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Security Analysis
This book is a part of the course by Jaipur National University, Jaipur..This book contains the course content for Security Analysis.
JNU, JaipurFirst Edition 2013
The content in the book is copyright of JNU. All rights reserved.No part of the content may in any form or by any electronic, mechanical, photocopying, recording, or any other means be reproduced, stored in a retrieval system or be broadcast or transmitted without the prior permission of the publisher.
JNU makes reasonable endeavours to ensure content is current and accurate. JNU reserves the right to alter the content whenever the need arises, and to vary it at any time without prior notice.
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Index
ContentI. ...........................................II
List of FiguresII. ................................VIII
List of TablesIII. ..................................IX
AbbreviationsIV. ................................X
Case StudyV. .....................................134
BibliographyVI. ..................................141
Self Assessment AnswersVII. ..............144
Book at a Glance
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Contents
Chapter I ...................................................................................................................... 1Securities Markets and Mutual Funds ...................................................................... 1Aim ............................................................................................................................... 1Objectives ..................................................................................................................... 1Learning outcome ....................................................................................................... 11.1 Primary Market .................................................................................................... 2 1.1.1 Public Issue ............................................................................................. 2 1.1.2 Rights Issue ............................................................................................. 5 1.1.3 Private Placement ................................................................................... 5 1.1.4 Preferential Allotment ............................................................................. 51.2 Secondary Market (Stock Market) ...................................................................... 6 1.2.1 National Stock Exchange (NSE) ............................................................. 6 1.2.2 Bombay Stock Exchange (BSE) ............................................................. 71.3 Securities Market Participants ............................................................................ 81.4 Initial Public Offer (IPO) ................................................................................... 101.5 Trading and Investing ......................................................................................... 101.6 Debt Market ........................................................................................................ 101.7 Money Market ..................................................................................................... 111.8 Mutual Funds ...................................................................................................... 111.9 Key Functions of Asset Management Companies ............................................ 111.10 Key Financial Numbers .................................................................................... 121.11 Performance Evaluation ................................................................................... 141.12 Performance Evaluation-US Experience ........................................................ 16Summary .................................................................................................................... 19References .................................................................................................................. 19Recommended Reading ............................................................................................ 20Self Assessment .......................................................................................................... 21
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Chapter II .................................................................................................................. 23Fundamental Analysis- Macroeconomic Analysis and Industry Analysis ........... 23Aim ............................................................................................................................. 23Objectives ................................................................................................................... 23Learning outcome ..................................................................................................... 232.1 What is Fundamental Analysis? ........................................................................ 242.2 Differences between Technical Analysis and Fundamental Analysis ............. 242.3 What is Intrinsic Value? ..................................................................................... 242.4 Fundamental Analysis Frameworks .................................................................. 252.5 Global Economy and Domestic Economy ......................................................... 262.6 Business Cycles .................................................................................................... 302.7 Economic Indicators ........................................................................................... 312.8 Monetary and Fiscal Policies ............................................................................. 322.9 Industry Life Cycles ............................................................................................ 34 2.9.1 Start-up Stage ........................................................................................ 35 2.9.2 Consolidation Stage .............................................................................. 36 2.9.3 Maturity Stage ....................................................................................... 36 2.9.4 Relative Decline .................................................................................... 362.10 Industry Structure and Performance .............................................................. 372.11 Profit Potential of Industries: Porter Model ................................................... 38 2.11.1 Threat of New Entrants ....................................................................... 38 2.11.2 Rivalry among Existing Competitors .................................................. 42 2.11.3 Pressure from Alternate Products ........................................................ 45 2.11.4 Bargaining Power of Buyers ............................................................... 46 2.11.5 Bargaining Power of Suppliers ........................................................... 46Summary .................................................................................................................... 47References .................................................................................................................. 48Recommended Reading ............................................................................................ 48Self Assessment .......................................................................................................... 49
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Chapter III ................................................................................................................. 51Company Analysis ..................................................................................................... 51Aim ............................................................................................................................. 51Objectives ................................................................................................................... 51Learning outcome ..................................................................................................... 513.1 Income Statement ................................................................................................ 523.2 Balance Sheet ....................................................................................................... 533.3 Footnotes .............................................................................................................. 563.4 Cash Flow Analysis ............................................................................................. 583.5 Directors’ Report ................................................................................................. 603.6 Management Discussion and Analysis .............................................................. 603.7 Auditor’s Report ................................................................................................. 603.8 Shareholding Pattern .......................................................................................... 613.9 Ratio Analysis ...................................................................................................... 613.10 Common Size Analysis ...................................................................................... 673.11 Cross-sectional Analysis .................................................................................... 683.12 Economic Value Added ..................................................................................... 69Summary .................................................................................................................... 70References .................................................................................................................. 71Recommended Reading ............................................................................................ 71Self Assessment .......................................................................................................... 72
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Chapter IV ................................................................................................................. 74Equity Valuation Models .......................................................................................... 74Aim ............................................................................................................................. 74Objectives ................................................................................................................... 74Learning outcome ..................................................................................................... 744.1 Intrinsic Value ..................................................................................................... 754.2 Beta and Capital Asset Pricing Model (CAPM) ............................................... 754.3 Discounted Cash Flow Model ............................................................................ 78 4.3.1 What is FCFF? ...................................................................................... 80 4.3.2 What is FCFE? ...................................................................................... 814.4 Dividend Discount Models ................................................................................. 854.5 Relative Valuation ............................................................................................... 85Summary .................................................................................................................... 90References .................................................................................................................. 90Recommended Reading ............................................................................................ 91Self Assessment .......................................................................................................... 92
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Chapter V ................................................................................................................... 94Technical Analysis ..................................................................................................... 94Aim ............................................................................................................................. 94Objectives ................................................................................................................... 94Learning outcome ..................................................................................................... 945.1 Introduction ......................................................................................................... 955.2 What is Technical Analysis? ............................................................................... 955.3 Basic Grounds ..................................................................................................... 955.4 Charting Methodologies ..................................................................................... 965.5 Technical Indicators .......................................................................................... 106 5.5.1 Market Sentiment Indicators ............................................................... 106 5.5.2 Breadth Indicators ............................................................................... 1075.6 Testing Technical Trading Rules ...................................................................... 108Summary .................................................................................................................. 109References ................................................................................................................ 109Recommended Reading .......................................................................................... 110Self Assessment ........................................................................................................ 111
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Chapter VI ............................................................................................................... 113Bond Analysis, Security Analysis and Wealth Management ............................... 113Aim ........................................................................................................................... 113Objectives ................................................................................................................. 113Learning outcome ................................................................................................... 1136.1 Introduction ....................................................................................................... 1146.2 Government Bonds ........................................................................................... 1156.3 Corporate Bonds ............................................................................................... 115 6.3.1 Zero Coupon Bonds ............................................................................ 115 6.3.2 Straight Bonds ..................................................................................... 115 6.3.3 Floating Rate Bonds ............................................................................ 116 6.3.4 Bonds having Embedded Options ....................................................... 116 6.3.5 Commodity-Linked Bonds ................................................................. 1166.4 Bond Yields ........................................................................................................ 116 6.4.1 Yield to Maturity ................................................................................. 116 6.4.2 Yield to Call ........................................................................................ 117 6.4.3 Realised Yield to Maturity .................................................................. 118 6.4.4 Current Yield ....................................................................................... 118 6.4.5 Yield to Maturity and Default Risk ..................................................... 118 6.4.6 Yield to maturity versus Holding Period Return ................................. 1186.5 Risks in Bonds ................................................................................................... 119 6.5.1 Inflation Risk ...................................................................................... 119 6.5.2 Interest Rate Risk ................................................................................ 119 6.5.3 Default Risk ........................................................................................ 120 6.5.4 Real Interest Rate Risk ....................................................................... 120 6.5.5 Liquidity Risk ..................................................................................... 120 6.5.6 Reinvestment Risk .............................................................................. 121 6.5.7 Foreign Exchange Risk ....................................................................... 121 6.5.8 Call Risk ............................................................................................. 1216.6 Rating of Bonds ................................................................................................. 1216.7 Rating Methodology.......................................................................................... 1246.8 Key Financial Ratios ......................................................................................... 1246.9 Debenture Rating Symbols of CRISIL ............................................................ 125 6.9.1 Investment Grades .............................................................................. 125 6.9.2 High Investment Grades ..................................................................... 125 6.9.3 Speculative Grades ............................................................................. 1256.10 The Yield Curve .............................................................................................. 1266.11 Introduction to Wealth Management ............................................................ 129Summary .................................................................................................................. 130References ................................................................................................................ 131Recommended Reading .......................................................................................... 131Self Assessment ........................................................................................................ 132
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List of Figures
Fig. 1.1 Classification of issues .................................................................................... 2Fig. 2.1 Top down approach ........................................................................................ 25Fig. 2.2 Bottom Up Approach ..................................................................................... 26Fig. 2.3 Share of global GDP by country .................................................................... 27Fig. 2.4 Growth rates in advanced economies ............................................................ 28Fig. 2.5 Growth rates in emerging economies ............................................................ 29Fig. 2.6 Business cycle ................................................................................................ 30Fig. 2.7 Business cycle and industry performance ..................................................... 31Fig. 2.8 Industry life cycle .......................................................................................... 35Fig. 2.9 Features of relative decline ............................................................................ 36Fig. 2.10 Porter’s 5 forces model ................................................................................ 38Fig. 3.1 Significant accounting policies ...................................................................... 56Fig. 3.2 Financial ratios comparisons ......................................................................... 62Fig. 3.3 Types of ratios ................................................................................................ 63Fig. 5.1 Basic concepts of chart analysis .................................................................... 96Fig. 5.2 Support and resistance ................................................................................... 97Fig. 5.3 Bar chart ........................................................................................................ 98Fig. 5.4 Line chart ....................................................................................................... 99Fig. 5.5 Head and shoulders ...................................................................................... 100Fig. 5.6 Dow theory .................................................................................................. 101Fig. 5.7 Moving average ........................................................................................... 103Fig. 5.8 Relative strength index ................................................................................ 105Fig. 6.1 Normal yield curve ...................................................................................... 127Fig. 6.2 Inverted yield curve ..................................................................................... 127Fig. 6.3 Flat yield curve ............................................................................................ 128
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List of Tables
Table 2.1 Difference between technical and fundamental analysis ............................ 24Table 3.1 Common size analysis of ABC Ltd. ............................................................ 68Table 3.2 Cross-sectional analysis .............................................................................. 68Table 4.1 Beta calculation ........................................................................................... 76Table 4.2 FCFF ........................................................................................................... 82Table 4.3 Total FCFF .................................................................................................. 83Table 4.4 WACC calculation ....................................................................................... 84Table 4.5 DCF calculation .......................................................................................... 85Table 4.6 PE Ratio Interpretation ................................................................................ 87Table 4.7 Relative valuation of IT companies ............................................................ 89Table 5.1 Moving average analysis of buy and sell signal........................................ 104Table 6.1 Key players in KPO .................................................................................. 129
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Abbreviations
AD - Aggregate DemandBSE - Bombay Stock ExchangeCAGR - Cumulative Annual Growth RateCAPM - Capital Asset Pricing ModelCAPM - Capital Asset Pricing ModelCIE - Company Industry EconomyCLB - Company Law BoardCSDL - Central Securities Depository LimitedDCA - Department of Company AffairsDCF - Discounted Cash FlowDEA - Department of Economic AffairsEIC - Economy Industry CompanyEVA - Economic Value AddedFCF - Free Cash FlowGDP - Gross Domestic ProductHEFRO - High-End Financial Research OutsourcingHNI - High Networth IndividualsHST - Head and Shoulders TopICICI - Industrial Credit and Investment Corporation of IndiaIPO - Initial Public OfferKPO - Knowledge Process OutsourcingMDA - Management Discussion and AnalysisNAV - Net Asset ValueNOPAT - NetOperatingProfitafterTaxNSCC - National Securities Clearing CorporationNSDL - National Securities Depository LimitedNSE - National Stock ExchangePF - Provident FundPFC - Point and Figure CartPSU - Public Sector UndertakingsPVC - Polyvinyl ChlorideQIB - QualifiedInstitutionalBuyersRBI - Reserve Bank of IndiaROIC - Return on Invested CapitalSEBI - Securities Exchange Board of IndiaVSAT - Very Small Aperture TerminalsWACC - Weighted Average Cost of CapitalYTC - Yield to CallYTM - Yield to Maturity
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Chapter I
Securities Markets and Mutual Funds
Aim
The aim of this unit is to:
defineprimarymarket•
differentiate between primary and secondary market•
explain participants in the securities markets•
Objectives
The objectives of this unit are to:
discuss the difference between trading and investing•
describe debt and call money market•
explain mutual funds•
Learning outcome
At the end of this unit, you will be able to:
understand key functions of asset management companies•
recognisekeyfinancialnumbers•
enlist different ratios•
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1.1 Primary MarketAlso, we can say that securities market is a system of interconnection between all participants (professional and nonprofessional) that provides effective conditions: to buy and sell securities. Security market can be divided into primary and secondary market.
The Primary Market is also known as new issues market. Many companies, especially small and medium scale, enter the primary market to raise money from the public to expand their businesses. They sell their securities to the public through an initial public offering. The securities can be directly bought from the shareholders, which is not the case for the secondary market. The primary market is a market for new capitals that will be traded over a longer period.
In the primary market, securities are issued on an exchange basis. The underwriters, that is, the investment banks, play an important role in this market: they set the initial price range for a particular share and then supervise the selling of that share. Equity capital can be raised in primary market by a company using any of the following four ways:
Issues
Initial Public
Offering
Fresh Issue
Fresh Issue
Offer for Sale
Offer for Sale
Further Public
Offering
Public Private placementRights Preferential
allotment
Fig. 1.1 Classification of issues
1.1.1 Public IssueAs the name suggests, public issue means selling securities to public at large. It is the most vital method to issue securities. The SEBI guidelines on investor protection, the provisions of the Companies Act, 195 and the listing agreement between the stock exchanges and the issuing company administer the public issues in India. The procedures that must be followed by the company while issuing shares to the public are stated by the Companies Act. It also mentions the information that must be disclosed in the prospectus. On the other hand, the SEBI guidelines,specifiestheextrainformationthatissuingcompanymustdiscloseto the investors. It also imposes certain conditions on the issuing company. An investor must be aware of the following aspects of public issues:
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A company going for public issue informs the public about the same by •means of legal announcements in newspapers, the application forms are made available to the public through stock brokers as well as other distributors and the subscription is kept open for about three to seven days. The public can then download these application forms from the website of various brokers or other distributors.On applying for a primary issue, an investor has to opt for allotment in •dematerialised form.In case of over-subscription of the issue, the exchange where the issue is to •belistedisconsultedfortheallotmentpattern.Afterfinalisingtheallotmentpattern, the allotment letter is mailed by the issuing company along with refund order, if any. This needs to be done within a couple of weeks of the subscription closure.During allotment, if the full amount has not been asked for, then the balance •is called in one or two calls later. Once the bank where the balance payment is made stamps the allotment letter, then that letter can be exchanged for share certificates(orevendebenturecertificates,dependingonthecase).Also,theletter of allotment itself can be sold by the allottee (i.e., if the allottee wishes to of course), by transmitting it with the transfer deed.In case of failure to pay the call monies by the allottee, the shares can be •forfeited and in such cases, the allottee is not eligible for any sort of refund of payments that are already made.If shares are issued by a company through public issue or bonus issue or rights •issue, then the entitlement of dividends for these shares is from the date of allotment only. According to one of the directives of central government, there should be only one quotation for the existing shares of a company as well as for any new shares that arise from the further issues of the same company.
Stockinvest schemeWhen public issues become over-subscribed, many investors lose their interest in the money that is locked with the company at the time of subscription giving the additionalbenefitofthisfloatingmoneytotheissuingcompany.Inordertopreventthis from happening, the SEBI has come up with the stockinvest scheme.
Stockinvest scheme is another way available to apply for public issues. So, we can say that it is an additional functionality available to the public apart from cash, cheques and drafts for applying for public issues. The usage of stockinvest schemes is restricted to individual investors and mutual funds only and so, banks, FIs, corporate and even stock brokers are not allowed to use this method to apply for public issues. The stockinvest scheme functions in the following manner:
Anapplicationforspecificnumberofstockinvestofrequisitedenominations•is made by an investor having a savings or current account with a bank that takes part in stockinvest scheme.
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As per the application, the stockinvests are issued by the bank with proper •dates. Also, an entry is created into the account of the investor indicating the amount of stockinvests issued.An application form is then submitted to the collector banker by the investor •forpublicissuealongwiththedulyfilledrequisitestockinvests(withcorrectdetails like name of company, number, and amount of shares).The application form with the stockinvests is transmitted by the collector bank •to the registrar of the issue.Oncetheallotmentisfinalised,therightsideofthestockinvestformisfilled•by the registrar indicating the entitlement of the investor.The amount pertaining to the allotment is claimed by presenting the stockinvest •form (by the registrar) to the controlling branch of the collecting bank for public issue.Stockinvests being guaranteed instruments, company’s account is credited •by the collecting bank.Once the company’s account is credited, formal allotment is done by the •registrar. The successful applications are intimated about the partial or full allotments via allotment advice by the registrar. In case of unsuccessful applicants, the application form along with the cancelled stockinvests is returned back by the registrar to the controlling bank which in turn informs the issuing bank.The applicants are then informed by the issuing bank regarding the release of •lien on the account as a result of non-allotment.
Book buildingA method to offer shares to the investors, where in the issue price is determined atthetimeofbiddingandisnotfixed(likethatoffixedpriceoffer),isknownasbook building. The book building method works as follows:
Apublicissueisannouncedbyacompanywhichalsospecifiesanindicative•price range that is obtained after discussion with its leading merchant bankers.Interested investors submit the application form along with the bid, indicating •their price and volume options to syndicate members. The syndicate members are on electronic linked platform across the country. The electronic platform of NSE and BSE is used. The submitted bid is uploaded on BSE or NSE system Investors can see the book status on the bidding terminals. The bids can be revised by the investors any number of times within the bidding period.After the closure of bidding period, depending on the demand function, the •issue price, and the allocation pattern is decided by the manager along with the issuer. Generally, the aim of pricing is to ensure that there is healthy demand overhang that leads to a post-listing price which is more than the issue price. As for the allotment, individuals biding up to 1000 shares must be allotted minimum of 12 percent, minimum of 15 percent must go to corporates, High Networth Individuals (HNIs) and individuals bidding more than 1000 shares,
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QualifiedInstitutionalBuyers(QIB)likebanks,FIscanbeallottedmaximumof 60 percent. In case of over-subscription, the allotment in 25 and 15 percent band needs to be done proportionately where as that in QIB band, the allotment needs to be done on discretionary basis.
1.1.2 Rights IssueWhenever a company needs to raise supplementary equity capital, the shares have to be offered to the present shareholders on a pro rata basis. This is called as the rights issue. Under section 81 of the company’s act 1956, it is required to issue the rights shares to the existing shareholders. The shareholders by a special resolution can surrender this right to help the company to issue extra capital to the general public.
Procedure for rights issueA letter of offer, along with an application form that consists of four forms – A, B, C, D, is sent by the company to the shareholders. Form A indicates the agreement ofrightsaswellasextrasharesapplication.Italsospecifiesthetotalnumberofrights issues for which the shareholder is entitled to. If in case the shareholder wishes to hand over the rights to someone else, then that can be done by using form B. The renounce to which the original allottee has handed over the rights needstofileanapplicationusingFormC.FormDisusedforapplicationofsplitforms. This compound application form should be submitted to the company withinafixedperiodwhichisnormallyof30days.
1.1.3 Private PlacementSelling securities to restricted number of classy investors like FIs, venture capital funds, mutual funds, banks etc comes under private placement and preferential allotment. The difference between preferential allotment and private placement is that in preferential allotment, the issuing company, while seeking the approval of the shareholders, knows the identity of the investors whereas in the latter case, the investor’s identity is unknown while preparing the offer document also known as the information memorandum. Generally, in case of India, it is observed that:
Sale of equity related instruments or equity itself of an unlisted company or sale •of debentures of unlisted or listed company comes under private placement.Preferential allotment involves selling equity related instruments or equity •of a listed company.
1.1.4 Preferential AllotmentIn Indian capital market, when a listed company issues an equity to a selected number of investors at a price that may or may not be pertaining to the market price is known as preferential allotment. It should be noted that preferential allotment is not at all related to public issue and so, it should not be mistaken with the reservations that may be made for certain group of investors in public issue on preferentialbasis.Inordertofightofftheriskoftakeover,inIndia,thepreferentialallotment is generally given to friendly investors or promoters. Preferential allotment is considered a very good way of raising new equity capital as
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The level of uncertainty as well as cost related to public issue is high.•A higher price is expected from classy investors like mutual funds and other •private equity investors.
1.2 Secondary Market (Stock Market)The stock market originated in India in eighteenth century, however, the actual beginning happened somewhere in the mid of nineteenth century after the Companies Act of 1850 was passed. The establishment of Native Share and Stock Brokers’ Association (originator of Bombay Stock Exchange) in 1875 in Bombay turned out to be the key development in the Indian stock market. Other exchanges were then formed in Ahmadabad, Calcutta, and Chennai. Apart from these, a number of exchanges were formed mostly in the optimistic period but were diminished subsequently in downfall period.
A legislation known as Securities Contracts (Regulation) Act, 1956 was established by the central government in order to control such irregularities and encourage a more disciplined growth of stock market. As per this regulation, it was imperative for any stock exchange to obtain recognition by government.
The formation of National Stock Exchange (NSE) in 1994 has been the most significantdevelopmentinIndianstockmarketsofar.Withinaveryshortspanof time, NSE has become India’s largest stock exchange, even surpassing BSE, which was considered the leading stock exchange in India. Due to NSE, the very existence of many of the regional stock exchanges is endangered. As a result, as a survival act, these regional stock exchanges have formed subsidiaries and these subsidiaries in turn have become institutional members of BSE and NSE. For example, BGSE Financial Services Ltd. is a subsidiary of Bangalore stock exchange and is an institutional member of BSE and NSE. This permits members of Bangalore stock exchange to trade both in BSE as well as NSE through BGSE.
1.2.1 National Stock Exchange (NSE)Founded in 1994, NSE looks for
establishing a country-wide facility for trading of debts, equities and •mixturesaid for equal access to the investors throughout the county •incorporateefficiency,justice,andtransparencytosecurities•reduce the settlement cycle•meet the market standards of international securities•
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Following are the characteristics of NSE:NSE is a computerised and national exchange•The two segments of NSE are Wholesale Debt Market Segment and Capital •Market Segment. The high-end transactions in PSU bonds, government securities, commercial papers and various other debt instruments come under Wholesale Debt Market, whereas, capital market segment is a market for equities, retail trade in nonconvertible debentures and convertible debentures.A satellite linkage connects the members trading in the capital market segment •to a central computer in Mumbai via very small Aperture Terminals (VSATS). On the other hand, some high speed lines connect the members trading in Wholesale Debt Market to the central computer in Mumbai.An over-driven system is chosen by NSE for its operations. Whenever any •trading member places an order, a unique order number is automatically generated by the computer and the member can then take a print of the confirmationslipoftheordercontainingthisuniqueordernumber.Onoccurrenceof a trade, a slip confirming this tradegets printedon the•terminalofthistrader.Theconfirmationslipshowsthetradedetailslikethecounterparty code number, volume, price etc.As the trading member’s identity is not disclosed to others when an order is •placed by him or when his orders in pending state are displayed, it is possible to place a large number of orders in NSE.Thecashandsecuritiesmustbedeliveredbythemembersonaspecificday•and the next day is the payment day.The National Securities Clearing Corporation (NSCC) guarantees all the NSE •trades. So, when P sells to Q, NSCC happens to be the counterparty for both the legs of the transaction which means NSCC becomes buyer from P and seller for Q. Thus, the counterparty risk is removed.
1.2.2 Bombay Stock Exchange (BSE)Bombay Stock Exchange was formed in 1875 and is one of the oldest exchanges in the world with an interesting history. Following are the features of BSE:
As a response to the threat from NSE, BSE was computerised in 1995.•A broker who trades on his own account thereby offering a bid-ask quote or a •two-wayquoteisknownasajobberandplaysasignificantroleinBSE.Thebid price is the price at which the jobber wishes to buy and the ask price is the price at which he wishes to sell.Transactions must take place through a broker or jobber who enters his buy •or sell price in his system which is linked to the main server in BSE. As both, the jobbers as well as buyers enter their orders; the BSE has implemented an order-driven system and a quote-driven system.
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1.3 Securities Market ParticipantsThe various participants of Indian securities market are:RegulatorsFollowingarethevitalagenciesthathaveconsiderableinfluenceoversecuritiesmarket:
The Reserve Bank of India (RBI) whose main responsibility is to monitor �the banks, government securities market, and money market.The Company Law Board (CLB) whose responsibility is to administer �the Companies Act, 1956.The Department of Company Affairs (DCA), a part of government �responsible for administration of corporate bodies.The Department of Economic Affairs (DEA), a part of government catering �tothedisciplinedfunctioningoffinancialmarketsintotality.
Stock exchangesA place where already issued securities are bought and sold is known as stock exchange. Currently, India has 23 stock exchanges and NSE and BSE are the most vital ones amongst them.
DepositoriesAnorganisationthatphysicalcertificatesandbringsintoeffect thetransferofownership by means of electronic book entries is known as a depository. In India, currently there are two depositories – the Central Securities Depository Limited (CSDL) and the National Securities Depository Limited (NSDL).
Listed securities•Listed Securities are the ones that are listed in different stock exchanges and so are eligible to be traded there. Currently, in India, there are altogether around 10,000 securities listed on all stock exchanges.
Brokers•The registered members of stock exchanges through whom all the transactions of the investors take place are known as brokers. India has around 10,000 brokers.
Merchant bankers•Merchantbankersarethefirmsthatfocusonmanagingtheissueofsecuritiesandmust be registered with SEBI.
Foreign institutional investorsForeign Institutional Investors are the institutional investors that are registered with SEBI in order to operate in the Indian capital market. They have surfaced majorly in the Indian capital market and there are about 500 foreign institutional investors.
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Mutual fundsA channel aimed at shared or collective investment is nothing but a mutual fund. In other words, mutual funds manage the funds of investors. There are around 30 mutual funds in India.
CustodiansAnentitytakingcareofamutualfund’sbackofficeisknownasacustodian.Itisresponsible for receiving as well as delivering securities, distribution of dividends, collecting income and separating assets amongst schemes.
Primary dealersPrimary dealers function as underwriters in primary market, where as in secondary market, they operate as market makers and are appointed by RBI.
RegistrarsA registrar is appointed by a mutual fund or a company to handle all service related to an investor. A registrar is also known as a transfer agent.
UnderwritersIn the event of insufficiencyof public subscription, an underwriter settles tosubscription of a given number of shares or any other security for that matter. Thus, we can say that an underwriter is acts as a guarantor for public subscription.
Bankers to an issueThe bankers to an issue are the ones who, on behalf of the company, collect money from the applicants.
Debenture trusteesWhen a company issues debentures, it must also appoint a debenture trustee to makesurethattheborrowingfirmabidesbyalltheobligationsmentionedinthecontract.
Credit rating agenciesA credit rating agency is responsible for assigning ratings mainly to debt securities.
Venture capital fundsA reserve of capital fundamentally invested in equity shares or equity related instruments of unlisted companies are known as a venture capital fund.
