It refers to a process of calculating market capitalisation of a company, which is a constituent of an index. It is derived by multiplying the market price of the security with the number free-float shares.
Free-float shares mean the numbers of shares that are available to trade at given point of time, and it does not include shares that are escrowed or locked-in shares.
What is market capitalisation? Market capitalisation is one of the ways employed to evaluate the valuation of a company. This aggregate valuation is based on the current market price of the company’s shares and the total number of outstanding stocks. One needs to make the calculation to determine the company valuation. It is primarily outlined by the total market value based on the company’s outstanding shares. This simply means that evaluation by this method can be done only for businesses that are publicly traded. Source: © Djbobus | Megapixl.com Why is it essential for investors? Understanding and calculating market capitalisation of a business are essential, especially for investors, as it guides them make sound investment decisions. A company’s correct value evaluation can help investors choose the right shares to invest in as per their need. However, it is imperative to keep in mind that various internal and external factors can also impact the number, as market capitalisation is based upon the value of the company’s current shares and number of outstanding stocks. The share price of a listed company can move in an upward or downward direction due to multiple factors, such as critical financial announcements made by the company, changes in the management or structure, fluctuations in market conditions, etc. As these factors impact the price of the company’s current shares, the market capitalisation also changes, going up or down with increase or decrease in the numbers. From an investor’s standpoint, evaluating market capitalisation using this method is crucial, especially while charting a long-term investment plan. Additionally, the returns and risks associated while investing in a particular company are also imperative for the investors. Market capitalisation plays an important role in aiding the investors while choosing stocks that meet their criteria while investing in various companies to maintain the portfolio. Meanwhile, it is vital to keep in mind that the market capitalisation demonstrates the stage of a company’s development. Source: © Noamfein | Megapixl.com What are the types of companies based on the market cap? Knowing the formula employed to calculate the market capitalisation can provide clarity to investors. For instance, a particular company has 10 million outstanding shares, and the current market price is $100 per share. In this case, market capitalisation of the company will be 100,00,000 x 100 = 1,000,000,000. The stocks of listed companies fall into three categories based on this popular method of evaluation. Investors usually choose stocks from judging market capitalisation valuation. Usually, investors also decide for balanced investment in different combinations of stocks with different market capitalisation to minimise risk. Stocks of companies with a market capitalisation of $10 million or above fall under the category of large-cap stocks. Companies with a market capitalisation in the range of $2 billion to $10 billion are called mid-cap players or mid-cap stocks. Companies with a market cap of $300 million to $2 billion are called small-cap stocks. Large-cap stocks: Companies with large capitalisation are usually considered stable businesses in the market. Thus, investing in large-cap companies is less risky compared to investing in other stocks. Though these are companies have a significant market cap, the returns they offer are generally on the lower side. It is believed that these companies have reached the highest point of their development by being in the market for many years and providing a stable performance for years. Thus, even with major announcements that could have a significant impact on the share price, investors are unlikely to see any significant change in their share price. Investing in large-cap companies offers minimum risk, and the growth is also less aggressive than emerging companies. Therefore, investment in a large-cap company is considered conservative. Mid-cap stocks: Companies with mid-range market capitalisation are poised for particular growth. These companies are also somehow stable, making them deliver a promise of future growth. Most importantly, they demonstrate that the business is set up in a particular way. Investing in mid-cap companies can be riskier compared to investing in large-cap companies. Though these companies are not fully established like the large-cap companies, these stocks have growth potential. On a positive note, investing in mid-cap companies is less risky than the small-cap ones. Notably, the returns mid-cap companies can offer are usually higher than the large-cap companies, making it attractive for the investors. Small-cap stocks: Investing in companies with small market capitalisation is a precarious step. However, these stocks are lucrative to many investors. Small-cap companies are new in town; they are up-and-coming and not very much established in the industry than the mid-cap and large-cap ones, making them highly risky. However, investors’ risk would be highly paid off if these players find success, as they hold strong potential to grow. Therefore, investing in small-cap stocks can be an aggressive investment option. Source: © Lovelyday12 | Megapixl.com Important aspects of valuation to keep in mind: While evaluating the market capitalisation of a company, investors need to study a few critical areas that could impact investment decisions. Following are the relevant ratios to take into consideration. Price-to-earnings ratio: One of the critical ratios is considered while evaluating any company’s market capitalisation is the price-to-earnings ratio. While buying shares of a particular company, this ratio will help the investors project returns for the future. Detailed discussion at: Price to Earnings Ratio - (P/E Ratio) Price-to-free-cash-flow ratio: This ratio is also utilised to measure the expected returns. Price-to-book value: This ratio is calculated by deducting the total value of liabilities from the total book value of the company's assets. Enterprise-value-to-EBITDA: This ratio helps investors evaluate and measure the operational returns generated in the short term. Free-float market cap: The number of outstanding shares that are kept for investors to trade publicly is called float. This method excludes the shares owned by the company's executives.
