EQUITY RESEARCH MODULE

National Stock Exchange of India Limited

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Table of Contents

Chapter No.

Topic Page No.

I Introduction to Equity Research and Economic Analysis 4

Investments – An Overview:

Real Assets Vs Financial Assets The Informational Role of Financial Markets Corporate Governance and Corporate Ethics

Recent Trends Equity Research -An Overview:

Types of Research: Time Value of Money – Basics: Concept of Risk Return Trade Off:

Overview of the Investment Process: Economic Analysis:

Inflation, Interest Rates, and Stock Prices:

5

6 8 11

12 15

18 24 34

36 37

40

II Industry and Company Analysis 43

What is an Industry? Rationale for Industry Analysis:

Steps in Industry Analysis: Frame-Work for Industry Analysis: Porter’s Five Forces:

Company Analysis: Understanding Financial Statements and Analysis:

Major Financial Statements:

44 44

46 46 54

56 59

60

III Valuation of Stocks and Firms 79

What is a Growth Company? What is a Growth Stock?

What is a Defensive Company? What is a cyclical company? What is a speculative company?

Value Stocks Vs Growth Stocks Cost of Capital (Kc):

Weighted Average Cost Of Capital – WACC: Cost of Debt (Kd): Cost of Equity (Ke):

Capital Asset Pricing Model (CAPM): CAPM and its Limitations:

Theory of Valuation: Form of Returns: Valuation of Bonds:

Valuation of Preferred Share: Approaches to the Valuation of Equity Share:

Discounted Cash Flow Valuation Approach- Why and When? Relative Valuation Techniques: Why and When to Use? Discounted Cash Flow (DCF) Valuation Techniques:

The Dividend Discount Model (DDM): Present Value of Operating Free Cash Flows:

80 80

81 81 82

82 83

83 83 84

84 86

89 89 91

92 93

94 95 95

96 96

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Present Value of Free Cash Flows to Equity:

Relative Valuation: Reasons for Popularity and potential pitfalls: Advantages and Disadvantages:

Further Classification of Relative Valuation Models: Applicability of multiples and limitations

97

97 98 99

100 102

IV Report Writing and Presentation 105

Points to be kept in mind while preparing an equity research report:

Template for the Equity Research Report: Sources of Information:

Validation: Expert / Legal Opinion: References:

106

107 109

109 109 135

Appendix Useful Formulas 136

Nominal Rate Effective Rate Flat Rate

Rule of ‘72’ Rule of ‘69’

Continuous Compounding Continuous Discounting DuPont analysis

ROE analysis High Turnover Industries

High margin industries High leverage industries ROA and ROE ratio

Time series analysis Cross series analysis

136 136 137

137 137

138 138 139

139 139

140 140 140

142 142

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Chapter-I

Introduction to Equity Research and

Economic Analysis

5

Investments – An Overview:

For most of your life, you will be earning and spending money. Rarely, though, will your current

money income exactly balances with your consumption desires. Sometimes, you may have more

money than you want to spend; at other times, you may want to purchase more than you can

afford. These imbalances will lead you either to borrow or to save to maximize the long-run

benefits from your income. When current income exceeds current consumption desires, people

tend to save the excess. They can do any of several things with these savings. One possibility is

to put the money under mattress or bury it in the backyard until some future time when

consumption desires exceed current income. When they retrieve their savings from the mattress

or backyard, they have the same amount they saved.

Another possibility is that they can give up the immediate possession of these savings for a

future larger amount of money that will be available for future consumption. This tradeoff of

present consumption for a higher level of future consumption is the reason for saving. What you

do with the savings to make them increase over time is investment. Those who give up

immediate possession of savings (that is, defer consumption) expect to receive in the future a

greater amount than they gave up. Conversely, those who consume more than their current

income (that is, borrowed) must be willing to pay back in the future more than they borrowed.

The rate of exchange between future consumption (future dollars) and current consumption

(current rupees) is the pure rate of interest. Both people‘s willingness to pay this difference for

borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate

referred to as the pure time value of money. This interest rate is established in the capital market

by a comparison of the supply of excess income available (savings) to be invested and the

demand for excess consumption (borrowing) at a given time. If you can exchange Rs.100 of

certain income today for Rs. 104 of certain income one year from today, then the pure rate of

exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent

(104/100 – 1). The investor who gives up Rs.100 today expects to consume Rs. 104 of goods and

services in the future. This assumes that the general price level in the economy stays the same.

This price stability has rarely been the case during the past several decades when inflation rates

have varied over a period of time with an average of about eight percent a year from 1970 to

2010. If investors expect a change in prices, they will require a higher rate of return to

compensate for it. For example, if an investor expects a rise in prices (that is, he or she expects

inflation) at the rate of 3 percent during the period of investment, he or she will increase the

required interest rate by 3 percent. Further, if the future payment from the investment is not

certain, the investor will demand an interest rate that exceeds the pure time value of money plus

the inflation rate. The uncertainty of the payments from an investment is the investment risk. The

additional return added to the nominal, risk-free interest rate is called a risk premium. In our

previous example, the investor would require more than Rs106 one year from today to

compensate for the uncertainty.

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Specifically, the term investments the current commitment of dollars for a period of time in order

to derive future payments that will compensate the investor for (1) the time the funds are

committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments. The

―investor‖ can be an individual, government, a pension fund, or a corporation. Similarly, this

definition includes all types of investments, including investments by corporations in plant and

equipment and investments by individuals in stocks, bonds, commodities, or real estate. This text

emphasizes investments by individual investors. In all cases, the investor is trading a known

dollar amount today for some expected future stream of payments that will be greater than the

current outlay. At this point, we have answered the questions about why people invest and what

they want from their investments. They invest to earn a return from savings due to their deferred

consumption. They want a rate of return that compensates them for the time, the expected rate of

Inflation and the uncertainty of the return. A central question of this material is how investors

select investments that will give them their required rates of return.

In other words, an investments the current commitment of money or other resources in the

expectation of reaping future benefits. For example, an individual might purchase shares of stock

anticipating that the future proceeds from the shares will justify both the time that her money is

tied up as well as the risk of the investment. The time you will spend studying this text (not to

mention its cost) also is an investment. You are forgoing either current leisure or the income you

could be earning at a job in the expectation that your future career will be sufficiently enhanced

to justify this commitment of time and effort. While these two investments differ in many ways,

they share one key attribute that is central to all investments: You sacrifice something of value

now, expecting to benefit from that sacrifice later.

Real Assets Vs Financial Assets

The material wealth of a society is ultimately determined by the productive capacity of its

economy, that is, the goods and services its members can create. This capacity is a function of

the real assets of the economy: the land, buildings, equipment, and knowledge that can be used

to produce goods and services. In contrast to such real assets are financial assets such as stocks

and bonds. Such securities are no more than sheets of paper or, more likely, computer entries and

do not contribute directly to the productive capacity of the economy. Instead, these assets are the

means by which individuals in well-developed economies hold their claims on real assets.

Financial assets are claims to the income generated by real assets (or claims on income from the

government).If we cannot own our own auto plant (a real asset), we can still buy shares in

General Motors or Toyota (financial assets) and, thereby, share in the income derived from the

production of automobiles.

While real assets generate net income to the economy, financial assets simply define the

allocation of income or wealth among investors. Individuals can choose between consuming

their wealth today or investing for the future. If they choose to invest, they may place their

wealth in financial assets by purchasing various securities. When investors buy these securities

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from companies, the firms use the money so raised to pay for real assets, such as plant,

equipment, technology, or inventory. So investors‘ returns on securities ultimately come from

the income produced by the real assets that were financed by the issuance of those securities.

More on Financial Assets

It is common to distinguish among three broad types of financial assets: debt, equity, and

derivatives. Fixed-income or debt securities promise either a fixed stream of income or a stream

of income that is determined according to a specified formula. For example, a corporate bond

typically would promise that the bondholder will receive a fixed amount of interest each year.

Other so-called floating-rate bonds promise payments that depend on current interest rates. For

example, a bond may pay an interest rate that is fixed at two percentage points above the rate

paid on U.S. Treasury bills. Unless the borrower is declared bankrupt, the payments on these

securities are either fixed or determined by formula. For this reason, the investment performance

of debt securities typically is least closely tied to the financial condition of the issuer.

Nevertheless, debt securities come in a tremendous variety of maturities and payment provisions.

At one extreme, the money market refers to fixed-income securities that are short-term, highly

marketable, and generally of very low risk. Examples of money market securities are U.S.

Treasury bills or bank certificates of deposit (CDs). In contrast, the fixed-income capital market

includes long-term securities such as Treasury bonds, as well as bonds issued by federal

agencies, state and local municipalities, and corporations. These bonds range from very safe in

terms of default risk (for example, Treasury securities) to relatively risky (for example, high

yield or ―junk‖ bonds). They also are designed with extremely diverse provisions regarding

payments provided to the investor and protection against the bankruptcy of the issuer. We will

take a first look at these securities and undertake a more detailed analysis in later chapters.

Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the

corporation. Equity holders are not promised any particular payment. They receive any dividends

the firm may pay and have prorated ownership in the real assets of the firm. If the firm is

successful, the value of equity will increase; if not, it will decrease. The performance of equity

investments, therefore, is tied directly to the success of the firm and its real assets. For this

reason, equity investments tend to be riskier than investments in debt securities.

Derivative securities such as options and futures contracts provide payoffs that are determined by

the prices of other assets such as bond or stock prices. For example, a call option on a share of

Intel stock might turn out to be worthless if Intel‘s share price remains below a threshold or

―exercise‖ price such as Rs30 a share, but it can be quite valuable if the stock price rises above

that level. 2 Derivative securities are so named because their values derive from the prices of

other assets. For example, the value of the call option will depend on the price of the stock. Other

important derivative securities are futures and swap contracts. Derivatives have become an

integral part of the investment environment. One use of derivatives, perhaps the primary use, is

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to hedge risks or transfers them to other parties. This is done successfully every day, and the use

of these securities for risk management is so commonplace that the multitrillion-dollar market in

derivative assets is routinely taken for granted.

Derivatives also can be used to take highly speculative positions, however. Every so often, one

of these positions blows up, resulting in well-publicized losses of hundreds of millions of dollars.

While these losses attract considerable attention, they are in fact the exception tithe more

common use of such securities as risk management tools.

Derivatives will continue to play an important role in portfolio construction and the financial

system. In addition to these financial assets, individuals might invest directly in some real assets.

For example, real estate or commodities such as precious metals or agricultural products are real

assets that might form part of an investment portfolio.

The Informational Role of Financial Markets

In a capitalist system, financial markets play a central role in the allocation of capital resources.