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1.4 Initial Public Offer (IPO)The sale of securities to public in primary market is known as an Initial Public Offer(IPO).IPOhappenswhenanunlistedcompany,forthefirsttimetopublic,either
makes fresh issue of securities or•offers existing securities for sale or•both of the above•
This gives way for listing and trading of the securities of the issuer. The sale of securities can take place either through normal public issue or through book building.
1.5 Trading and InvestingTrading is an operation of buying and selling securities on the market. On-line trading denotes buying and selling on the Internet through sites provided by financialbrokerslikeICICIDirectandbanks.
Investment is the use of money through various vehicles or an individual’s time and effort to make more income or increase capital or both. The term “investment” infers that the safety of principal is important. On the other hand, speculation connotes that risking principal is acceptable.
The main difference between “trading” and “investing” is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future.
1.6 Debt MarketSince mid-1990s, the corporate debentures market has really perked up. Following factors indicate that the debentures market is headed for a healthy growth in future:
Complete freedom is enjoyed by the companies in debt instrument •designing.A portion of provident fund money can be used as an investment in corporate •debentures that are approved.The limitations on foreign institutional investors in investing in debt securities •have reduced.The debentures have become more alluring to the investors since the acute •fall in the returns on equity in mid-1990s.Astheinfrastructuresectorreliesheavilyondebtfinance,moreinvestments•are expected from this sector.A new segment known as Wholesale Debt Market segment has been set up by •NSE for gilt-edged securities, Treasury Bills and Bonds issued by Public Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon
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Bonds,CommercialPapers,CertificateofDeposits,CorporateDebentures,State Government loans, SLR and Non-SLR Bonds issued by Financial Institutions,UnitsofMutualFundsandSecuritiseddebtbybanks,financialinstitutions, corporate bodies, trusts and others. Also, a number of corporate debentures have been listed on the capital market segment of NSE.
1.7 Money MarketThe market for short term debt funds is known as money market. It includes repo market, call and notice money market as well as debt instruments market like treasury bills having less than one year of maturity.
Themoneymarketisnotconfinedtoanyparticularphysicallocation,oronesetofrules or even post single set of prices. Instead, it symbolizes a network of borrowers and lenders who are connected via computers and telephones and deal with short term debt funds. The crucial participants in money market include companies, government,banks,andFIs.Centralbank,whosepoliciesholdsignificantbearingon the interest rates of money market, lies in the centre of this network.
The demand and supply of short term funds is evened out by the mechanisms provided by the money market. In addition, money market also acts as a crucial point for the interference by the central bank (RBI in case of India) in order to influencetheinterestratesandliquidityinfinancialsystem.Variousmoneymarketinstruments are:
Treasury bills•Certificatesofdeposits•Repos•Commercial paper•
1.8 Mutual FundsThe funds are collected from individual investors and invested into a wide range ofsecuritiesandotherrelevantassetsbysomefinancialmediatorscalledmutualfunds. The key idea behind any investment company is collection of assets. Every investor is entitled to the portfolio built by the investment company in proportion to the invested amount. So, a mechanism is provided by these companies for small-scale investors to join hands for obtaining the perks of large-scale investing.
1.9 Key Functions of Asset Management CompaniesSome of the key functions performed by these investment companies for the benefitoftheirinvestorsare:
Administration and record keeping: • Status reports that keep track of dividends, investments, redemptions etc. are issued periodically by the investment companies who can also reinvest interest income and dividends for their shareholders.
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Professional management: • Full-time portfolio managers as well as security analysts are employed by many investment companies for better investment results.
Divisibility and diversification: • Investors are allowed to possess fractional shares of various securities by collecting their funds. So, even though individual shareholders cannot, they can act as large investors.
Lower transaction costs: • Since large blocks of securities are traded, con-siderable savings on commission and brokerage fees are achieved by the investment companies.
1.10 Key Financial NumbersAnunderstandingoffollowingkeyfinancialnumbersisessentialforamutualfund scheme participant:
Asset mix: • The distribution of the body of the scheme in three sections, viz, stocks, bond and cash is referred to as asset mix of a scheme An asset mix 40:30:30 indicates that 40 percent of the scheme is invested in stocks, 30 percent in bonds and remaining 30 percent in cash.
Net asset value: • The actual value of the share per unit on any business day is known as the Net Asset Value (NAV). The formula for computing NAV is as follows.
NAV =
Let us take a simple example for better understanding of calculation of NAV:
Scheme Name: PQRScheme Size: Rs. 200 croreFace value of the share: Rs. 5Number of Outstanding shares: 5 croreMarket Value of Fund’s Investment: Rs 200 croreReceivables: Rs 2 croreAccrued Income: Rs. 2 croreLiabilities: Rs.0.75 croreAccrued expenses: Rs. 0.5 crore
NAV = (200 + 2 + 2 – 0.75 – 0.5)/5 = Rs.40.55
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Market, repurchase price and reissue price: • It is essential to list a close-ended scheme on a reputed stock exchange in order to make sure that its participants enjoy liquidity. Normally, the NAV of a close-ended scheme tends to be more than its market price. If NAV is more than its market price, then the scheme is said to be selling at discount where as lower NAV means that the scheme is selling at a premium. Besides listing, the facility of repurchase may also be offered by the mutual fund. Generally, the repurchase price is connected to NAV.
As opposed to a closed-end scheme, an open-ended scheme is not listed on the stock exchange. As a result, the mutual funds must continuously issue its units or shares and must be ready for repurchase. Again, here also the repurchase and reissue prices are linked to NAV.
Discount: • Normally, closed-ended schemes sell at a discount, which may be at times very abrupt over their NAV, as per Benjamin Graham, the reason being the performance and not the structure of such schemes. Probably they do not suit well for any vital group of investors. As open-ended schemes are sold more extensively,theytemptthesmallinvestors;thelargeinvestorsmaynotfindmutual funds very alluring; as the closed-ended schemes lack the excitement of particular scrip, even speculators have very less interest in them.
Rate of return: • The rate of return is on a mutual fund scheme is calculated periodically (may be monthly, quarterly, yearly, or any other interval) as follows:
Rate of Return for the period =
Let us take a simple example for better understanding of calculation of Rate of Return:NAV (beginning): Rs. 15NAV (ending): Rs. 18Dividend paid: Rs. 2
Rate of return: 18-15 + 2 / 15 = 33.33 percent
The return to investors on a mutual fund scheme since the issue date is represented by the composite annual total return (in percent per annum). In this, the dividends are reinvested and adjustments are made for bonus and rights. The calculation is based on NAV or price basis. The return that fund manager generates on NAV isreflectedonNAVbasis.Inthismethodofcalculation,anassumptionismadethat the dividend is reinvested at the NAV existing on the day of payment. The price basis indicates the return on the grounds of market or repurchase price. Calculation by this basis is made assuming that the dividend reinvestment is done at the market or reissue price.
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Standard deviation: • Standard deviation is the square root of the mean of the square of deviations around the arithmetic average and is a measure of dispersion. Normally, computation of standard deviation, beta and Ex-Mark is donebyconsideringthemonthlyreturnsforaperiodofthreetofiveyears.
Ex-mark: • According to John C Bogle, the degree to which any particular financialmarket explains the return of amutual fund is defined by theterminology Ex-Mark . This term is indicated as R-squared (R2) in statistics. A conventional equity fund has an Ex-Mark of around 80-90 percent.
Beta: • Beta is used to measure a fund’s past price precariousness with respect to any particular stock market index. So, we can say that, it acts as a risk measure providing vital statistical information, especially when applied to portfolios (instead of individual stocks). A conventional equity fund has Beta somewhere between 0.85 -1.05.
Gross dividend yield: • The gross dividend yield serves as a crucial indicator of the investment features of a mutual fund. Generally, in equity funds, the growth-oriented funds tend to have lower gross dividend yield as compared to that of value oriented funds that tend to have higher gross dividend yield. It is considered to be a dependable differentiator of an investment policy of a fund.
Portfolio turnover ratio: • The churn in the portfolio is represented by the portfolio turnover ratio and is calculated as:
Portfolio Turnover Ratio =
Expense ratio: • The yearly recurring costs are referred to as a percentage of net assets of the scheme by an Expense Ratio.
1.11 Performance EvaluationThe key factors of performance evaluation of a mutual fund are rate of return and risk.
Rate of return• The rate of return for a given duration (say a period of 1 year) from a portfolio is given as:
Let us take an example to demonstrate the calculation of rate of return.
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Initial market value of the portfolio: Rs. 200,000Dividend and interest income received at the yearend: Rs. 15,000Terminal market value of the portfolio: Rs. 120,000Rate of Return = 15,000 + (210,000 – 200,000) / 200, 000 = 12.5 percent
The following steps can be followed in order to calculate average rate of return over a period of years:
Arithmetic average of yearly rates of return �Internal rate of return (also referred to as money-weighted rate of �return)Geometric average of yearly rates of return (also referred to as time- �weighted rate of return)
The discount rate that leads to equality among initial investment and the value of future gains associated with the investment is known as internal rate of return.
The geometric mean of annual rates of return is the nth root of the product of n annual wealth ratios (annual ratio is 1 + annual rate of return) minus 1.
Arithmetic average of annual rates measure is simple to compute and hence is most widely used measure of return but can be misleading at times.
The limitation of internal rate of return measure is that it is highly vulnerable to the cashflowspattern.Thequalityofperformanceofaninvestmentcannotbegaugedby the internal rate of return. However, it is useful in getting the total experience ofthefund,indicatingthecashflowsandtheinvestmentperformance.
Geometric rate of return is considered as the most superior of all the measures asitgivesequalweightagetothefinalresultsanddoesnotdependonthecashflowpatterns.
Risk• There are several ways to measure a portfolio risk,, two key measures of risk being variability and beta.
Variability: � It was recommended by the Bank Administration Institute of US to use variability of the quarterly rates of returns of a portfolio. The use of variability is also supported by Sharpe as well as others. However, standard deviation happens to be their preferred measure of variability.Beta: � Beta is a commonly used risk measure. The computation of Beta of a portfolio is same like that of an individual security. In order to compute beta of a portfolio, the rate of return of the portfolio must be regressed on the market index rate of return. The beta of portfolio is indicated by the slope of this regression line. It should be noted that it indicates the systematic portfolio risk.
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Performance measuresIt is necessary to take into consideration both, risk and return in order to evaluate the performance of a portfolio. Let us have a look at the three most widely used performance measures:
Treynor measure: � According to Jack Treynor, as per the suggestion of capital asset pricing model, beta or systematic risk is a suitable measure of risk. In Treynor’s portfolio performance measure, the excess return on a portfolio is related to the beta of the portfolio. Thus,
Treynor measure =
=
The risk premium gained by the portfolio forms the numerator of the Treynor’s measure while the denominator is Beta (systematic risk). Thus, the excess return earned on per unit of risk is indicated by the Treynor’s measure. It is assumed by theTreynor’smeasurethattheportfolioiswelldiversifiedsincethesystematicrisk is a measure of risk.
Sharpe measure: � Sharpe Measure differs from Treynor’s measure only in one aspect. Unlike Treynor’s measure, Sharpe measure uses standard deviation as a measure of risk. Thus,
Sharpe Measure=
Jensen measure: � Similar to Treynor’s measure, the Jensen measure or Jensen’s alpha is also based on the pricing model of capital asset. Given the portfolio’s beta as per the capital asset pricing model, Jensen measure depicts the difference between the actual return earned on a portfolio and the expected return on the portfolio. Thus,
Jensen Measure = Average return on portfolio – (Risk free return + Portfolio Beta (Average return on market portfolio – Risk free return))
1.12 Performance Evaluation-US ExperienceFund performance is the acid test of fund management, and in the institutional context accurate measurement is a necessity. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialise in performancemeasurement.The leading performancemeasurementfirms(forexample,FrankRussellintheUSA)compileaggregateindustry data, for instance, showing how funds in general performed against given indices and peer groups over various time periods.
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In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned), every quarter and would show a percentage change compared with the prior quarter (for example, +4.6% total return in US dollars).Thisfigurewouldbecomparedwithothersimilarfundsmanagedwithinthe institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurementfirmscalculatequartileanddeciledataandcloseattentionwouldbe paid to the (percentile) ranking of any fund.
Generallyspeaking,itisprobablyappropriateforaninvestmentfirmtopersuadeits clients to assess performance over longer periods (for example, 3 to 5 years) tosmoothoutveryshorttermfluctuationsinperformanceandtheinfluenceofthebusinesscycle.Thiscanbedifficulthoweverand,industrywide,thereisaserious preoccupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).
An enduring problem is whether to measure before-tax or after-tax performance. After-taxmeasurementrepresentsthebenefittotheinvestor,butinvestors’taxpositions may vary. Before-tax measurement can be misleading, especially in regimens that tax realised capital gains (and not unrealised). It is thus possible that successful active managers (measured before tax) may produce miserable after-tax results. One possible solution is to report the after-tax position of some standard taxpayer.
Absolute versus relative performanceIn the USA and the UK, two of the world’s most sophisticated fund management markets, the tradition is for institutions to manage client money relative to benchmarks. For example, an institution believes it has done well, if it has generated a return of 5% when the average manager (usually culled from amongst its peer class) generates a 4% return.
Risk-adjusted performance measurementPerformance measurement should not be reduced to the evaluation of fund returns alone, but must also integrate other fund elements that would be of interest to investors, such as the measure of risk taken. Several other aspects are also part of performance measurement: evaluating if managers have succeeded in reaching theirobjective,i.e.,iftheirreturnwassufficientlyhightorewardtheriskstaken;howtheycomparetotheirpeers;andfinallywhethertheportfoliomanagementresults were due to luck or the manager’s skill. The need to answer all these questions has led to the development of more sophisticated performance measures, many of which originate in modern portfolio theory.
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Modern portfolio theory established the quantitative link that exists between portfolio risk and return. The Capital Asset Pricing Model (CAPM) developed bySharpe(1964)highlightedthenotionofrewardingriskandproducedthefirstperformance indicators, be they risk-adjusted ratios (Sharpe ratio, information ratio) or differential returns compared to benchmarks (alphas). The Sharpe ratio is the simplest and best known performance measure. It measures the return of a portfolio in excess of the risk-free rate, compared to the total risk of the portfolio. This measure is said to be absolute, as it does not refer to any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it does not allow the separation of the performance of the market in which the portfolio is invested from that of the manager. The information ratio is a more general form of the Sharpe ratio in which the risk-free asset is replaced by a benchmark portfolio. This measure is relative, as it evaluates portfolio performance in reference to a benchmark, making the result strongly dependent on this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active management. In fact, we have to distinguish between normal returns, provided by the fair reward for portfolio exposure to different risks, and obtained through passive management, from abnormal performance (or outperformance) due to the manager’s skill, whether throughmarkettimingorstockpicking.Thefirstcomponentisrelatedtoallocationand style investment choices, which may not be under the sole control of the manager, and depends on the economic context, while the second component is an evaluation of the success of the manager’s decisions. Only the latter, measured by alpha, allows the evaluation of the manager’s true performance.
Portfolionormalreturnmaybeevaluatedusingfactormodels.Thefirstmodel,proposed by Jensen (1968), relies on the CAPM and explains portfolio normal returns with the market index as the only factor. It quickly becomes clear, however, that one factor is not enough to explain the returns, and that other factors have to be considered. Multi-factor models were developed as an alternative to the CAPM, allowing a better description of portfolio risks and an accurate evaluation of managers’ performance. For example, Fama and French (1993) have highlighted two important factors that characterise a company’s risk in addition to market risk. These factors are the book-to-market ratio and the company’s size as measured by its market capitalisation. Fama and French therefore proposed a three-factor model to describe portfolio normal returns. Carhart (1997) proposed to add momentum as a fourth factor to allow the persistence of the returns to be taken into account. Also of interest for performance measurement is Sharpe’s (1992) style analysis model, in which factors are style indices. This model allows a custom benchmark for each portfolio to be developed, using the linear combination of style indices that best replicate portfolio style allocation, and leads to an accurate evaluation of portfolio alpha.
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SummarySecuritiesmarket defines the role ofPrimaryMarket anddifferentiates it•from Secondary Market. The participants in the stock market make the place more interesting and action-packed. The NSE and the BSE are the two places in India which provide platform to trade and liquidity. This chapter also explains the basic terms- trading and investing and explains how they are different from each other. The securities market is not only about stocks butalsocoversfinancialinstrumentslikedebentures,repoandothermoneymarket instruments.A mutual fund is a medium for joint investment. When you invest in the mutual •funds schemes you become owner of the scheme to the extent.Any mutual fund entity needs participants like the sponsor, the mutual fund, •the trustees, the asset management company, the custodians, the registrars, the transfer agents.Investments portfolio of any mutual fund schemes consists of basically stocks, •bonds and cash.Schemes are segregated into equity schemes, debt schemes and hybrid schemes •as per their asset mix.Equity schemes can be sub grouped as index schemes, sectoral schemes, •diversifiedandtaxplanningschemes.The important numbers while analysing any schemes are- asset mix, net asset •value, market price, repurchase price, reissue price, discount, rate of return, standard deviation, R2, beta, gross yield, portfolio turnover ratio and expense ratio.Rankings or evaluations are given by the rating companies like CRISIL, Value •Research India, and The Economic Times group.Risk of a portfolio can be measured by standard deviation and beta.•Performance of a portfolio can be measured by its Risk and Return.•To calculate average rate of return of a portfolio calculate – arithmetic average, •internal rate of return, and geometric average.
ReferencesFocus on Business, 2008. • Managing Assets and Investment [Online] Available at: <http://www.focus-on-business.com/html/Investments.html> [Accessed 18 July 2011].Investopedia, 2011. • Mutual Funds: Introduction [Online] Available at: <http://www.investopedia.com/university/mutualfunds/#axzz1SRifPEg0> [Accessed 18 July 2011].Savingandinvesting, 2007. • 22. Mutual Funds 1: What is a Mutual Fund? [Video Online] Available at: <http://www.youtube.com/watch?v=ky7GWCksyRg> [Accessed 18 July 2011].
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HouseResourceOrg, 2011. • Securities Markets and Federal Laws [Video Online] Available at: <http://www.youtube.com/watch?v=If8bUVrgK8g> [Accessed 18 Jul 2011].Arnett, G. W., 2011. • Global Securities Markets: Navigating the World’s Exchanges and OTC Markets, 1st ed., Wiley.Gremillion, L., 2005. • Mutual Fund Industry Handbook: A Comprehensive Guide for Investment Professionals, 1st ed., Wiley.
Recommended ReadingChandra, P., 2006. • Investment Analysis and Portfolio Management, New Delhi: Tata McGraw-Hill.Bodie, Z., Kane, A., Marcus, A. J., Mohanty, P., 2006. • Investments, New Delhi: Tata McGraw-Hill.Collins, P. S., 2011. • Regulation of Securities, Markets, and Transactions: A Guide to the New Environment, 1st ed., Wiley.
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Self Assessment
Which of the following is NOT the part of raising equity capital in primary 1. market?
Rights Issuea. Bonus issueb. Public issuec. Preferential issued.
In case of oversubscription, the company has to send refund order 2. in___________.
a yeara. a month’s timeb. a couple of weeksc. 2 days’ timed.
In case of share forfeiture, the company has to refund_____________.3. all the moneya. 50% of moneyb. no refundsc. 50% of refundsd.
In case of rights issue, the existing shareholders______________.4. are forced to subscribe to the issuea. can surrender the rightb. can subscribe the rightc. are forced the surrender to the issued.
Match the columns.5. Growth equity fund 1. RA. 2
Value equity fund 2. Sensitivity to stock marketsB. Beta3. Low dividend yieldC. Ex-Mark 4. High dividend yieldD.
1-C, 2-D, 3-B, 4-Aa. 1-D, 2-C, 3-A, 4-Bb. 1-B, 2-A, 3-D, 4-Cc. 1-A, 2-D, 3-B, 4-Cd.
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The key factors of performance evaluation of a mutual fund are_________.6. rate of return and riska. risk and betab. alpha and Rc. 2
liquidity and riskd.
Two key measures of risk are___________.7. liquidity and returnsa. alpha and betab. variability and betac. liquidity and betad.
Which of the following is incorrect?8. NAV is published daily.a. NAV is important for valuation of mutual funds.b. NAV calculation is done once in a year.c. NAV refers to Net Asset Value.d.
Which of the following statements is true?9. Beta measures liquidity.a. Rb. 2 measures EX-Mark.Mutual funds invest in swaps and options.c. Mutual funds are a part of direct investments in the capital market for d. common investors.
Identify the odd one among the four options.10. Mutual Fundsa. NAVb. Betac. Short sellingd.
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Chapter II
Fundamental Analysis- Macroeconomic Analysis and Industry Analysis
Aim
The aim of this unit is to:
definefundamentalanalysisandintrinsicvalue•
differentiate between fundamental and technical analysis•
explain Michael Porter model for industry analysis•
Objectives
The objectives of this unit are to:
describe global economy and domestic economy•
highlight economic indicators•
discussmonetaryandfiscalpolicies•
Learning outcome
At the end of this unit, you will be able to:
comprehend importance of economic analysis for security analysis•
recognise fundamental analysis frameworks•
understand the concept of industry analysis•
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2.1 What is Fundamental Analysis?Fundamentalanalysiscanbedefinedas“amethodofevaluatingasecuritybyattemptingtomeasureitsintrinsicvaluebyexaminingrelatedeconomic,financial,and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors(liketheoveralleconomyandindustryconditions)andindividuallyspecificfactors(likethefinancialconditionandmanagementofcompanies).”
The end goal of performing fundamental analysis is to produce a value �that an investor can compare with the security’s current price in hopes of figuringoutwhatsortofpositiontotakewiththatsecurity(underpriced= buy, overpriced = sell or short). This method of security analysis is considered to be the opposite of technical analysis. Fundamental analysis is about using real data to evaluate a security’s value.One of the most famous and successful users of fundamental analysis �is the Oracle of Omaha, Warren Buffett, who has been well known for successfully employing fundamental analysis to pick securities. His abilities have turned him into a billionaire.
2.2 Differences between Technical Analysis and Fundamental AnalysisThe important difference between technical and fundamental analysis are as follows:
Technical Analysis Fundamental Analysis
Technical analysis primarily aims to estimate short-term price movements
Fundamental analysis focuses on determining long-term values
Technical analysis mainly emphasises on internal market data, prices, and volumes to be precise
Fundamental analysis focuses on basic factors related to firm, industry, andeconomy.
Technical analysis tempts short-term traders
Fundamental analysis attracts long-term investors
Table 2.1 Difference between technical and fundamental analysis
2.3 What is Intrinsic Value?In valuing equity, securities analysts may use fundamental analysis - as opposed to technical analysis - to estimate the intrinsic value of a company. Here, the “intrinsic”characteristicconsideredistheexpectedcashflowproductionofthecompanyinquestion.Intrinsicvalueisthereforedefinedtobethepresentvalueofallexpectedfuturenetcashflowstothecompany;itiscalculatedviadiscountedcashflowvaluation.
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As opposed to the book value, or break-up value, of a business, the intrinsic value is the value of a business’ ongoing operations. Warren Buffett is best known for his ability to calculate the intrinsic value of a business, and then buy that business at a discount to its intrinsic value.
2.4 Fundamental Analysis FrameworksThere are mainly two frameworks of fundamental analysis based on the stock researching technique as listed below.
Top Down Approach (EIC)In top down approach, the analyst first scansmacroeconomic environment,understands government policies, and then accordingly selects the industry to study. While studying the industry, he analyses different players in the industry and then selects one company to invest in. The approach is Economy- industry- company analysis, so it is called top down approach.
Top down Approach (EIC)
Economic Analysis
Industry Analysis
Company Analysis
Fig. 2.1 Top down approach
Bottom Up Approach (CIE)Inbottomupapproach,theanalystfirststudiesacompany,understandsratioandother valuation metrics, and then accordingly studies the industry by comparing the different peers in the same industry. After studying the industry, he analyses economic indicators to be doubly sure about the company selected. The approach is company-industry- Economy- analysis, so it is called bottom up approach.
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Bottom up Approach (CIE)
Economic Analysis
Industry Analysis
Company Analysis
Fig. 2.2 Bottom Up Approach
Researchers have found that stock price changes can be attributed to the following factors:
Economy-wide factors: 30-35 %•Industry Factors: 15-20 %•Company Factors: 30-35%•Other Factors: 15-25%•
Fundamental analysis requires 3-step examination.understanding of the macro-economic environment and developments•analysingtheprospectsoftheindustrytowhichthefirmbelongs•assessing the projected performance of the company and the intrinsic value •of its shares
2.5 Global Economy and Domestic EconomyTheglobaleconomyhasabearingontheexportprospectsofthefirm,the•competitionfrominternationalplayers,andtheprofitabilityofitsoverseasinvestments.Although the economies of most countries are linked, economic performance •varies widely across industries at any time.From time to time countries may experience turmoil due to a complex interplay •between political and economic factors. The currency and stock market crisis of Asian economies such as Thailand, Indonesia and South Korea in 1997 and 1998 and the shock waves that followed the devaluation of the Russian rouble in 1998 are reminders of this phenomenon.
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The exchange rate between a country’s currency and other currencies is a •key factor affecting the international competitiveness of its industries. Many believe that Chinese industries are currently very competitive internationally because the Chinese currency is undervalued vis-à-vis the US dollar and other currencies.A good part of East Asia and Latin America is driven by external sector demand •emanating from the US, Euro zone, Japan and China.
2000 Goldman Sachs; International Monetary Fund; The New York Times
2006
30.0 %
25.0 %
20.0 %
15.0 %
10.0 %
5.0 %
0.0 %
Share of Global GDP by Country
U.S
.
Chi
na
Shar
e of
Glo
bal G
DP
(%)
Rus
sia
Bra
zil
Indi
a
Fig. 2.3 Share of global GDP by country
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GDP growth rateGrowth rate in advanced economies (2006)
Growth Rates in Advanced Economics
Gro
wth
Rat
es (%
)
6
5
4
3
2
1
0
Japan Korea UK US OECDEuroArea
Fig. 2.4 Growth rates in advanced economies
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Growth rate in emerging economies (2006)
Growth Rates in Emerging Economics
Gro
wth
Rat
es (%
)Bra
z il
China
Indi
a
Indo
nesia
M
alay
siaTh
ailan
d
0
2
4
6
8
10
12
Fig. 2.5 Growth rates in emerging economies
Domestic macroeconomic factorsGrowth rate of Gross Domestic Product (GDP)•Industrial growth rate•Agriculture and monsoon•Savings and investments•Governmentbudgetanddeficit•Money supply•Government spending•Pricelevelandinflation•Interest rates•Balance of payment, forex reserves and exchange rate•Infrastructural facilities and arrangements•Sentiments•Employment Rate•Aggregatecorporateprofits•
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Demand and supply shocks•Central government policy•
Fiscal policy �Monetary policy �Supply-side policies �
2.6 Business CyclesThebusiness cycle or economic cycle refers to thefluctuations of economicactivity about its long term growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession). These fluctuationsareoftenmeasuredusingtherealgrossdomesticproduct.Despitebeingnamedcycles,thesefluctuationsineconomicgrowthanddeclinedonotfollow a purely mechanical or predictable periodic pattern
Expansion
Time
Contraction
Peak
Trough
Eco
nom
y
Recovery Prosperity
Fig. 2.6 Business cycle
Business cycles featuresArecessionisasignificantdeclineineconomicactivityspreadacrosstheeconomy,lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades. The period from a peak to a trough is a recession and the period from a trough to a peak is an expansion.