Capital Adequacy Ratio is a bank’s level of capital for its inherent risks, and capital under the requirement serves a loss-absorbing purpose for banks. It is stated as a percentage of an institution’s risk-weighted assets. Capital of a bank is segregated into two parts, namely Tier 1 and Tier 2 Capital. Both the tiers are intended to save the bank in the event of a crisis, which may lead to a threat to the bank’s going concern. However, each tier of capital has its purpose when a bank incurs losses or risks to the going concern increases. To calculate CAR for an institution, the sum of Tier 1 and Tier 2 capital of the banks is divided by risk-weighted assets. Tier 1 capital consists of Common Equity Tier 1 (CET1) and Additional Tier 1 Capital (AT1). Under Basel III, the Basel Committee requires banks to have over 4.5% CET1 capital, and after including AT1, the level of Tier 1 Capital should be over 6%. Also, the sum of capital instruments held by banks, including Tier 1 and Tier 2 capital should be minimum 8%. AT1 capital of the institutions could include perpetual contingent convertible instruments, but CET1 capital is pure common equity. How Capital Adequacy Ratio Arrived In Banking Regulations? Money has sometimes been mankind’s problem. In the Great Depression of the 1930s, there was a dramatic imbalance between fiscal policy and monetary policy, reflecting the inability of policymakers to strike a balance since interest-rates were raised at the outset of an economic crisis. This was also partly responsible for the development of Keynesian Economics, which laid the foundations for monetary policy. Capital Adequacy Ratio is administered by the banking regulator in a country, which could be the Central Bank, like in the US or a separate body like the Australian Prudential Regulation Authority (APRA) in Australia. The growing internationalisation of banks led to the creation of Committee on Banking Regulation and Supervisory Practices in 1974. Also known as Basel Committee, it was headquartered in Basel at the Bank for International Settlements. After the failure of Bankhaus Herstatt in West Germany, the Basel Committee was formed to oversee the international supervisory standards, improve resilience in the financial system worldwide, and to co-operate on banking supervision with member nations. Since 1975, the Basel Committee on Bank Supervision (BCBS) has published landmark supervision protocols for national regulators and global standards, including Basel I, Basel II, Basel III capital adequacy accords. The need for Capital Adequacy Ratio was felt after the Latin American crisis in the early 1980s. Over the past two decades into the 1980s, the Latin American nations borrowed heavily to fund industrialisation, but a global recession and interest rate hikes in 1970s and 1980s led to the Latin American Debt crisis. It was the time when global policy thinktanks stressed on the need for capital reserves; commercial banks held a large amount of capital invested in Latin American bonds, which were then presented with looming risks of default. The Basel Committee was concerned with the deteriorating capital ratios of international banks, resulting in the need for measurement of capital adequacy and abolishment of erosion of capital standards. Now banks started measuring capital adequacy based on weighted risks, including on and off-balance sheet risks. How Is the Origin And Evolution Of Basel Accord Mapped? In July 1988, the G10 Governors approved Basel I, which required banks to maintain a minimum ratio of capital to risk-weighted assets of 8%. Banks were given until 1992 to implement Basel I Accord, which was also adopted by members outside the Committee. Additional amendments to Basel I continued until the proposal of Basel II, which was a new capital framework. The new accord led to a revised capital framework in 2004. It sought to develop and expand the rules for minimum capital requirements enacted in 1988. Basel II also focused on the supervision of capital adequacy and internal assessment process by institutions, and disclosure requirements to bolster ethical practices and market discipline. As a result of financial innovation, there was a need for a framework to better reflect the underlying risks. It also set the tone for continued improvement in efficiency of risk measurement and control. But the Committee realised the need of further improving capital framework before the collapse of Lehmann Brothers in 2008. The Global Financial Crisis during 2007-09 reinforced the need for an improved capital framework in the wake