Investors in the stock market ultimately decide which companies will live and which will die. If

a corporation seems to have good prospects for future profitability, investors will bid up its stock

price. The company‘s management will find it easy to issue new shares or borrow funds to

finance research and development, build new production facilities, and expand its operations.

The nearby box provides an illustration of this process.

As Facebook‘s stock price surpassed Rs45 a share in 2012, it was able to expand and initiate

many new business prospects. If, on the other hand, a company‘s prospects seem poor, investors

will bid down its stock price. The company will have to downsize and may eventually disappear.

The process by which capital is allocated through the stock market sometimes seems wasteful.

Some companies can be ―hot‖ for a short period of time, attract a large flow of investor capital,

and then fail after only a few years.

But that is an unavoidable aspect of economic progress. It is impossible to accurately predict in

advance which ventures will succeed and which will fail. But the stock market encourages

allocation of capital to those firms that appear at the time to have the best prospects. Many smart,

well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on

the stock market. Stock prices reflect their collective judgment.

Consumption Timing

Some individuals in an economy are earning more than they currently wish to spend. Others, for

example, retirees, spend more than they currently earn. How can you shift your purchasing

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power from high-earnings periods to low-earnings periods of life? One way is to ―store‖ your

wealth in financial assets. In high-earnings periods, you can invest your savings in financial

assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide

funds for your consumption needs. By so doing, you can ―shift‖ your consumption over the

course of your lifetime, thereby allocating your consumption to periods that provide the greatest

satisfaction. Thus, financial markets allow individuals to separate decisions concerning current

consumption from constraints that otherwise would be imposed by current earnings.

Allocation of Risk

Virtually all real assets involve some risk. When GM builds its auto plants, for example, it

cannot know for sure what cash flows those plants will generate. Financial markets and the

diverse financial instruments traded in those markets allow investors with the greatest taste for

risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on

the sidelines. For example, if Maruti Udyong Ltd., (MUL) raises the funds to build its auto plant

by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can

buy shares of stocking MUL, while the more conservative ones can buy MUL bonds. Because

the bonds promise to provide a fixed payment, the stockholders bear most of the business risk

but reap potentially higher rewards. Thus, capital markets allow the risk that is inherent to all

investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their

investments. When investors are able to select security types with the risk-return characteristics

that best suit their preferences, each security can be sold for the best possible price. This

facilitates the process of building the economy‘s stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organization is

well suited to small businesses and, in fact, was the most common form of business organization

before the Industrial Revolution. Today, however, with global markets and large-

scaleproduction, the size and capital requirements of firms have skyrocketed. For example, in

2006General Electric listed on its balance sheet about Rs71billion of property, plant, and

equipment,

and total assets in excess of Rs660 billion. Corporations of such size simply cannot exist as

owner-operated firms. GE actually has about 650,000 stockholders with an ownership stake in

the firm proportional to their holdings of shares. Such a large group of individuals obviously

cannot actively participate in the day-to-day management of the firm. Instead, they elect a board

of directors which in turn hires and supervises the management of the firm.

This structure means that the owners and managers of the firm are different parties. This gives

the firm a stability that the owner-managed firm cannot achieve. For example, if some

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stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to

other investors, with no impact on the management of the firm. Thus, financial assets and the

ability to buy and sell those assets in the financial market sallow for easy separation of

ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds holding

hundreds of thousands of shares to small investors who may hold only a single share, agree on

the objectives of the firm? Again, the financial markets provide some guidance. All may agree

that the firm‘s management should pursue strategies that enhance the value of their shares. Such

policies will make all shareholders wealthier and allow them all to better pursue their personal

goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted

to engage in activities not in the best interest of shareholders. For example, they might engage in

empire building or avoid risky projects to protect their own jobs or over consume luxuries such

as corporate jets, reasoning that the cost of such perquisites is largely borne by the shareholders.

These potential conflicts of interest are called agency problems because managers, who are hired

as agents of the shareholders, may pursue their own interests instead. Several mechanisms have

evolved to mitigate potential agency problems. First, compensation plans tie the income of

managers to the success of the firm. A major part of the total compensation of top executives is

typically in the form of stock options, which means that the managers will not do well unless the

stock price increases, benefiting shareholders. (Of course, we‘ve learned more recently that

overuse of options can create its own agency problem. Options can create an incentive for

managers to manipulate information to prop up stock price temporarily, giving them a chance to

cash out before the price returns to a level reflective of the firm‘s true prospects.

Second, while boards of directors are sometimes portrayed as defenders of top management, they

can, and in recent years increasingly do, force out management teams that are underperforming.

The chief executives of Viacom, Boeing, Fannie Mae, 3 Hewlett-Packard, and Bristol-Myers

Squibb all have been replaced in recent years. Even boards in Europe, which traditionally have

been viewed as more management-friendly, have become more willing to force out

underperforming managers: for example, senior management at Deutsche Telekom, Shell, and

Vivendi Universal have recently been replaced. Third, outsiders such as security analysts and

large institutional investors such as pension funds monitor the firm closely and make the life of

poor performers at the least uncomfortable.

Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in

monitoring management, unhappy shareholders in principle can elect a different board. They can

do this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to

vote the shares of other shareholders) to take control of the firm and vote in another board.

However, this threat is usually minimal. Shareholders who attempt such a fight have to use their

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own funds, while management can defend itself using corporate coffers. Most proxy fights fail.

The real takeover threat is from other firms. If one firm observes another underperforming, it can

acquire the underperforming business and replace management with its own team. The stock

price should rise to reflect the prospects of improved performance, which provides incentive for

firms to engage in such takeover activity.

Corporate Governance and Corporate Ethics

We‘ve argued that securities markets can play an important role in facilitating the deployment of

capital resources to their most productive uses. But for markets to effectively serve this purpose

there must be enough transparency for investors to make well-informed decisions. If firms can

mislead the public about their prospects, then much can go wrong. Despite the many mechanisms

to align incentives of shareholders and managers, the three years between 2000 and 2002 were

filled with a seemingly unending series of scandals that collectively signaled a crisis in corporate

governance and ethics. For example, the telecom firm WorldCom overstated its profits by at least

Rs3.8 billion by improperly classifying expenses as investments. When the true picture emerged,

it resulted in the largest bankruptcy in U.S. history.

The second-largest U.S. bankruptcy was Enron, which used its now notorious ―special purpose

entities‖ to move debt off its own books and similarly present a misleading picture of its

financial status. Unfortunately, these firms had plenty of company. Other firms such as Rite Aid,

HealthSouth, Global Crossing, and Qwest Communications also manipulated and misstated their

accounts to the tune of billions of dollars. And the scandals were hardly limited to the U.S.

Parmalat, the Italian dairy firm, claimed to have a Rs4.8 billion account at Bank of America that

turned out not to exist, and in the end the size of its bankruptcy will likely rival those of World-

Com or Enron. In India too, we have most recently Satyam scam which jolted the entire country.

These episodes suggest that agency and incentive problems are far from solved. Other scandals

of that period included systematically misleading and overly optimistic research reports put out

by stock market analysts (their favorable analysis was traded for the promise of future

investment banking business, and analysts were commonly compensated not for their accuracy

or insight, but for their role in garnering investment banking business frothier firms) and

allocations of initial public offerings to corporate executives as a quid pro quofor personal favors

or the promise to direct future business back to the manager of the IPO.

What about the auditors who were supposed to be the watchdogs of the firms? Here too,

incentives were skewed. Recent changes in business practice made the consulting businesses of

these firms more lucrative than the auditing function. For example, Enron‘s (now defunct)auditor

Arthur Andersen earned more money consulting for Enron than auditing it; given its incentive to

protect its consulting profits, it should not be surprising that it, and other auditors, were overly

lenient in their auditing work. In 2002, in response to the spate of ethics scandals, Congress

passed the Sarbanes-Oxley Act, which attempts to tighten the rules of corporate governance.

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For example, the Act requires corporations to have more independent directors, that is, more

directors who are not themselves managers (or affiliated with managers). The Act also requires

each CFO to personally vouch forth corporation‘s accounting statements, creates a new oversight

board to oversee the auditing of public companies, and prohibits auditors from providing various

other services to clients.

Wall Street and its regulators are seeking ways to restore credibility. There is (admittedly

belated) recognition that markets require trust to function. In the wake of the scandals, the value

of reputation and straightforward incentive structures has increased. Ultimately, a firm‘s

reputation for integrity is key to building long-term relationships with its customers and is

therefore one of its most valuable assets. Indeed, the motto of the London Stock Exchange. Is

―My word is my bond.‖ Every so often firms forget this lesson, but in the end, investments in

reputation are in fact good business practice.

Recent Trends

Four important trends have changed the contemporary investment environment:

(1) Globalisation,

(2) Securitisation,

(3) Financial engineering, and

(4) Information and computer networks.

Globalisation

If a wider range of investment choices can benefit investors, why should we limit ourselves to

purely domestic assets? Increasingly efficient communication technology and the dismantling of

regulatory constraints have encouraged globalization in recent years. U.S. investors commonly

can participate in foreign investment opportunities in several ways:

(1) Purchase foreign securities using American Depository Receipts (ADRs), which are

domestically traded securities that represent claims to shares of foreign stocks;

(2) Purchase foreign securities that are offered in dollars;

(3) Buy mutual funds that invest internationally; and

(4) Buy derivative securities with payoffs that depend on prices in foreign security markets.

Brokers who act as intermediaries for American Depository Receipts purchase an inventory of

stock from some foreign issuer. The broker then issues an American Depository Receipt that

represents a claim to some number of those foreign shares held in inventory. The ADR is

denominated in dollars and can be traded on U.S. stock exchanges but is in essence no more than

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a claim on a foreign stock. Thus, from the investor‘s point of view, there is no more difference

between buying a British versus a U.S. stock than there is in holding a Massachusetts based

company compared with a California-based one. Of course, the investment implications may

differ: ADRs still expose investors to exchange-rate risk.

World Equity Benchmark Shares (WEBS) are a variation on ADRs. WEBS use the same

depository structure to allow investors to trade portfolios of foreign stocks in a selected country.

Each WEBS security tracks the performance of an index of share returns for a particular country.

WEBS can be traded by investors just like any other security and thus enable U.S. investors to

obtain diversified portfolios of foreign stocks in one fell swoop.

A giant step toward globalization took place in 1999 when 11 European countries replaced their

existing currencies with a new currency called the euro.7The idea behind the euro is that a

common currency will facilitate trade and encourage integration of markets across national

boundaries. Figure 1.1 is an announcement of a debt offering in the amount of 500 million Euros.

(In June 2007, the euro was worth about Rs1.35; the symbol for the euro is €.)