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Business cycle and industry performance
Time
Phase 1
Phase 2 Phase 3
Phase 4
Average growth~ 2.5%
PositiveNegative
GO
P gr
owth
rate
Favo
red
grou
psIn
tere
st
rate
s
Consumercyclicals
Energy
Basicmaterials
Technology
Industrials
Financials
Consumernoncyclicals
Utilities
Fig. 2.7 Business cycle and industry performance(Source: Paul and Carole Huebotter, the Fundamentals of Sector Rotation,
www.traders.com)
2.7 Economic IndicatorsAn economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance.
Economic indicators include various indices, earnings reports, and economic summaries, such as unemployment, housing starts, consumer price index (a measure for inflation), industrial production, bankruptcies,GrossDomesticProduct, broadband internet penetration, retail sales, stock market prices, and money supply changes. Economic indicators are primarily studied in a branch of macroeconomics called “business cycles”.
Economic indicators fall into three categories: leading, lagging and coincident. Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Personal income, GDP, industrial production, and retail sales are coincident indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.
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2.8 Monetary and Fiscal PoliciesFiscal policy, taking the scope of budgetary policy, refers to government policy that attemptstoinfluencethedirectionoftheeconomythroughchangesingovernmenttaxes,orthroughsomespending(fiscalallowances).
Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilise the economy by controlling interestratesandthesupplyofmoney.Thetwomaininstrumentsoffiscalpolicyare government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
Aggregate demand and the level of economic activity•The pattern of resource allocation•The distribution of income•
Economic effects of fiscal policyFiscalpolicyisusedbygovernmentstoinfluencethelevelofaggregatedemandin the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working towardfullemployment.Thegovernmentcanimplementthesedeficit-spendingpoliciesduetoitssizeandprestigeandstimulatetrade.Intheory,thesedeficitswould be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the new deal.
During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflationishigh,inordertoachievetheobjectiveofpricestability.Theremovalof funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.
Despite the importance of fiscal policy, a paradox exists. In the case of agovernment running a budget deficit, fundswill need to come frompublicborrowing (the issue of government bonds), overseas borrowing, or the printing ofnewmoney.Whengovernmentsfundadeficitwiththereleaseofgovernmentbonds, an increase in interest rates across the market can occur. This is because governmentborrowingcreateshigherdemandforcreditinthefinancialmarkets,causing a higher aggregate demand (AD) due to the lack of disposable income, contrary to theobjectiveof abudgetdeficit.This concept is called crowdingout. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project.
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Another problem is the time lag between the implementation of the policy and detectableeffectsintheeconomy.Anexpansionaryfiscalpolicy(decreasedtaxesor increased government spending) is usually intended to produce an increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead toinflation.Hence,checksneedtobekeptinplace.
Role of fiscal policy in developing countries like IndiaThemaingoalofthefiscalpolicyindevelopingcountriesisthepromotion•of the highest possible rate of capital formation. Underdeveloped economies areintheconstantdeficitofthecapitalintheeconomyandthus,inordertohave balanced growth accelerated rate of capital formation is required. For thispurposethefiscalpolicyhastobedesignedinawaytoraisethelevelof aggregate savings and to reduce the actual and potential consumption of people.To divert existing resources from unproductive to productive and socially •moredesirableuses.Hence,fiscalpolicymustbeblendedwithplanningfordevelopment.To create an equitable distribution of income and wealth in the society.•Toprotecttheeconomyfromtheillsofinflationandunhealthycompetition•from foreign countries.Tomaintainrelativepricestabilitythroughfiscalmeasures.•The approach to fiscal policymust be aggregate aswell as segmental.•The sectoral imbalances can be curbed by appropriate segmental fiscalmeasures.The government expenditure on developmental planning projects must •beincreased.Forthisdeficitfinancingcanbeused.Itreferstocreationofadditional money supply either by creation of new money by printing by government or by borrowing from the central bank.Public borrowing, loans from foreign nations etc can be used in the development •of the resources for public sector.Fiscal policy in the developing economy has to operate within the framework •of social, cultural, and political conditions which inhibit formation and implementation of good economic policies.In order to reduce inequalities of wealth and distribution, taxation must be •progressive and government spending must be welfare-oriented.Thehindrancesintheeffectiveimplementationoffiscalpolicyinthedeveloping•countries are loopholes in taxation laws, corrupt tax administration, a high population growth, extravagant governmental spending on non-developmental items, an orthodox society etc.
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Monetary policyMonetary policy is the process by which the government, central bank, or monetary authority of a country controls
the supply of money•availability of money and•cost of money or rate of interest, in order to attain a set of objectives oriented •towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interestratesinordertocombatinflation.Monetarypolicyshouldbecontrastedwithfiscalpolicy,whichreferstogovernmentborrowing,spending,andtaxation.Reserve Bank of India is the central bank of India and forms the monetary policies in India.
2.9 Industry Life CyclesIfyouobserve thegaming industryclosely,youwillfind that therearemanyfirmsouttherehavinghighinvestmentrates,highratesofreturnoninvestmentsand low rates of dividend payout. The same observation can be conducted on steelindustryandyouwillfindfirmswithlowratesofinvestment,lowratesofreturn and higher dividends payout. What could be the possible reason for this difference?
In recent times, better opportunities have been created by available technologies for substantiallyprofitableinvestmentofresources.Patentssafeguardnewproductsandtherearehighprofitmargins.Suchrewardingopportunitiesallurethefirmsinputtingalltheprofitsbackintothefirmandthegrowthoffirmsisspeedyonaverage.
However, the growth must slow down in due course of time. Looking at the high profitrates,moreandmorefirmsareencouragedtoenterintotheindustry.Asaresult,thecompetitionincreasesaffectingthepricesandprofitrates.Advancedandnew technologies start becoming more obvious, extent of risks decreases making theentryeasier.Thedegreeofreinvestmentinthefirmsreducesastheinternalopportunities become less lucrative and the cash dividends become high.
Eventually, cash cows are noticed in a mature industry. By cash cows we mean firmshavingconsistentcashflows,dividends,andlowrisklevels.Growthratesmay be analogous to that of overall economy. High risk and high returns on
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investment are offered by industries in initial stages of their life cycles. On the other hand, low risk and low returns are offered by mature industries.Thus,fromaboveanalysis,wecansaythatanindustrylifecyclecanbeclassifiedinto 4 stages: start-up stage in which growth is extremely fast, consolidation stage in which growth is not as fast as start-up stage but is faster than the general economy, maturity stage in which growth is not faster than the general economy and the relative decline stage in which in which the growth rate is less than that of general economy.
Introduction Growth Maturity Decline
Time
Indu
stry
out
put
O
Fig. 2.8 Industry life cycle(Source: www. openlearn.open.ac.uk)
2.9.1 Start-up StageNew technologies like personal computers or wireless communication portray the initialstagesofanindustry.Atthisstage,itisverydifficulttoanticipatewhichfirmswill succeed; somefirmswill be a total successwhile somemight failcompletely.Hence,theriskinvolvedinselectinganyspecificfirmintheindustryis quite risky at this stage.
However,atthisstage,sincethenewproducthasnotyetfloodeditsmarket,therewill be a rapid growth in sales and earnings at industry level. Like, for example, in 1980’s, personal computers were a part of very few houses, while on the other hand, products like fans or even refrigerators were part of almost every household. So naturally, the growth rate of products like refrigerators will be much less.
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2.9.2 Consolidation StageOnce the product has proved itself in the market, several leaders in the industry start surfacing. The start up stage survivors become more stable and market share can be easily envisaged. Thus the performance of the industry in general will be moreminutelytrackedbytheperformanceofthefirmsthathavesurvived.Astheproduct breaks through the market place and is used commonly, the growth rate of the industry is still faster than the rest of economy.
2.9.3 Maturity StageThe product has attained the full aptitude to be consumed at this stage by the users. So, any growth from this point just tracks the growth of the economy in general. At this stage, as the product gets more and more standardised, it compels theproducerstocompeteheavilyonpricebasis.Asaresult,theprofitmarginsareloweredandaddtothepressureonprofits.Mostoften,firmsatthisstagearereferredtoascashcowsastheircashflowsarequiteconsistentbutofferverylittleopportunityforgrowthofprofit.Insteadofreinvestingthecashflowsinthecompany, they are best milked from.
2.9.4 Relative DeclineInthisstage,followingfeaturesareidentified:
Costs become counter-optimal
Prices, profitability
diminish
Features of Relative Decline
Sales volume decline or stabilise
Profit becomes more a challenge
of production/ distribution
efficiency than increased sales
Fig. 2.9 Features of relative decline
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2.10 Industry Structure and PerformanceThe competitive conditions prevailing in an industry can provide vital information in gauging its future. The prosperity of an industry is decided by the level and intensity of competition that exists in that industry. The author of the famous book “Competitive Strategy”, Professor Michael Porter, has taken up an in-depth analysis of the various factors that form the competitive structure of an industry. The sections covered below are based on the citations from this book.
One factor that works on an ongoing basis towards downgrading the rate of returnonthecapitalinvested,tothecompetitivefloorrateofreturn,orthereturnthat would be gained by the perfectly competitive industry of economists is, competition. The yield on long-term government securities amended upward by thecapitallossrisk,approximatesthiscompetitivefloororfreemarket return. As investors have choice to invest in other industries, they will not accept returns belowthisrate,andfirmsconsistentlyearningreturnslessthanthiswillgooutofbusinessinduecourseoftime.Thecapitalinflowintoanindustryeitherthroughnew entrants or via supplementary investments made by existing competitors is stimulated by the existence of higher rates of return than the amended free market return.Thecapacityofafirmtosustainaboveaveragereturnsasthepotencyof competitive forces in an industry decides the level towhich the inflowofinvestment transpires and gains the return to the free market level.
The fact that the competition that prevails in an industry extends far beyond the well-knownplayersisrepresentedbythefivecompetitiveforces–newentries,substitution threat, bargaining power of buyers, bargaining power of suppliers, andtherivalryamongstthepresentcompetitors.Thecompetitorsofafirminanindustry may be suppliers, customers, substitutes or even the potential entrants, andthesecompetitorsmaybeprominentbasedonspecificsituation.Competitionon a larger scale can be termed as rivalry. Competition in any industry of course develops from various prominent forces.
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2.11 Profit Potential of Industries: Porter ModelMichael Porter, the great strategist developed this model to study the industries and their characteristics. This is called Porter’s 5 forces model.
Potential Entrants
IndustryCompetitors
Substitutes
Suppliers Buyers
Rivalry Among Existing Firms
Threat of substitute products or services
Bargaining power of suppliers
Bargaining power of buyers
Threat of new entrants
Fig. 2.10 Porter’s 5 forces model
Industry analysis using Porter’s 5 forces modelAccordingtoMichaelPorter,theprofitpotentialofanindustrydependsonthecombinedstrengthofthefollowingfivebasiccompetitivefactors.
Threat of new entrants•Rivalryamongtheexistingfirms•Pressure from substitute products•Bargaining power of buyers•Bargaining power of sellers•
2.11.1 Threat of New EntrantsNew entrants in an industry often bring with them new potential, yearning to gain marketshareaswellassignificantresources.Thecurrentcostscanbeinflatedorpricescanbeendeavoureddown,therebyreducingtheprofitability.Companiesthat broaden their horizons into the industry from other markets via acquisition often tend to use their resources to create a shake up. Although a completely new entry may not be created, any kind of acquisition into an industry with an intention to raise market position should also be considered as a new entry.
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The possible threat for entering into an industry depends on the hurdles that are already present in the industry, along with the expected reactions from the existing competitors. If in case the hurdles are more and the novice expects share retaliation coming from deep-rooted competitors, then the potential threat to entry is quite less.
The major sources for entry barriers are:
Economies of scaleThe drop down in the unit cost of a product or a function or an operation that is involved in making that product due to increase in the absolute volume per period is referred to by the economies of scale. The entry is hampered by the economies of scale either by compelling the new entrants to make an entry at large scale and riskintensereactionsfromexistingfirmsorentersatasmallscaleacceptingcostdisadvantage. Clearly, both the options are unfavourable for the new entrant.
Economies of scale may exist in almost every operation of business including buying, manufacturing, research and development, marketing, sales and distribution.
Scale economiesmay arise fromcertain specific activities or operations thatbelong to any functional area or they may even relate to a complete functional area just like in the case of sales force. It is essential to study each cost component individuallyforitsspecificconnectionbetweenscaleandunitcost.
Multibusinessfirmunitscanharvesteconomiesthataresimilartothoseofscaleifit is possible for them to share operations that are exposed to scale economies with other businesses in the company. Let’s say for example, one such Multibusiness company manufactures electric motors which in turn are used for producing electronic items like hair dresser or any other cooling system for an electronic equipment. If economic scales in manufacturing of electric motors surpasses the actual number of motors required in any particular market, then the Multibusiness firmexpandedinthismannermaygaineconomiesinmotormanufacturingthatis far more than those available if it only produced motors for use in, let’s say, a coolingsystem.Inthisway,diversificationlinkedaroundthecommonoperationscaneliminate thevolumerestrictions inflictedby thesizeofan industry.Theupcomingentrantiscompelledtobediversifiedorconfrontcostdisadvantage.The possibly shareable activities or functions that are exposed to economies of scale include distribution system, sales forces, purchasing etc.
The advantages of sharing are especially persuasive in case of joint costs. Joint costs come into picture when a company producing a product say, X must also innately possess the capability to produce another product say, Y. An example of this can be an air cargo and air passenger services where, due to technological limitations, only enough space in the air craft can be occupied with the passengers leaving the remaining space and cargo capacity. Huge costs must be borne in
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order to put the plane in air and there is also space for cargo irrespective of the numberofpassengerstheplaneiscarrying.Hence,thefirmthatcompetesinbothpassengersaswellascargohasmorecompetitiveedgethanthefirmthatdealsonly in one market.
A familiar situation of joint costs is when business units can share intangible assets like brand names. The cost involved in building an intangible asset needs to be borne only once, but after that, the asset can be used freely and applied to other business that need to bear only the cost required to adapt or amend it. Hence, the circumstances where intangible assets are share give way to considerable economies.
A kind of economies of scale entry hurdle takes place when economies in vertical integration are involved, i.e., functioning in consecutive phases of production or distribution. In such a case, the entrant must make an entry into the market integrated or confront the cost inconvenience along with probable foreclosure of inputs or even markets for its product if there are well-known competitors involved. In such cases, foreclosure arises from the fact that customers normally buy from in-house units or, in other words, suppliers sell their products in-house. The individualfirmshavea tough timegettinganalogouspricesandmaygetpressurised if different terms are offered to it by the integrated competitors than totheirconfinedunits.Theneedtoenterthemarketinanintegratedmannermaynot only increase the retribution risks, but may also raise other entry barriers discussed below.
Product differentiationByproductdifferentiation,wemeanthatrenownedfirmscarrycustomerloyaltiesand brand identification, that has arisen fromgood customer service, heavyadvertisinginthepast,uniqueproductorevenbysimplybeingfirstofitskindin the industry. Differentiation poses a strong entry barrier to the entrants by compelling them to spend on a larger scale to beat the existing customer loyalties. This activity normally leads to start-up losses and also extended time period. As such kind of investments made in brand building have no means of recovery in case of failure, they can be very risky.
Switching costsAnother entry barrier is created by the existence of switching costs, i.e., one-time costs facing the buyer of switching from product of one supplier to the product of another supplier. Some of the costs included under switching costs are retraining cost of employees, new auxiliary equipment cost, new source testing cost and time, technical help cost, product redesign cost and also clairvoyant costs required to maintain a relationship. If the switching costs involved are high, then the new entrantmustcomeupwithasignificantimprovementinperformanceorcosttoinduce the buyer to switch from the current product or supplier.
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Capital requirementsAnentrybarrieriscreatedbytheneedtoinvesthugefinancialresourcesinorderto compete. The barrier is created especially when the capital investment is done for risky or irrecoverable advertising or research and development. Capital may be required not only for production related facilities, but also for various other things like inventories, customer credit, or to cover-up the initial losses. In spite of the availability of capital in the capital market, an entry means a risky usage ofthatcapitalanditmustbereflectedinriskpremiumsthatarechargedtothenew entrant.
Distribution channels accessAn entry barrier can be created out of the need of the new entrant to secure distribution of its products; the level to which its product is accepted by the distribution channels through co-operative advertising allowances, price breaks, andothersimilarways;therewillbedropdownintheprofits.Forinstance,themanufacturer of a new food product should convince the retailer to give its space on the highly competitive supermarket shelf by means of promotion promises, severe efforts of selling to the retailer or any other such means.
The more restricted the retail mediums for a product are and the more present competitors have these tied up, needless to say, the entry in the industry will be evenmoredifficult.Theexistingestablishedcompetitorsmaybeholdingtieswithchannels depending on long relationships, extremely good service or even via specialrelationshipsinwhichthechannelisuniquelyidentifiedwithaspecificmanufacturer. At times, this entry barrier is so big that in order to overcome it, new entrants are needed to create a completely new distribution channel.
Exit barriersExit barriers are economic, strategic, and even emotional aspects that drive the companies to compete in the businesses even though their returns on investment may be meagre or even negative at times. Following are the major sources of exit barriers:
Fixed costs of exit: Costs like resettlement costs, labour agreements, spare •partcapabilitiesmaintenanceetc.comeunderfixedcosts.Specialised assets: Assets that are highly specialised to suit a particular location •or business less liquidation values or high conversion or transfer costs.Emotional barriers: Several reasons like loyalty towards employees, •identificationwithaspecificbusiness,price,fearforone’sowncareeretc.contribute to management’s reluctance in taking economically reasonable exit decisions.Strategic interrelationships: Interrelationships between a business unit and •others in a firmwith respect tomarketability, image, access to financialmarkets, shared facilities etc. Due to such interrelationships, a strategic significanceisattachedbythefirmsforbeingapartofthebusiness.
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Social and Government restrictions: The discouragement or denial by the •government for exit out of the apprehension for job, loss and regional economic effects come under this.
When there are high exit barriers, then the capacity in excess does not leave the industry; also, the companies losing the competitive war do not quit. Instead, they persevere and due to their limitations, they need to take up some extreme tricks. Asaresult,theprofitabilityoftheentireindustrycanbeconsistentlyless.Thejoint level of entry and exit barriers is a crucial aspect of industry analysis even though they differ conceptually. The exit and entry barriers are often correlated.
For instance, sizeable economies of scale in production are generally related to specialised assets, also is the existence of proprietary technology. The best situation fromindustryprofitspointofviewiswhentherearehighentrybarriersbutlowexit barriers. In this case, the entry will be discouraged and the competitors who do not fare well will eventually quit the industry. In the case where both entry and exitbarriersarehigh,probabilityofprofitsishighbutatthecostofmorerisks.Here,eveniftheentryisdiscouraged,failedfirmswillhangonandstruggleinthe industry.
The scenario of low entry and exit barriers is not very thrilling, however, matters can be worse when entry barriers are low but there are high exit barriers. Here, entry is possible easily and will be fascinated by rise and fall in economic conditions. The capacity, however, won’t quit the industry even if results drop down. Due to this,capacitypilesupintheindustryandtheprofitabilitynormallyislow.Forexample,thefirmmaybeinthissorryconditionifthelenderspromptlyfinancetheentrybutoncein,thefirmneedstodealwithsizeablefixedfinancialcosts.
2.11.2 Rivalry among Existing CompetitorsRivalry prevailing amongst existing competitors eventually takes the typical mode of striving for position by using tricks like advertising campaigns, price competition, introduction of product, and improved warranties and customer service. Rivalry stems out of the fact that the competitor(s) either are pressurised or seek an opportunity to better their positions. In many industries, competitive stepstakenbyonefirmhassignificantimpactsonitscompetitors,therebyinducingvengeanceoreffortstooffsetthemove,makingthefirmsmutuallydependent.Suchtypeofactionandreactionmayormaynotleavethestart-upfirmoreventheindustryintotalityatanadvantage.Allthefirmsintheindustrymaysufferand worsen if the moves and counter moves soar up.
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Some kinds of competitions, mostly price competition, are very unpredictable andlikelytoleavethecompleteindustryinabadshapefromprofitabilitypointof view. Cut down in prices are easily met by the rivals, and once met, they bring downtherevenuesforallthefirmsintheindustryuntil thepriceelasticityofdemand in the industry is quite high. On the other hand, advertising wars may increase the demand or even the level of differentiation of product in the industry forthebettermentofallfirms.In some industries, rivalry is expressed by terms like bitter or warlike or cut-throat, whereas in other industries it is expressed as gentlemanly or polite. A number of interacting structural factors give rise to intense rivalry.
Abundant or equally balanced competitorsWhen there are plentifulfirms in an industry, the probability of eccentrics ishighandalso, theremaybe fewfirmswho startbelieving that theycan takestepswithoutbeingnoticed.Instabilityisalsocreatedeveniftherearefewfirmsthat are comparatively balanced with respect to size and resources; this kind of instabilityiscreatedasthesefirmsmaybeinclinedtofightamongsteachotherandmayhaveoneorfewfirmsdominatetheirresources.However,thestrengthofthesefirms,ontheotherhand,alsocannotbeunderemphasised.Theleader(s)can impose control and also play the role of a coordinator in an industry by using mechanisms like price leadership. In various industries, a significant role inindustry competition is played by the foreign investors who get involved directly through foreign investment or export in the industry.
Slow industry growthCompetition, due to slow industry growth, is turned into a market share competition forthefirmswhoaspiretoexpand.Thereisasituationwhereinfastindustrygrowthassures that thefirmsmayproducebetterresults justbykeepingpacewiththeindustryandwherealltheirmanagerialaswellasfinancialresourcesmay be utilised by growing with the industry. Market game is far more volatile than such a situation.
Excessive fixed or storage costsSoaringcostspressurisesallthefirmstofillcapacity.Thisoftengiveswaytospeedy rise in price cutting when capacity is present in excess. Many basis properties like aluminium and paper suffer from this problem. Fixed costs relative tovalueaddedandnotfixedcostasaproportionoftotalcostisthedistinctivefeature of costs. Firms that purchase a high proportion of costs may experience tremendouspressuretofill-inthecapacityinordertobreak-even,irrespectiveofthefactthattheabsoluteproportionoffixedcostsisverylow.Atypicalscenarioofhighfixedcosts iswhenaproductwhenonceproduced, isverystrenuousorcostlyfromstoragepointofview.Insuchasituation,thefirmsmayalsobetempted to lower the prices in order to ensure good sales. This kind of burdens reducestheprofitabilityinindustrieslikemanufactureofsomeharmfulchemicals,fishingetc.
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Capacity boost in large augmentationOn one hand where scale economies command that capacity must be largely enhanced, such capacity increments can prove to be hazardous to industry balance of demand and supply, especially where grouping capacity additions related risks are involved. The industry may have to bear recurring periods of price cutting and overcapacity.
Lack of switching costs and differentiationThe choice by the purchaser is by and large dependant on the price and service in the case where product and service is considered as a commodity or near commodity. This gives way to strong competition in price and service and these competitions in particular are extremely volatile. On the other hand, in product differentiation, as buyers hold loyalties and preferences to specific sellers, itgenerates layers of cushioning against competitive rivalry. Switching costs also bear similar impact.
Varied competitorsCompetitors vary in origins, personalities, strategies, and relationship with their parent companies. They have different competitive targets and strategies and in this process, they may continually bump into each other. They may also have a tough time in gauging each other’s objectives and come up with a set of rules and regulations of the game for the industry. Strategic choice made by one competitor may not work for others. Diversity to industries is added to a greater extent by foreign competitors their changing goals and circumstances. The owner-cum-managersof smallfirmmaybecontentedby thesubnormal rateof returnontheir invested capital so as to maintain the independence that come with self-ownershipofthefirm.Ontheotherhand,forbigpubliclyheldcompanies,suchan outlook and philosophy may appear to be unreasonable and unacceptable. In suchanindustry,thebearingofsmallfirmsmayrestricttheprofitabilityoflargertrepidation.Likewise,thefirmsthatconsidermarketasaventforovercapacitywillembracepoliciesthatcontradicttothoseoffirmsthatconsidermarketascrucialone.Lastbutnottheleast,asignificantsourceofdiversityinanindustryisthedifference in the relationship of the competing business units to their corporate parents. For instance, the goals and strategies of a business unit which is a part of a vertical link of businesses its corporate organisation may be contradictory to thoseofaself-supportingfirmbelongingtothesameindustry.
High strategic stakesWhenanumberoffirmsholdhighstakesintobesuccessfulinanindustry,thentherivalryinsuchanindustrybecomesmorevolatile.Forexample,adiversifiedfirmmaypaymoreattentioninbecomingsuccessinagivenindustrysoastobroaden its corporate strategy by and large. Or a foreign company may comprehend an intense need to build a strong hold in the market in order to achieve status globallyorevenfortechnologicalcredibility.Insuchcases,theaimsofthefirmsmay be even more varied and unstable as they entail impending eagerness to forgoprofitability.
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Shifting rivalryThe factors deciding the competitive rivalry may and do vary. A common example is the transformation in the growth of an industry due to industry maturity. With the industry maturity, the growth rate reduces, there by leading to strengthened rivalry,droppingprofitlevelsandevenashakeout.
When an acquisition brings in a different personality to an industry, then yet another change in rivalry takes place. Also, advancements in technology may upliftthedegreeoffixedcostintheprocessofproductionandmayincreasetheprecariousness of rivalry.
Eventhoughafirmshouldlivewithnumberoffactorsthatrevealtheextentofindustry rivalry, it may have some scope to better the matter through strategic shifts. Like, for instance, it may try to increase switching cost of buyers by giving engineering aid to the customers for designing its product into operations or to make them needy for technical help. Or the company can try to improve product differentiation by offering newer services, marketing advancements, or through amendments in the product. The impact of rivalry in an industry can be reduced by concentrating the selling efforts on rapidly growing sections of an industry oronmarketareasthathavelowestfixedcosts.Also,ifpossible,afirmcanstayaway from facing competitors having high exit barriers and hence can avoid grave price cutting, or it can also lessen its own exit hurdles.
2.11.3 Pressure from Alternate ProductsAllfirms in an industry competewith the industries that produce alternativeproducts. An upper limit is placed on the prices by the alternative products, which a firmcouldhavecharged,therebyrestrictingtheprospectivereturnsofanindustry.The more lucrative the price performance choice offered by replacements, the strongeristhecapontheprofitsinanindustry.
To identify replacement or alternative products means to look out for other products that have the capability to serve the same purpose as the product present in the industry.Attimes,thistaskofidentificationcanbequitedelicateandmayalsolead the analysts to businesses that appear to be far removed from the industry. For example, securities brokers need to face various substitutes like insurance money market funds, real estate, and many such ways for the individual to make his capital investment.
Position, with regard to replacement products may also be a matter of joint industry actions.Forinstance,advertisingeffortsbyonefirmmaynotbesufficientenoughto boost an industry’s position against a substitute; however, if all the participants ofanindustryindulgeintosustainedandheavyadvertising,thenitcandefinitelyimprove the overall position of an industry. Same thing applies to other areas like marketing efforts, improvising the quality of product, greater product availability etc. Substitute products that are most attention-deserving are the ones that are:
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prone to trends that improve their price trade-off with the product in an industry •orproducedbyhighprofit-earningindustries
In the latter case, products normally come swiftly into action if certain improvements raise the level of competition in their industry and lead to price decline or improvement in performance.
