by January 2, 2000 0 comments

Traditional capitalistic economics assumes that you do business for profit. Part of the profit, at the end of the year is held back as reserve for future investments. Part is distributed amongst the people who provided the business with its capital (shareholders) as dividend. This dividend is expressed as a percentage of the face value of a share. The face value is the actual value of the share as printed on it, and rarely changes. Normally, the face value of a single share in India is Rs 10, but there are exceptions.
The traditional method for a company to get the capital it requires for doing business is to issue shares to people and to other companies. If the company makes an offer in the open market, it’s called a primary market issue or a public issue. When a company does this for the first time, it’s called an IPO (Initial Public Offering) in the US stock market. This term has now caught the fancy of companies, particularly IT companies, here too. 

The stock market is the secondary market for shares. Here, you can buy and sell shares that have already been issued in the primary market. The price at which a share trades in the stock market is called the market price of the share. This value could change even by the minute. The market capitalization–or marcap, as the current lingo goes–of a listed company (one whose shares are available for trade in a stock market) is the current market value of a single share, multiplied by the total number of shares issued by the company. The marcap of a company can be taken as the market value of that company.

Traditionally, the market price of a share is determined by the current dividend record of the company–which can be proportional to its profitability, the future outlook for the industry in which the company is operating, the strength of it brands, etc. Of these factors, it was the current (and immediate past) dividend percentage that was perhaps the most significant influence on the market price of a share. So, companies have been known to declare high dividends even if profit margins were low, in order to keep their stock prices up. By the same token, a company with a long record of losses would almost never be a hot shot with the investor community.

Why not banks?
Traditionally, a company wouldn’t sell its shares to the public (go public) immediately on incorporation. That’s because it probably had nothing by which it could induce investors to put their faith and money on its stocks. Also, Indian laws require a company to be in operation for some time before it can make a public issue. But that doesn’t mean that the company doesn’t require capital. So what does it do? Why not approach a bank, you’d ask.

Banks give loans and not share capital. Loans have to be repaid over or after a predetermined time period, and call for interest to be paid at a fixed rate, irrespective of how the company performed, which could be a problem during the gestation period of the project. Also, banks don’t give finance based on the company’s ideas for business–they need collateral (things they can take away or sell if the company defaults on payment, such as plant and machinery and buildings). 

On the other hand, share capital requires dividend to be paid, but there’s no stipulation on this for ordinary shares. Dividend is paid if and when profits are made. Also, the business doesn’t have to repay the amount invested by the investor. The investor can also be made to pay a premium over the face value of a share, which then belongs to the business. It doesn’t have to pay back this amount or even pay interest or dividend on it. 

So, the company typically goes in for private placement of shares. That is, it used to go to a small number of investors with large investible funds, and convince them to invest in the company. These days, things work the other way around too. And that’s where venture capitalists come in. 

The venture capitalist
Venture capitalists look for individuals or companies with a killer idea, that are in search of funding. They don’t give loans, but provide funds by buying shares in the company. If the company makes good, the venture capitalist laughs his way to the bank. He would make many times his investment when the business makes a public issue at a premium, or as in the case of Hotmail, when it’s sold off at a premium to someone else. Sure, not all such great ideas strike it rich. But if a venture capitalist makes a good job of picking and choosing the projects to invest in, he’s more likely to emerge a winner than a loser. 

Software’s edge
Technology companies, or rather software companies, have another advantage over, say manufacturing companies or service companies, when it comes to the stock market. For software companies, plant and machinery is computers, computers, and more computers. As for the others, they have to invest in the plant and machinery of their chosen industry, and then in computers too. Obviously, for a comparable turnover, the capital investment required for most software companies can be much lower than for companies in other industries. And when the software company invests in rupees and earns in dollars, it looks all the more attractive to a potential investor.

Companies set aside a part of their profits as depreciation. Depreciation can be considered to be a fund kept aside to replace plant and machinery in future, once their useful life is over. Depreciation rates vary for different equipment, depending on their useful lives. Computers have one of the shortest periods of depreciation, approximately three years.

Consider a company starting up, or starting a new operation. If, for example, Reliance Industries were to set up a new petroleum plant, it would require a few hundred crores of investment. The plant’s book life would typically be taken to be around 25 years. So, the depreciation of this plant (fixed asset) would be a low percentage, and would come over a long period of time. On the contrary, depreciation on computer equipment is faster (three years) and so the equipment is written off faster. As we saw, depreciation is taken out of profits. So with faster depreciation, profits available from which dividends can be paid is much larger in later years. Of course, the need to buy faster computers almost every quarter (three months) negates this benefit to a large extent.

No wonder then that where the stock market is concerned, information technology companies have for long enjoyed an enviable edge over other industries. Internet companies, or the so called dot com companies, whether they sell soap or shampoo, have for some strange reason been associated with IT companies, than with say supermarkets or convenience store chains on the stock market. And this IT edge has automatically rubbed on to them. Also, it’s interesting to note that e-com companies like and Ebay are listed at the NASDAQ, which lists infotech companies, and not at exchanges like the NYSE (New York Stock Exchange) that lists companies engaged in manufacturing, distribution, etc.

Traditionally, the market capitalization of a company is a function of its dividend-paying capability, which in turn is a function of profits. If a large chunk of a company’s profits were being taken in for depreciation, the market capitalization could be directly affected. The market value of a share and hence the market capitalization of the company would be dependent upon other things too, including the future earnings potential and brand value. But major weightage is normally on current profitability. 

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