Securitisation

In 1970, mortgage pass-through securities were introduced by the Government National

Mortgage Association (GNMA, or Ginnie Mae). These securities aggregate individual home

mortgages into relatively homogeneous pools. Each pool acts as backing for a GNMA pass

through security. Investors who buy GNMA securities receive prorated shares of all the principal

and interest payments made on the underlying mortgage pool.

For example, the pool might total Rs100 million of 8%, 30-year conventional mortgages. The

banks that originated the mortgages continue to service them (receiving fee-for-service), but they

no longer own the mortgage investment; they pass the cash flows from the underlying mortgages

through to the GNMA security holders. Pass-through securities represent a tremendous

innovation in mortgage markets.

The securitization of mortgages means mortgages can be traded just like other securities.

Availability of funds to homebuyers no longer depends on local credit conditions and is no

longer subject to local banks‘ potential monopoly powers; with mortgage pass-through trading in

national markets, mortgage funds can flow from any region (literally worldwide) to wherever

demand is greatest.

Securitization also expands the menu of choices for the investor. Whereas it would have been

impossible before 1970 for investors to invest in mortgages directly, they now can purchase

mortgage pass-through securities or invest in mutual funds that offer portfolios of such securities.

Other loans that have been securitized into pass-through arrangements include car loans, student

loans, home equity loans, credit card loans, and debts of firms.

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Securitization also has been used to allow U.S. banks to unload their portfolios of shaky loans to

developing nations. So-called Brady bonds (named after former Secretary of Treasury Nicholas

Brady) were formed by securitizing bank loans to several countries in shaky fiscal condition. The

U.S. banks exchanged their loans to developing nations for bonds backed by those loans. The

payments that the borrowing nation would otherwise make to the lending bank were directed

instead to the holder of the bond. These bonds could be traded in capital markets. Therefore, if

they chose to, banks could remove these loans from their portfolios simply by selling the bonds.

Financial Engineering:

Financial engineering refers to the creation of new securities by unbundling—breaking up and

allocating the cash flows from one security to create several new securities—or by bundling —

combining more than one security into a composite security. Such creative engineering of new

investment products allows one to design securities with custom-tailored risk attributes. Boise

Cascade, with the assistance of Goldman, Sachs and other underwriters, has issued a hybrid

security with features of preferred stock combined with various call and put option contracts.

The security is structured as preferred stock for four years, at which time it is converted into

common stock of the company. However, the number of shares of common stock into which the

security can be converted depends on the price of the stock in four years, which means that the

security holders are exposed to risk similar to the risk they would bear if they held option

positions on the firm.

Often, creating a security that appears to be attractive requires the unbundling of an asset. A

mortgage pass-through certificate is unbundled into classes. Class 1 receives only principal

payments from the mortgage pool, whereas Class 2 receives only interest payments. The process

of bundling and unbundling is called financial engineering, which refers to the creation and

design of securities with custom-tailored characteristics, often regarding exposures to various

sources of risk. Financial engineers view securities as bundles of (possible risky) cash flows that

may be carved up and rearranged according to the needs or desires of traders in the security

markets.

Computer Networks

The Internet and other advances in computer networking have transformed many sectors of the

economy and few more so than the financial sector. These advances will be treated in greater

detail in Chapter 3, but for now we can mention a few important innovations: online trading,

online information dissemination, and automated trade crossing. Online trading connects a

customer directly to a brokerage firm. Online brokerage firms can process trades more cheaply

and therefore can charge lower commissions. The average commission for an online trade is

below 0.7%, compared to more than 1% at full-service brokers. The Internet has also allowed

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vast amounts of information to be made cheaply and widely available to the public. Individual

investors today can obtain data, investment tools, and even analyst reports that just a decade ago

would have been available only to professionals.

Electronic communication networks that allow direct trading among investors have exploded in

recent years. These networks allow members to post buy or sell orders and to have those orders

automatically matched up or ―crossed‖ with orders of other traders in the system without benefit

of an intermediary such as a securities dealer.

Equity Research -An Overview:

Companies constantly produce large amounts of information regarding their financial status,

their success in business markets and their current investments. Much of this information is

required for legal purposes, but it also provides necessary data for the stock market. Most

investors do not have the time or resources to follow this massive amount of company

information. Equity research analysts work to compile this data, along with relevant market

information, to provide investors with useful recommendations.

Definition

In stock market terms, "equity" refers to ownership of a business, which a business can sell as

shares to interested investors. An equity research analyst specializes in examining what shares

are for sale, what shares are selling well and what companies appear to be growing and will be

worthwhile investments. Equity research analysts also track which stocks are falling so they can

point out trends and provide useful information to brokers and investors. Analysts spend much of

their time analyzing individual stocks, especially stocks that have earned a lot of interest due to

changing value. They look at the company that issued the stock and its history, and then analyze

the company's industry as a whole and what major changes are influencing it. The analyst will

then look at businesses similar to the company they are studying to find information about

overall value and average earnings for that kind of business.

Role of Equity Research Analysts:

Equity research analysts have many different jobs. Once they have compiled information, many

use basic formulas and programs to create financial models of specific companies and industries,

or ratios that show important facts about a business's financial standing. Many follow up these

models by writing reports for investors summarizing their findings. Some may tap into

independent sources and contacts to keep up on recent events. All research analysts must ensure

they use only publicly available knowledge and not illegal, insider information. Equity research

analysts tend to be influenced by current events, and many tend to make recommendations based

on market activity. This means that as the market changes, analysts' attitudes also change to

16

mirror current interest. This can create a tendency for some analysts to become myopic, only

reporting on popular news and backing certain stocks because they are trendy in the short term.

Types

There are two basic types of equity research analysts. The first type works for major brokerage

firms on Wall Street and are interested primarily in highly liquid stocks, big cap shares and other

high-profit investment data. The other type of analyst is independent, providing information for

all types of stocks for their firms as needed.

Hence, the role of equity research analysts is to study the companies, analyzing its financial

statements, products, management, market share, and analyze the quantitative and qualitative

aspects with the main objective of arriving logical and informed decisions about where to invest

and on what stocks to invest?

By and large fee-based research analysts or the firms have the following characteristics:

1. Equity research analysts provide analytical and unbiased services.

2. Normally they are paid an annual fee in cash and normally they do not accept any form

of equity, which may cause conflicts of interest.

3. They provide full disclosure of the relationship between the company and the research

analysts /firm, so investors can evaluate objectivity.

Generally, an equity research analyst is expected to possess the following skill sets.

a. Good understanding about the Global Economies and various macro and micro factors

that will affect the economies of the various countries

b. Excellent knowledge about the various industries, their business models, different phases

of the business life cycles.

c. Aptitude towards number crunching. Skill to analyse the financial statements namely

profit and loss account, balance sheet, cash flow statement and draw inferences about the

financial status and performance of the firm.

d. Clarity in oral and written communication

Market Participants who will avail the services of Equity Research Analysts:

There are basically three categories of participants in the securities market namely, the issuers of

securities, investors in securities and the intermediaries, such as merchant bankers, brokers etc.

17

As far as the debt (bond) market is concerned, as it is predominantly a wholesale market, with

dominant institutional investor participation. The investors in the debt markets are mainly banks,

financial institutions, mutual funds, provident funds, pension funds, insurance companies and

corporate. With the growing number of market participants, the growth in volume of securities

transactions, the reduction in transaction costs, the significant improvements in transparency and

safety have enhanced the requirement of services of equity research analysts many fold in the

Indian securities market.

Table No.1Table No.1.1

Market Participants in Securities Market

Market Participants 2009 2010 As on Sep 30, 2010

Securities Appellate Tribunal (SAT) 1 1 1

Regulators* 4 4 4

Depositories 2 2 2

Stock Exchanges

With Equities Trading 20 20 20

With Debt Market Segment 2 2 2

With Derivative Trading 2 2 2

With Currency Derivatives 3 3 4

Brokers (Cash Segment) 9,628 9,772 10,018

Corporate Brokers (Cash Segment) 4,308 4,424 4,618

Brokers (Equity Derivatives) 1,587 1,705 1,902

Brokers (Currency Derivatives) 1,154 1,459 1,811

Sub-brokers 60,947 75,577 81,713

FIIs 1626 1713 1726

Portfolio Managers 232 243 250

Custodians 16 17 17

Registrars to an issue & Share Transfer Agents 71 74 68

Primary Dealers 18 20 20

Merchant Bankers 134 164 184

Bankers to an Issue 51 48 52

Debenture Trustees 30 30 27

Underwriters 19 5 6

Venture Capital Funds 132 158 168

Foreign Venture Capital Investors 129 143 150

Mutual Funds 44 47 48

Collective Investment Schemes 1 1 1

Source: SEBI, RBI

* DCA, DEA, RBI & SEBI.

18

Types of Research:

There are broadly three types of equity research that are in practice.

A: Fundamental Analysis:

This is the very popular methods of analysis amongst the analysts. Under this method of analysis

a share is evaluated by its intrinsic value by examining related economic, financial and other

qualitative and quantitative factors. This is also called as a „top-down approach‟ wherein first the

economies of the various countries were analyzed followed by an analysis of the industries and

then the companies. The whole idea here is that by analyzing the economies of various countries

one can identify the counties economies which are booming or nearing booming and then within

those countries what are the industries which are in the growth part of their life cycle and then

the companies which are really doing well within those industries. For instance by analyzing the

various economies of the world as of now, one can identify two economies (among other

countries) as emerging economies like India and China. Having identified the economy the

researcher needs to zoom further what are the industries within these economies are doing well.

For instance auto, information technology, telecom and pharmaceutical industries are considered

to be in their growth phase in these countries. Then the analysts further investigates what are the

companies within these industries are doing well comparing to other players in the market and

then takes a call to invest in those companies.

Exhibit No.1.1

19

Source: Adopted from Reilly and Brown, 8th Edition

B. Technical Analysis

This is the second branch of analysis where in the stock price movements are largely predicted

by analyzing statistics generated by market activity, such as past prices and volume. No attempt

is made to measure a share's intrinsic value, but instead use charts and other tools to identify

patterns that can suggest future direction of price.

Exhibit No.1.2

Source: Adopted from Reilly and Brown, 8th Edition

C: Quantitative Analysis:

This is a method that attempts to understand the behavior of stock price movement through

complex mathematical and statistical modeling. By assigning a numerical value to variables,

quantitative analysts try to replicate reality mathematically. The tools that are largely used over

here are stochastic processing, optimization, artificial neural network, economy-physics, applied

mathematics and the like

Major Classification of Stocks:

Stocks were classified in different manner in the literature. Let us discuss some of the most

common classifications of shares. Please be noted that the term stock and share are used

interchangeably.