2.11.4 Bargaining Power of BuyersBuyers compete with an industry by compelling the prices be brought down, demanding and bargaining for additional services and better quality, and also playing the competitors against each other, and all this is done at the cost of profitabilityofanindustry.Thestrengthofeverykeybuyergroupofanindustryisbasedonvariouscharacteristicsofmarketsceneandalsoonthevirtualsignificanceof its purchases from an industry as compared to its business in general. A group of buyers is said to be powerful if following holds true:
If they are focused and buy in huge volumes relative to the supplier’s sales.•Ifalargechunkisboughtbythepurchaser,thenitincreasesthesignificance•of the buyer’s business.Iftheindustryisdistinguishedbyheavyfixedcosts,thenthelargevolume•purchasers are especially powerful forces and also increase the stakes in order tokeepthecapacityfilled.
Aconsiderableportionofthebuyer’spurchasesorcostsisreflectedbytheproductspurchased by him from the industry.
2.11.5 Bargaining Power of SuppliersSuppliers, like buyers, can exert a competitive force in an industry as they can raise prices, lower quality, and curtail the range of free services they provide. Powerfulsupplierscanhurttheprofitabilityofthebuyerindustry.Suppliershavestrong bargaining power when:
Few suppliers dominate and the supplier group is more concentrated than the •buyer group.There are hardly any viable substitutes for the product supplied.•The switching costs for the buyers are high.•Suppliers do present a real threat of forward integration.•
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SummaryThe end goal of performing fundamental analysis is to produce a value that •aninvestorcancomparewiththesecurity’scurrentpriceinhopesoffiguringout what sort of position to take with that security.While technical analysis primarily aims to estimate short-term price movements, •fundamental analysis focuses on determining long-term values.Intrinsicvalue is thereforedefined tobe thepresentvalueofallexpected•futurenetcashflows to thecompany; it iscalculatedviadiscountedcashflowvaluation.Intopdownapproach,theanalystfirstscansmacroeconomicenvironment,•understands government policies, and then accordingly selects the industry to study. While studying the industry, he analyses different players in the industry and then selects one company to invest in.In bottomup approach, the analyst first studies a company, understands•ratio and other valuation metrics, and then accordingly studies the industry by comparing the different peers in the same industry. After studying the industry he analyses economic indicators to be doubly sure about the company selected.Although the economies of most countries are linked, economic performance •varies widely across industries at any time.Arecession isasignificantdecline ineconomicactivityspreadacross the•economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.An economic indicator (or business indicator) is a statistic about the economy. •Economic indicators allow analysis of economic performance and predictions of future performance.Coincident indicators are those which change at approximately the same •time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Personal income, GDP, industrial production and retail sales are coincident indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.Thedegreeofreinvestmentinthefirmsreducesastheinternalopportunities•become less lucrative and the cash dividends become high.Anindustrylifecyclecanbeclassifiedinto4stages:start-upstageinwhich•growth is extremely fast, consolidation stage in which growth is not as fast as start-up stage but is faster than the general economy, maturity stage in which growth is not faster than the general economy and the relative decline stage in which in which the growth rate is less than that of general economy.At maturity stage, as the product gets more and more standardised, it compels •the producers to compete heavily on price basis.
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The competitive conditions prevailing in an industry can provide vital •information in gauging its future. The prosperity of an industry is decided by the level and intensity of competition that exists in that industry.AccordingtoMichaelPortertheprofitpotentialofanindustrydependson•thecombinedstrengthofthefollowingfivebasiccompetitivefactors:Threatofnewentrants,Rivalryamongtheexistingfirms,Pressurefromsubstituteproducts, bargaining power of buyers, bargaining power of sellers.The drop down in the unit cost of a product or a function or an operation that •is involved in making that product due to increase in the absolute volume per period is referred to by the economies of scale.
ReferencesNifty Direct-Nifty Trading Tips, • Macroeconomic and Industry Analysis [Online] Available at: <http://www.niftydirect.com/nsebse/market-gyan/Learning%20Session%204th.pdf> [Accessed 19 July 2011].Investopedia, 2011. • Fundamental Analysis [Online] Available at: <http://www.investopedia.com/terms/f/fundamentalanalysis.asp> [Accessed 19 July 2011].currencycollege, 2007. • Fundamental Analysis Part One [Video Online] Available at: <http://www.youtube.com/watch?v=NRJ-6LOSx1I> [Accessed 19 July 2011].VirtualNYIF, 2009. • Business and Industry Analysis – Sample [Video Online] Available at: <http://www.youtube.com/watch?v=L6at6Zd34Lg> [Accessed 19 July 2011].Thomsett, M., 2006. • Getting Started in Fundamental Analysis, 1st ed., Wiley.David Wanetick, 1997. • Bound for Growth: How to Pick Winning Stocks Using Industry Analysis, Irwin Professional Publishing.
Recommended ReadingPrasanna, C., 2006. • Investment Analysis and Portfolio Management. New Delhi: Tata McGraw-Hill.Bodie, Z., Kane, A., Marcus, A. and Mohanty, P., 2006. • Investments. New Delhi: Tata McGraw-Hill.Lowenstein, R. and Lowe, J., 2006. • Fundamental Analysis, Value Investing and Growth Investing (Secrets of the Great Investors), Unabridged edition, Blackstone Audio Inc.
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Self Assessment
Cash cows means___________.1. cows which are purchased by casha. cashflowrichcompaniesb. companies having lot of cash investedc. cash hungry companiesd.
Identify the odd one.2. growtha. declineb. maturityc. inflationd.
The prosperity of an industry is decided by_____________.3. the competition that exists in that industrya. its sizeb. its agec. its placed.
Porter’s 5 forces model is created by_______________.4. Warren Buffetta. Mike Porterb. Peter Lynchc. Michael Porterd.
Thebusinesscyclereferstothefluctuationsof_____________.5. economic activitya. trading activityb. unemploymentc. generation of powerd.
Identify the odd one.6. Peaka. Troughb. Maturityc. Contractiond.
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An economic indicator is a _________ about the economy.7. arithmetica. statisticb. activityc. management of resourcesd.
Themaingoaloffiscalpolicyis__________.8. Capital Formationa. Employmentb. Liquidityc. Money Supplyd.
The central bank of India is_____________.9. ICICI Banka. RBIb. SBIc. HDFC Bankd.
Monetary policy is generally referred to as either an expansionary policy, 10. or a__________.
growth policya. monetary policyb. fiscalpolicyc. contractionary policyd.
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Chapter III
Company Analysis
Aim
The aim of this unit is to:
describecomponentsoffinancialstatements•
definebalancesheet•
explain ratio analysis•
Objectives
The objectives of this unit are to:
discusshowtousefinancialinformation•
differentiate between EVA from other valuation methods•
analysecashflowanalysis•
Learning outcome
At the end of this unit, you will be able to:
understandtheimportanceoffinancialstatementsforsecurityanalysis•
comprehend common size analysis•
recognise cross-sectional analysis•
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3.1 Income StatementIncomestatementisthestatementthatmeasuresacompany’sfinancialperformanceoveraspecificaccountingperiod.Financialperformanceisassessedbygivinga summary of how the business incurs its revenues and expenses through both operatingandnon-operatingactivities.Italsoshowsthenetprofitorlossincurredoveraspecificaccountingperiod,typicallyoverafiscalquarteroryear.
Income statement componentsSales•Other income•
Profitfromthesaleofassets �Dividends (from investments, in the shares of the other companies) �Rent (lease rental earned from commercial buildings) �Interest (Interest received on deposits made and loans given to corporate �bodies and others.)
Materials cost ( opening stock + purchases made during the year - closing •stock)Employment Costs: (salaries + wages + bonus + gratuity + contribution to •PF + welfare expenses)Operating and other expenses–Costs incurred in running a company•
Selling expenses: Advertising, Sales promotion, commission paid to �salesmen, cash discountsAdministrationexpenses:Rentofofficesandfactories,municipaltaxes, �insurance, repairs, printing and stationery, telephone, legal, electricity costs, other exps to administer a companyOthers:Lossmadeon the saleoffixedassets, donationsmadeby the �company
Interest andfinance charges:• When mony is borrowed from third parties, interest has to be paid.
Bank overdrafts: Monies extended by banks for working capital �Termloans:Borrowingsfrombanksandfinancialinstitutionstopurchase �machineryFixed deposits: Fixed deposits taken from shareholders and the general �public for working capitalDebentures: Issued to general public and shareholders for long term capital �needs usuallyIntercorporate loans: Such loans are taken from other companies for �workingcapitalpurposesortotideoveratemporarycashdeficiency.
Depreciationistheamountbywhichthefixedassetshavesufferedwearand•tearduringtheyear.Thisistheamountsetasidefromprofitssothatwhenthe existing asset has been written down entirely, there would be a provision equal to the cost of asset which could be utilised to purchase another. As, on
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accountofinflation,amachinecannotbeboughtatthepricerulingfouryearsearlier, many companies provide for an additional amount. This additional amount would, however, not be charged as depreciation expense) but would beshownasanappropriationofprofits(transfertogeneralreserves)Taxation•
Current tax -35%+2.5% surcharge �Deferred tax is the impact of current year timing differences between �taxable income and accounting income for the year and reversal of timing differences of earlier years.Fringebenefittax:Thetaxationofperquisites-orfringebenefits-provided �by an employer to his employees, in addition to the cash salary or wages paid,isfringebenefittax.
Proposed dividends: Normally, the mature companies pay dividends while the •growing companies pay less or no dividends. Most companies pay dividends twice a year
Interim dividends: These are paid during the year in anticipation of �satisfactory resultsFinal dividend: This is normally declared after the results of the year �have been arrived at. This is recommended by the directors, discussed at the annual general meeting, and paid after it has been approved by the members at the meeting.
3.2 Balance SheetBalance sheet is a financial statement that summarises a company’s assets,liabilitiesandshareholders’equityataspecificpointintime.Thesethreebalancesheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders. The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders’ Equity
Components of balance sheet•Sources of funds: A company can raise funds from its shareholders or by �borrowingShareholders’ funds: A company sources funds from its shareholders by �eithertheissueofshares(sharecapital)orbytheploughbackofprofits(reserves). Shareholders’ funds represent the stake the shareholders have in the company.Authorised share capital: It would depend entirely on the promoters’ �estimate of the funds required by the business to purchase its assets and fund its working capital.
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Share capital is issued in a number of ways.•Public issue – Shares are offered to the public at large �Private placement – Shares are offered to selected individuals or �institutions.Rights issue – Existing shareholders are offered as a “matter of right” shares �in the company in proportion to the holding they have (for instance,1:4) Reliance in 1987 offered rights shares at Rs.60 to the existing shareholders when the market price of the share was Rs.120.Bonus issue- Here, no mony is raised. Existing reserves such as the �premiumon shares issued or profit ploughed back are capitalised orconverted to bonus shares. Here, the patterns of shareholding will not changes as these shares cannot be refused and allotted in proportion. The main purpose of bonus issues are apart from pleasing the shareholders by giving them additional shares, to widen and strengthen the capital base so that the foundation for growth is tangible, real and solid.
Reserves are profits or gains retained in the business for growth or •expansion.
Capital reserve are reserves that have resulted from the increase in the �value of assets. Example could be share premium account. This arises from the sales of shares at a premium”(for example, the share premium account, capital revaluation reserve, capital redemption reserve) Example– Reliance issued rights shares at Rs.60 with Rs.50 as premiumC � apital Revaluation Reserve: This arises when assets acquired many years earlier such as land is revalued at current market price. This can only be mentioned when the gain is realized. Example– ABC Ltd. Purchased a land at Pune in 1950 at Rs.50,000. Now the revaluation of the land comes to Rs. 1, 00, 00000. So, the land will be shown in the balance sheet at current market price, and the difference of Rs.99,50,000 would be shown as a capital reserve
Loan funds can be divided into secured and unsecured.•Secured loans are those that have been taken by a company by pledging �some of its assets such as land, buildings, stocks, and debtors. The usual secured loans that a company has are debentures, bank, overdrafts, and longtermloanstakenfrombanksorfinancialinstitutionsforthepurchaseof machinery or some other long term asset.Unsecured loans are loans taken by the company for which the company �has not pledged any of its assets. The security the lender has is usually the creditworthinessofthecompany.Theseareusuallyfixeddepositsandshort term loans. At times banks give overdrafts against which they are not required to hypothecate stocks or debtors. These are known as clear overdrafts and shown as unsecured loans.
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Fixed assets are those assets that a company owns for use in its business. •Thekindoffixedassetsacompanywouldownwouldvaryenormouslyfromcompanytocompany.Amanufacturingcompany’smajorfixedassetswouldbe its factory and machinery whereas that of service industry would be its officebuilding.Similarlyatransportationcompany’smajorfixedassetswouldbe its trucks.Depreciation methods•
Straight line method �Reducing balance method �
Exceptlandallotherfixedassetsaredepreciatedovertheirusefullives.•Capital work in progress – projects like construction of a factory or installation •of machinery which is not complete and which are of capital nature are known as “capital work in progress”Investments: deployment of short term funds•
Trade Investments are shares or debentures held of competitors or others �in similar businesses. Many companies have nominal holdings in their competitor companies. This is done to have access to information on their growth,profitabilityandotherimportantmatters.Investments in Subsidiary and Associate Companies: Companies hold �shares in their subsidiary and associate companies. The United Breweries group and the Tata group are prime examples that have an intricate cross-ownership of group companies.Other Investments: There are shares or debentures or other security held �that is not in any way trade or subsidiary investments. It is in this category thatcompaniesinvesttheirsurpluscashforprofitandincomeQuoted Investments are those shares/debentures that are quoted in a �recognised stock exchange and are traded.Unquoted Investments are shares of companies (usually private) that are �not quoted in a recognised stock exchange.
Current assets: Any assets that are turned into cash within a year is •considered a current asset. Examples: Cash and Cash Equivalents, Stocks (Inventories– raw materials, workinprogress,finishedgoods,loosetoolsandspareparts),tradedebtors,prepaid expenses, other current assets.Loans and advances•
Loans given to staff members or other companies �Advances given to raw material suppliers or other contractors �
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Current liabilities and provisions:•Current liabilities are amount due and payable by the company within the �next twelve months.Provisions are amounts set aside for a likely payment or expense which �is estimated and likely to be incurred.
Examples: Trade creditors, accrued expenses, Sundry creditors, provisions for proposed dividend and taxation
RevenueReserves:Profitsareappropriatedandtransferredtogeneralreserves•for various reasons such as plough back, increasing shareholders funds and thus commitment, meet unexpected expenditure, and provide funds to purchase machinery and other assets at a future date. These are revenue reserves and can be distributed to shareholders as dividends. (example: P&L account, general reserve and the likes)
3.3 FootnotesThe footnotes give a detailed description of the practices and reporting policies of the company’s accounting methods along with the disclosure of additional information that can’t be shown in the statements themselves.
Significantaccountingpolicies•
Basis of accounting
Fixed assets and intangible assets
Use of estimates
Depreciation/ Amortisation,
Revenue recognition (sale of goods, Interest, Dividend)
Changes in accounting policies, Foreign Operations
EPS, Employee stock options, Inventories, Investments
Accounting policies
Fig. 3.1 Significant accounting policies
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Reading footnotesWhat to look for?
Thefirst thing is to look at a company’s accountingmethod and how it•compares to the generally accepted accounting method and industry standards. If the company is using a policy that differs from others in the industry or one that seems far too aggressive, it could be a sign that the company may be tryingtomanipulateitsfinancialstatementstocoverupanundesirableeventor give the perception of better performance.The second item of importance that should be examined is any changes that •have been made in an account from one period to the next and the effect it willhaveonthebottom-linefinancialstatements
Notes to accounts contain explanation Changes in accounting policies
Provisions•Deferred tax assets/liabilities•EPS(Earnings per share), Operating leases•ESOPs, Managerial remuneration•Licensed and installed capacities of production•Details of opening stock, turnover, and closing stock•Raw material consumed•Foreign currency transactions•Related party disclosure•Segment reporting•Contingent liabilities•
Notes to accounts - ExamplesDell transferred$2.5billion incustomerfinancing toa jointventurewith•Tyco, which effectively removed that money as a liability from their balance sheet. This made Dell’s liquidity numbers and capital structure seem better when, in fact, little had changed.Amazon – has mentioned in its annual report” We may be unable to prevent •users of our Amazon Marketplace, Auctions and zShops services from selling unlawful goods, we may face civil or criminal liability for unlawful and fraudulent activities by our user any costs we incur as a result of liability relating to the sale of unlawful good could harm our business.”In example using revenue recognition at Ford Motors, let’s assume that •instead of booking revenue upon ownership transfer, Ford books the revenue when a car is produced. This strategy is far too aggressive because Ford can’t ensure that dealerships will ever take possession of that car. Another example would be a magazine company that books all of its sales at the start of the subscription. In this case, the company has not performed its side of the sale
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(delivering the product) and should only book revenue when each magazine is sent to the subscriber.Changes in GAAP are meant to correct accounting rules that resulted in •disasters of Enron and others. Companies must disclose when the rules will be adopted and what impact it will have. Being able to read between the lines ofdisclosuresmadeinSECfilingscangiveinvestorsanearlywarningsystemto spot potential issues.
3.4 Cash Flow AnalysisCashflowstatementisafinancialstatementthatshowsacompany’sincomingand outgoing money during a time period. The statement shows how changes in balance sheet and income accounts affected cash and cash equivalents, and breaks theanalysisdownaccordingtooperating,investing,andfinancingactivities.Asananalyticaltoolthestatementofcashflowsisusefulindeterminingtheshort-term viability of a company, particularly its ability to pay bills
Operating activitiesOperating activities include the production, sales, and delivery of the •company’s product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.Theamountofcashflowsarisingfromoperatingactivitiesisakeyindicatorof•theextenttowhichtheoperationsoftheenterprisehavegeneratedsufficientcashflowstomaintaintheoperatingcapabilityoftheenterprise,paydividends,repay loans and make new investments without recourse to external sources offinancing.Cashflowsfromoperatingactivitiesareprimarilyderivedfromtheprincipal•revenue producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profitorloss.
Examplesofcashflowsfromoperatingactivitiesare:Receipts from the sale of goods or services•receipts for the sale of loans, debt or equity instruments in a trading •portfolioInterest received on loans•Dividends received on equity securities•Payments to suppliers for goods and services•Payments to employees or on behalf of employees•Tax payments•Interestpayments(alternatively,thiscanbereportedunderfinancingactivities•in IAS 7, but not in US GAAP)
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Payments for the sale of loans, debt or equity instruments in a trading •portfolioItemswhichareaddedbacktothenetincomefigure(whichisfoundonthe•Income Statement)toarriveatcashflowsfromoperationsgenerallyinclude:Depreciation, Deferred Tax, AmortisationAny gains or losses associated with an asset sale (unrealized gains/losses are •also added back from the income statement)
Investing activitiesItincludesthecashflowsthatrepresenttheextenttowhichexpenditureshave•beenmadeforresourcesintendedtogeneratefutureincomeandcashflows.Examplesofcashflowsarisingfrominvestingactivitiesare:collectionsonloanprincipalandsalesofotherfirms’debtinstruments•investment returns fromotherfirms’ equity instruments, including saleof•those instrumentsreceipts from sale of plant and equipment•expenditure for purchase of plant and equipment•loansmadeandacquisitionofotherfirms’debtinstruments•expenditureforpurchaseofotherfirms’equityinstruments(unlessheldfor•trading or considered cash equivalents)Items under investing activities include:•
Capital expenditures, which include purchases (and sales) of property, �plant and equipmentInvestments �
FinancingActivities include the inflow of cash from investors such as•banksandshareholders,debentureholdersaswellastheoutflowofcashtoshareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listedinthefinancingactivitiessectionofthecashflowstatementFinancingcashflowsinclude•
proceeds from issuing shares �proceeds from issuing short-term or long-term debt �payments of dividends �payments for repurchase of company shares �repayment of debt principal, including capital leases �fornon-profitorganizations,receiptsofdonor-restrictedcashthatislimited �to long-term purposes
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3.5 Directors’ ReportRead carefully the following points in Directors’ report
Financial Results•Any Merger or Acquisition, Amalgamation•Appropriations – Dividends, Transfer to general reserves•Change in capital structure (if any)•Appointment and retirement of directors•Subsidiaryandconsolidatedfinancialstatements•Employee stock options•Director’s responsibility statement•Corporate Governance•Conservation of energy, Technology absorption, foreign exchange used and •earned
3.6 Management Discussion and AnalysisMDA will contain following pointers:
Industry structure and developments•Current status (across the major markets of the world where the company �operates) of the industryPotential of the industry �Key drivers to the growth of the industry �Company’s competitive strengths (For example, strong management team, �enhanced value chain, market leader)
Company’s Risks and concerns (For example, Risks like regulatory, •competition, foreign exchange, risk related to acquisitions)Outlook and strategic focus, Internal control systems•Financial performance (For example, share capital, reserves,fixed assets,•investments,sales,depreciation,profit.
3.7 Auditor’s ReportAuditor’squalificationexamples
The term “subject to” is important•Issues like under provision of depreciation, non-provision of doubtful debt•L & T (1985-86) – “No provision had been made in the accounts in respect of •liability for future payment of gratuity to certain employees of the company – gross Rs.130.10 lakhs.
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The effect of the provision made would have been as follows:TheprofitwouldbelowerbyRs.13.67lakhs•Reserves would be lower by Rs.65.05 lakhs•Current liabilities and provisions would be higher by Rs.65.05 lakhs•
Hindustan Zinc Ltd (2003): Long-term investment in shares of Andhra Pradesh Gas PowerCorporationLtd has been re-classified as Intangible assets anddepreciation of Rs.986.14 lacs has been charged. This treatment is in preference to AS-13 & Schedule XIV of Companies Act, 1956 and resulted in decrease in profitbyRs.986.14lacs,decreaseininvestmentbyRs.8304.32lacsandincreasein Intangible assets by Rs7318.18 lacs.”
JKSyntheticsltd.:AuditorsReportsconsistsofAuditorsQualificationsfornonprovision of Interest on Debentures as Estimated by Management Rs. 12786 Lacs, has this to be stated in notes. Should this item be entered in other unprovided loses, unadjusted provisions etc, which will affect Tangible Net worth & further the Ratios.
3.8 Shareholding PatternShareholding pattern consists of following investors
Promoter and Promoter Group•Indian �Foreign �
Public shareholding•Institutions (Mutual Funds, UTI, FIs, Banks, FIIs, Insurance �Companies)Non-Institutions (Bodies Corporate, Individuals, NRIs, OCBs, Trusts �
Shares held by custodians and against which depository receipts have been issued.
3.9 Ratio AnalysisRatioanalysiscanbedefinedas“Theprocessofcalculating therelationshipsbetweenvariouspairsoffinancialstatementvaluesforthepurposeofassessingacompany’sfinancialconditionorperformance.”
Infinance,afinancialratiooraccountingratioisaratioofselectedvaluesonanenterprise’sfinancialstatements.Therearemanystandardratiosusedtoevaluatetheoverallfinancialconditionofacorporationorotherorganization.Financialratiosareusedbymanagerswithinafirm,bycurrentandpotentialshareholders(owners)ofafirm,andbyafirm’screditors.Securityanalystsusefinancialratiosto compare the strengths and weaknesses in various companies. If shares in a companyaretradedinafinancialmarket,themarketpriceofthesharesisusedincertainfinancialratios.
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Valuesusedincalculatingfinancialratiosaretakenfromthebalancesheet,incomestatement,cashflowstatement,and(rarely)statementofretainedearnings.Thesecomprisethefirm’s“accountingstatements”orfinancialstatements.Ratios are always expressed as a decimal value, such as 0.10, or the equivalent percent value, such as 10%.
Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to thefinancialaspectofthebusinesswhichtheratiomeasures.Liquidityratiosmeasuretheavailabilityofcashtopaydebt.Activityratiosmeasurehowquicklyafirmconvertsnon-cashassetstocashassets.Debtratiosmeasurethefirm’sabilitytorepaylong-termdebt.Profitabilityratiosmeasurethefirm’suseofitsassetsandcontrol of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock.
Financial ratios allow for comparisons
between companies
between different time
periods for one company
Financial ratios
comparisons
between a single
company and its industry
average
between industries
Fig. 3.2 Financial ratios comparisons
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The ratios offirms in different industries,which face different risks, capitalrequirements and competition are not usually comparable.
Differenttypesofratioswhichfallunderfinancialstatementanalysisareasshowninthebelowfigure.
Dividend policy ratios
Liquidity ratios
Profitability ratios
Turnover ratios
Financial leverage
ratios
Performance ratios
Types of ratios
Fig. 3.3 Types of ratios
Performance ratios •
Book Value per Share =
Comparing the market value to the book value can indicate whether or �not the stock in overvalued or undervalued.Duringbullmarkets,thestockpriceismorelikelytotradesignificantly �higher than book value, and in a bear market the two values may be close to equal.
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One situation where BV can be useful is if the market value is trading �below the book value. This rarely happens, but if it does it could mean that the company is undervalued and might be an attractive buy.
Liquidity ratios•Liquidity ratios provide information about afirm’s ability tomeet its �short-termfinancialobligations.It is important for those extending short-term credit to thefirm.Two �frequently used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.
Current Ratio =
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholdersmaypreferalowercurrentratiosothatmoreofthefirm’sassetsareworkingtogrowthebusiness.Typicalvaluesforthecurrentratiovarybyfirmandindustry.Forexample,firmsincyclicalindustriesmaymaintainahighercurrentratio in order to remain solvent during downturns.
Quick Ratio=
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.
One drawback of the current ratio is that inventory may include many items that aredifficulttoliquidatequicklyandthathaveuncertainliquidationvalues.Thequick ratio is an alternative measure of liquidity that does not include inventory in the current assets.
Cash ratio =
The cash ratio is the most conservative liquidity ratio. It excludes all current �assets, except the most liquid: cash and cash equivalents.Thecashratioisanindicationofthefirm’sabilitytopayoffitscurrent �liabilities if for some reason immediate payment were demanded.
Turnover ratios•Turnover ratios also referred to as activity ratios or asset management ratios, measurehowefficientlytheassetsareemployedbyafirm.
Inventory turnover ratio =
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Thisratiomeasureshowfasttheinventoryismovingthroughthefirm �and generating sales.This ratio reflects theefficiencyof the inventorymanagement.Higher �theratio,highertheefficiency,butthisisnotgoodifthisiscausedbyalow level of inventory which may result in frequent stock outs and loss of sales and customer goodwill.
Total assets turnover =
This ratio is akin to the output- capital ratio in economic analysis �Thisratiomeasureshowefficientlyassetsareemployed �
Financial leverage ratios•Financialleveragereferstotheuseofdebtfinance. �Whiledebtcapitalisacheapersourceoffinance,itisalsoariskiersource �offinanceStructural ratios – are based on the proportions of debt and equity in the �financialstructureofthefirmExample – Debt-equity ratio, debt-asset ratio �Coverage Ratios show the relationship between debt servicing commitments �and the sources for meeting these burdens
Example – Interest Coverage ratio, debt service coverage ratio
Debt –equity ratio =
Debt = Short term and long term debt
Equity = Net worth + Deferred tax liability (as a quasi-equity)The lower the ratio, the higher the degree of protection enjoyed by the �creditors.The book value of equity often understates its market value. This happens �because tangible assets are carried at their historic values less depreciation and many highly valuable tangible assets are not recorded on the balance sheet.Some forms of debt (like term loans, secured debentures, and secured �short-termbankborrowing)areusuallyprotectedbychargesonspecificassets and hence enjoy superior protection.
