Tuesday, 24 May 2011

Sensex Simplified

For most of us, the indices displayed at the Dalal Street, Mumbai present an obscure score of market performance. For those of us who have dabbled in this quest, the directions in index changes are somewhat understood. Let’s try to develop a concrete understanding of the index and appreciate its importance in the larger scheme of things.

To begin with, let us first try to understand some of the concepts used in corporate finance.
Equity Financing: We know that public companies issue or sell shares to generate the financial capital required to expand their operations. By issuing the shares at a certain share price, companies gain access to large pools of money at cheaper cost than that through debt financing viz., bank loans etc.

Shares Outstanding: Shares outstanding is the number of shares authorized, issued and purchased by investors.
Market Capitalization: Market cap is equal to Share Price times the Share Outstanding. Thus, if a company issues 1000 shares at a share price of Rs. 10 per share, then the market capitalization is equal to Rs. 10000.
--> Public Float: Apart from public investors, the company employees, directors, officers also purchase shares in the form of large holdings of founding shareholders, cross-corporate holdings, Governments holdings etc. The public float of a company is the amount of capital invested by the general public but not by the company’s private investors. Thus, the public float of the company indicates the public investment- an indicator of public confidence-of the company.

-->Computation of BSE Sensex:
The market capitalizations of 30 well-established companies form the basis for BSE Sensex. These companies involve high volumes of public financial trading and represent the various industrial sectors of Indian economy.

--> Suppose the market consists of following three companies, as on May 2011, with the specified share prices and number of issued public shares:

-->The sum of public float market capitalizations of the three companies is Rs. 2050000, the sum of Rs. 600000, Rs. 1200000 and Rs. 250000.
The base year for Sensex computation is 1978-79. Suppose the total market capitalization of the industry, in 1979, is Rs. 10000.

Then, the value of BSE Sensex, for May 2011 is:

--> We have illustrated the computation for three companies in this example. The above method is applied for 30 companies and the resultant index is displayed by the BSE.

Higher the index, higher is the aggregate market capitalization, which simply means to say that larger amounts of public equity are pumped into the market. This indicates higher investor confidence- an expectation of higher future earnings- in the markets.

Similarly, a reduction in the index reflects a decrease in the aggregate market capitalization; a withdrawal of public equity from the market. Loss of public equity in the markets signify economic slowdown or in more adverse situations, a large-scale financial breakdown.

Thus, in essence, the Sensex is well and truly a Sensitive Index.