20

Equity Stock / Common Stock:

Equity is a stock or any other security representing an ownership interest. On a

company's balance sheet, the amount of the funds contributed by the owners (the stockholders)

plus the retained earnings (or losses). It is also referred to as "shareholders' equity". In finance, in

general, you can think of equity as ownership in any asset after all debts associated with that

asset are paid off.

Preferred Stock:

A class of ownership in a company that has a higher claim on the assets and earnings than

common stock. Preferred stock generally has a dividend that must be paid out before dividends

to common stockholders and the shares usually do not have voting rights.

The precise details as to the structure of preferred stock are specific to each corporation.

However, the best way to think of preferred stock is as a financial instrument that

has characteristics of both debt (fixed dividends) and equity (potential appreciation). There are

further classifications within preferred stock such as cumulative preference shares, non-

cumulative preference shares, convertible preference shares, non-convertible preference shares,

participating and non-participating preference shares.

When a company issues preferred stock, it generally creates an obligation to pay a fixed dividend

on the stock. Accounting rules have conventionally not viewed preferred stock as debt because

the failure to meet preferred dividends does not result in bankruptcy. At the same time, the fact

the preferred dividends are cumulative makes them more onerous than common equity. Thus,

preferred stock is viewed in accounting as a hybrid security, sharing some characteristics with

equity and some with debt. Preferred stock is valued on the balance sheet at its original issue

price, with any cumulated unpaid dividends added on. Convertible preferred stock is treated

similarly, but it is treated as equity on conversion. However, the focus of this course is on equity

shares only.

NSE Classification of Shares:

The National Stock Exchange classifies stocks broadly under six categories namely A, B, T, S,

TS and Z. The classification stocks are being done on the basis of their size, liquidity and

exchange compliance and, in some cases, also the speculative interest in them.

A Group – Highly Liquid:

a) These are the most liquid shares among the whole lot of shares that are listed in the NSE.

21

b) These are companies which are rated excellent in all aspects; Market capitalization is one

key factor in deciding which scrip should be classified in Group A.

c) Volumes are high and trades are settled under the normal rolling settlement (i.e. to say

intraday buy-sell deals are netted out).

d) These are best fit for a novice investor‘s portfolio considering that information about

them is extensively available. For instance, all the 30 stocks which constitute Sensex are

‗A‘ grade stocks.

T Group – Trade to Trade:

a) The stocks that fall under the trade-to-trade settlement system of the exchange come

under this category.

b) Each trade here is seen as a separate transaction and there‘s no netting-out of trades as in

the normal rolling system.

c) The trader needs to pay to take delivery for his/her buys and deliver shares for his/her

sells, both on the second day following the trade day (T+2).

For instance, suppose Mr. A bought 100 shares of ‗T‘ grade shares and sold another 100

of it on the same day. Then, for the shares Mr. A had bought, he would have to pay the

exchange in two days. As for the other bunch that Mr. A sold, Mr. A should deliver the

shares by T+2 days, for the exchange to deliver it to the one who bought it. to produce

delivery shares against the sale made would be considered as short sales. The exchange

will, in that case, on the T+3rd day, debit an amount that is 20 per cent higher than the

scrip‘s closing price that day. This means unless the scrip‘s price falls more than 20 per

cent from the price of your sale transaction, you would have to pay a penalty for the short

sale so made. Even so, there will be no credit made to you in the case of substantial fall in

the share price. The exchange will, instead, credit the gain to its investor fund. Stocks are

regularly moved in and out of trade-to-trade settlement depending on the speculative

interest that governs them.

S Group – Small and Medium

a) These are shares that fall under the NSE‘s Indonext segment.

b) The NSE Indonext comprises small and medium companies that are listed in the regional

stock exchanges (RSE).

c) S‘ grade companies are small and typically ones with turnover of Rs 5 Crore and tangible

assets of Rs 3 Crore. Some also have low free-float capital with the promoter holding as

high as 75 per cent.

d) Besides their smaller size, the other risk that comes with investing in them is low

liquidity. Owing to lower volumes, these stocks may also see frenzied price movements.

22

TS Group – A Mix of T and S Groups:

a) Stocks under this category are but the ‗S‘ grade stocks that are settled on a trade-to-trade

basis owing to surveillance requirements.

b) This essentially means that these counters may not come with an easy exit option, as

liquidity will be low and intraday netting of buy-sell trades isn‘t allowed either.

Z Group – Caution

a) ‗Z‘ grade stocks are companies that have not complied with the exchange‘s listing

requirements or ones that have failed to redress investor complaints.

b) This grade also includes stocks of companies that have dematerialization arrangement

with only one of the two depositories, Central Depository Services (India) Ltd (CDSL)

and National Securities Depositories Ltd (NSDL).

c) These stocks may perhaps be the riskiest in terms of various grades accorded. For one,

not much information would be available in the public domain on these companies,

making it tough to track them. Second, the low media coverage that keeps them relatively

hidden from public scrutiny also makes them more vulnerable to insider trading. Third,

these companies already have a poor score in redressing investor complaints.

B Group – Left Over

a) This category comprises stocks that don‘t fall in any of the other groups.

b) These counters see normal volumes and are settled under the rolling system; in all

respects these stocks resemble their counterparts in ‗A‘ but for their size; typically, stocks

of mid- and small market capitalization come under this grade.

SLB Group

a) Securities Exchange Board of India, in 2007, has announced the introduction of Securities

Lending & Borrowing Scheme (SLBS).

b) Securities Lending & Borrowing provides a platform for borrowing of securities to

enable settlement of securities sold short.

c) There are 207 companies in the SLB list; Investors can sell a stock which he/she does not

own at the time of trade.

d) All classes of investors, viz., retail and institutional investors, are permitted to short sell.

Other Classifications

The “F” Group represents the Fixed Income Securities.

23

Trading in Government Securities by the retail investors is done under the “G” group.

Classification Based on the Market Capitalization:

What is market capitalization?

Market capitalization is often known as ―market cap‖ or ―m-cap‖ which is the total value of the

shares outstanding in the market on a particular point of time. It could be computed with the

following formula:

Price per share * Number of tradable shares

For instance, the market capitalisaiton of ACC shares as on 22nd

November 2012 is computed as

below:

Rs.1390 * 1854649499 = Rs.25,928 crores

Large Cap or Big Cap:

Generally companies with a market capitalization value of more than Rs10 billion are classified

as large cap. The term large cap is abbreviation of the term ‗large market capitalization‘

Mid Cap:

Companies with a market capitalization between Rs2 and Rs10 billion are known as Mid Cap.

Mid cap is an abbreviation for the term "middle capitalization"

Small Cap:

Normally, the companies with a market capitalization of between Rs300 million and Rs2 billion

are known as small cap. Small cap is an abbreviation for the term "small capitalization"

A word of caution to be kept in mind is that these classification as above are only

approximations that change over time. Also, the exact definition of these terms can vary among

the various participants in the investment business.

24

Time Value of Money – Basics:

The time value of money is a mathematically based recognition that money received today is worth

more than an equal amount of money received months or years in the future. Why so, because of the

concept of ‗interest‘.

What is interest?

Interest is the reward given for the sacrifice made i.e. by sacrificing the current consumption

someone is anticipating a higher amount.

Concept of Present value and Future Value:

Present value (PV) ), represents the rupee value today of a future amount, or the amount you

would invest today at a given interest rate for a specified time period to equal the future amount.

Future value (FV), the value of a present amount at a future date, is calculated by applying

compound interest over a specific time period.

Generally, financial managers prefer present value to future value because they typically make

decisions at time zero, before the start of a project.

Rationale to know the above mentioned concepts:

a) Most financial decisions involve costs & benefits that are spread out over time.

b) Time value of money allows comparison of cash flows from different periods.

The answer for the above question is a function of the „prevailing rate of interest‟.

Simple Interest: In simple interest no interest on interest. Let us understand this through a simple

example.

• Year 1: 5% of Rs.100 = Rs.5 + Rs.100 = Rs.105

• Year 2: 5% of Rs.100 = Rs.5 + Rs.105 = Rs.110

• Year 3: 5% of Rs.100 = Rs.5 + Rs.110 = Rs.115

Would it be better for a company to invest Rs.100,000 in a financial

instrument that would return a total of Rs.200,000 after one year, or

one that would return Rs.200,000 after two years? Assuming both

instruments has the same rate of return.

25

• Year 4: 5% of Rs.100 = Rs.5 + Rs.115 = Rs.120

• Year 5: 5% of Rs.100 = Rs.5 + Rs.120 = Rs.125

Compound Interest: In compound interest, one earns interest on interest.

• Year 1: 5% of Rs.100.00 = Rs.5.00 + Rs.100.00 = Rs.105.00

• Year 2: 5% of Rs.105.00 = Rs.5.25 + Rs.105.00 = Rs.110.25

• Year 3: 5% of Rs.110.25 = Rs.5 .51+ Rs.110.25 = Rs.115.76

• Year 4: 5% of Rs.115.76 = Rs.5.79 + Rs.115.76 = Rs.121.55

• Year 5: 5% of Rs.121.55 = Rs.6.08 + Rs.121.55 = Rs.127.63

Nominal and Effective Interest Rate:

The nominal interest rate is the stated or contractual rate of interest charged by a lender or

promised by a borrower. The effective interest rate is the rate actually paid or earned. In general,

the effective rate > nominal rate whenever compounding occurs more than once per year.

Effective Annual Interest Rate = (1 + k/m) m

-1

For example, what is the effective rate of interest on your credit card if the nominal rate is

18% per year, compounded monthly?

Effective Annual Interest Rate = (1 + .18/12) 12

-1

Effective Annual Interest Rate = 19.56%

How to compute Present Value and Future Value?

Present value is the current dollar value of a future amount of money, and it is based on the

idea that a rupee today is worth more than a dollar tomorrow. Calculating present value is

also known as discounting. The discount rate is often also (crudely) referred to as the

opportunity cost, the discount rate, the required return, or the cost of capital.

There are multiple methods of computing present value such as using the equations, using the

financial tables and use of spreadsheets (Excel)

Single amount cash flow refers to an individual, stand alone, value occurring at one point in

time. An annuity consists of an unbroken series of cash flows of equal dollar amount occurring

over more than one period. A mixed stream is a pattern of cash flows over more than one time

period and the amount of cash associated with each period will vary.

Compounding of interest occurs when an amount is deposited into a savings account and the

interest paid after the specified time period remains in the account, thereby becoming part of the

26

principal for the following period. The general equation for future value in year n (FVn) can be

expressed using the specified notation as follows:

FVn = PV x (1+i)n

A decrease in the interest rate lowers the future amount of a deposit for a given holding period,

since the deposit earns less at the lower rate. An increase in the holding period for a given

interest rate would increase the future value. The increased holding period increases the future

value since the deposit earns interest over a longer period of time.