of the banking crisis. Initially, the Committee released guidelines on liquidity risk management in the month when Lehmann Brothers failed. BCB extended the approach of Basel II and released guidelines on the treatment of trading book exposure, off-balance sheet vehicles, and securitisation. In September 2010, the body introduced higher minimum capital guidelines. During the same year, Basel III was endorsed by the Committee, which has amended the accord several times since 2010, including implementation dates. This accord included a range of areas for efficient risk management and control in the banking system. Improved guidelines on quality, quantity of regulatory capital, especially common equity capital. Capital Conservation Buffer (CCB), an additional layer of common equity, was introduced. Failure to meet CCB requirement restricts pay-out to meet the minimum common equity requirement by the banks. Countercyclical Capital Buffer was announced to limit a bank’s participation in widespread credit booms. Basel III also introduced leverage ratio, minimum liquidity ratio, liquidity coverage ratio, and further requirements for systematically important banks. ASX Banks And Capital Requirements Australian major banks include Commonwealth Bank of Australia (ASX:CBA), National Australia Bank Limited (ASX:NAB), Westpac Banking Corporation (ASX:WBC), and Australia and New Zealand Bank Limited (ASX:ANZ). Over the past years, the banking regulations in Australia galloped forward in contrast to the global developments. Financial System Inquiry 2014, under the leadership of David Murray AO, also recommended increasing the bank’s capital requirements to over 10%. As a result of these recommendations, the banks now have large capital reserves in Australia. Basel III implementation pushed further ahead to 2023 In the wake of COVID-19, the implementation of Basel III standards has been further postponed to one year later to 1 January 2023. It was understood that the deferral of implementation would provide the banking sector the necessary capacity in response to COVID-19 economic deterioration. In addition to meeting the Basel III requirements, global systemically important financial institutions (SIFIs) must have higher loss absorbency capacity to reflect the greater risks that they pose to the financial system. The Committee has developed a methodology that includes both quantitative indicators and qualitative elements to identify global systemically important banks (SIBs). The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance.
Financial pundits have often stated that the most important thing in business is liquidity. But what is liquidity? Let us deep dive- What Is Liquidity? As the term suggests, liquidity is the quality of being liquid or flowing free like water. In the business sense, liquidity refers to the amount of money that is easily accessible for spending and investment. As deciphered, the concept related to quick access to cash. Some experts even regard liquidity to be the amount of cash and cash equivalents. Another way to look at the concept is this- both individuals and businesses hold assets or security. Liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash. It involves the trade-off between the price at which a particular asset can be bought, and how quickly it can be sold. Getting the basics- In a liquid market, the trade-off is mild, which means that assets can be sold quickly without having to accept a significantly lower price. On the contrary, in a comparatively illiquid market, an asset is required to be discounted to sell quickly. Why Is Liquidity Important? The answer to the above is simple- Liquidity may be the most effective silver lining when one encounters the need for urgent cash, which can occur anytime. Liquidity is the ability to get one’s money whenever one needs it. It can be looked upon as an emergency savings account or cash lying with someone that can be easily accessed in case of any unforeseen happening or any financial setback. Besides, liquidity plays a vital role as it allows individuals and businesses to seize opportunities. This is because if one has cash and easy access to fund, it is easier to seize any opportunity that comes along. Financial experts often stress upon the importance of liquidity when one is planning investments. It is crucial to factor liquidity in financial plans to ensure that one has secured its long-term as well as short-term needs. This further should ensure that one does not utilize/ incur a loss to discount their long-term investments when in need. Discussing