on the Free-float Methodology
o    NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) – QQQ is based on the Free-float Methodology

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Adjustments for Corporate Actions

Adjustments for Corporate Actions (Bonus, Rights & Newly Issued Capital)
-    Index calculation needs to be adjusted of issue of Bonus or Right shares, if no adjustments were made, discontinuity would arise between current value of index and previous value despite the non-occurrence of any economic activity
-    At the BSE Index Cell, the base value is adjusted, which is used to alter market capitalization of the components stocks to arrive at the SENSEX value.  The cell keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all the 19 Indices
-    Adjustments for Right Issues
o    When a company issues bonus shares, the market cap does not undergo any change, so there is no change in the Base Market cap, only the ‘number of shares’ in the formula is updated
-    Other issues
o    Base market cap adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc

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Base Market capitalization Adjustment

The formula for adjusting the Base Market capitalization is as follows:

New Base Market capitalization = Old Base Market Capitalization x New Market Capitalization / Old Market Capitalization

To illustrate, suppose a company issues right shares, which increases the market capitalization of the shares of that company by say, Rs.100 crores.  The existing Base Market capitalization (Old Base Market capitalization), say is Rs.2450 crores and the aggregate market capitalization of all the shares included in the index before the right issue is made is, say Rs.4781 crore.  The “New Base Market capitalization” will then be:

New Base Market capitalization = 2450 x (4781 + 100) / 4781 = Rs.2501.24 cr

This figure of Rs.2501.24 crore will be used as the Base Market capitalization for calculating the index number from then onwards till the next base change becomes necessary

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What is P / E Multiple

Introduction to the P / E Multiple

-    The P / E Multiple (or ratio) is one of the most common indicators to judge the worth of a company’s shares
-    Most people generally watch the movements of stock market indices like Sensex, Nifty et., to understand if the market is falling or rising.  However, the movement of only these numbers does not reveal the full story.
-    Investing in shares of a particular company required investors to look at some numbers which give an indication of the true earnings prospects of the company
-    The P / E multiple is one important measure to understand whether a rise or fall is justified by the earnings prospects of the company
-    The multiple basically tells investors what is the price to be paid per share for one rupee of earning generated by that company

P / E multiple : (Price per share / Earnings per Share)

Price : Current Market Price of a single shares of the company

EPS: Net Income of a company in the most recent 12 month period / No. of shares outstanding

-    For eg: If the current shares price of a particular company ‘X’ is 275, and the New Earnings of the company Rs.10 lakh, with total outstanding shares numbers 1 lakh
-    EPS = Rs.10,00,000 / 1,00,000 or Rs.10 per share
-    P/E multiple = 275/10 or 27.5

Higher P/E ratio means that investors are playing more for each unit of income, indicating that the stock is more expensive compared to one with a lower P/E ration all other parameters being equal

What does this multiple mean?

-    From our previous example, P/E multiple = 275/10 or 27.5
-    This means for purchasing a share that earns Rs.10 every year, the share is available at a price which is 27.5 times the earnings of the company
-    Purchaser of stock ‘X’ is paying Rs.27.5 for every RE of earning
-    One can study similar companies in the peer group of company ‘X’, to figure out how favorably the P/E of 27.5 compares against other companies
-    Stocks with higher forecast earnings growth will usually have a higher P/E, and those expected to have lower earnings growth will in most cases have a lower P/E.
-    It is usually not enough to look at the P/E ratio of one company and determine its status.  Usually, one should look at a company’s P/E ratio compared to the industry the company is in, the sector the company is in, the indices it could be benchmarked against, as well as the overall market.

Applications of the P / E Multiple
-    Investors can use the P/E ratio to compare the value of stocks: if stock ‘X’ has a P/E twice that of stock ‘Y’, all things being equal (especially the earnings growth rate), ‘X’ is less attractive than ‘Y’ as one has to pay double the amount to get the same Re1 of earning.
-    By comparing price and earnings per share for a company, one can analyze the market’s valuation of a company’s future earning potential.
-    Companies are rarely equal, however, comparisons between industries, companies, and time periods may be misleading.
-    Another way to look at this ratio is that, it indicates the number of years required to pay back the current purchase price of the shares (ignoring the time value of money)