The present value, PV, of a future amount indicates how much money today would be equivalent

to the future amount if one could invest that amount at a specified rate of interest. Using the

given notation, the present value (PV) of a future amount (FVn) can be defined as follows:

n)i1(

1FVPV

An increasing required rate of return would reduce the present value of a future amount, since

future dollars would be worth less today. Looking at the formula for present value in question 5,

it should be clear that by increasing the i value, which is the required return, the present value

interest factor would decrease, thereby reducing the present value of the future sum.

Present value calculations are the exact inverse of compound interest calculations. Using

compound interest, one attempts to find the future value of a present amount; using present

value, one attempts to find the present value of an amount to be received in the future.

An ordinary annuity is one for which payments occur at the end of each period.

An annuity due is one for which payments occur at the beginning of each period.

The ordinary annuity is the more common. For otherwise identical annuities and interest rates,

the annuity due results in a higher future value because cash flows occur earlier and have more

time to compound.

The present value of an ordinary annuity, PVAn, can be determined using the formula:

PVAn = PMT x (PVIFAi%,n)

where:

PMT = the end of period cash inflows

PVIFA = the present value interest factor of an annuity for interest rate i and n

periods.

27

The PVIFA is related to the PVIF in that the annuity factor is the sum of the PVIFs over the

number of periods for the annuity. For example, the PVIFA for 5% and 3 periods is 2.723, and

the sum of the 5% PVIF for periods one through three is 2.723 (.952 + .907 + .864).

The FVIFA factors for an ordinary annuity can be converted for use in calculating an annuity due

by multiplying the FVIFAi%,n by 1 + i.

The PVIFA factors for an ordinary annuity can be converted for use in calculating an annuity due

by multiplying the PVIFAi%,n by 1 + i.

A perpetuity is an infinite-lived annuity. The factor for finding the present value of a perpetuity

can be found by dividing the discount rate into 1.0. The resulting quotient represents the factor

for finding the present value of an infinite-lived stream of equal annual cash flows.

The future value of a mixed stream of cash flows is calculated by multiplying each year's cash

flow by the appropriate future value interest factor. To find the present value of a mixed stream

of cash flows multiply each year's cash flow by the appropriate present value interest factor.

There will be at least as many calculations as the number of cash flows.

As interest is compounded more frequently than once a year, both (a) the future value for a given

holding period and (b) the effective annual rate of interest will increase. This is due to the fact

that the more frequently interest is compounded, the greater the future value. In situations of

intra-year compounding, the actual rate of interest is greater than the stated rate of interest.

Continuous compounding assumes interest will be compounded an infinite number of times per

year, at intervals of microseconds. Continuous compounding of a given deposit at a given rate of

interest results in the largest value when compared to any other compounding period.

The nominal annual rate is the contractual rate that is quoted to the borrower by the lender. The

effective annual rate, sometimes called the true rate, is the actual rate that is paid by the

borrower to the lender. The difference between the two rates is due to the compounding of

interest at a frequency greater than once per year.

APR is the Annual Percentage Rate and is required by ―truth in lending laws‖ to be disclosed to

consumers. This rate is calculated by multiplying the periodic rate by the number of periods in

one year. The periodic rate is the nominal rate over the shortest time period in which interest is

compounded. The APY, or Annual Percentage Yield, is the effective rate of interest that must be

disclosed to consumers by banks on their savings products as a result of the ―truth in savings

laws.‖ These laws result in both favorable and unfavorable information to consumers. The good

news is that rate quotes on both loans and savings are standardized among financial institutions.

The negative is that the APR, or lending rate, is a nominal rate, while the APY, or saving rate, is

an effective rate. These rates are the same when compounding occurs only once per year.

The size of the equal annual end-of-year deposits needed to accumulate a given amount over a

certain time period at a specified rate can be found by dividing the interest factor for the future

28

value of an annuity for the given interest rate and the number of years (FVIFAi%,n) into the

desired future amount. The resulting quotient would be the amount of the equal annual end-of-

year deposits required. The future value interest factor for an annuity is used in this calculation:

n%,

n

FVIFAi

FVPMT

Amortizing a loan into equal annual payments involves finding the future payments whose

present value at the loan interest rate just equals the amount of the initial principal borrowed.

The formula is:

n%,

n

PVIFAi

PVPMT

Either the present value interest factor or the future value interest factor can be used to find the

growth rate associated with a stream of cash flows.

The growth rate associated with a stream of cash flows may be found by using the following

equation, where the growth rate, g, is substituted for k.

)g1(

FVPV

n

To find the rate at which growth has occurred, the amount received in the earliest year is divided

by the amount received in the latest year. This quotient is the PVIFi%;n. The growth rate

associated with this factor may be found in the PVIF table. To find the interest rate associated

with an equal payment loan, the Present Value Interest Factors for a one rupee Annuity Table

would be used.

To determine the interest rate associated with an equal payment loan, the following equation may

be used:

PVn = PMT x (PVIFAi%,n)

Solving the equation for PVIFAi%,n we get:

PMT

PVPVIFA

nn%,i

Then substitute the values for PVn and PMT into the formula, using the PVIFA Table to find the

interest rate most closely associated with the resulting PVIFA, which is the interest rate on the

loan.

To find the number of periods it would take to compound a known present amount into a known

future amount you can solve either the present value or future value equation for the interest

factor as shown below using the present value:

29

PV = FV x (PVIFi%,n)

Solving the equation for PVIFi%,n we get:

FV

PVPVIF n%,i

Then substitute the values for PV and FV into the formula, using the PVIF Table for the known

interest rate find the number of periods most closely associated with the resulting PVIF.

The same approach would be used for finding the number of periods for an annuity except that

the annuity factor and the PVIFA (or FVIFA) table would be used. This process is shown below.

PVn = PMT x (PVIFAi%,n)

Solving the equation for PVIFAi%,n we get:

PMT

PVPVIFA

nn%,i

Let us move onto understand the important concepts of Risk and Return:

What is risk?

Risk, for most of us, refers to the likelihood that in life‘s games of chance, we will receive an

outcome that we will not like. For instance, the risk of driving a car too fast is getting a speeding

ticket, or worse still, getting into an accident. Webster‘s dictionary, in fact, defines risk as

―exposing to danger or hazard‖. Thus, risk is perceived almost entirely in negative terms. In

finance, our definition of risk is both different and broader. Risk, as we see it, refers to the

likelihood that we will receive a return on an investment that is different from the return we

expected to make. Thus, risk includes not only the bad outcomes, i.e., returns that are lower than

expected, but also good outcomes, i.e., returns that are higher than expected. In fact, we can refer

to the former as downside risk and the latter is upside risk; but we consider both when measuring

risk. In fact, the spirit of our definition of risk in finance is captured best by the Chinese symbols

for risk, which are reproduced below:

30

The first symbol is the symbol for ―danger‖, while the second is the symbol for ―opportunity‖,

making risk a mix of danger and opportunity. It illustrates very clearly the tradeoff that every

investor and business has to make – between the higher rewards that come with the opportunity

and the higher risk that has to be borne as a consequence of the danger. Much of this chapter can

be viewed as an attempt to come up with a model that best measures the ―danger‖ in any

investment and then attempts to convert this into the ―opportunity‖ that we would need to

compensate for the danger. In financial terms, we term the danger to be ―risk‖ and the

opportunity to be ―expected return‖.

What makes the measurement of risk and expected return so challenging is that it can vary

depending upon whose perspective we adopt. When analyzing Boeing‘s risk, for instance, we

can measure it from the viewpoint of Boeing‘s managers. Alternatively, we can argue that

Boeing‘s equity is owned by its stockholders and that it is their perspective on risk that should

matter. Boeing‘s stockholders, many of whom hold the stock as one investment in a larger

portfolio, might perceive the risk in Boeing very differently from Boeing‘s managers, who might

have the bulk of their capital, human and financial, invested in the firm.

We will argue that risk in an investment has to be perceived through the eyes of investors in the

firm. Since firms like Boeing often have thousands of investors, often with very different

perspectives, we will go further. We will assert that risk has to be measured from the perspective

of not just any investor in the stock, but of the marginal investor, defined to be the investor most

likely to be trading on the stock at any given point in time. The objective in corporate finance is

the maximization of firm value and stock price. If we want to stay true to this objective, we have

to consider the viewpoint of those who set the stock prices, and they are the marginal investors.

Equity Risk and Expected Return

To demonstrate how risk is viewed in corporate finance, we will present risk analysis in three

steps. First, we will define risk in terms of the distribution of actual returns around an expected

return. Second, we will differentiate between risk that is specific to one or a few investments and

risk that affects a much wider cross section of investments. We will argue that in a market where

the marginal investor is well diversified, it is only the latter risk, called market risk that will be

rewarded. Third, we will look at alternative models for measuring this market risk and the

expected returns that go with it.

Defining Risk

Investors who buy assets expect to earn returns over the time horizon that they hold the asset.

Their actual returns over this holding period may be very different from the expected returns and

it is this difference between actual and expected returns that is source of risk. For example,

assume that you are an investor with a 1-year time horizon buying a 1-year Treasury bill (or any

other default-free one-year bond) with a 5%expected return. At the end of the 1-year holding

period, the actual return on this investment will be 5%, which is equal to the expected return.

31

The Components of Risk

When an investor buys stock or takes an equity position in a firm, he or she is exposed to many

risks. Some risk may affect only one or a few firms and it is this risk that we categorize as firm-

specific risk. Within this category, we would consider a wide range of risks, starting with the risk

that a firm may have misjudged the demand for a product from its customers; we call this project

risk. For instance, if one analyse Boeing‘s investment in a Super Jumbo jet. This investment is

based on the assumption that airlines want a larger airplane and are will be willing to pay a

higher price for it. If Boeing has misjudged this demand, it will clearly have an impact on

Boeing‘s earnings and value, but it should not have a significant effect on other firms in the

market. The risk could also arise from competitors proving to be stronger or weaker than

anticipated; we call this competitive risk. For instance, assume that Boeing and Airbus are

competing for an order from Quantas, the Australian airline.

The possibility that Airbus may win the bid is a potential source of risk to Boeing and perhaps a

few of its suppliers. But again, only a handful of firms in the market will be affected by it.

Similarly, the Home Depot recently launched an online store to sell its home improvement

products. Whether it succeeds or not is clearly important to the Home Depot and its competitors,

but it is unlikely to have an impact on the rest of the market. In fact, we would extend our risk

measures to include risks that may affect an entire sector but are restricted to that sector; we call

this sector risk. For instance, a cut in the defense budget in the United States will adversely

affect all firms in the defense business, including Boeing, but there should be no significant

impact on other sectors, such as food and apparel. What is common across the three risks

described above project, competitive and sector risk – is that they affect only a small sub-set of

firms.