Interest Coverage Ratio =
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If a company borrows money in the form of debt, it most likely incurs �interest charges on it. (Money isn’t free, after all!) The interest coverage ratio measures a company’s ability to meet its interest obligations with incomeearnedfromthefirm’sprimarysourceofbusiness.Higher interest coverage ratios are typically better, and interest coverage �closetoorlessthanonemeansthecompanyhassomeseriousdifficultypaying its interest.Thisratioiswidelyusedbylenderstoassessafirm’sdebtcapacity �It is a major determinant of bond rating. �
Debt service coverage ratio =
This ratio measures the capacity of the company to service its debt, i.e., �repayment of principal and interest.This ratiowill help to evaluatewhether adequate cash flowwill be �available to meet debt obligation and also for providing margin of safety to lenders.This ratio also helps to determine the time when repayment should �commence and the payback period of the loan. This ratio is a good indicator of the long-term solvency of a company.
Profitabilityratios•Profitabilityreflectsthefinalresultofbusinessoperations.ProfitmarginRatiosshowtherelationshipbetweenprofitandsales.Example:GrossProfitMargin,NetProfitMargin.
Rate of return ratios reflect the relationship between profit and investment.Example: Return on Capital Employed, Return on Equity
GrossProfitMarginRatio= �
GrossProfit=NetSales-CostofgoodsSold
This ratio shows the margin left after meeting manufacturing costs. It measures the efficiencyofproductionaswellaspricing.Toanalysethefactorsunderlyingthevariationingrossprofitmargin,theproportionofvariouselementsofcost(labour,materials, and manufacturing overheads) to sales may be studied in detail.
NetProfitMarginRatio � =
This ratio shows the earning left for shareholders (both equity and preference) asapercentageofnet sales. Itmeasures theoverall efficiencyofproduction,administration,selling,financing,pricing,andtaxmanagement.Jointlyconsidered,thegrossandnetprofitmarginratiosprovideavaluableunderstandingofthecost
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andprofitstructureofthefirmandenabletheanalysttoidentifythesourcesofbusinessefficiency/inefficiency.
Return on Capital employed: ROCE is the post-tax version of earning power.
ROCE=
Return on Equity =
Average Equity = Paid up capital + Reserve and surplusIt reflects theproductivityof theownership (or risk) capital employed in thefirm.
Dividend policy ratios•Dividendpolicyratiosprovideinsightintothedividendpolicyofthefirmandtheprospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.
Dividend Yield =
A high dividend yield does not necessarily translate into a high future rate �of return. It is important to see the prospects for continuing and increasing the dividend in the future.If you are a value investor or looking for dividend income then this metric �is important to you.
Dividend payout ratio =
Growingcompanieswilltypicallyretainmoreprofitstofundgrowthand �pay lower or no dividends.Companies that pay higher dividends may be in mature industries where �there is little room for growth and paying higher dividends is the best use ofprofits(utilitiesusedtofallintothisgroup,althoughinrecentyearsmany of them have been diversifying).
3.10 Common Size AnalysisIn common size analysis, the ratios often are expressed as percentages of the reference amount. Common size statements usually are prepared for the income statement and balance sheet, expressing information in percentage (%) terms.
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Following is the example of common size analysis of ABC Ltd.
Income StatementCommon-Size
Income StatementRevenue 70, 134 100%Cost of goods sold 44,221 63.10%Gross profit 25, 913 36.90%SG&A expense 13, 531 19.30%Operating income 12,382 17.70%Interest expense 2,862 4.10%Provision for taxes 3,766 5.40%Net income 5,754 8.20%
Table 3.1 Common size analysis of ABC Ltd.
3.11 Cross-sectional AnalysisIn cross-sectional analysis, afirm is compared to its industry as awhole.Tocomparetotheindustry,theratiosarecalculatedforeachfirmintheindustryandan average for the industry is calculated. Comparative statements then may be constructed with the company of interest in one column and the industry averages inanother.Theresultisaquickoverviewofwherethefirmstandsintheindustrywithrespecttokeyitemsonthefinancialstatements.
Example- Cross-sectional analysis
No. Ratio Formula InfoTech Ltd.
Industry Average
Current ratio Current assets/Current liabilities 1.32 1.26
Debt-Equity ratio Debt/Equity 0.81 1.25
Return on equity Equity earnings/Aver-age net worth 13.10% 11.90%
Price-earnings ratio Market price per share/Earnings per share 9.25 9.26
Netprofitmarginratio Netprofit/Netsales 4.90% 4%
Table 3.2 Cross-sectional analysis
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3.12 Economic Value AddedIn corporate finance,EconomicValueAdded or EVA is an estimate of true economic profit aftermaking corrective adjustments toGAAP accounting,including deducting the opportunity cost of equity capital. GAAP is estimated to ignore US$300 billion in shareholder opportunity costs. EVA can be measured as NetOperatingProfitAfterTaxes(orNOPAT)lessthemoneycostofcapital.Moneycost of capital refers to the amount of money rather than the proportional rate (cost of capital). The amortisation of goodwill or capitalisation of brand advertising andothersimilaradjustmentsarethetranslationsthatoccurtoEconomicProfittomake it EVA. The EVA is a registered trademark by its developer, Stern Stewart & Co.
Inthefieldofcorporatefinance,economicvaluesaddedisawaytodeterminethevalue created, above the required return, for the shareholders of a company.The basic formula is:
EVA = (r-c).K = NOPAT-c.K
Where, r = is called the Return on Invested Capital (ROIC).
Theformulaisthefirm’sreturnoncapital,NOPATistheNetOperatingProfitafterTax, c is the Weighted Average Cost of Capital (WACC), and K is capital employed. Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital; see Working capital management. Any value obtained by employees of the company or by product users is not included in the calculations.
Economicvalue-addedmeasurestheprofitabilityofacompanyaftertaking•into account the cost of capital.It is the post-tax return on capital employed (adjusted for the tax shield on •debt) less the cost of capital employed.Companies which earn higher returns than cost of capital create value. •Companies which earn lower returns than cost of capital are deemed destroyers of shareholder value.
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SummarySecurity analysis consists of analysis of primarily financial statements,•management, economic and other industry as well as company factors.Interestandfinancecharges–Whenmoniesareborrowedfromthirdparties•interest has to be paid.Termloansareborrowingsfrombanksandfinancialinstitutionstopurchase•machineryDepreciationistheamountbywhichthefixedassetshavesufferedwearand•tear during the year.Normally, the mature companies pay dividends while the growing companies •pay less or no dividends. Most companies pay dividends twice a year.Final dividend is normally declared after the results of the year have been •arrived at. This is recommended by the directors, discussed at the annual general meeting, and paid after it has been approved by the members at the meeting.In private placement shares are offered to selected individuals or •institutions.Ratioanalysiscanbedefinedas“Theprocessofcalculatingtherelationships•betweenvariouspairsoffinancialstatementvaluesforthepurposeofassessingacompany’sfinancialconditionorperformance.”Valuesusedincalculatingfinancialratiosaretakenfromthebalancesheet,•income statement, cashflow statement, and (rarely) statement of retainedearnings.These comprise thefirm’s “accounting statements” or financialstatements.Financial ratios quantify many aspects of a business and are an integral part •offinancialstatementanalysis.Financial ratios allow for comparisons -between companies/between industries/•between different time periods for one company /between a single company and its industry average.Comparing the market value to the book value can indicate whether or not •the stock in overvalued or undervalued.One situation where BV can be useful is if the market value is trading below the •book value, this rarely happens, but if it does it could mean that the company is undervalued and might be an attractive buy.Liquidityratiosprovideinformationaboutafirm’sabilitytomeetitsshort-•termfinancialobligations.The cash ratio is the most conservative liquidity ratio. It excludes all current •assets except the most liquid: cash and cash equivalents.Turnover ratios also referred to as activity ratios or asset management ratios, •measurehowefficientlytheassetsareemployedbyafirm.Financialleveragereferstotheuseofdebtfinance.•
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Profitabilityreflectsthefinalresultofbusinessoperations.•Dividendpolicyratiosprovideinsightintothedividendpolicyofthefirmand•the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.In common size analysis, the ratios often is expressed as percentages of the •reference amount. Common size statements usually are prepared for the income statement and balance sheet, expressing information in percentage (%) terms.Incross-sectionalanalysisafirmiscomparedtoitsindustryasawhole.•Economicvalue-addedmeasurestheprofitabilityofacompanyaftertaking•into account the cost of capital.
ReferencesInvestopedia, 2011. • Balance Sheet [Online] Available at: <http://www.investopedia.com/terms/b/balancesheet.asp> [Accessed 20 July 2011].Investopedia, 2011. • Cross-Sectional Analysis [Online] Available at: <http://www.investopedia.com/terms/c/cross_sectional_analysis.asp> [Accessed 20 July 11].growthink, 2008.• Writing the Company Analysis Section of Your Business Plan [Video Online] Available at: <http://www.youtube.com/watch?v=oazAYiiakFY> [Accessed 20 July 2011]. Khanacademy.org, 2009. • Introduction to the Income Statement [Video Online] Available at: <http://www.youtube.com/watch?v=Z7C4cz2HkeY> [Accessed 20 July 2011].Hussey, D., 2001. • Company Analysis: Determining Strategic Capability, 1st ed., Wiley.Bruce, B, R. and Epstein, C. B., 1994. • The Handbook of Corporate Earnings Analysis: Company Performance and Stock Market Valuation, Irwin Professional Publishing.
Recommended ReadingBodie, Z., Kane, A., Marcus, A. J. and Mohanty, P., 2006. • Investments. New Delhi: Tata McGraw-Hill.Palat, R. R., 2007. • How to read Annual Reports and Balance Sheets, Mumbai: Jaico Publishing House.Palepu, K. G. and Healy, P. M., 2007. • Business Analysis and Valuation: Using Financial Statements, Text and Cases (with Thomson ONE Access), 4th ed., South-Western College Publication.
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Self Assessment
Interestandfinancechargesareapartof____________.1. income statementa. balance sheetb. financialinformationc. valuation methodsd.
Shareholder’s fund is a part of_____________.2. income statementa. cashflowstatementb. balance sheetc. fixedassetsd.
Pick the odd one out________________.3. administrative expensea. interestandfinancechargesb. raw material expensec. fixedassetsd.
A company can raise funds from its ____________ or by borrowing4. creditorsa. debtorsb. shareholdersc. Governmentd.
Shares offered to selected individuals or institutions is called as_________.5. Private Placementa. Governmental supportb. Private equityc. Promoter’s contributiond.
The cash ratio is the most ___________ liquidity ratio.6. expansivea. conservativeb. insignificantc. significantd.
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Turnover ratios also referred to as activity ratios or _______________.7. asset management ratiosa. leverage ratiosb. debt management ratiosc. cash management ratiosd.
Financialleveragereferstotheuseof__________finance.8. Equitya. Debtb. cashflowc. assetsd.
Inwhichof the followinganalysis isafirmcompared to its industryasa9. whole?
cross-sectional analysisa. common size analysisb. Ratio analysisc. EVAd.
The EVA is developed by_____________.10. Infosysa. Microsoftb. Oracle corporationc. Stern Stewart and Co.d.
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Chapter IV
Equity Valuation Models
Aim
The aim of this unit is to:
explain the meaning of intrinsic value•
elucidate the beta model•
describe capital asset pricing model•
Objectives
The objectives of this unit are to:
discussthediscountedcashflowmodel•
definerelativevaluation•
highlight price-earnings ratio•
Learning outcome
At the end of this unit, you will be able to:
understand different valuation metrics•
recognise use of different valuation methods•
identify dividend discount models•
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4.1 Intrinsic ValueInfinance,intrinsicvaluereferstothevalueofasecuritywhichisintrinsictoor contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset according to a criterion of present value.
In valuing equity, securities analysts may use fundamental analysis - as opposed to technical analysis - to estimate the intrinsic value of a company. Here the “intrinsic”characteristicconsideredistheexpectedcashflowproductionofthecompanyinquestion.Intrinsicvalueisthereforedefinedtobethepresentvalueofallexpectedfuturenetcashflowstothecompany;itiscalculatedviadiscountedcashflowvaluation.
As opposed to the book value or break-up value of a business, the intrinsic value is the value of a business’ ongoing operations. Warren Buffett is best known for his ability to calculate the intrinsic value of a business, and then buy that business at a discount to its intrinsic value.
4.2 Beta and Capital Asset Pricing Model (CAPM)What is Beta?Beta is a relative measure of risk associated with the company’s shares as against the market as a whole. Beta measures the volatility of the stock. When the market is going up, the stocks which have higher betas (more than 1) are preferred and in falling markets the stocks having lower betas (less than 1) are preferred.
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Calculation of betaThe calculation of beta may be illustrated with an example. The rates of return on stock A and the market portfolio for 15 periods are given below:
Peri
odR
etur
n on
st
ock
A
(RA
Ret
urn
on
mar
ket
port
folio
, R
M
Dev
iatio
n of
ret
urn
on
stoc
k A
from
its
mea
n (R
A
- mea
n of
R
A)
Dev
iatio
n of
ret
urn
on M
arke
t Po
rtfo
lio
from
its
mea
n (R
M
– m
ean
of
RM
)
Prod
uct o
f th
e de
via-
tion,
(RA
- m
ean
of
RA
) (R
M
– m
ean
of
RM
)
Squa
re o
f th
e de
-vi
atio
n of
re
turn
on
mar
ket
port
folio
fr
om it
s m
ean
(RM
–
mea
n of
R
M)2
1 10
12
0
3 0
92
15
14
5 5
25
253
18
13
8 4
32
164
14
10
4 1
4 1
5 16
9
6 0
0 0
6 16
13
6
4 24
16
7 18
14
8
5 40
25
8 4
7 -6
-2
12
4
9 -9
1 -1
9-8
15
264
10
14
12
4 3
12
911
15
-1
1 5
-20
-100
400
12
14
16
4 7
28
4913
6
8 -4
-1
4
114
7
7 -3
-2
6
415
-8
10
-18
1 -1
81
Table 4.1 Beta calculation
ΣRA=150(RA-meanofRA)(RM–meanofRM)=221ΣRM=135Σ(RM–meanofRM)2=624Mean RA = 10Mean RM = 9
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Now, the beta of stock A is equal to:
So, from the above table we can put the values in the formula.
Cov (RA, RM ) = = = 15.79
∂2M= = = 44.57
So, the beta for stock A is 15.79/ 44.57 = 0.35
Capital Asset Pricing Model (CAPM)-Cost of EquityInfinance, theCapitalAsset PricingModel (CAPM) is used to determine atheoretically appropriate required rate of return of an asset, if that asset is to be addedtoanalreadywell-diversifiedportfolio,giventhatasset’snon-diversifiablerisk.Themodeltakesintoaccounttheasset’ssensitivitytonon-diversifiablerisk(also known as systemic risk or market risk), often represented by the quantity betainthefinancialindustry,aswellastheexpectedreturnofthemarketandtheexpected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor, William Sharpe, Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification andmodern portfolio theory. Sharpe received theNobelMemorial Prize in Economics (jointly with Markowitz and Merton Miller) for thiscontributiontothefieldoffinancialeconomics.
Formula: Expected Rate of Return = Rf+B (Rm-Rf)
The general idea behind CAPM is that investors need to be compensated in •two ways: Time value of money and RiskThe time value of money is represented by the risk-free (Rf) rate in the formula •and compensates the investors for placing money in any investment over a period of time.The other half of the formula represents risk and calculates the amount of •compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm- Rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.Using the CAPM model and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 9%, the beta (risk measure) of
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the stock (Infosys) is 0.59 and the expected market return over the period is 25%, the stock is expected to return 16% (9%+0.59(20%-9%)).
4.3 Discounted Cash Flow ModelInfinance, the discounted cashflow (or DCF) approach describes a method of valuing a project, company, or asset using the concepts of the time value of money.Allfuturecashflowsareestimatedanddiscountedtogivethemapresentvalue. The discount rate used is generally the appropriate cost of capital, and may incorporatejudgmentsoftheuncertainty(riskiness)ofthefuturecashflows.
Discountedcashflowanalysisiswidelyusedininvestmentfinance,realestatedevelopment,andcorporatefinancialmanagement.Verysimilaristhenetpresentvalue.
A Discounted Cash Flow Model can be explained as:“A valuation method used to estimate the attractiveness of an investment opportunity.Discounted cashflow (DCF) analysis uses future free cashflowprojections and discounts them (most often using the weighted average cost ofcapital-whichreflects theriskinessof thecashflows) toarriveatapresentvalue, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.”
Anexamplewouldmaketheconceptclearer.Toshowhowdiscountedcashflowanalysisisperformed,considerthefollowingsimplifiedexample.NikhilJoshibuys a house for Rs.30, 00,000. Three years later, he expects to be able to sell this houseforRs.45,00,000.SimplesubtractionsuggeststhatthevalueofhisprofitonsuchatransactionwouldbeRs.45,00,000−Rs.30,00,000=Rs.15,00,000,or50%. If that Rs. 15, 00,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at thosefigures,hemightbejustifiedinthinkingthatthepurchaselookedlikeagood idea.
1.1453 x 100000 = 150000 approximately.
However, since three years have passed between the purchase and the sale, any cashflowfromthesalemustbediscountedaccordingly.WhenNikhilJoshibuysthe house, the 3-year Indian Treasury Note rate is 5% per annum. Treasury notes are generally considered to be inherently less risky than real estate, since the value of the note is guaranteed by the Indian government and there is a liquid market for the purchase and sale of T-Notes. If he hadn’t put his money into buying the house, he could have invested it in the relatively safe T-Notes instead. This 5% per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years).
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Using the DPV formula above, that means that the value of Rs. 45, 00, 000 received in three years actually has a present value of Rs. 38, 87, 269 (rounded off). Those future rupees aren’t worth the same as the rupees we have now.
Subtracting the purchase price of the house (Rs. 30, 00, 000) from the present value results in the net present value of the whole transaction, which would be Rs.8, 87, 269 or a little more than 29% of the purchase price.Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (14.5%-5.0%)/(100%+5%) or approximately 9.0% (still very respectable). (As a check, 1.050x1.090 = 1.145 approximately.)
But what about risk?We assume that the Rs. 45, 00, 000 is Nikhil’s best estimate of the sale price that he will be able to achieve in 3 years time (after deducting all expenses, of course). There is of course a lot of uncertainty about house prices, and the outturn may end up higher or lower than this estimate. (The house Nikhil is buying is in a “good neighbourhood”, but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that Nikhil might not be able to get the full Rs. 45, 00, 000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.)
Under normal circumstances, people entering into such transactions are risk-averse, that is to say that they are prepared to accept a lower expected return for the sake of avoiding risk. See Capital asset pricing model for a further discussion ofthis.Forthesakeoftheexample(andthisisagrosssimplification),let’sassumethat he values this particular risk at 5% per annum. Therefore, allowing for this risk, his expected return is now 9.0% per annum (the arithmetic is the same as above). And the excess return over the risk-free rate is now (9.0%-5.0%)/(100% + 5%) which comes to approximately 3.8% per annum.
That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profittocompensatefortyingupcapitalandincurringriskwithalittleextraleftover. When investors and managers perform DCF analysis, the important thing is thatthenetpresentvalueofthedecisionafterdiscountingallfuturecashflowsatleast be positive (more than zero). If it is negative, that means that the investment decision would actually lose moneyevenifitappearstogenerateanominalprofit.For instance, if the expected sale price of Nikhil Joshi’s house in the example above was not Rs.45,00,000 in three years, but Rs.40,00,000 in three years or Rs.45,00,000 in five years, then on the above assumptions buying the house would actually cause Nikhil to lose money in present-value terms. Similarly, if the house was located in an undesirable neighborhood and the Reserve Bank of India
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wasabouttoraiseinterestratesbyfivepercentagepoints,thentheriskfactorwouldbealothigherthan5%:itmightnotbepossibleforhimtomakeaprofitindiscounted terms even if he could sell the house for Rs50,00,000 in three years.
Inthisexample,onlyonefuturecashflowwasconsidered.Foradecisionwhichgeneratesmultiplecashflowsinmultipletimeperiods,allthecashflowsmustbediscounted and then summed into a single net present value.
Let us look at the DCF model in detail.Inputs to discounted cash flow models
Discount Rates =Cost of Debt+Cost of Equity•Expected Cash Flows =FCFF , FCFE , Dividends•Expected Growth Rate•
4.3.1 What is FCFF?“Ameasureoffinancialperformancethatexpressesthenetamountofcashthatisgeneratedforthefirm,consistingofexpenses,taxesandchangesinnetworkingcapital and investments.”
Formula:FCFF = Operating Cash Flow – Expenses - Taxes - Changes in NWC - Changes in Investments
Steps in FCFF valuationTakethesalesfigure.•DeductOperatingexpensesfromit.YouwillgetEBITfigure.•Deduct(CapitalExpenditures–Depreciation)figurefromit.•Deduct“Changeinworkingcapital”figurefromit.•YouwillgetFCFFfigure.•CalculateCostofCapitalforthefirm.•Assume“expectedgrowthrate”forthecompany.(Itshouldnotbesignificantly•higher than the nominal growth rate of the economy.)
Valueofthefirm=
=
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4.3.2 What is FCFE?“This is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment, and debt repayment.”
Formula: FCFE = Net Income - Net Capital Expenditure - Change in Net working capital+ New Debt - Debt Repayment
In short, FCFE = FCFF - Debt Payments + New Debt issued
Steps in DCFForecasting/measuring free cash flow1. Estimate thecashflowfor thenext5yearsand thengo for terminalcash•flowsWhile measuring Cash Flow to Firm, •EBIT (1-Tax Rate) - (Capital Expenditures – Depreciation) - Change in WorkingCapital=CashFlowtothefirmWhile measuring Cash Flow to Equity •EBIT(1-Tax Rate) - (Capital Expenditures – Depreciation) - Change in Working Capital +( New Debt – Debt Repayment) – Investments = Cash Flowtothefirm
Estimate WACC/cost of equity2. WACC = Weighted Average Cost of Capital•Acalculationofafirm’scostofcapitalinwhicheachcategoryofcapitalis•proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.WACC is calculated by multiplying the cost of each capital component by its •proportional weight and then summing.WACC is the combination of Cost of Equity and Cost of Debt with their •weightages respectively.As we know Cost of Equity is calculated by CAPM method.•Cost of Equity = Rf + B (Rm-Rf)•
Cost of Capital WACC = E/V x Ke + D/V x Kd x(1-T) Where, Ke = cost of equity Kd = cost of debt E=marketvalueofthefirm’sequity D=marketvalueofthefirm’sdebt V = E + D E/V=percentageoffinancingthatisequity D/V=percentageoffinancingthatisdebt T = corporate tax rate
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For example, if the market value of a company’s equity is Rs.600 crores •and it has Rs.400 crores of debt on its balance sheet, then 60% of its capital is equity and 40% is debt. If the company’s cost of equity is 10% and its cost of debt is 7%, then its WACC is: (60% x 10%) + (40% x 7%) = 8.8%
Use WACC to discount FCF3. TheFreecashflowshouldbediscountedattheWACCrate(forfirmvaluation)or that of Cost of equity (for equity valuation) rate. Here, Discount rate is 9%
Year Cash flow DCF/PV
2007 100 92
2008 120 101
2009 140 108
2010 175 124
2011 200 130
Total 735 555
Table 4.2 FCFF
Estimate terminal value4. Perpetuity Value• = ( CFn x (1+ g) ) / k - gCFn = Cash Flow in the Last Individual Year Estimated •g = Long-Term Growth Rate k = Discount Rate, or Cost of CapitalTobetterunderstandtheperpetuityvalue,supposewe’reusingafive-year•DCF model for a company with a 9% cost of capital. We estimate that thecompany’sfreecashflowinYear5willbeRs.100Crores,andthatitscashflowwill growat 5%after that.Theperpetuity valuewill equal to: (100 Crores x (1 + .05) ) / (.09 -.05) = Rs. 2625 Crores
Use WACC to discount terminal value5. Remember,theperpetuityvalueiscalculatedasoffiveyearsfromnow.To•findoutwhatthevalueistoday,wehavetodiscountthecalculatedvalueusingthe formula we learned earlier:Present Value of Perpetuity Value = Rs.2625 Crores / (1 + .09)^5 = Rs.1706 •Crores
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Once we’ve found the present value of the perpetuity, we simply add this •numbertothepresentvalueofthecashflowsweestimatedinYears1through5 to determine the fair value, or intrinsic value, of the company.
Estimate total present value of FCF6. Here, we need to combine the Present Values of the foreseeable period and the terminal period.
Year Cash flow DCF/PV
2007 100 92
2008 120 101
2009 140 108
2010 175 124
2011 200 130
Terminal Value 2625 1706
Total 3360 2261
Table 4.3 Total FCFF
Add value of non-operating assets7. Non-operating assets include all assets whose earnings are not counted as •part of the operating income. The most common of the non-operating assets is cash and marketable securities
Operating Income from minority holdings in other companies �Value of idle or unutilised assets �
Subtract value of non-equity claims8. Subtract value of liabilities like
Value of Interest bearing debt•Present value of operating lease commitments•Estimated value of minority interests in consolidated companies•Unfunded health care or pension Obligations•Expected litigation payout•
Calculate value of common stock9. After doing these 8 steps, we will come to a value = Value of Equity.
Value per share =
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DCF Valuation: exampleLet’s take ABC Ltd. for DCF Valuation, Discount rates are as under:
Discount rates
Current Yr 2008 2009 2010 2011 2012
COST OF EQUITY 0.27 0.27 0.27 0.27 0.27
COST OF DEBT 0.03 0.03 0.03 0.03 0.03
COST OF DEBT AFTER TAX 0.02 0.02 0.02 0.02 0.02
WACC 0.13 0.13 0.13 0.13 0.13
CUMULATIVE WACC 1 1.13 1.28 1.44 1.63 1.84
Table 4.4 WACC calculation
DCF model
Figures in Rs. Lakhs Current Yr 2008 2009 2010 2011 2012
A. EBIT*(1-T) 2234 3449 3665 3893 4137 4395
B. Add - Depreciation 775 868 923 980 1042 1107
C. Capital Expenditure 2322 1255 1333 1417 1505 1599
D. Change in Net Working Capital 43 -278 -295 -314 -333 -354
E. Free Cash Flow to Firm (FCFF) ( A+B-C-D)
1976 3191 3406 3635 3878 4137
D. Terminal Cash Flow 66318
E.PVofcashflowforthefirm 2234 3052 2869 2697 2535 2383 35955
F. Value of the Firm 51724
G. Value of Investments 4070
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H. Value of Debt 12271
I. Value of Equity(F+G-H) 43523
Value per share in Rs. (No of shares-1 Crores)
435
Table 4.5 DCF calculation
4.4 Dividend Discount ModelsIn dividend discount models, dividend is the main factor and we can value only dividend paying companies by this method.
Gordon growth modelA model for determining the intrinsic value of a stock, based on a future series •of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rateinperpetuity,themodelsolvesforthepresentvalueoftheinfiniteseriesof future dividends.
Formula:Stock Value (P) = Where,D = expected dividend per share one year from nowK = required rate of return for equity investorG = Growth rate in dividends (in perpetuity)
Since the model assumes a • constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.
Example:ABC Ltd. Gave Rs. 25 dividend for year 2006-07 and is expected to grow it by 20% next year. Cost of Equity is 14% and expected growth in dividend by 10 % forever.
DDM = = Rs.750
4.5 Relative ValuationIt compares a stock’s valuation with those of other stocks or with the company’s own historical valuations. Idea is similar assets should sell at similar price and relative valuation is typically implemented using price multiplies.