Higher P/E Multiples may indicate overvaluation while Low P/E Multiples, under valuation
Examples of P/E analysis
-    Normally, stocks with high earnings growth potential are traded at high P/E
-    For example, lets assume share price of high growth stock ‘Y’=Rs300
o    Current EPS = Rs10 per share
o    Hence P/E=Rs300 / 20 or 15
-    Next year’s expected earnings per share = Rs20 per share
o    Hence forward P/E=Rs300 / 20 or 15

-    This means purchases of this stock is paying lesser now than in the previous year, making the stock more attractive for purchase

Conclusion
-    The P/E multiple shows how much investors re willing to pay per rupee of earnings.
o    If a company were currently trading at a multiple (P/E) or 20, interpretation is that an investor is willing to pay Rs.20 for Re 1 current earnings.
-    A higher P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, a higher P/E may also indicate overvaluation
-    Hence, this multiple doesn’t tell us the whole story by itself.  It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E to come to a reasonable conclusion about the attractiveness of the stock

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What is Recession?

-    Recession is defined as significant decline in economic activity/output spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment, industrial production, and wholesale-retail sales
-    Its usually preceded by server al quarters of slowing but positive growth.  But when GDP growth slows down, businesses stop expanding, employment falls, unemployment rises, and housing prices decline
-    Recession normally takes place when consumers lose confidence in the growth of the economy and spend less
-    Its natural for countries to experience mild recessions, at is it a built-in/endogenous factor of a society

è    Recession is not due to lack of productive capacity in the economy
è    Real problem is due to insufficient spending to support the normal level of production
Recession is a natural result of the economic cycle and will adjust for changes in consumer spending and consumption or increasing and decreasing of goods and labor

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What / Who Decides Output in an Economy?

-    John Maynard Keynes, the well known British economist of the 20th century wrote his seminal work-
The General Theory of Employment, Interest & Money during the great depression of the 1930s, in which he studied factors affecting output and growth in an economy
-    Output (both goods and services) is decided by those with the purchasing power
-    Basically, people who earn money with one hand and spend it with the other ultimately decide how much goods and services will be produced in the economy
-    Fluctuation in spending or aggregate demand by this section consumers could result in short term fluctuations in output and employment
-    Hence, firms will try to meet demand for goods and services at a ‘set’ price by altering the supply

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How do Producers “Fix’ Prices?

-    If demand for product ‘X’ has fallen, the producer should have to decrease its price in order to boost its demand
-    However, it is impractical & difficult to increase/decrease price of products frequently as setting a fresh price level every day will be a nightmare for both producers as well as consumers
-    Further, the input costs in production of ‘X’ may also keep varying, thereby rendering it next to impossible for the producer to plan for the future, or even to merely recover his cost of production if he sells below a certain price
-    The producer can then let the price of ‘X’ remain the same, but will have to decrease production (responding to lower demand) – Hence he meets the demand at a set price matching his supply with the prevalent demand.

Producers meet the demand at a set price by matching supply with the prevalent demand.

What happens in Recessionary Times?
-    Demand falls to very low levels, which makes it unsustainable for producers to maintain output
-    This results in a significant drop in production of goods and services
-    Hence it is important to introduce measures in the economy that boost demand
-    There could be various methods to help in doing this: Interest rate cuts, Stimulus packages etc

If ¯ in demand results in ¯ in production, it is important to take measures to boost demand



Countering Recession
-    As mentioned earlier, the best way to counter recession is to introduce measures to push up demand

Fiscal Stimulus Package
-    Increase Govt. Spending
o    Effective way to increase aggregate demand of goods and services
-    Decrease Taxes
o    Resulting in increase in the disposable income in the hands of the people

(This measure was suggested by Keynes)

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Multiple Effect

People use the extra income (due to decline in taxes) on consuming extra goods and services.  For example: When one buys more bread from the banker, the baker busy more milk from the milkman, who buys something else, thereby generating an incrase in demand on various levels

Fiscal Stimulus Package results in an ­ in demand: An instant sour of ENERGY

-    Fiscal Stimulus is a potent tool to fight recession, but its crucial to get the following right
o    Timing of the stimulus package
o    Size of the stimulus package
o    This is tricky business since it is almost impossible to figure out where the reversionary period began and where it will end- Wrong timing could spoil things further by increasing fiscal deficit as well as inflation

Timing of the Stimulus Package is crucial; otherwise this it can fuel further problems

Courtesy:  DSP Black Rock Investment Managers, DSP Black Rock Investment Managers

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