There is other risk that is much more pervasive and affects many if not all investments. For

instance, when interest rates increase, all investments are negatively affected, albeit to different

degrees. Similarly, when the economy weakens, all firms feel the effects, though cyclical firms

(such as automobiles, steel and housing) may feel it more. We term this risk market risk.

Finally, there are risks that fall in a gray area, depending upon how many assets they affect. For

instance, when the dollar strengthens against other currencies, it has a significant impact on the

earnings and values of firms with international operations. If most firms in the market have

significant international operations, it could well be categorized as market risk. If only a few do,

it would be closer to firm-specific risk.

How do we measure risk?

Different versions of risk are usually measured by calculating the standard deviation of

the historical returns or average returns of a specific investment. Generally, a high standard

32

deviation indicates a high degree of risk. This is the crude way of measuring risk, of course more

refined methods of risks are available in the literature.

Further Classifications of Risk:

a) Systematic Risk / Market Risk

b) Fundamental Risk / Non Systematic Risk / unique risk

Systematic risk or market risk are those risks that affect the overall stock market, which can‘t be

avoided (through diversification) such as interest rates, recession, rise inflation, wars and the

like. The sub-division of systematic risks is given below:

i) Purchasing Power Risk: It is the risk that the return on an investment will be

reduced in significant measures by inflation. Such risk is applicable to fixed income

investment, particularly short dated ones, such as money market and stable value

funds, the historically low yields of which are most vulnerable to inflation over time.

Intermediate and longer term bonds do not escape purchasing power risk, either.

ii) Risk: This is the risk that interest rate changes will affect securities' value. Rising

interest rates force down bond prices. Stock prices are negatively affected since

borrowing costs tend to rise and bonds become more attractive due to their higher

yields.

iii) Exchange Rate Risk: It is the risk of a change between the value of a dollar and the

value of a foreign currency in which the investment is made. Such risk exists in

international funds. As an example, a U.S. dollar based investor keeps score in dollars

and will receive less of a return on his or her investment, all else being equal, if the

dollar strengthens relative to the foreign currency. The foreign currency returns

translate into fewer dollars. By contrast, a weak dollar benefits the dollar based

investor.

iv) Reinvestment Risk: It is the risk that earnings from current investments will not be

able to be reinvested at a yield equal or superior to the yield on those current

investments. As an example, if an issuer calls a bond yielding 8% in a decreasing

interest rate environment, the bondholder is faced with having to reinvest at a lower

rate.

b) Fundamental Risk / Non-Systematic Risk:

Fundamental risks are by and large related or arising out of the business. Normally, by means

of diversification such risks could be avoided.

33

i) Business Risk: It is the risk that the business in which one invests experiences

downturns or even fails due to any number of factors. Examples would be the delay

of a product rollout, key employee turnover, etc.

ii) Liquidity and Marketability Risk: If an investment is liquid if it can be converted into

cash quickly with minimal effect upon its value. Liquid investments are typically

more desirable in consequence and more marketable. Less liquid or illiquid

investments may or may not be marketable and, as a result, are better suited for

investors with little or no need for near term liquidity. Investments in real estate (not

securitized), private equity funds, hedge funds, any private placement, thinly traded

stocks, all manner of distressed securities and private ventures are subject to such

risks. Suitability requirements often exist. (e.g. investor accreditation rules).

iii) Financial Risk: It refers to the effect that a firm's capital structure may have upon its

profitability. For example, large amounts of debt can act as a double edged sword,

both increasing a firm's return on its equity (ROE) and possibly reducing it as well.

Also termed event risk, financial risk can result from an event that impacts the credit

quality such as leveraged buyouts, mergers, acquisitions, share buybacks, de

capitalizations, recapitalizations and restructurings.

Concept of Risk Return Trade Off:

The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-

risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are

associated with high potential returns. According to the risk-return tradeoff, invested money can

render higher profits only if it is subject to the possibility of being lost. Because of the risk-

return tradeoff, one must be aware of that his personal risk tolerance when choosing

investments for his own portfolio. Taking on some risk is the price of achieving returns;

therefore, if one wants to make money, he / she can't cut out all risk. The goal instead is to find

an appropriate balance between the risk and return.

Beta and its relevance in Equity Research:

As discussed earlier, the concept of risk is hard to pin down and factor into stock analysis and

valuation. One of the most popular indicators of risk is a statistical measure called beta. Stock

analysts use this measure all the time to get a sense of stocks' risk profiles. While beta does say

something about price risk, it has its limits for investors looking for fundamental risk factors.

Beta (β) is a measure of a stock's volatility in relation to the market. By definition, the market has

a beta of 1.0, and individual stocks are ranked according to how much they deviate from the

market. A stock that swings more than the market over time has a beta above 1.0. If a stock

moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be

riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower

34

returns. Beta is a key component for the capital asset pricing model (CAPM), which is used to

calculate cost of equity. All things being equal, the higher a company's beta is, the higher its cost

of capital.

Where:

βa = Beta value of asset a

Cov (ra, rp) = Covariance between stock ‗a‘ return and the market return

Var (rp) = Variance of the market return

Interpretations of beta are explained in the following table:

Table No.1.2

Value

of Beta Interpretation Example

β < 0 Asset generally moves in the opposite

direction as compared to the index

Gold, which often moves opposite to the

movements of the stock market

β = 0 Movement of the asset is uncorrelated

with the movement of the benchmark

Fixed-yield asset, whose growth is unrelated to

the movement of the stock market

0 < β <

1

Movement of the asset is generally in

the same direction as, but less than the

movement of the benchmark

Stable, "staple" stock such as a company that

makes soap. Moves in the same direction as

the market at large, but less susceptible to day-

to-day fluctuation.

β = 1

Movement of the asset is generally in

the same direction as, and about the

same amount as the movement of the

benchmark

A representative stock, or a stock that is a

strong contributor to the index itself.

β > 1

Movement of the asset is generally in

the same direction as, but more than the

movement of the benchmark

Volatile stock, such as a tech stock, or stocks

which are very strongly influenced by day-to-

day market news.

35

Equity beta basically measures how volatile a given stock‘s price movement tends to be relative

to the overall market‘s movements. This considers company‘s capital structure i.e. if a company

has mode debt then it tends to be more volatile. Contrary to this we should know the other term

known as Asset Beta. This measure how volatile the underlying business is, irrespective of

capital structure. Here the beta is computed after stripping out the capital structure.

Asset beta = Equity Beta / (1+ (1-tax rate) * (debt / equity ratio))

Asset beta is important because we can compare companies and not have the comparison be

affected by their capital structure choices.

Concept of Intrinsic Value:

The actual value of a company or an asset is based on an underlying perception of its true value

including all aspects of the business, in terms of both tangible and intangible assets and other

factors. This value may or may not be the same as the current market value. Investors use a

variety of analytical techniques in order to estimate the intrinsic value of shares in hopes of

finding investments where the true value of the investment exceeds its current market value. For

example, investors will look at both qualitative (business model, governance, target market

factors etc.) and quantitative (ratios, financial statement analysis, etc.) aspects of a business in

order to arrive at the fair value than the value depicted in the stock market.

Introduction to Security Valuation:

Investors always want to select investments that will provide a rate of return that compensates

his / her for your time, the expected rate of inflation, and the risk involved. To help them to find

these investments, let us focus on the theory of valuation by which one can derive the value of an

investment using their required rate of return.

We consider the investment decision processes, which are the top-down, three-step approach.

Although it is recognized that this process can provide abnormal positive returns if the analyst is

superior, and this is a preferable approach where in one initially consider the aggregate economy

and market, then examine alternative global industries, and finally analyze individual firms and

their stocks.

36

Overview of the Investment Process:

Exhibit No.1.3

Source: Adopted from Reilly and Brown, 8

th Edition.

Economic Analysis:

A top-down analysis of a firm‘s prospects must start with the global economy. The international

economy might affect a firm‘s export prospects, the price competition it faces from foreign

competitors, or the profits it makes on investments abroad. Certainly, despite the fact that the

economies of most countries are linked in a global macro economy, there is considerable

variation in economic performance across countries at any time. Consider, for example, Table

12.1, which presents data on several major economies. The table documents striking variation in

growth rates of economic output. For example, while the Chinese economy grew by 10.4% in

2006 (see last column), output in Japan grew by only 1.6%. Similarly, there has been

considerable variation in stock market returns in these countries in recent years.

The macro economy is the environment in which all firms operate. The importance of the

macroeconomic determining investment performance could be understood well, if we the level

of the S&P 500 stock price index to estimates of earnings per share of the S&P500 companies.

The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock

price to earnings per share varies with factors such as interest rates, risk, inflation rates, and other

variables, the graph does illustrate that, as a general rule, the ratio has tended to be in the range

of 12 to 25. Given ―normal‖ price-to-earnings ratios, we would expect the S&P 500 Index to fall

within these boundaries. While the earnings-multiplier rule clearly is not perfect—note the

dramatic increase in the P/E multiple in the 1990s—it also seems clear that the level of the broad

market and aggregate earnings do trend together. Thus, the first step in forecasting the

performance of the broad market is to assess the status of the economy as a whole.

The ability to forecast the macro economy can translate into spectacular investment performance.

37

But it is not enough to forecast the macro economy well. One must forecast it better than one‘s

competitors to earn abnormal profits. In this section, we will review some of the key economic

terms used to describe the state of the macro economy.

Monetary and fiscal policy measures enacted by various agencies of national governments

influence the aggregate economies of the respective countries. The resulting economic conditions

influence all industries and companies within the economies. Fiscal policy initiatives, such as tax

credits or tax cuts, can encourage spending, whereas additional taxes on income, gasoline,

cigarettes, and liquor can discourage spending. Increases or decreases in government spending

on defense, on unemployment insurance or retraining programs, or on highways also influence

the general economy. All such policies influence the business environment for firms that rely

directly on such government expenditures. In addition, we know that government spending has a

strong multiplier effect. For example, increases in road building increase the demand for

earthmoving equipment and concrete materials. As a result, in addition to construction workers,

the employees in those industries that supply the equipment and materials have more to spend on

consumer goods, which raise the demand for consumer goods, which affects another set of

suppliers.

Monetary policy produces similar economic changes. A restrictive monetary policy that reduces

the growth rate of the money supply reduces the supply of funds for working capital and

expansion for all businesses. Alternatively, a restrictive monetary policy that targets interest rates

would raise market interest rates and therefore firms‘ costs and make it more expensive for

individuals to finance home mortgages and the purchase of other durable goods, such as autos

and appliances. Monetary policy therefore affects all segments of an economy and that

economy‘s relationship with other economies.