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If Wipro has a P/E ratio of 16 and Infosys has average P/E of 26 and the average for the industry is closer to, say, 25, Wipro’s shares are cheap on a relative basis. You could also compare Wipro’s P/E with the average P/E of an index, such as the SENSEX or Nifty, to see whether Wipro still looks cheap.
Let us see some valuation methods in relative valuation:
Price-Earnings Ratio (P/E) = •
PE is the ratio or the multiple �It tells you how much investors are willing to every unit of the EPS. It also �tells you whether the stock is undervalued, overvalued or fairly valuedTrailing PE, Forward PE are used to estimate the price of the stock �Reverse of PE is called Earnings yield. �It is the most popular ratio in relative valuation �PE should be compared with its peers in the same industry �PE can also be compared with the company’s track record. �
Understand PE in a simple wayLet’s say I offer you a privilege to collect a rupee every year from me forever. How much are you willing to pay for that privilege now? Let’s say you are only willing to pay me 50 paisa, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Mukesh Ambani, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 paisa, let’s say, Rs.20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of rupees the market is willing to pay for a privilege to be able to earn a rupee forever in perpetuity. Mukesh Ambani s’ P/E ratio is 20 and my P/E ratio is 0.5.
Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Mukesh Ambani, it would have taken you at least 20 years, while investing in me could have taken you less than a year, that is, only 6 months.
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PE Ratio Interpretation
N/A A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treatedashavinganundefinedP/Eratio,althoughanegativeP/Eratio can be mathematically determined
0–10 Either the stock is undervalued or the company’s earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends.
10–17 For many companies a P/E ratio in this range may be considered fair value.
17–25 Either the stock is overvalued or the company’s earnings have increasedsince the lastearningsfigurewaspublished.Thestockmay also be a growth stock with earnings expected to increase substantially in future.
25+ A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble
Table 4.6 PE Ratio Interpretation
Price-to Book Value• =
Book Value is a company’s assets minus its liabilities �It is an accounting jargon for what would be left over for shareholders if �the company was sold and its debt retired. The price/book ratio measures what the market is paying for those net assets (also known as shareholder equity). The lower the number, the betterThis ratio works best with companies in the sectors like – Steel, Factories, �Ore reserves having a lot of hard assets and in – Insurance, Banks – having lotsoffinancialassets.This ratio doesn’t work well with the companies which have lots of �intellectual assets like patents, trademarks — even their employees’ collective brains — that don’t appear on the balance sheet.That’swhyhigh-techoutfitslikeTCShaverelativelylowbookvalues, �whichgivethemartificiallyhighprice/bookratios.Theotherdrawbacktobookvalueisthatitoftenreflectswhatanasset �was worth when it was bought, not the current market value. So it is an imprecise measure even in the best case.Like the P/E ratio it is simple to compute and easy to understand, making it a �good way to compare stocks across a broad array of old-line industries
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It also gives you a quick look at how the market is valuing assets vs. �earningsFinally, because assets are assets in any country, book-value comparisons �work around the world. It is not true of a P/E ratio since earnings are strongly affected by different sets of accounting rules
EV/EBITDA• Enterprise Multiple =
Enterprise value = Market Capitalization + debt at market value + minority interest at market value, if any – associate company at market value, if any - cash and cash equivalents.
This ratio is used to determine the value of a company. The enterprise multiple looksatafirmasapotentialacquirerwould,becauseittakesdebtintoaccountan item which other multiples like the P/E ratio do not include.A low ratio indicates that a company might be undervalued. The enterprise multiple is used for several reasons
It’s useful for transnational comparisons because it ignores the distorting �effects of individual countries’ taxation policies.It is used tofind attractive takeover candidates.Enterprise value is a �better metric than market cap for takeovers. It takes into account the debt which the acquirer will have to assume. Therefore, a company with a low enterprise multiple can be viewed as a good takeover candidate.
Keep in mind that enterprise multiples can vary depending on the industry. Therefore, it’s important to compare the multiple to other companies or to the industry in general. Expect higher enterprise multiples in high growth industries (like biotech) and lower multiples in industries with slow growth (like railways).
EV/EBITDA is the metric most used to measure how many years it would take to pay back the investment. This metric is equivalent to the payback period used by debt holders (Debt/EBITDA). The P/E metric used by shareholders is similar exceptitmeasuresearnings,notcashflow.
EBITDA/EV is the metric most used to measure the cash rate of return on the investment
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Example: Relative valuation of IT companies
Parameters Wipro Satyam TCS Infosys
Price (Market Value) (Rs.) 463 444 895 1698
Price/Book Value (Times) 7 5 11 9
Price/Sales (Times) 5 5 6 7
EPS (Rs.) 21 26 46 78
Price/Earning (Times) 21 17 19 21
Enterprise Multiple(Enterprise Value/EBITDA) 14 16 15 15
Table 4.7 Relative valuation of IT companies
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SummaryInfinance,intrinsicvaluereferstothevalueofasecuritywhichisintrinsic•to or contained in the security itself.As opposed to the book value, or break-up value, of a business, the intrinsic •value is the value of a business’ ongoing operations.Beta is a relative measure of risk associated with the company’s shares as •against the market as a whole. Beta measures the volatility of the stock. When the market is going up, the stocks which have higher betas (more than 1) are preferred and in falling markets the stocks having lower betas (less than 1) are preferred.The Capital Asset Pricing Model (CAPM) is used to determine a theoretically •appropriate required rate of return of an asset, if that asset is to be added to an alreadywell-diversifiedportfolio,giventhatasset’snon-diversifiablerisk.The general idea behind CAPM is that investors need to be compensated in •twoways:timevalueofmoneyandrisk.Thediscountedcashflow(orDCF)approach describes a method of valuing a project, company, or asset using the conceptsofthetimevalueofmoney.Allfuturecashflowsareestimatedanddiscounted to give them a present value. The discount rate used is generally the appropriate cost of capital, and may incorporate judgments of the uncertainty (riskiness)ofthefuturecashflows.Ameasureoffinancialperformancethatexpressesthenetamountofcash•thatisgeneratedforthefirm,consistingofexpenses,taxes,andchangesinnet working capital and investments is called FCFF.FCFE is the measure of how much cash can be paid to the equity shareholders •of the company after all expenses, reinvestment, and debt repayment.Gordon Growth Model is a model for determining the intrinsic value of a •stock, based on a future series of dividends that grow at a constant rate.Relative valuation compares a stock’s valuation with those of other stocks or •with the company’s own historical valuations. Idea is similar assets should sell at similar price and relative valuation is typically implemented using price multiplies.
ReferencesThe Boston Security Analysts Society - Continuing Education• , Equity Valuation Models: Implementation, Integration & Validation [Online] Available at: <http://www.crowther-investment.com/images/EquityValuationModelsMar03.pdf> [Accessed 20 July 2011].Gazhoo, 2011. • Venture Capital & Private Equity Valuation Model [Online] Available at: <http://www.gazhoo.com/doc/3891/Venture+Capital+%26+Private+Equity+Valuation+Model> [Accessed 20 July 2011].wstss, 2008. WST: 7.2 • Basic Financial Modeling - Valuation Model & DCF [Video Online] Available at: <http://www.youtube.com/watch?v=feNNXcqk8NE> [Accessed 20 July 11].
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AllenResources, 2008. • CFA Exam Prep: Level 2 Equity Investments: Valuation Models [Video Online] Available at: <http://www.youtube.com/watch?v=_IQu7o2jgS8> [Accessed 20 July 11].Hawkins, D. F. and Campbell, W. J., 1978. • Equity Valuation: Models, Analysis and Implications, Financial Executives Res Found.Kelleher, J., 2010. • Equity Valuation for Analysts and Investors, 1st ed., McGraw-Hill.
Recommended ReadingChandra, P., 2006. • Investment Analysis and Portfolio Management, New Delhi: Tata McGraw-Hill.Bodie, Z., Kane, A., Marcus, A. J. and Mohanty, P., 2006. • Investments, New Delhi: Tata McGraw-Hill.Viebig, J., Poddig, T. and Varmaz, A., 2008. • Equity Valuation: Models from Leading Investment Banks, 1st ed., Wiley.
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Self Assessment
DCF is______________.1. Discontinuedcashflowa. Discountedcashflowb. Discounted cash freec. Continuedcashflowd.
Security analysts use ________ analysis to calculate intrinsic value.2. technicala. liquidityb. fundamentalc. fusiond.
Which is the value of a business’ ongoing operations?3. The intrinsic valuea. Book valueb. Break-up valuec. Final valued.
____________ measures the volatility of the stock.4. Liquiditya. Alphab. Gammac. Betad.
Identify the odd term from the following.5. Risk free ratea. Market Returnsb. Betac. Intrinsic Valued.
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Match the columns.6.
FCFE1. ForthewholefirmA.
FCFF2. For expected rate of returnB.
CAPM3. For equity holdersC.
DCF4. For intrinsic valueD. 1-C, 2-A, 3-B, 4-Da. 1-D, 2-C, 3-B, 4-Ab. 1-B, 2-A, 3-D, 4-Cc. 1-A, 2-D, 3-C, 4-Bd.
WACC is____________.7. weighted average capital conversiona. weighted average cost of capitalb. weighted average of combined capitalc. weighted average cost of conversiond.
Book value is a company’s ___________ minus its liabilities.8. assetsa. capitalb. net worthc. incomed.
Identify the odd term from the following. 9. patentsa. trademarksb. copyrightsc. Factoriesd.
Discount Rates= Cost of Debt+___________.10. Expected Cash Flows a. Cost of Equityb. Expected Growth Ratec. Taxesd.
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Chapter V
Technical Analysis
Aim
The aim of this unit is to:
explain technical analysis•
describe basic grounds•
outline charting methodologies•
Objectives
The objectives of this unit are to:
discuss technical indicators•
highlight fundamental concepts beneath chart analysis•
definerelationshipbetweenvolumeandtrend•
Learning outcome
At the end of this unit, you will be able to:
identify technical trading rules•
understand resistance and support levels•
analyse mutual fund liquidity•
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5.1 IntroductionAs a move towards investment analysis, technical analysis differs drastically from fundamental analysis. Fundamental analysts considers that the market is 90 percent rational and 10 percent psychological where as technical analysts believes its other way round, i.e. they believe that market is 90 percent psychological and only 10 percent rational. A number of fundamental factors related to company, industry and economy are not assessed by technical analysts. Instead, the analysis of internal market data is done by using graphs and charts. Technical analysts look at the game of investment as a way to estimate the behaviour of the market players. They view charts for better understanding of the activities of the market participants and believe that it provides a base for anticipating the future behaviour.Dating back to late 19th century, technical analysis is the oldest approach for equity investment and has continuously prospered in modern times also. As newspapers cover technical analysis, technical experts are called on regular basis for their comments and investment advisory services distribute technical reports, as an investor, you will more often than not come across it. It is widely used due to its spontaneity. However, in recent times, its soundness is being gravely challenged.
Although technical analysis is applicable to currencies, commodities, bonds and equity stocks, we limit our conversation to equity stocks only.
5.2 What is Technical Analysis?Technical analysis is a study of market data like volumes and price so as to anticipate the direction of price advances in future. Martin J Pring explains technical analysis in his book Technical Analysis explained as “The technical approachtoinvestingisessentiallyareflectionoftheideathatpricesmoveintrends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political, and psychological forces. The art of technical analysis-for it is an art-is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has been reversed.”
5.3 Basic GroundsRobert A Levy expresses basis premises of technical analysis as follows:
Market prices are determined by the interaction of supply and demand •forces.Supply and demand are influenced by a variety of factors, both rational•and irrational. These include fundamental factors as well as psychological factors.Barring minor deviations, stock prices tend to move in fairly persistent •trends.Shifts in demand and supply bring about changes in trends.•
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Irrespective of why they occur, shifts in demand and supply can be detected •with the help of charts of market action.Because of persistence of trends and patterns, analysis of past market data •can be used to predict future price behaviour.
5.4 Charting MethodologiesA variety of charting techniques is used by technical analysts. The most accepted amongst them are bar and line charts, Dow theory, the moving average line, thepointandfigurechartandtherelativestrengthline.Beforemovingaheadto understand these techniques, let us have a look at the basic concepts that lie beneath the chart analysis.
Fundamental concepts related to chart analysisFollowing are the basic concepts of chart analysis:
Resistance and
support levels
Chart analysis
Trend persistence
Relationship between
volume and trend
Fig. 5.1 Basic concepts of chart analysis
Trend persistenceThe chartists primarily believe that the stock prices are inclined to advance in moderately persistent trends. The behaviour of stock prices is described by inertia, i.e., the price continuously moves along a certain direction (upward, downward orsideways)untilitismetwithanopposingforcethatstemsoutofamodifieddemand supply relationship.
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Relationship between volume and trendIt is believed by chartists that usually, volume and trend work hand in hand. With thebeginningofasignificantrise,tradingvolumesincreaseswiththeincreasein prices and decreases with the fall in prices. In case of a major decline, exactly opposite conditions occur, i.e., trading volume increases with decrease in prices and decreases with the increase in prices.
Resistance and support levels
40,0000
46,0000
60,0000
80,0000
100,0000
120,0000
140,0000
160,0000
180,0000
April July October 2000January
April
RESISTANCE
SUPPORT
Fig. 5.2 Support and resistance(Source: rightline.net)
Chartists presume that it is hard for share prices to go above a certain level known as resistance level and drop below a certain level known as support level. You mustbewonderingwhyso?Thereasonforthefirstassertionisasfollows.
If investors observe that the prices drop down after they have purchased, they continue to cling to their shares with the hope of recuperation. And so, when the prices bounce back up to the level at which they had purchased, they do away with their shares by selling them and feel relaxed as they break even. This kind ofbehavioural trendof the investorarousessignificantsupplywhenthepricebounces back to the level at which sizeable shares were bought by the investors. Thus the shares do not tend to go above this resistance level.
The level at which a falling share may invoke a considerable rise in demand is knownassupportlevel.Itessentiallyreflectsthelevelfromwhichthesharehadgone up in the past with huge trading volumes. With the price dropping down to this level, there is solid demand from various quarters like the ones who had
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missed the opportunity earlier and feel sorry for their failure to be a part of the former progress; short-sellers who have sold short at high price and wish to book profitsbynetting-offtheirpositions;andalsovalueinclinedinvestors.
Bar and line charts
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
Bar Chart
Fig. 5.3 Bar chart(Source: rff.com)
Bar chart is one of the simplest and most widely used technical analysis tools. It represents the day-to-day price range along with the closing price. It may also depict the daily volume of the trades.
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Last Time: 29/06/2005 16:00:00 Open: 1.2050 High: 1.2063 Low: 1.2031 Close: 1.20 Time: 28/04/2005 20:00:00 Open: 1.29.16 High: 1.2918 Low: 1.2880 Close: 1.2894 Left
1.2999
1.2978
1.2957
1.2936
1.2915
1.2894
1.2873
1.2852
1.2831
1.2810
1.2999
1.2978
1.2957
1.2936
1.2915
1.2894
1.2873
1.2852
1.2831
1.281028/04 29/04 29/04 02/05 03/05 03/05 04/05
Fig. 5.4 Line chart(Source: forexrealm.com)
Alinechartisasimplificationoverbarchartanddepictsthelinethatconnectsthe consecutive closing prices.
It is a belief of technical analysts that some patterns seen on the bar chart or line chart have indicative value. The key patterns and their suggestions are as follows:
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Head and Shoulders Top (HST) Pattern:
Head
Shoulder
Neckline
Enter on break
Target 430 pointsExample by Informedtrades.com
Chart from prorealtime.com
Shoulder
117.50-113.20=430 points
Stop loss
118
117
116
115
114
113
112
111
109.86
109
Value USD/JPY Spot Year Low: 107.22 High: 124.15 Moving average20 Moving average50
Fig. 5.5 Head and Shoulders
The HST pattern consists of a left shoulder, a head and a right shoulder and it reflectsabearishprogress.Adeclineinpriceisexpectedifthepricedropsdownbelow the neckline, i.e., the line tangent to the left and right shoulder. Thus, it is an indication to sell.
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Inverse Head and Shoulders Top (HST) Pattern:As suggested by the name, the IHST pattern is simply the inverse of HST pattern, i.e., it depicts a bullish advancement. With the price going above the neckline, a rise in price is expected. Thus, it is an indication to buy.
Flags and Pennants Formation:It essentially represents a halt after which the earlier price trend is expected to continue.
Triangle or Coil Formation:Anuncertaintypatternisreflectedbythisformationmakingithardtoanticipatethe direction of price break out.
Double top Formation:It depicts the bearish progress, indicating the probable fall in price.
Double Bottom Formation:It depicts the bullish progress, indicating the probable rise in price.
The Dow Theory
Time
Downwardprimary trend
Upwardprimary trend
Upwardprimary trend
Clo
sing
Pri
ces
The Dow Theory
Secondarymovements
Fig. 5.6 Dow Theory(Source: performancetrading.it)
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The Dow Theory was proposed by Charles H Dow, the editor of the Wall Street Journal, in late nineteenth century, and is probably the oldest and best technical analysis theory. According to Charles Dow “The market is always considered ashavingthreemovements,allgoingatthesametime.Thefirstisthenarrowmovement from day to day. The second is the short swing, running from two weeks to a month or more; the third is the main movement, covering at least four years in its duration”.
The Dow Theory supporters refer to the three movements as:dailyfluctuationsthatarearbitrarydailywiggles•secondary movements or amendments that may continue for a few weeks to •few monthsprimary trends that represent the bullish and bearish states of the market.•
A bull market is represented by an upward primary trend while a downward primary trend represents abearmarket.Asignificantupwardmove is said totake place when the peak point of every rally is higher than the peak point of the previous rally and the low point of each fall is higher than the low point of the previousfall.Similarly,asignificantdownwardmovetakesplacewhenthepeakpoint of each rally is lower than the peak point of the previous rally and the low point of each fall is lower than the low point of the previous fall.
The technical amendments are represented by the secondary movement. They reflectthecorrectionsmadetothesurplusthatmighthaveoccurredintheprimarymovements. These movements bear a lot of importance in the application of the Dow Theory.
The day-to-day variations are considered to have minor importance. Even ardent technical analysts normally do not attempt to forecast movements in the market on day-to-day basis.
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The Moving Average Line
Base data Moving Average - 10Moving Average - 20
200
150
100
50
0
Moving Averages
Fig. 5.7 Moving Average(Source: Swiftchart.com)
Theabovefigureshowsthemovingaveragefor10daysand20daysrespectively.The calculation of a moving average is done by considering the latest ‘n’ observations. In order to recognise the trends, the moving average analysis used by technical analysts is:
A 10-day moving average of every day prices may be used to identify a short-•term trend.A 60-day moving average of every day prices may be used to identify an •intermediate-term trend.A 200-day moving average of every day prices (or otherwise, a 30-week moving •average of weekly prices) may be used to identify a long-term trend.
The buy and sell signal that a moving average analysis provides is as follows:
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Buy Signal Sell Signal
When the graph of the moving average line is flattening out, theline of stock prices rises through the moving average line.
When the graph of the moving averagelineisflatteningout,thelineof stock prices drops down through the moving average line.
Stock price line drops below the rising moving average line.
Stock price line goes above the falling moving average line.
Stock price line that is above the moving average line drops down but again starts rising up before reaching the moving average line.
Stock price line that is below the moving average line rises but again starts declining before reaching the moving average line.
Table 5.1 Moving average analysis of buy and sell signal
The Point and Figure ChartApointandfigurecart(PFC)ismorecomplicatedthanabarchart.Followingare the features of PFC:
PFC records only vital price changes. Like for example, a stock lying in a •price range of Rs. 10 to Rs. 30, a price change of one rupee or more may be recorded.Even though the vertical scale of PFC indicates the stock price, the horizontal •scale however foes not represent the time scale like in general case.A key reversal of the price movement and not the trading day is represented •by each column on the horizontal scale of PVC.
The PFC compresses the recording of changes in price by doing away with the time scale andother small changes.Thismakes the identification of patternsand changes a lot more easier. Technical analysts drive their attention on the congestion areas on a PFC. The congestion area corresponds to a band of Xs and Os on a PFC which is formed due to a series of reversals that occurred around some price level. A congestion area surfaces when demand and supply are almost same. A breakout from the top portion of a congestion area is an indication of price movement in upward direction. While on the other hand, a penetration via the bottom of congestion area is an indication of downward price movement.
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The Relative Strength Line
Relative Strength Index (RSI)Daily Chart -Wal-Mart (WMT)
Overbought (70)
RSI (14-day) Oversold (30)
Fig. 5.8 Relative strength index
The relative strength analysis assumes that prices of certain securities go up quickly during the bullish phase while it also falls down during the bearish phase with respect to the market as a whole. In other words, such type securities hold greater relative strength and thus outshine the market.
Relative strength is measured in several ways by technical analysts. A simple method computes rates of return and categorizes securities that have gained excellent historical returns as having relative strength. In most of the cases, technical analysts consider some ratios to decide whether a security, or even an industry for that matter, possesses relative strength.
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5.5 Technical IndicatorsApart from charts that form the foundation of technical analysis, analysts also make use of some indicators, viz., market sentiment indicators and breadth indicators to judge market situation in general.
5.5.1 Market Sentiment IndicatorsLiquidityAs per the contrary opinion theory, it is sometimes good to go against the crowd as the crowd is usually wrong. Several indicators have been developed based on this theory, one of them being mutual fund liquidity.
Low mutual fund liquidity indicates bullish mutual funds. So, people following contrary opinion theory claim that the market is at or almost at a peak and thus is liable to fall. Hence, low mutual fund liquidity is often regarded as a bullish indicator.
On the other hand, high mutual fund liquidity means mutual funds are bearish. So, it is believed by the contrarians that market has hit the bottom means it is likely to rise. Thus, high mutual fund liquidity is a bearish indicator.
Pull/call ratioPull/Call ratio is yet another indicator watched by contrary technical analysts. Calls are bought by speculators when they are bullish while puts are bought when they are bearish. As speculators are often wrong, pull/call ratio is considered as ausefulindicator.Thepull/callratioisdefinedasfollows:
Forinstance,aratioof0.50indicatesthatonlyfiveputsarepurchasedforeveryten calls purchased.A rise in the put/call indicates negative view of the speculators. However, since contrarians believe that option speculators are usually wrong, they consider this as an indication for buying.On the other hand, a fall in the put/call indicates positive view of the speculators. However, contrarians consider this as an indication for selling.
Short-interest ratioThe short interest in a security is nothing but the number of securities that are sold short but not bought back yet. The short interest ratio is
Short interest ratio =
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Investors indulge into short selling when they think the prices will fall down. So a high short interest ratio means that the investors believe that the prices will drop. However, the technical analysts read this in a different way. A high short interest ratioisconsideredasabullishindicatorbythetechnicalanalysts.Hisjustificationbehind this is: “A high short interest ratio will lead to increase in demand for securitiesasthosewhohaveshortsoldthemwoulddefinitelywanttorepurchasethem to net off their positions, irrespective of whether their anticipations prove to be correct or not. This demand will bear a marker effect on the prices.”
Trin statisticMarket volume may be used to gauge the intensity of rise or fall of market. Advances are considered as more bullish by technical analysts if they are accompanied with improved trading volume.The trin statistic is the ratio of the number of advancing to declining issues divided by the ratio of volume in advancing to declining issues. Thus,
Trin =
The above expression can also be rearranged as follows:
Trin =
Hence, the ratio of average volume in declining issues to average volume in advancing issues is measured by trin. Normally, a trin ratio of more than one is reckoned as bearish because it suggests that the dropping securities have higher average volume as compared to the progressing securities, indicating a net selling pressure.
5.5.2 Breadth IndicatorsNew highs and lowsInformation on the 52-week high and low prices for each stock is provided as a part of stock market reporting. When a considerable number of stocks reach the 52-week high each day, the market is considered as bullish by technical analysts. While on the other hand, if market indices increase but still only few stocks reach new highs, then it is considered as a negative sign by the technical analysts.
VolumeVolume analysis is a crucial part of technical analysis. High trading volumes when other things are equal is taken as a bullish signal. And if such heavy volumes are followed by rising prices, then it is considered even more bullish sign.
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The advance-decline lineThe advance-decline line, also known as the breadth of the market, involves following two measurement steps:
Compute the number of net advances/declines on a day-to-day basis. (For this, •subtract the number of shares that have declined on that day from the number of shares that have advanced on that day.)Calculate the breadth of the market by cumulating the daily net advances/•declines.
Generally, the breadth of the market is compared with one or two market averages. Typically, it is expected that the breadth of the market moves in tandem with the market average. However, if there are variations between the two, then technical analysts believe that it is indicating something. To be more precise, if the market average is moving upwards while the breadth of the market is going downwards, then it is considered as a signal for market turning bearish. Similarly, if the market average is going downwards while the breadth of the market is heading upwards, it indicates that the market may turn bullish.
5.6 Testing Technical Trading RulesVarious technical trading rules are in rage. In order to evaluate whether a technical trading rule is valid, you should ask minimum following questions:
After being amended for risk, does the trading rule give excess returns? •Considering other things are equal, one would anticipate a more risky strategy for gaining higher returns than a less risky strategy. Thus, if there are two trading strategies with different levels of risk associated with them, then their returns must be gauged on the grounds of risk-amended.Does the trading rule generate excess returns after amending for transaction •and other related costs like taxes? If transaction and other costs are neglected, various technical trading rules seem to generate excess returns. However, on deducting such costs, the rule appears to be no better than a basic buy-and-hold policy which involves very less transaction costs.Is the trading rule performing steadily? A trading rule may outshine an •alternative for a short span of time; however, the real test is whether it is able to maintain its performance over a longer time period.Does the validity of the trading rule sustain outside the sample? If various •rules are applied to a trading sample, then there is a probability that you may findacertainrulethatworks.WilliamSharpehadsaid:“Ifyoutorturethedata long enough, it will confess to any crime”. So, it is imperative that the ruleworksonthedataapartfromtheonethatwasusedtofinditout.
Experiential proof points out that even the renowned technical trading rules do not fare up to the mark in these tests. However, supporters of technical analysis claimthattheyhaveanumberoftechniquesintheirlistthatactuallyworksfine.May be there are certain proprietary tactics that work. However, unless and until they are thoroughly tested, one can not really comment on their soundness
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SummaryFundamental analysts considers that the market is 90 percent rational and •10 percent psychological where as technical analysts believes its other way round, i.e., they believe that market is 90 percent psychological and only 10 percent rational.As newspapers cover technical analysis, technical experts are called on regular •basis for their comments and investment advisory services distribute technical reports, as an investor, you will more often than not come across it. It is widely used due to its spontaneity. However, in recent times, its soundness is being gravely challenged.Technical analysis is applicable to currencies, commodities, bonds and equity •stocksSupply and demand are influenced by a variety of factors, both rational•and irrational. These include fundamental factors as well as psychological factors.Because of persistence of trends and patterns, analysis of past market data •can be used to predict future price behaviour.The chartists primarily believe that the stock prices are inclined to advance •in moderately persistent trends.It is believed by chartists that usually, volume and trend work hand in hand.•Chartists presume that it is hard for share prices to go above a certain level •known as resistance level and drop below a certain level known as support level.Bar chart is one of the simplest and most widely used technical analysis tools. •It represents the day-to-day price range along with the closing price. It may also depict the daily volume of the trades.Alinechartisasimplificationoverbarchartanddepictsthelinethatconnects•the consecutive closing prices.