the importance of liquidity from an investment perspective- It plays a critical role in balancing one’s portfolio with trade-offs between risk and return. It may help accelerate transactions, as having liquid funds reduces the time-lapse from when the asset is put for sale and by the time one finds a buyer. Liquid funds are known to retain their value when they exchange hands, unlike many illiquid funds. ALSO READ: What Is Market Liquidity? Features Of A Liquid Asset A liquid asset may have some or all of the following features- What Are The Measures Of Liquidity? There are two main measures of liquidity- Market Liquidity- Indicates market situation where assets may be purchased or sold off quickly. This type of liquidity is particularly evident in the case of real estate, the stock market or financial market. Markets for real estate are typically far less liquid than stock markets. The shares traded on stock exchanges are usually found to be liquid due to a large number of buyer and seller available, which leads to easy conversion to cash. Accounting Liquidity- The comfort with which a business or an individual can meet financial obligations through liquid assets is accounting liquidity. It requires a comparison of the liquid assets held by the business or an individual to that of current liabilities in a financial year. The current ratio and cash ratio measure this. What Are The Different Liquidity Ratios? Businesses and individuals use liquidity ratios to evaluate their liquidity. These ratios help them to measure their financial health. The three most important ratios include the current ratio, quick ratio, and cash ratio. Let us look at a few interesting facts about the above ratios- The current ratio is believed to be the simplest and less stringent. Quick Ratio is also referred to as the acid-test ratio. The cash ratio is believed to be the most exacting of the liquidity ratios. More than the other two ratios, it assesses the business’ or individual’s ability to stay solvent in the case of an emergency. Liquidity Management At any point in time, and especially in turbulent times, a Company may be asked to demonstrate its ability to remain viable and liquid. This is where liquidity management comes into the picture. Liquidity management describes a company’s ability to meet financial obligations via cash flow, funding activities, and capital management. It is impacted by revenue and cost generating activities, capital and dividend plans, and tax strategies- making it a challenging concept. Liquidity management is strongly associated to broader market, credit and general business risks. So how is liquidity managed? For starters, monitoring the liquidity ratio is key to keep a regular grasp of the company’s liquidity risk. To do so, most liquid assets are compared with short term liabilities or near-term debt obligations. Other techniques comprise- Receivables management– the stringent methodology to make sure that clients and customers maintain payments in a timely and orderly fashion. Netting portfolio management techniques- which allows the company to consolidate debt obligations. Herein, the company nets third-party invoices. It is usually applied when the company has several outstanding invoices from the same vendor and agree on terms by which the total outstanding amount will be paid on a certain date. By practising this approach, a single payment suffices rather than a number of instances to unsettle cash reserves. Understanding Liquidity Glut & Liquidity Trap While walking through the concept of liquidity, understanding liquidity glut & liquidity trap is essential. Liquidity Glut—when savings exceeds the desired investment As understood, high liquidity means a lot of capital. But what happens when there is too much capital and too few investments? A liquidity glut. This is a situation wherein savings exceeds the desired investment. Often a liquidity glut may lead to inflation. Cheap money pursues lesser profitable investments, and prices of those assets increases. Liquidity Trap- monetary policy becomes ineffective This occurs when the Government’s monetary policy does not create more capital; for example, post a recession. In this situation, interest rates are extremely low, whereas savings are high, making monetary policy ineffective. Consumers ideally prefer to save rather than invest in higher-yielding bonds or other investments. Raising interest rates is one of the most effective ways to get out of a liquidity trap, the other being increasing government spending, which may in turn aid unemployment too.