Any economic analysis requires the consideration of inflation. Inflation causes differences

between real and nominal interest rates and changes the spending and savings behavior of

consumers and corporations. In addition, unexpected changes in the rate of inflation make it

difficult for firms to plan, which inhibits growth and innovation. Beyond the impact on the

domestic economy, differential inflation and interest rates influence the trade balance between

countries and the exchange rate for currencies.

In addition to monetary and fiscal policy actions, such events as war, political upheavals in

foreign countries, or international monetary devaluations produce changes in the business

environment that add to the uncertainty of sales and earnings expectations and therefore the risk

premium required by investors. It is difficult to conceive of any industry or company that can

avoid the impact of macroeconomic developments that affect the total economy. Because

aggregate economic events have a profound effect on all industries and companies within these

industries, these macroeconomic factors should be considered before industries are analyzed.

38

Unemployment Rate:

The unemployment rate is the percentage of the total labor force (i.e., those who are either

working or actively seeking employment) yet to find work. The unemployment rate measures the

extent to which the economy is operating at full capacity. The unemployment rate is a statistic

related to workers only, but further insight into the strength of the economy can be gleaned from

the employment rate of other factors of production. Analysts also look at the factory capacity

utilization rate, which is the ratio of actual output from factories to potential output.

Inflation:

Inflation is the rate at which the general level of prices is rising. High rates of inflation often are

associated with ―overheated‖ economies, that is, economies where the demand for godsend

services is outstripping productive capacity, which leads to upward pressure on prices. Most

governments walk a fine line in their economic policies. They hope to stimulate their economies

enough to maintain nearly full employment, but not so much as to bring on inflationary

pressures. The perceived trade-off between inflation and unemployment is at the heart of many

macroeconomic policy disputes. There is considerable room for disagreement as tithe relative

costs of these policies as well as the economy‘s relative vulnerability to these pressure sat any

particular time.

Interest Rates:

High interest rates reduce the present value of future cash flows, thereby reducing the

attractiveness of investment opportunities. For this reason, real interest rates are key

determinants of business investment expenditures. Demand for housing and high-priced

consumer durables such as automobiles, which are commonly financed, also is highly sensitive

to interest rates because interest rates affect interest payments. In Section 12.3 we will examine

the determinants of real interest rates.

Sentiment:

Consumers‘ and producers‘ optimism or pessimism concerning the economy is important

determinants of economic performance. If consumers have confidence in their future income

levels, for example, they will be more willing to spend on big-ticket items. Similarly, businesses

will increase production and inventory levels if they anticipate higher demand frothier products.

In this way, beliefs influence how much consumption and investment will be pursued and affect

the aggregate demand for goods and services.

Fluctuations in security markets are related to changes in the aggregate economy. The price of

most bonds is determined by the level of interest rates, which are influenced by overall economic

39

Activity and Reserve Bank of India‘s policy. Individual stock prices reflect investor expectations

about an issuing firm‘s performance in terms of earnings, cash flow, and the investor‘s required

rate of return. This performance is likewise affected by the overall performance of the economy.

In its monitoring of business cycles, the National Council of Applied Economic Research

(NCAER) has examined the relationship of alternative economic series to the behavior of the

entire economy and has classified numerous economic series into three groups: leading,

coincident, and lagging indicator series. Further, extensive analysis of the relationship between

the economy and the stock market has shown that stock prices are one of the better leading

indicator series.

There are two possible reasons why stock prices lead the economy. One is that stock prices

Reflect expectations of earnings, dividends, and interest rates. As investors attempt to estimate

these future variables, their stock price decisions reflect expectations for future economic

activity, not current activity. A second possible reason is that the stock market reacts to various

leading indicator series, the most important being corporate earnings, corporate profit margins,

interstates, and changes in the growth rate of the money supply. Because these series tend to lead

the economy, when investors adjust stock prices to reflect expectations for these leading

economic series, it makes stock prices a leading series as well.

Because stock prices lead the aggregate economy, our macroeconomic approach to market

analysis concentrates on economic series that lead the economy by more than stock prices do.

First, let us discuss cyclical indicators includes:

a) Leading indicators

b) Coincident indicators

c) Lagging indicators

Leading indicators – economic series that usually reach peaks or troughs before corresponding

peaks or troughs in aggregate economy activity

Coincident indicators – economic series that have peaks and troughs that roughly coincide with

the peaks and troughs in the business cycle

Lagging indicators – economic series that experience their peaks and troughs after those of the

aggregate economy

Selected series – economic series that do not fall into one of the three main groups

Apart from the above, another popular index is known as “Diffusion Indexes”.

It indicates how pervasive a given movement in a series. Diffusion index values are measured by

computing the % of reporting units in a series that indicate a given result. For example, if 100

40

co‘s constitute the sample reporting new orders for equipment, the diffusion index for this series

would indicate what proportion of 100 co‘s was reporting higher orders during an expansion. In

addition knowing that aggregate new orders are increasing, it is helpful to know whether 55% or

95% of the companies in the sample are reporting higher orders. This information on the

pervasiveness of the increase in new orders would help you to project the future length and

strength of an expansion.

Other Economic Variables and stock prices:

The following variables to be significant in stock returns:

Growth in industrial production

Changes in the risk premium

Twists in the yield curve

Measures of unanticipated inflation

Changes in expected inflation during periods of volatile inflation

Inflation, Interest Rates, and Stock Prices:

The relationship between inflation, interest rates, and stock prices is not direct and consistent.

The reason is that the cash flows from stocks can change along with inflation and interest rates,

and we cannot be certain whether this change in cash flows will augment or offset the change in

interest rates.

The Positive Scenario:

Interest rates rise due to an increase in the rate of inflation, and corporate earnings likewise

experience an increase in growth because firms are able to increase prices in line with cost

increases. In this case, stock prices might be fairly stable because the negative effect of an

increase in the required rate of return is partially or wholly offset by the increase in the growth

rate of earnings and dividends, which means that the returns on stock increase in line with the

rate of inflation.

Mild Negative Scenario:

Interest rates increase due to inflation, but expected cash flows change very little or not at all

because firms are not able to increase prices in response to higher costs. This would cause a

decline in stock prices similar to what happens with a bond. The required rate of return would

increase, but the growth rate of dividends would be constant. As a result, the spread discussed in

would widen and stock prices would decline.

Very Negative Scenario:

Interest rates increase due to inflation, while cash flows decline because the inflation that caused

the rise in interest rates has a negative impact on earnings. For example, during 1981 to 1982,

interest rates increased and remained high during a period of economic decline, which caused

sales and earnings to decline. Alternatively, one can envision a period of inflation wherein the

41

costs of production increase, but many firms are not able to increase prices, which causes a

decline in profit margins. The impact of this set of events can be disastrous. Given this scenario,

stock prices will experience a significant decline because cost will increase as growth declines,

causing a large increase in the spread.

In contrast to these scenarios, one can envision a comparable set of scenarios when inflation and

interest rates decline. The relationship between inflation, interest rates, and stock prices is not as

direct or consistent as the relationship between interest rates and bonds. There is ample evidence

of a strong and consistent relationship between economic activity and the stock market, although

stock prices consistently seem to turn from four to nine months before the economy does.

Therefore, to project the future direction of the stock market using the macroeconomic approach,

one must either forecast economic activity about twelve months ahead or examine economic

indicator series that lead the economy by more than stock prices do. Recent studies of the

relationship between the money supply and stock prices have indicated a significant relationship

but typically found that stock prices generally turn before the money supply does.

*****

End of the chapter Questions:

1. Discuss the overall purpose people have for investing. Define investment.

2. As a student, are you saving or borrowing? Why?

3. Divide a person‘s life from ages 20 to 70 into 10-year segments and discuss the

likely saving or borrowing patterns during each period.

4. Discuss why you would expect the saving-borrowing pattern to differ by

occupation (for example, for a doctor versus a plumber).

5. Suppose you discover a treasure chest of Rs.10 billion in cash while digging the

agriculture land

a. Is this a real or financial asset?

b. Is society any richer for the discovery?

c. Are you wealthier?

d. Can you reconcile your answers to ( b) and ( c )? Is anyone worse off

as a result of the discovery?

6. Financial engineering has been disparaged as nothing more than paper shuffling.

Critics argue that resources used for rearranging wealth (that is, bundling and

unbundling financial assets) might be better spent on creating wealth (that is,

creating real assets). Evaluate this criticism.

42

7. Are any benefits realized by creating an array of derivative securities from various

primary securities?

8. Discuss the advantages and disadvantages of the following forms of managerial

compensation in terms of mitigating agency problems, that is, potential conflicts

of interest between managers and shareholders.

a. A fixed salary.

b. Stock in the firm.

c. Call options on shares of the firm.

9. We noted that oversight by large institutional investors or creditors is one

mechanism to reduce agency problems. Why don‘t individual investors in the firm

have the same incentive to keep an eye on management?

43

CHAPTER II

INDUSTRY AND

COMPANY ANALYSIS

44

Industry analysis is the second step as we progress toward selecting specific firms and stocks for

our investment portfolio. As the first step, in Chapter 1, we discussed the microanalysis of the

stock market to decide whether the expected rate of return from investing in common stocks was

equal to or greater than our required rate of return.

What is an Industry?

• An industry is a group of companies which produce similar goods and/or services.

• Until recently (and often still), industries were classified by Standardized Industrial

Classification (SIC) codes, but this was replaced by the North American Industry

Classification System (NAICS, http://www.census.gov/epcd/www/naics.html) which is

much more detailed than SIC.

• SIC codes were 4-digit, while the NAICS uses 6 digits for a much finer, and more useful,

breakdown of industries.

• NAICS will also facilitate comparisons of companies in the US, Canada, and Mexico (it

was developed by all three countries for this purpose).

• Classification by compustat (www. compustat.com)

• Another popular Classification by CMIE(www.cmie.com)

Rationale for Industry Analysis:

Equity research analysts perform industry analysis because they believe it helps them isolate

investment opportunities that have favorable return-risk characteristics. Infact, it is a part of

three-step, top-down plan for valuing individual companies and selecting stocks for inclusion in

our portfolio. Based up on the large number of empirical evidences it was found that Industry

analysis is important and necessary to uncover these substantial performance differences that will

help identify both unprofitable and profitable opportunities.