ReferencesInvestopedia, 2011. • Technical Analysis: Introduction [Online] Available at: <http://www.investopedia.com/university/technical/> [Accessed 20 July 2011].Technical Traders.com, 2011. • Make Money In Up or Down Markets [Online] Available at: <http://www.technicaltraders.com/> [Accessed 20 July 2011].markofibo, 2007.• Technical Analysis Indicator MACD part one [Online] Available at: <http://www.youtube.com/watch?v=OR8vwFv-5iU> [Accessed 20 July 2011].Investtech, 2009. • Learn about Technical Analysis - Investtech.com [Online] Available at: <http://www.youtube.com/watch?v=SOHHdrgDZCA> [Accessed 20 July 2011].
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Murphy, J., 1999. • Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications, New York Institute of FinanceCarlson, E., 2011. • George Lindsay and the Art of Technical Analysis: Trading Systems of a Market Master, 1st ed., FT Press.
Recommended ReadingChandra, P., 2006. • Investment Analysis and Portfolio Management, New Delhi: Tata McGraw-Hill.Bodie, Z., Kane, A., Marcus, A. J. and Mohanty, P., 2006. • Investments, New Delhi: Tata McGraw-Hill.Mcallen, F., 2010. • Charting and Technical Analysis, CreateSpace.
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Self Assessment
__________analysts believe that market is 90 percent psychological and only 1. 10 percent rational.
Fundamentala. Technicalb. Institutionsc. Investorsd.
Technical analysts look at the game of investment as a way to estimate the 2. behaviour of the ______________.
market playersa. fundamental analystsb. investorsc. institutionsd.
Technical analysis is all about______________.3. volume onlya. price onlyb. volume and pricec. institutionsd.
Identify the odd term from the following.4. Tendersa. Patternsb. Chartsc. Cashflowd.
Market prices are determined by the interaction of supply 5. and_____________.
demand supplya. interaction forceb. demand forcesc. priced.
Identify the odd term from the following:6. Book valuea. Bar and line chartsb. Dow theoryc. The moving average lined.
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______________expresses basis premises of technical analysis.7. Martin J Pringa. A. J., Mohantyb. Robert A Levyc. Bodie, Z., Kaned.
IHST is________________.8. Inverse Head and Shoulders Topa. Initial Head and Shoulders Topb. Integrated Head and Shoulders Topc. Integrated Head and Sold Topd.
The sentence “A bull market is represented by an upward primary trend while 9. a downward primary trend represents a bear market” is
Correcta. Incorrectb. Partially Correctc. Acceptabled.
In moving average, buy signal is given when__________________.10. rising moving average line drops below the Stock price linea. stock price line drops below the rising moving average lineb. rising moving average line drops and Stock price line are at similar levelc. stock price line drops below the Stock price lined.
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Chapter VI
Bond Analysis, Security Analysis and Wealth Management
Aim
The aim of this unit is to:
explain how to value a bond •
definegovernmentbonds•
analyse wealth management•
Objectives
The objectives of this unit are to:
describe the importance of security analysis in wealth management•
highlight the risks in bonds•
analyse rating of bonds•
Learning outcome
At the end of this unit, you will be able to:
understandthekeyfinancialratios•
identify bond yields•
recognise rating methodology•
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6.1 IntroductionA security that is issued in relation with a borrowing arrangement is represented by a bond. It is essentially an “IOU” issued by the borrower. In bonds, the issuer is obliged to make the necessary payments such as principal and interest to the bondholder. A bond may be expressed in terms of coupon rate, par value, and maturity date. The value which is mentioned on the face of the bond is known as the par value. It is the amount the issuer assures to pay at maturity.
The coupon rate represents the rate of interest payable to the bondholder. The date on which the principal amount is payable to the bondholder is the maturity date. Theparvalue,couponrateandthematuritydateisspecifiedinthebondtreaty.
Working with the best firms on Wall Street is a dream for several Indian professionals. This is exactly what many of them are doing right now; the only difference is that they are based in India. Financial research and its analysis drive markets across the world. And Indians are making their presence felt across the entire value chain. Financial research for investment banks, brokerage houses, andfinancialinstitutionsamongothersistodayaboomingpartoftheknowledgeprocess outsourcing (KPO) arena. The Internet and telecommunication revolution has opened a new world of opportunities in the outsourcing business processes across continents. What started on a small scale few years back has become a buzzword today, i.e., High-end Financial research Outsourcing (HEFRO).
According to a study by Evalueserve, the global High-end KPO market is expected to grow at a cumulative annual growth rate (CAGR) of 46 per cent, from $1.2 billion in 2003 to $17 billion in 2010. India’s share would be 70% of this market. NASSCOM report says Financial Research Outsourcing is the second in revenue earning and fourth in employment. So just imagine the kind of opportunities MBAs and CAs and post graduates in security analysis and wealth management can look forward to. Already a large number of Indian and foreign Investment BanksandresearchfirmshavemadesuccessfulentriesintotheHigh-endfinancialresearch outsourcing in India. These include Genpact, Evalueserve, JP Morgan, Morgan Stanley, Smart Analyst, McKinsey, Value Notes, WNS Global, HSBC, OfficeTiger,Citigroup,Reuters,Fidelity,GoldmanSachsandCopalPartners.Thejobprofilethesecompaniesareofferingrangesfromfinancialdatamining,fundmanagement,riskmanagement,financialanalysistovaluation,equityresearchandcorporateandmarketresearch.CostSavings,Operationalefficiencies,accessto a highly talented workforce and improved quality are the key drivers behind thisfinancialoutsourcingtoIndia.
Indiaisfastdevelopingasafinancialresearch-outsourcinghub.TherearemanycompaniesprovidingfinancialresearchopportunitiesforprofessionalslikeCAsand MBAs and post graduates in security analysis and wealth management. The followingtablewillgivetheideaaboutthekeyplayersinthisarea,thejobprofilethey are offer and the skills required to perform these jobs.
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6.2 Government BondsThe state and central governments are the largest borrowers not only in India, but also in other countries. The government securities or gilt-edged securities are the bonds that are frequently issued by the government of India. Usually, the interests on these bonds are paid semi-annually. State governments also indulge in selling of bonds. The Reserve Bank of India issues these medium to long-term bonds on behalf of state governments, the interest payment of which are also done semi-annually.
A number of governmental agencies, other than central and state governments, also issue bonds that are pledged by the central or state government. Again, the interest payments on such bonds are normally semi-annual.
6.3 Corporate BondsLike the governments, money is also borrowed by the companies by issuing bonds known as corporate bonds. Corporate bonds are also referred to as corporate debentures. In global terms, a corporate bond is a secured corporate debt instrument whereas a corporate debenture is an unsecured debt instrument. Typically in India, debentures represent corporate debt instruments even though they are secured. For simplicity purpose, we will address all corporate debt instruments as corporate bonds.
India has been issuing a variety of innovative bonds since early 1990s. Amongst other factors, the most important factor that has stirred this motivation is the increasedfluctuation in the interest rates and also the changes in the tax andregulatory structure.
Various types of corporate bonds are described below in brief.
6.3.1 Zero Coupon BondsThe zero coupon or zero bonds are issued at a sheer discount on its face value and are redeemed at face value at the time of maturity. They do not hold any regular interest payment. For example, lets say, in 1996, ABC bank issued some discount bonds at a face value of Rs. 1, 00,000 with a maturity period of 20 years. The bonds were issued at Rs. 5000.
6.3.2 Straight BondsThestraightbondorplainvanillabondmakeafixedperiodicpaymentofcouponduring its lifetime and returns the principal on maturity. The period is generally semi-annual. Straight bond is the most admired type of bond.
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6.3.3 Floating Rate BondsUnlikestraightbondsthatpayfixedinterestrate,floatingratebondspayinterestrate which is related to some yardstick rate like a Treasury Bill interest rate. For example,in1993,abankissuedafloatinginterestratebondforthefirsttimeinIndia.Itissued5millionredeemable,unsecured,subordinated,floatingratebondsat the face value of Rs.1000 and holding interest rate of 3 percent per annum over the maximum term deposit rate of the bank.
6.3.4 Bonds having Embedded OptionsOptions may also be embedded in bonds. These options provide some rights to investors as well as issuers. Some of the common bonds having embedded options are:
Callable Bonds: In callable bonds, the issuer of the bond is given an •option or right to redeem those bonds before maturity on certain terms and conditions.Puttable Bonds: In puttable bonds, the investor hold the right to sell them •prematurely back to the issuer based on certain terms.Convertible Bonds: With convertible bonds, the investors get the right to •convert those bonds into equity shares on certain terms.
6.3.5 Commodity-Linked BondsThe payoff from a commodity-linked bond is to certain extent related to the price of the commodity. For example, in 1986, certain Oil Corporation, say ABC Oil Corporation issued zero coupon notes with maturity in 1992. The payoff from each note was termed as $2000 + 100 [price in dollars of per oil barrel - $20]. However,thesecondtermofpayoffwassubjecttoafloorofzero.
6.4 Bond YieldsThe trading of bonds is done typically on the basis of their prices. However, they aregenerallynotcomparedonbasisofpricesduetoconsiderablefluctuationsinpatternsofcashflowaswellasduetootherfeatures.Instead,yieldisusedasameasure of comparison. The yield measures that are used most commonly are: yield to maturity, yield to call, realised yield to maturity and current yield.
Let us see the calculations of these measures of yield.
6.4.1 Yield to MaturityWhenyoubuyabond,youarenotassuredaspecificrateofreturn.Basedontheinformation like the price of the bond, coupon payments and maturity date, you make out the rate of return that the bond offers over its life.
Typically,thediscountratethatmakesthecurrentvalueofthecashflowsreceivablefrom possessing the bond equal to the bond price is known as Yield to Maturity (YTM).
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It is the interest rate that can be expressed mathematically as:
P = + + ........+ +
where,P = bond priceC = annual interest in rupeesM = maturity value in rupeesn = number of years left for maturity
The YTM computation requires a trial and error process. However, if you are not much inclined towards taking the trial and error route to compute YTM, then you can use the following formula to calculate approximate YTM:
YTM≈
where,
YTM = yield to maturityC = annual interest in rupeesM = maturity value in rupeesn = number of years left for maturityp = current price of the bond
The calculation of YTM takes into account the present coupon income and also the capital gain or less that the investor will incur by possessing the bond till maturity.Apartfromthis,thetimingofthecashflowsisalsoconsidered.
The internal rate of return on an investment is the YTM of a bond. It can be read as the compound rate of return over the lifetime of the bond, presuming that all the coupons can be invested again at a rate of return that is equal to YTM of the bond.
The yields are reported on an annualised basis in the financial press.Theannualisation is achieved by doubling the semi-annual yield. So, for example, if the semi-annual yield is say 5 percent, then the annualised yield, also known as annual percentage rate (APR) is quoted as 8 percent. APR is essentially based on simple interest. Bond equivalent yields are annualised yields that are based on simple interest. However, the effective annual yield of a bond can be calculated using the compound interest.
6.4.2 Yield to CallThere are certain bonds that carry with them a call feature that gives the issuer the right to call or buy back the bond before the maturity date as per the call schedule (acallschedulespecifiesthecallpricepertainingtoeachcalldate).Incaseofsuch bonds, yield to call (YTC) as well as YTM is calculated.
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The process of computing YTC is same as that of YTM. In mathematical terms, YTC is represented by the value of r in the following formula:
P =
where,M* call price (in rupees)n* = number years before the assumed call date
6.4.3 Realised Yield to MaturityThe computation ofYTMmakes an assumption that the cashflows that areobtained throughout the lifetime of a bond are invested again at a rate which is equaltotheyieldtomaturity.Thisassumptionhowevermaynotbejustifiableastherate(s)ofreinvestmentthatareapplicabletofuturecashflowsmayvary.It is essential to ascertain the future reinvestment rates and reckon the realised yield to maturity.
6.4.4 Current YieldThe annual coupon interest is linked to the market price by the current yield which can be expressed as
Current yield = Annual interest / Price
Thecalculationofcurrentyield reflectsonly thecoupon interest rate. Itdoesnottakeintoaccountthecapitalprofitorlossthatthebondholderwillincuronpurchase of the bond on discount or premium and is possessed till the time of maturity. The time value of money is also overlooked. All these things make it an incomplete and naïve measure of yield.
6.4.5 Yield to Maturity and Default RiskAs corporate bonds are exposed to default risk, it is necessary to differentiate between the bond’s expected and stated YTM. The YTM assured by the bond willberealisedonlyifthefirmthatissuesthebondmeetsalltherequirementson the bond issue. Thus, the promised YTM is the maximum possible YTM on the bond. However, in case of expected YTM, the possibility of a default is taken into consideration.
6.4.6 Yield to Maturity versus Holding Period ReturnThe yield to maturity of a bond should not be confused with its holding period return. YTM is the sole discount rate at which the current value of the payments receivedfromthebondisequaltoitsprice.Itreflectstherunofthemillrateof return from a bond when it is possessed till maturity. On the other hand, the income gained over a particular holding period as a percentage of its price at the start of the period is the holding period return.
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6.5 Risks in BondsJust like any other investment, bonds too should be looked at in terms of risk and return.Thedifferenttypesofriskstowhichbondsareexposedincludeinflationrisk, interest rate risk, default risk, real interest rate risk, liquidity risk, reinvestment risk and call risk.
6.5.1 Inflation RiskInterest rates are defined in nominal termswhichmean that they reflect theexchange rate between current and future rupees. For example, for Rs. 500 borrowed today for a period of one year, then a nominal interest of 10 percent loan indicates that Rs. 550 is to be paid a year hence. However, the real rate of interest, exchange rate between current and future goods and services, is what really matters.Asthefinancialcontractsareessentiallyexpressedinnominalterms,therealrateofinterestshouldbeamendedfortheexpectedinflation.AspertheFishereffect,the following relationship exists between the real rate a, nominal rate r and the expectedinflationrateEI.
(1 + r) = (1 + a) (1 + EI) Or, r = a + EI + a EI
Letussayforexample,therequiredrealrateis5percentandtheexpectedinflationrate is 7 percent, then the nominal rate will be(0.05) + (0.07) + (0.05) (0.07)= 0.1235= 12.35%
Whentheinflationexceedstheexpected,thenitisborrower’sgainatthecostoflenderandviceversa.Inotherwords,inflationisazero-sumgame.Thechangeininflationratehasthesamerateasthatofchangeininterestratewhichmeansthattheinflationriskishigherforlong-termbonds.Thus,duringprecariousinflationrates,borrowerswouldbereluctanttoissuelong-termfixed-interestbonds,andthe investors too would be hesitant to purchase such shares. It is during such periodthattheshort-termmaturitybondsandthefloatingratebondsgainmorepopularity.
6.5.2 Interest Rate RiskAs interest rates are inclined to vary over time, they cause volatility in prices of bonds. A hike in interest rate lowers the market prices of outstanding bonds where as a decrease in interest rates causes the market prices to go up.The percentage change in the value of a bond in response to a particular change in interest rate gives the interest rate risk, also known as market risk. It is the function of a bond’s maturity period and its coupon rate. This can be appreciated by considering the formula for current price of a bond.
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Current price of a bond = Current value of interest payments + Current value of principal payments
P =
The above formula indicates that longer the maturity period, higher is the sensitivity of price to changes in interest rates. And bigger the coupon payment, lesser is the sensitivity of price to changes in interest rates.
6.5.3 Default RiskThe fact that the borrower may not make timely payment of interest and/ or principal gives rise to default risk.
If other things are equal, bonds that bear higher default risk are traded at a higher yield to maturity. In other words, they are sold at lower price as compared to the government securities that carry zero default risk.
Barring the case of highly risky debt instruments known as junk bonds, the investors are more apprehensive about the apparent risk of default rather than the actual occurrence of default. Even though the possibility of occurrence of actual default is very remote, they believe that a change in the bond’s apparent default risk would immediately impact its market price.
6.5.4 Real Interest Rate RiskBorrowers and lenders are subject to real interest rate risk even in absence of inflationrisk.Changesindemandand/orsupplyoffundschangetherealinterestrate.
Let’s take an example for better understanding of impact of real interest rate risk. Suppose that a real interest rate drops from 5 to 3 percent. Then, in this case, the firmthathasborrowedfundsattherateof6percentwillsufferasitearnsonly3percentonitsassetsbuthastopay5percentforitsdebt.Afirmwhichhasalong-termdebtoffixedcostmayexperiencedrasticimplicationsduetochangesin real interest rates, irrespective of whether it gains or losses due to such changes in the real interest rate. As these kinds of changes in the real interest rate are rarely anticipated, borrowers and lenders are often subjected to this kind of risk.
6.5.5 Liquidity RiskExcept a few Government of India securities, most of the debt instruments do not have a highly liquid market. The market of debt instrument is largely comprised of the over the counter market and most of the activities occur in primary market. Considering this poor liquidity in the debt market, investors face problems in trading the debt instruments especially when large volumes are involved. So,
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they may have to pay premium while purchasing but accept a discount over the quoted price while selling. This indeed is a major problem in some segments of debt market. In fact, it is bigger than most investors realise.
6.5.6 Reinvestment RiskWhen a bond pays interest periodically, then there is a risk involved that the payment of interest may have to be invested again, but at a lower interest rate. This kind of risk is known as reinvestment risk and is higher of bonds with longer maturity period as well as for bonds with higher interest payments.
6.5.7 Foreign Exchange RiskBonds having payments denominated in foreign currency have uncertain cash flowsintermsofrupees.Foreignexchangerisk,alsoknownascurrencyrisk,isthe risk that the foreign currency will depreciate with respect to Indian rupee.
6.5.8 Call RiskA bond may carry a call option that gives the issuer the right to call the bond before its maturity. The issuer may employ this call option when the interest rates drop. Clearly, it is alluring for the issuers but at the same time, it exposes the investors to the call risk. As the bonds are normally called for prepayment after the decline ininterestrates,theinvestorsmaynotfindequivalenttoolsforinvestment.Theyare left with no choice but to accept the lower returns when they reinvest the amount obtained after premature redemption.
6.6 Rating of BondsThe rating that is associated with a bond by an independent credit rating agency normally estimates the default risk or the credit risk. Rating of the debt securities issued by the governments, quasi-government organisations and the companies firstinstigatedfromUnitedStatesthatcurrentlyhaveminimumfivefirmsthatprovide such services. In recent times, such rating agencies have been established in several other countries as well. The rating companies in India are ICRA, CARE, CRISIL, and Fitch Ratings
Meaning of debt ratingsFor better understanding of meaning of debt ratings, let’s take a look at some of the descriptions offered by renowned rating agencies.
Standard and Poor’s: “A Standard and Poor’s corporate or municipal debt •rating is a current assessment of the credit worthiness of an obligator with respecttospecificobligation.”Australian Ratings: “A corporate credit rating provides lenders with a simple •system of gradation by which the relative capacities of companies to make timely repayment of interest and principal on a particular type of debt can be noted.”Moody’s: “Ratings are designed exclusively for the purpose of grading bonds •according to their investment qualities.
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Cleary, the above description points that a debt rating typically represents the likelihood of timely payment of principal and interest by a borrower. Higher debt rating indicates high probability of the borrowers to make the payment of principal and interest in time.
Now that we know what debt rating is, let’s have a look at what it is not.A debt rating is not the usual assessment of the issuing corporation. If a debt •issueofafirmAishigherthanthatoffirmB,thenitdoesnotmeanthatfirmAisbetteroffthanfirmB.Itshouldbewellnotedthatasdebtratingissecurityspecific,itisexpectedtoevaluatethecreditriskofaspecificsecurity,nothingmore and nothing less.A debt rating does not mean that an audit function is performed by the rating •agency. Even though a rating agency may scrutinise various aspects of the functioning of the company, and may also collect information related to its operations, it is not expected to perform the task of audit or even testify the genuineness of the information shared by the user.A debt rating does not endorse buying, selling or possessing a security. The •essential rudiments required for making investment-related decisions in a debt security are
Investor’s risk tolerance �Yield to maturity �Security’s credit risk �Obviously, as the debt rating emphasises on only one of the above three elements, it cannot be considered as the one and only factor for decision making in an investment.
Nofiduciary relationship is createdby the debt ratingbetween the rating•agency and the users of a rating as there is no legal base for such type of relationship.A debt rating is not one time assessment of credit risk, which can be considered •to be valid for the entire life-time of a security. Variations in the vibrant business world may also mean a change in the characteristics of risk of the security.That’swhythebusinessandfinancialstateoftheissuersiswatchedby the rating agencies in order to determine whether an amendment in the rating is reasonable.
Debt rating functionsDebt rating agencies are expected to
Offer low-cost information•Operate as a base for a good risk-return transaction•Provide high quality information•Inflictregulationsoncorporateborrowersingoodspirit•Offergreatercredibilitytofinancialandotherrepresentatives•
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Aid the formulation of guidelines to public policy on institutional •investment
Low-cost informationA cost-effective agreement is represented by a rating agency that collects, studies, interprets and then sums up the complicated information in a simple and easily understandable format to be used by large public. Such kind of arrangement is highlybeneficialfortheinvestorswhowouldfinditcostlyorevenimpossibletoperform such credit assessment on their own.
Base for a good risk-return transactionIf professional debt rating is performed on the securities and such ratings are widely accepted, then a more realistic risk-return trade-off would be formed in the capital market. Securities with higher rating would have a lower return and vice versa.
Provide high quality informationDebtratingdonebyaprofessionalratingfirmprovideshigh-qualityandreliablesource of information on credit-risks due to three correlated reasons:
Unlike underwriters and brokers who have a vested interest in an issue, an •independentratingfirmismorepronetoprovideanunprejudicedopinion.Ability to evaluate risks is more due to presence of professional resources.•Accesstolotcrucialinformationisavailabletoaratingfirm.•
Healthy regulations on corporate borrowersExposuretopublicisagoodmotivatorforbetteringperformance.Afirm’sdebtsecurity rating makes it more publicly visible and generally has a positive impact over its management due to its craving for a clear image. The impact of a rating firmissimilartoascore-keeperinagamei.e.ifitsknownthatsomeoneiskeepingtrack of the score, then you are inclined to play well.
Greater credibility to financial and other representativesThereputationofaratingfirmitselfisatstakewhenitratesthedebtsecurityofafirm.So,itlooksforfinancialandotherrelevantinformationwithreasonablequality.Thefinancialandotherrepresentativesofanissuergainmorecredibilityas he continually abides by the demands of the rating agency.
Formulation of guidelines to public policy on institutional investmentIf debt securities are rated by professional rating firms, then public policyguidelines on what all securities are eligible to be included in various types of institutionalportfolioscanbebuiltupmoreconfidently.It must be stressed that the execution of above operations pivots crucially on the reliability of the debt ratings. Standard and Poor’s expresses this point more powerfully as: “Ratings are of value only so long as they are credible…Credibility is fragile… S&P operates with no governmental mandate, subpoena powers, or
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anyotherofficialauthority.Itsimplyhasaright,aspartofthemedia,toexpressits opinions in the form of letter symbols.”
6.7 Rating MethodologyRegardless of distinctions across individual rating agencies, the commonly observed features in the rating methodology adopted by various agencies are:
Two types of analysis performed are:•business and industry analysis �financialanalysis �
The vital factors taken into account in business and industry analysis are;•relationship with economy and growth rate �features of industry risk �industry structure and nature of competition �managerial potential of the issuer �competitive position of the issuer �
Theimportantfactorsconsideredforfinancialanalysisare:•businessandfinancialrisks �earning capacity �cashflowsufficiency �protection of asset �accounting quality �financialflexibility �
Subjective judgment plays a key role in the evaluation of issue or issuer on •several factors.Each factor is generally scored individually; however, no mechanical •formula is used to merge the scores on several factors for reaching a rating conclusion. Ultimately, in the analysis, all variables are looked at as mutually dependent.The characteristics of industry risk are likely to set a ceiling for rating.•
6.8 Key Financial RatiosThetrendanddegreeoffinancialratiosofanissuerhaveasignificantimpactonbond ratings. The important ratios that are normally used are:
Leverage ratios like debt-equity ratio•Liquidity ratios like quick ratio and current ratio•Coverage ratios likefixed charge coverage ratio and time-interest-earned•ratioCashflowtodebtratio•Profitabilityratiolikereturnonequityandreturnoncapitalemployed•
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6.9 Debenture Rating Symbols of CRISILCRISIL is the biggest credit rating agency in India. The rating of preference shares,debentures,fixeddeposits,andshort-terminstrumentslikecommercialpaper is done byCRISIL. The symbols that are used by CRISIL for rating debentures are primarily of three types:
6.9.1 Investment GradesDebenturesthataregiven‘A’ratingareexpectedsufficientsafetyforthewell-timed payment of principal and interest. However, it should be noted that any change in the state of affairs can have an adverse impact on such issues; probably severe than those belonging to higher rated groups.
Debenturesthataregiven‘BBB’ratingarejudgedtoprovidesufficientsafetyfor the well-timed payment of principal and interest. However, it should be noted that any change in the state of affairs may result in weakening of ability to make payments of interest and principal than for debentures belonging to higher rated groups.
6.9.2 High Investment GradesDebentures that are given a rating of ‘AAA’ are judged to provide maximum safety for the well-timed payment of principal and interest. Even if the circumstances that provide this degree of safety are susceptible to changes, such changes can be foreseen and are less prone to adversely affect the primarily strong position of such issues. Debentures that are given ‘AA’ rating are judged to provide high safety for the well-timed payment of principal and interest and differ in safety only slightly from ‘AAA’ rated issues.
6.9.3 Speculative GradesDebentures that are given a ratingof ‘BB’ are judged to provide insufficientsafety for the well-timed payment of principal and interest. Although they are less prone to default in the immediate future as compared to other speculative gradedebentures,theambiguitiesthattheissuerconfrontsmayleadtoinsufficientability to pay the interest and principal in time.Debentures with ‘B’ rating are judged to carry high probability to default. Even though the current interest and principal payments are made, unfavourable economic and business conditions may result in lack of capacity or even willingness to make the interest and principal payments.
Debentures with ‘C’ rating are judged to carry some factors that may make them weak enough to default. Only in case of ongoing favourable circumstances, the well-timed payment of interest and principal is possible.
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Debentures holding ‘D’ rating are in default and have amounts overdue in terms of interest or principal payments and are anticipated to default on maturity. Such types of debentures are highly speculative and yields from them can be realised only on liquidation or reorganisation.
Note:A ‘+’ (plus) or ‘-‘(minus) sign may be used for rating from ‘AA’ to ‘D’ by 1. CRISIL to indicate relative position within a category.The text enclosed in parenthesis is just guidance on how to pronounce the 2. symbols used for rating.The rating symbols used for preference shares are analogous to symbols used 3. toratedebentureswiththeexceptionoflettersbeingprefixedtodebenturerating symbols. For example pfBB (pf Double B).
6.10 The Yield CurveTheyieldcurve,alsoknownasstructureofinterestrates,reflectshowyieldtomaturity is lined to term to maturity for bonds that bear similarities in several ways, except maturity.Infinance, theyieldcurve is the relationbetween the interest rate (orcostofborrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current Indian Rupee interest rates paid on Indian. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph which is informally called “the yield curve.” More formal mathematical descriptions of this relation are often called the term structure of interest rates.
The yield of a debt instrument is the annualised percentage increase in the value of the investment. For instance, a bank account that pays an interest rate of 5% per year has a 5% yield. In common parlance, the percentage per year that can be earned is dependent on the length of time that the money is invested. For example, a bank may offer a “savings rate” higher than the normal checking account rate if thecustomerispreparedtoleavemoneyuntouchedforfiveyears.Investingfora period of time t gives a yield Y(t).