Trading is an economic activity which involves buying and selling of goods and services in exchange for money. In the financial market, trading is the same concept; the only difference is it deals with securities, currency, commodity etc. What is the Significance of Paper Trading for Beginners? To trade successfully on a consistent basis is not everyone’s cup of tea. Often at times, new traders end up blowing up their entire capital quite early. This happens due to a lot of reasons which are difficult to rectify early on and at once. These hindrances could be lack of knowledge, lack of patience, no prior experience and inability to control the two primary emotions, fear and greed which eventually drive the market etc. To counter these issues gradually, paper trading is often recommended, especially at the very beginning stage. What Do We Mean by Paper Trading? Paper trading, as the name suggests, is a dummy form of trading in which the trades are not executed on an exchange but are written on a paper, which allows investors/traders to hone their trading skills without putting a penny at risk. These trading skills could include the timings of entries and exits, position-sizing, risk management strategies etc. There is no capital at risk as the trades are only written on paper. But the simulation of these trades is done in accordance with the actual price that is being quoted on the exchange. With all the hypothetical positions, portfolios and risk but with real price fluctuation, an aspiring trader can learn a lot of things which a mere theoretical book cannot teach. Like any other skill in life, one needs to practice trading in order to improve upon the skill. Paper-trading solves this purpose of practice without putting actual money at risk. What is the Purpose of Virtual Trading – Technology based paper trading? With the constant upgradation in technology, nowadays there is an improved version of paper trading called virtual trading. The underlying concept remains the same, to help new traders to practice and improve their trading skills in a simulated environment but with the integration of technology. In conventional paper trading, the trader continually needs to keep updating prices manually. This could be a tedious task if the frequency of trades is high, especially for intraday trading. Also, a manual log of all the trades needs to be created if the trader wants to look back at the past few trades for any analysis purposes. Another drawback shows up in the errors. While manually updating prices or another field like net P&L etc. there is a good chance of making a few errors which could lead to the false representation of the P&L. All these issues are being taken care by technology-based paper trading where all the data feeds are being updated automatically, and live prices are updated. Some of these virtual trading platforms are free while others with advanced features like graphical representation of data or calculation of some advanced metrics etc. can be paid once. What are the Advantages of Paper trading? A few of the advantages of paper trading for which it is considered to be one of the best ways to learn to trade in the beginning phase are; Testing of a strategy Before deploying a specific strategy, it is always advisable to first test it. Paper trading helps the trader to test his strategy within a simulated condition which is identical to the live market conditions. This helps to ensure whether the strategy would work or not in the live market. Also, if the strategy fails to work, then the loss will only be virtual as no real money is involved. No additional infrastructure required Virtual trading platforms are quite easily available nowadays. Even some brokers have started to offer this service to their clients. Most of the platforms are free and only requires a sign up to start doing paper trading. No legal documents are required to open a virtual trading account unlike a live trading account. No stress Stress is something which even the best of the traders goes through, especially during the period of losses. As with paper trading, no real money is involved; hence high stress is generally not there. Confidence Boost After a few months, once the trader gets the hang of his strategy, understands the shortcomings of his methodology and strengths and also gains relevant experience, he can confidently start to trade with the real money in the live market. What are the Disadvantages of Paper Trading? Despite being such a helpful and effective way to learn to trade, it has some drawbacks too, which must be taken into consideration while paper trading. Ignores some associated cost While paper trading helps to keep track of P&L of individual positions but there are some exclusions from it like brokerage and slippages. Slippage is the difference between the bid and ask price which can reduce the P&L by a meaningful amount, especially when the market is illiquid. As different brokers charge different brokerages, it is not possible to incorporate it in a trading platform, although it can be written manually. Ignores emotions and psychology If topmost traders of the world were asked to define the single biggest factor which sets a successful trader apart from the crowd, psychology would be heard from most of them. Trading psychology alone can turn a good trading strategy or a specific analysis into a bad one, the sole cause of which is the involvement of money. Whenever money is at risk in any decision, most of the time, the emotions take over and hamper the ability to think clearly. These two emotions are Greed and Fear. As there is no money involved in paper trading, these emotions are generally muted and may go onto a completely different level while trading live with real money. This may create a humongous difference between the performance in both the scenarios. Is there any alternative to paper trading? To eliminate the drawbacks of paper trading, some traders start directly with the live trading with real money but with a very less quantity. The quantity is so small that the P&L fluctuation is almost meaningless. This is as good as paper trading but also eliminates the drawbacks of paper trading as trades are executed live on an exchange which accounts for brokerage and slippages and gives realistic P&L figures. Also, money is involved, which helps to practice emotional stability and psychological resilience.