The shape of the yield curve is closely examined because it helps to give an idea of future interest rate change and economic activity. There are three main types ofyieldcurveshapes:normal,invertedandflat.Anormalyieldcurveisoneinwhich longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcomingrecession.Aflatyieldcurveisoneinwhichtheshorter-andlonger-term yields are very close to each other, which is also a forecaster of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
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8%
7%
6%
5%
4%
3%
2%
1%
Yie
ld
5 10 15 20 25 30
Time to Maturity (in years)
“Normal” Yield Curve
Fig. 6.1 Normal yield curve
8%
7%
6%
5%
4%
3%
2%
1%
Yie
ld
5 10 15 20 25 30
Time to Maturity (in years)
“Inverted” Yield Curve
Fig. 6.2 Inverted Yield Curve
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8%
7%
6%
5%
4%
3%
2%
1%
Yie
ld
5 10 15 20 25 30
Time to Maturity (in years)
“Flat” Yield Curve
Fig. 6.3 Flat yield curve
No. Company Job Profile Qualification / Skills Required
1. Lehman Brothers Sectorreports,financialmodelling,monitorfinancialand economic news
MBA, CA, 1-3 yrs exp. Sector Knowledge, Quantitative Skills
2.
Adventity Investment Banking, M&A, Hedge Funds, Private Equity, Credit/Equity Research
MBA, CA, 0-4 yrs of experience, knowledge of US/UK GAAP
3. Pipal Research Statistical,financialdataanalysis, development of research strategies
Advanced degree in Business Discipline/Economics
4. Progeon
Financial Planning & analysis, Credit Analysis, Equity Analysis, Economic Research
Postgraduate in Management, Credit Analysis, Financial Analysis
5. GENPACT Finance & Accounting analytics
Financial Research skills, postgraduate ,CA
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6. OfficeTiger
Fund Accounting, Treasury Management, Portfolio Analysis, Investment Banking
Postgraduate in Management
7. Evalueserve Financial Analytics MBA/CA/CFA financialanalysisskills
8. WNS Global Fraud risk management, Underwriting, Accounting
MBA, CA 1-2 yrs exp, accounting skills
9. Copal Partners Equity Research, Credit Research, Financial Research
MBA/CA with 1-2 yrs exp. Financial analysis skills
10. Value Notes Equity Research, Financial Analysis, Business Intelligence
MBA with 1-2 yrs exp., Financial Analysis and research, writing skills
Table 6.1 Key players in KPO
6.11 Introduction to Wealth ManagementWealth Management is an advanced investment advisory discipline that incorporates financialplanningandspecialistfinancialservices.Thekeyobjectivesaretoprovidehigh net worth individuals and families with tailored retail banking services, estate planning, legal resources, taxation advice and investment management, with the goalof sustainingandgrowing long-termwealth.Whereasfinancialplanningcan be helpful for individuals who have accumulated wealth or are just starting toaccumulatewealth,youmustalreadyhaveaccumulatedasignificantamountof wealth for the wealth management process to be effective.
Wealthmanagementcanbeprovidedbyindependentfinancialadvisorsorlargecorporate entities whose services are designed to focus on high-net worth retail customers.Suchcustomerswouldbeconsidered‘massaffluent’or‘upperretail’clients because of their net worth, the number of potential products they own fromfinancial institutions, theirassetsundermanagement,andothermethodsof segmentation. Large banks and brokerage houses create separate sales forces, servicesandother‘benefits’toretainorattractthesecustomerswhoaretypicallymoreprofitable thanother retail banking, brokerage, or insurance customers.However, wealth management clients are not Private Banking clients because they simply do not have the Net Worth or Assets under management to justify the level of banking services that Private Banks provide.
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SummaryA security that is issued in relation with a borrowing arrangement is represented •by a bond.The coupon rate represents the rate of interest payable to the bondholder.•The date on which the principal amount is payable to the bondholder is the •maturity date.The government securities or gilt-edged securities are the bonds that are •frequently issued by the government of India.Like the governments, money is also borrowed by the companies by issuing •bonds known as corporate bondsThe zero coupon or zero bonds are issued at a sheer discount on its face value •and are redeemed at face value at the time of maturity. They do not hold any regular interest payment.Unlikestraightbondsthatpayfixedinterestrate,floatingratebondspayinterest•rate which is related to some yardstick rate like a treasury bill interest rate.In puttable bonds, the investor hold the right to sell them prematurely back •to the issuer based on certain terms.The yield measures that are used most commonly are: yield to maturity, yield •to call, realised yield to maturity and current yield.Thediscountratethatmakesthecurrentvalueofthecashflowsreceivable•from possessing the bond equal to the bond price is known as Yield to Maturity (YTM).Thedifferenttypesofriskstowhichbondsareexposedtoincludeinflationrisk,•interest rate risk, default risk, real interest rate risk, liquidity risk, reinvestment risk and call risk.The rating that is associated with a bond by an independent credit rating agency •normally estimates the default risk or the credit risk.The rating companies in India are ICRA, CARE, CRISIL, and Fitch •Ratings.Debentures that are given a rating of ‘AAA’ are judged to provide maximum •safety for the well-timed payment of principal and interest. Debentures that aregivenaratingof‘BB’arejudgedtoprovideinsufficientsafetyforthewell-timed payment of principal and interest.Security analysis is a foundation for any wealth management professional areas •like:mutualfunds,bondsvaluation,ratioanalysisandfinancialstatementanalysis, equity valuation, economic, industry and company analysis, technical analysis are parts of this subject and every wealth management professional should study these subjects.There are numerous opportunities available for wealth managers in India.•Youcanworkinknowledgeprocessoutsourcing(KPO),Brokeragefirms,•mutual funds, investment banks and also practice independently after successfully completing this program.
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Yourjobprofilemayincludeareaslike:sectorreports,financialmodelling,•monitorfinancial and economic news, investment banking,M&A,hedgefunds, private equity, credit/equity research.
ReferencesCzech Financial Academy, 2011. • Bond Analysis - Level I [Online] Available at: <http://www.moneco.com/Bond-Analysis-Level-I> [Accessed 21 July 2011].Inovest-Wealth Management. LLC, 2011. • Security Analysis and Wealth Management [Online] Available at: <http://inovestwealth.com/index.php> [Accessed 21 July 2011].r4jen, 2011. • Bond market analysis: Bund, Schatz, Euribor Spread Trading [Video Online] Available at: <http://www.youtube.com/watch?v=mKaYC0fCVR4> [Accessed 21 July 2011].ignousom• s, 2008. Security Analysis and Portfolio Management part-5 [Video Online] Available at: <http://www.youtube.com/watch?v=1A1HqsrAro4> [Accessed 21 July 2011].Penman, S., 2009. • Financial Statement Analysis and Security Valuation, 4th ed., McGraw-Hill/Irwin.Choudhry, M., 2003. • Bond and Money Markets: Strategy, Trading, Analysis, 1st ed., Butterworth-Heinemann.
Recommended ReadingBodie, Z., Kane, A., Marcus, A. J. and Mohanty, P., 2006. • Investments, New Delhi: Tata McGraw-Hill.Graham, B. and Dodd, D., 2002. • Security Analysis: Principles and Techniques, 2nd ed., McGraw-Hill.Mindel, N. M. and Sleight, S. E., 2010. • Wealth Management in the New Economy: Investor Strategies for Growing, Protecting and Transferring Wealth, 1st ed., Wiley.
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Self Assessment
The _____________ rate represents the rate of interest payable to the 1. bondholder.
coupona. Discountb. Bonusc. Repod.
The government securities are also called as___________.2. equity issuesa. Gilt-edged securitiesb. nationalc. internationald.
Zero coupon bonds are __________.3. issued at premiuma. extra coupon is givenb. issued at discountc. default graded.
Foreign exchange risk is also known as______________.4. Dollar riska. Currency riskb. international market riskc. inflationriskd.
Which one of the following is the bond issuing company_______________.5. ICRAa. CAREb. CRISILc. None of the aboved.
KPO is_____________.6. Knowledge Process Outsourcinga. Knowledge Process Offeringb. Knowledge Planning and Outsourcingc. Outsourcingd.
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Match the columns.7. Investment Grades 1. BBA. High Investment Grades 2. AB. Speculative Grades 3. AAAC. Default Grade 4. DD.
1-C, 2-A, 3-D, 4-Ba. 1-B, 2-C, 3-A, 4-Db. 1-D, 2-C, 3-B, 4-Ac. 1-B, 2-D, 3-A, 4-Cd.
Wealth management combines ____________. 8. financialplanningandspecialistfinancialservicesa. brokerage services and mutual fund advisoryb. Projectfinanceandfinancialderivativesc. financialplanningandbrokerageservicesd.
Wealth management can be provided by ____________ or large corporate 9. entities.
Insurance companiesa. independentfinancialadvisorsb. Governmentc. Precious metal companiesd.
Identify the odd term from the following:10. Mutual Fundsa. Bonds Valuationb. Equity Valuationc. Incomed.
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Case Study I
Top 3 banks: Technical Analysis holds Clue
There is a question that investors and traders often ask, ‘which one?’ This question comes up because money is a limited resource. So while we would like to go out and buy every investment idea, there is not enough money to go around.
Technical analysis can answer this question. In fact, investors can use chart reading by itself or hand in hand with fundamental analysis.
Let’s look at a case study involving our three local banks: UOB, OCBC, and DBS. Two basic TA concepts can give us a clue which one might be more attractive.
Insert a 200-day moving average:• This average is the most commonly used guide of long term direction for investors. When price is above this average, the stock is on an uptrend. The further price is above this line, the stronger it is. However, the further it goes, the more premium (on top of the average price) that an investor has to pay.
Inspect for 52-week high:• This level is known as a ‘year-high’. When stocks are near to and above its 52-week, investors, and traders regard it as in a very strong trend. In fact, short term traders who want to ride on momentum want to buy such a stock.
Based on the two TA concepts, quick visual inspect of charts of the three banks on top of one another reveals that price of OCBC is stronger but an investor has topayapremium.Aninvestorwhoisconfidentaboutthebanksbutnotwishingto pay a premium might consider the DBS and UOB. The former might be more attractive then because it is able to stay above its 200-day moving average.
Chart reading can help investors and traders enormously. While fundamental analysis is necessary for stock and sector picking, mastering the analysis can take a long term. While technical analysis can appear to be abstract to a beginner, it has simple rules that can reveal powerful information.
Source: Hum, S. T. 2010. Case study with top 3 banks; Technical Analysis holds clue [Online] Available at: <http://www.terraseeds.com/mymarketscreen/2010/11/case-study-with-top-3-banks-technical-analysis-holds-clue/>. [Accessed 21 July 2011.]
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Questions:WhatarethetwobasicconceptsofTechnicalAnalysis?Definethem.1. Answer: Two basic TA concepts are:Insert a 200-day moving average: This average is the most commonly used •guide of long term direction for investors. When price is above this average, the stock is on an uptrend. The further price is above this line, the stronger it is. However the further it goes, the more premium (on top of the average price) that an investor has to pay.Inspect for 52-week high: This level is known as a ‘year-high’. When stocks •are near to and above its 52-week, investors, and traders regard it as in a very strong trend. In fact, short term traders who want to ride on momentum want to buy such a stock.
How can traders and investors choose their banks?2. Answer: Choose the best bank is important because money is a limited resource. Investors can use chart reading by itself or hand in hand with fundamental analysis to select the best bank for their investment.
Why is fundamental analysis necessary?3. Answer: Fundamental analysis is necessary for stock and sector picking, mastering the analysis can take a long term. While technical analysis can appear to be abstract to a beginner, it has simple rules that can reveal powerful information.
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Case Study II
Whirlpool Corporation: Evolution of a Supply Chain
SummaryWhirlpool Corporation is the world’s leading manufacturer and marketer of major home appliances, with annual sales over $19 billion, more than 80,000 employees and more than 60 manufacturing and technology research centers globally. Consumers around the world enjoy Whirlpool’s innovative products marketed under Whirlpool, Maytag, KitchenAid, Jenn-Air, Amana, Brastemp, Bauknecht and other major brand names. With this varied inventory, plus a large direct sales force in more than 170 countries and an unpredictable sales cycle, effective supply chain management is critical for continued growth. Whirlpool has not always considered logistics a competitive advantage. However, since naming Penske its lead logistics supplier, Whirlpool experienced cost savings, increased customer satisfaction and found a partner to help integrate the recent acquisition of Maytag.
Challenges To effectively leverage its supply chain to maximise cost savings, while also •positivelyinfluencingtheoverallWhirlpoolcustomerexperienceToswiftlyandefficientlyintegrateMaytagoperations•
SolutionsThrough the Penske/Whirlpool LLP relationship, Penske assumed responsibility •for execution and management of 3PLs, and provided an enhanced ability to vieweachsupplier’skeyperformanceindicatorsintegratedwithfinancials.PenskebuiltanewroutingtoolspecificallyforWhirlpoolthatofferedoverall•cost optimisation and mode selection. Penske helped to integrate Maytag operations through consolidating LDC •networks,optimisingroutingofRDCshipments,determiningoptimalfleetsize and operating network, combining collocated Maytag and Whirlpool RDS locations and integrating the Hi/Lo network to improve product availability andfillrates.
Taking a customer-centric approachSupply chain management was not always a competitive advantage for Whirlpool. Penske initially partnered with Whirlpool as its single logistics provider for the Quality express network. Penske was responsible for the logistics of the entire network, including managing the relationship of the two regions it subcontracted to Kenco. This Penske-Whirlpool partnership replaced Whirlpool’s previous
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logistics solution, comprised of two incumbent third-party logistics providers. The partnership accomplished Whirlpool’s early logistics objectives, most notably, to establish effective processes and procedures, allow for more visibility of the company’s distribution network and reduce supply chain costs.
Recently, Whirlpool’s management took a more customer-centric approach to analysing its supply chain and began benchmarking its supply chain against other companies to identify “best in class” practices. This exercise prompted Whirlpool to question whether having a single logistics provider was the best structure to exceed customer expectations and maximise cost savings. At the same time, Whirlpool was gearing up for the monumental acquisition of Maytag.
Penske Provides the Solution “Our business relationship with Whirlpool is one of Penske Logistics’ longest-standing and most successful engagements. It’s because of that relationship that we are able to quickly understand and evaluate Whirlpool’s supply chain and propose solutionstoimproveefficiencyandprovidedeepersupplychainvisibility.”RayRussell, Senior Vice President - Operations, Penske Logistics.
After completion of its customer-centric supply chain analysis, Whirlpool knew innovation was necessary to maintain a competitive advantage. After careful consideration, Whirlpool decided to adjust the company’s supply chain structure and introduce additional third-party logistics providers (3PLs) into the mix. By taking this step, Whirlpool hoped to further reduce supply chain costs.
However, having multiple 3PLs created the need for an objective resource to keep homogeneity for the consumer, select and manage the 3PLs and analyse the overall supply chain. After reviewing internal options, Whirlpool realised it lacked the capability or resources in-house to manage the 3PL relationships and madethedecisionnottoincreasestafftofillthisrole.Thisdecisioncrystallisedthe need to hire a lead logistics provider (LLP).
As Whirlpool searched for the right LLP, Penske Logistics continually surfaced as the leader in technology and engineering. Plus, after years of working together, Penske’s capabilities were already embedded in Whirlpool’s processes and structure. The main concern facing Whirlpool in its decision to appoint Penske as its LLP was that Penske would have to remain objective when reviewing 3PLs. Essentially, Whirlpool was concerned about whether Penske could objectively award or remove business from a 3PL based exclusively on the business requirements and not showanyfavoritismtoPenske3PL.PenskeactuallyassumedtheunofficialroleofLLPwhentheneedarose.Penskefilledthegapstore-engineertheWhirlpoolnetwork to accommodate the new multiple 3PL structure. By demonstrating its
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capabilityaheadofofficiallybeingawardedthecontract,Penskebuiltthetrustof Whirlpool senior management and made the transition easier. Source: Penske, 2011. Whirlpool Corporation: Evolution of a supply chain [Online] Available at: <http://www.penskelogistics.com/casestudies/whirlpool2.html>. [Accessed 21 July 2011]
Questions:What are the disputes that are faced by the Whirlpool Corporation?1. Who provided the solution for the above case study and what are the 2. solutions?Summarise the above case study.3.
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Case Study III
Investment in a brand protection program at Veris corporation brings big returns
Situation analysisVeris is a well-known and respected company that manufactures leading consumer products for the retail market. An estimated 20 percent of its product on the shelf is counterfeit. Veris is concerned about the diminished value of its trusted brand and the lost sales that could result from substandard counterfeit products, as well as frequent warranty claims and potential product liability lawsuits. In addition, Veris recognises that results of channel audits and tracking are limited because its personnel do not have a reliable and quick method to determine product authenticityinthefield.
A cross-functional anti-counterfeiting task force boldly decided to introduce a brand protection program to address these counterfeit product issues. The task force selected a vendor that offers global customer and technical service support through local employees; multiple security technologies, many of which are proprietary to the vendor; and technology and product migration paths. This allows the brand protection program to be adapted as needed without the interruption newvendor qualificationbrings.Thevendor alsoprovides complete support, including supply of quality seals, design assistance with application equipment, andfieldinvestigationservices.
In its brand protection program, Veris products are marked with quality assurance seals that serve multiple purposes. First, consumers become familiar with the unique appearance of the seal and associate it with the quality Veris products they know and trust. Second, the seal is used in combination with point-of-purchase displays as a promotional vehicle for the marketing department. Third, the seal provides a definitive,quickandeasymeansfor investigators tocheckfor the authenticity of Veris products throughout the distribution channel.
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Before Program After Program
Product Price $50 $50
Annual Volume 10,000,000 10,500,000 5% increase
Annual Revenue $500,000,000 $525,000,000 5% increase
Cost of Goods Sold $200,000,000 $210,000,000
Gross Margin $300,000,000 $315,000,000
Fixed Costs $100,000,000 $100,000,000
Variable Costs $150,000,000 $157,500,000
Brand Protection Program* – $1,015,256
Profit $50,000,000 $56,484,744 13% increase
Table 1 Veris Corporation
Note: * Includes cost of quality seals, application of seals, application equipment, shipping of seals, inventory costs, training materials, investigative services
ResultsWithin six months of introducing the brand protection program, counterfeit Veris products in the market were reduced by 60 percent. Capturing 50 percent of the displaced sales increased Veris’ annual unit volume by nearly 5 percent. And, with aninvestmentof$1millionperyear,Verisincreaseditsannualprofitsbyover$6 million — a 600 percent return! In addition, Veris retained brand equity and customer loyalty, while minimising costly litigation and warranty repairs.
Source: Security Market Centre Case Study: Counterfeiting, 1999. Investment in a Brand Protection Program at Veris Corporation Brings Big Returns [Online] Available at: <http://multimedia.3m.com/mws/mediawebserver?mwsId=66666UuZjcFSLXTtlxf2lXftEVuQEcuZgVs6EVs6E666666--&fn=CounterfCase%20Study.PDF> [Accessed 22 July 2011]
Questions:Discuss the problem of the above case study.1. Analyse the situation of the problem in the case study.2. How does the Veris Company resolves its problem?3.
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Biblography
ReferencesAllenResources, 2008. CFA Exam Prep: Level 2 Equity Investments: Valuation •Models [Video Online] Available at: <http://www.youtube.com/watch?v=_IQu7o2jgS8> [Accessed 20 July 11]Arnett, G. W., 2011. Global Securities Markets: Navigating the World’s •Exchanges and OTC Markets, 1st ed., Wiley.Bruce, B, R. and Epstein, C. B., 1994. The Handbook of Corporate Earnings •Analysis: Company Performance and Stock Market Valuation, Irwin Professional Publishing.Carlson, E., 2011. George Lindsay and the Art of Technical Analysis: Trading •Systems of a Market Master, 1st ed., FT Press.Choudhry, M., 2003. Bond and Money Markets: Strategy, Trading, Analysis, •1st ed., Butterworth-Heinemann.currencycollege, 2007. Fundamental Analysis Part One [Video Online] •Available at: <http://www.youtube.com/watch?v=NRJ-6LOSx1I> [Accessed 19 July 2011]Czech Financial Academy, 2011. Bond Analysis - Level I [Online] Available •at: <http://www.moneco.com/Bond-Analysis-Level-I> [Accessed 21 July 2011].David Wanetick, 1997. Bound for Growth: How to Pick Winning Stocks Using •Industry Analysis, Irwin Professional Publishing.Focus on Business, 2008. Managing Assets and Investment [Online] Available •at: <http://www.focus-on-business.com/html/Investments.html> [Accessed 18 Jul 2011]Gazhoo, 2011. Venture Capital & Private Equity Valuation Model [Online] •Available at: <http://www.gazhoo.com/doc/3891/Venture+Capital+%26+Private+Equity+Valuation+Model> [Accessed 20 July 2011]Gremillion, L., 2005. Mutual Fund Industry Handbook : A Comprehensive •Guide for Investment Professionals, 1st ed., Wiley.growthink, 2008. Writing the Company Analysis Section of Your •Business Plan [Video Online] Available at: <http://www.youtube.com/watch?v=oazAYiiakFY> [Accessed 20 July 2011]. Hawkins, D. F. and Campbell, W. J., 1978. Equity Valuation: Models, Analysis •and Implications, Financial Executives Res Found.HouseResourceOrg, 2011. Securities Markets and Federal Laws [Video •Online] Available at: <http://www.youtube.com/watch?v=If8bUVrgK8g> [Accessed 18 Jul 2011]Hussey, D., 2001. Company Analysis: Determining Strategic Capability, 1st •ed., Wiley.
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ignousom• s, 2008. Security Analysis and Portfolio Management part-5 [Video Online] Available at: <http://www.youtube.com/watch?v=1A1HqsrAro4> [Accessed 21 July 2011].Inovest-Wealth Management. LLC, 2011. Security Analysis and Wealth •Management [Online] Available at: <http://inovestwealth.com/index.php> [Accessed 21 July 2011].Investopedia, 2011. Balance Sheet [Online] Available at: <http://www.•investopedia.com/terms/b/balancesheet.asp> [Accessed 20 July 2011].Investopedia, 2011. Cross-Sectional Analysis [Online] Available at: <http://•www.investopedia.com/terms/c/cross_sectional_analysis.asp> [Accessed 20 July 11].Investopedia, 2011. Fundamental Analysis [Online] Available at: <http://•www.investopedia.com/terms/f/fundamentalanalysis.asp> [Accessed 19 July 2011]Investopedia, 2011. Mutual Funds: Introduction [Online] Available at: <http://•www.investopedia.com/university/mutualfunds/#axzz1SRifPEg0> [Accessed 18 Jul 2011]Investopedia, 2011. Technical Analysis: Introduction [Online] Available at: •<http://www.investopedia.com/university/technical/> [Accessed 20 July 2011]Investtech, 2009. Learn about Technical Analysis - Investtech.com [Online] •Available at: <http://www.youtube.com/watch?v=SOHHdrgDZCA> [Accessed 20 July 2011]James Kelleher, 2010. Equity Valuation for Analysts and Investors, 1st ed., •McGraw-Hill.Khanacademy.org, 2009. Introduction to the Income Statement [Video Online] •Available at: <http://www.youtube.com/watch?v=Z7C4cz2HkeY> [Accessed 20 July 2011].markofibo, 2007.TechnicalAnalysis IndicatorMACDpart one [Online]•Available at: <http://www.youtube.com/watch?v=OR8vwFv-5iU> [Accessed 20 July 2011]Murphy, J., 1999. Technical Analysis of the Financial Markets: A Comprehensive •Guide to Trading Methods and Applications, New York Institute of FinanceNifty Direct-Nifty Trading Tips, Macroeconomic and Industry Analysis •[Online] Available at: <http://www.niftydirect.com/nsebse/market-gyan/Learning%20Session%204th.pdf> [Accessed 19 July 2011]Penman, S., 2009. Financial Statement Analysis and Security Valuation, 4th •ed., McGraw-Hill/Irwin.r4jen, 2011. Bond market analysis: Bund, Schatz, Euribor Spread Trading [Video •Online] Available at: <http://www.youtube.com/watch?v=mKaYC0fCVR4> [Accessed 21 July 2011].
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savingandinvesting, 2007. 22. Mutual Funds 1: What is a Mutual Fund? [Video •Online] Available at: <http://www.youtube.com/watch?v=ky7GWCksyRg> [Accessed 18 Jul 2011]Technical Traders.com, 2011. Make Money In Up or Down Markets [Online] •Available at: <http://www.technicaltraders.com/> [Accessed 20 July 2011]The Boston Security Analysts Society - Continuing Education, Equity Valuation •Models: Implementation, Integration & Validation [Online] Available at: <http://www.crowther-investment.com/images/EquityValuationModelsMar03.pdf> [Accessed 20 July 2011]Thomsett, M., 2006. Getting Started in Fundamental Analysis, 1st ed., •Wiley.VirtualNYIF, 2009. Business and Industry Analysis – Sample [Video Online] •Available at: <http://www.youtube.com/watch?v=L6at6Zd34Lg> [Accessed 19 July 2011]wstss, 2008. WST: 7.2 Basic Financial Modeling - Valuation Model & DCF [Video •Online] Available at: <http://www.youtube.com/watch?v=feNNXcqk8NE> [Accessed 20 July 11]
Recommended ReadingChandra, P., 2006. • Investment Analysis and Portfolio Management, New Delhi: Tata McGraw-Hill.Collins, P. S., 2011. • Regulation of Securities, Markets, and Transactions: A Guide to the New Environment, 1st ed., Wiley.Fred Mcallen, 2010. • Charting and Technical Analysis, CreateSpace.Graham, B. and Dodd, D., 2002. • Security Analysis: Principles and Techniques, 2nd ed., McGraw-Hill.Lowenstein, R. and Lowe, J., 2006. Fundamental Analysis, Value Investing •and Growth Investing (Secrets of the Great Investors), Unabridged edition, Blackstone Audio Inc.Mindel, N. M. and Sleight, S. E., 2010. • Wealth Management in the New Economy: Investor Strategies for Growing, Protecting and Transferring Wealth, 1st ed., Wiley.Palat, R. R., 2007. How to read Annual Reports and Balance Sheets, Mumbai: •Jaico Publishing House.Palepu, K. G. and Healy, P. M., 2007. Business Analysis and Valuation: Using •Financial Statements, Text and Cases (with Thomson ONE Access), 4th ed., South-Western College Pub.Prasanna, C., 2006. Investment Analysis and Portfolio Management. New •Delhi: Tata McGraw-Hill.Viebig, J., Poddig, T. and Varmaz, A., 2008. • Equity Valuation: Models from Leading Investment Banks, 1st ed., Wiley.
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Self Assessment Answers
Chapter Ib 1. c 2. c 3. b 4. a 5. a 6. c 7. c 8. b 9. d10.
Chapter IIb 1. d 2. a 3. d 4. a 5. c 6. b 7. a 8. b 9. d10.
Chapter IIIa 1. c 2. d 3. c 4. a 5. b 6. a 7. b 8. a 9. d10.
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Chapter IVb 1. c 2. a 3. d 4. d 5. a 6. b 7. a 8. d 9. b10.
Chapter Vb 1. a 2. c 3. d 4. c 5. a 6. c 7. a 8. a 9. b10.
Chapter VIa 1. b 2. c 3. b 4. d 5. a 6. b 7. a 8. b 9. d 10.