Industry Performance over Time:

Whether individual industries that perform well in one time period would continue to perform

well in subsequent time periods or at least outperform the aggregate market in the later time

period. It was found that almost no association in individual industry performance year to year or

over sequential rising or falling markets. These time-series studies imply that past performance

alone does not help project future industry performance. The results do not, however, negate the

usefulness of industry analysis. They simply confirm that variables that affect industry

performance change over time and each year it is necessary to project the future performance for

individual industries on the basis of future estimates of these relevant variables.

Performance of the Companies within an Industry:

Various research studies were designed to determine whether there is consistency in the

performance of companies within an industry. If all the firms within an industry performed

consistently during a specified time period, investors would not need company analysis. In such

45

a case, industry analysis alone would be enough because once you selected a profitable industry;

you would know that all the stocks in that industry would do well. It was found wide dispersion

in the performance among companies in most industries. There is enough evidence of an industry

effect in specific industries, such as oil or autos, but most stocks showed a small industry effect

that has been declining over a period of time.

What is the implication of dispersion within Industries?

There are some observers who have contended that industry analysis is useless because all firms

in an industry do not move together. Obviously, consistent firm performance in an industry

would be ideal because you would not need to do company analysis. For industries that have a

strong, consistent industry influence, such as oil, gold, steel, autos, and railroads, one can reduce

the extent of company analysis after the industry analysis. Most analysts do not expect such a

strong industry influence, which means that a thorough company analysis is still necessary. Even

for industries that do not have a strong industry influence, industry analysis is valuable because it

is much easier to select a superior company from a good industry than to find a good company in

a poor industry. By selecting the best stocks within a strong industry, you avoid the risk that your

analysis and selection of a good company will be offset by poor industry performance.

Differences in Industry Risk:

(1) Does risk differ among industries during a given time period?

(2) Are industry risk measures stable over time?

It was found that the dispersion of risk found a wide range of risk among different industries at a

point in time, and the differences in industry risk typically widened during rising and falling

markets. The results on the analysis of risk stability were positive—analysis of the risk measures

for individual industries over time indicated that they were reasonably stable over time. These

findings indicate that although risk measures for different industries showed substantial

dispersion during a period of time, individual industries‘ risk measures are stable over time.

This means that the analysis of industry risk is necessary, but this analysis of risk is useful when

one attempt to estimate the future risk for an industry.

Following are the major take away from the various research works that are dealing with

industry analysis are:

During any time period, the returns for different industries vary within a wide range,

which means that industry analysis is an important part of the investment process.

The rates of return for individual industries vary over time, so we cannot simply

extrapolate past industry performance into the future.

The rates of return of firms within industries also vary, so analysis of individual

companies in an industry is a necessary follow-up to industry analysis.

During any time period, different industries‘ risk levels vary within wide ranges, so we

must examine and estimate the risk factors for alternative industries.

Risk measures for different industries remain fairly constant over time, so the historical

risk analysis is useful when estimating future risk.

46

Steps in Industry Analysis:

How one should you structure your industry analysis? In our previous analysis of the economy

and the aggregate equity market for the country, we contended that it is necessary to examine the

macro economy for two related reasons.

First, although the security markets tend to move ahead of the aggregate economy, it is

recognized that the markets are driven by what happens in the economy—that is, security

markets reflect the strength or weakness of the economy.

Second, most of the variables that drive the valuation models for the security markets are macro

variables such as interest rates, GDP, and corporate earnings.

The point is, the industry analysis process is similar—it contains first a macro analysis of the

industry in order to derive a very clear understanding of how this industry relates to the business

cycle and what economic variables ―drive‖ this industry in terms of success or failure. This part

of the process will make the second component easier and better. The second component is a

microanalysis of the industry that involves deriving a specific valuation for the industry using the

several valuation techniques introduced earlier. As noted, if we have done our macro analysis

so that we thoroughly understand the industry, estimating the valuation inputs of a discount rate

and expected growth for earnings and cash flows (both the rate and the duration of growth)

should be relatively easy.

Frame-Work for Industry Analysis:

1. The business cycle and industry sectors

2. Structural economic changes and alternative industries

3. Evaluating an industry‘s life cycle

4. Analysis of the competitive environment in an industry

THE BUSINESS CYCLE AND INDUSTRY SECTORS

Economic trends can and do affect industry performance. By identifying and monitoring key

assumptions and variables, we can monitor the economy and gauge the implications of new

information on our economic outlook and industry analysis. Recall that in order to ―beat the

market ―on a risk-adjusted basis, we must have forecasts that differ from the market consensus

and we must be correct more often than not.

Economic trends can take two basic forms:

Cyclical changes that arise from the ups and downs of the business cycle; and

Structural changes that occur when the economy is undergoing major change in how it

functions.

For example, excess labor or capital may exist in some sectors whereas shortages of labor and

capital exist elsewhere. The ―downsizing‖ of corporate America during the 1990s, transitions

from socialist to market economies in Eastern Europe, and the transition in the United States

from a manufacturing to a service economy are all examples of structural change. Industry

analysts must examine structural economic changes for the implications they hold for the

47

industry under review. It is believed that industry performance is related to the stage of the

business cycle. What makes industry analysis challenging is that every business cycle is different

and those who look only at history miss the evolving trends that will determine future market

performance. Switching from one industry group to another over the course of a business cycle is

known as a rotation strategy. When trying to determine which industry groups will benefit from

the next stage of the business cycle, investors need to identify and monitor key variables related

to economic trends and industry characteristics.

Exhibit No.2.1

The above exhibit presents a stylized graphic of which industry groups typically perform well in

the different stages of the business cycle. Toward the end of a recession, financial stocks rise in

value because investors anticipate that banks‘ earnings will rise as both the economy and loan

demand recover. Brokerage houses become attractive investments because their sales and

earnings are expected to rise as investors trade securities, businesses sell debt and equity, and

there is an increase in mergers during the economic recovery. These industry selections assume

that when the recession ends there will be an increase in loan demand, housing construction, and

security offerings.

Once the economy begins its recovery, consumer durable firms that produce expensive consumer

items, such as cars, personal computers, refrigerators, lawn tractors, and snow blowers become

attractive investments because a reviving economy will increase consumer confidence and

personal income. Once businesses recognize the economy is recovering, they begin to think

about modernizing, renovating, or purchasing new equipment to satisfy rising demand and

reduce costs. Thus, capital goods industries such as heavy equipment manufacturers, machine

tool makers, and airplane manufacturers become attractive. Cyclical industries whose sales rise

and fall along with general economic activity are attractive investments during the early stages of

an economic recovery because of their high degree of operating leverage, which means that they

48

benefit greatly from the sales increases during an economic expansion. Industries with high

financial leverage likewise benefit from rising sales volume.

Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to

outstrip supply. Basic materials industries such as oil, metals, and timber, which transform raw

Materials into finished products, become investor favorites. Because inflation has little influence

on the cost of extracting these products and they can increase prices, these industries experience

higher profit margins.

During a recession, some industries do better than others. Consumer staples, such as

pharmaceuticals, food, and beverages, outperform other sectors during a recession because,

although overall spending may decline, people still spend money on necessities so these

―defensive ―industries generally maintain their values. Similarly, if a weak domestic economy

causes a weak currency, industries with large export components to growing economies may

benefit because their goods become more cost competitive in overseas markets.

We have identified certain industries that typically make attractive investments over the course

of the business cycle. Generally, investors should not invest based upon the current economic

environment because the efficient market has already incorporated current economic news into

security prices. Rather, it is necessary to forecast important economic variables at least thereto

six months in the future and invest accordingly.

As discussed in the earlier chapter, higher inflation is generally negative for the stock market,

because it causes higher market interest rates, it increases uncertainty about future prices and

costs, and it harms firms that cannot pass their cost increases on to consumers. Although these

adverse effects are true for most industries, some industries benefit from inflation. Natural

resource industries benefit if their production costs do not rise with inflation, because their

output will likely sell at higher prices. Industries that have high operating leverage may benefit

because many of their costs are fixed in nominal terms whereas revenues increase with inflation.

Industries with high financial leverage may also gain because their debts are repaid in cheaper

rupees. Banks generally benefit from volatile interest rates, because stable interest rates lead to

heavy competitive pressures that squeeze their interest margins. High interest rates clearly harm

the housing and the construction industry, but they might benefit industries that supply the loans.

High interest rates also benefit retirees whose income is dependent on interest income.

Therefore, the performance of consumer cyclical industries will be affected by changes in

consumer sentiment and by consumers‘ willingness and ability to borrow and spend money.

Lifestyle:

Lifestyles deal with how people live, work, form households, consume, enjoy leisure, and

educate themselves. Consumer behavior is affected by trends and fads. The rise and fall of jeans,

―designer‖ jeans, chinos, and other styles in clothes illustrate the sensitivity of some markets to

changes in consumer tastes. The increase in divorce rates, dual-career families, population shifts

49

away from cities, and computer-based education and entertainment have influenced numerous

industries, including housing, automobiles, convenience and catalog shopping, services, and

home entertainment.

Demographics:

Influences other than the economy are part of the business environment. Demographics, changes

In technology, and political and regulatory environments will affect the cash flow and risk

prospects of different industries. Demographics also include the geographical distribution of

people, the changing ethnic mix in a society, and changes in income distribution. Wall Street

industry analysts carefully study demographic trends and attempt to project their effect on

different industries and firms. The changing age and education profile of Indians has

implications for resource availability; namely, availability of labour force of entry-level workers

leading to an increase in productivity and more employment especially in software industries this

is good for the financial services industry, which offers assistance to those who want to invest

their savings.

Technologies:

Trends in technology can affect numerous industry factors including the product or service and

how it is produced and delivered. There are literally dozens of examples of changes that have

taken or are taking place due to technological innovations. For example, demand has fallen for

carburetors on cars because of electronic fuel-injection technology. The engineering process has

changed because of the advent of computer-aided design and computer-aided manufacturing.

Perpetual improvement of designs in the semiconductor and microprocessor industry has made

that industry a difficult one to evaluate. Innovations in process technology allowed steel mint

mills to grow at the expense of large steel producers. Advances in technology allow some plant

sites and buildings to generate their own electricity, bypassing their need for power from the

local electric utility. Trucks have reduced railroads‘ market share in the long-distance carrier

industry, and planes, not trains, now mainly carry people long distances. The ―information

superhighway‖ is becoming a reality and may lead to linkages between telecommunications and

cable television systems.

Changes in technology have spurred capital spending in technological equipment as firms try to

use microprocessors and software as a means to gain competitive advantages. The future effect

of the Internet is astronomical. The retailing industry is a user of new technology. Some

forecasters envision ―relationship merchandising,‖ in which customer databases will allow closer

links between retail stores and customer needs. Rather than doing market research to focus on

aggregate consumer trends, specialized retailers can offer products that particular consumer

segments desire in the locations that consumers prefer. Technology may allow retailers to

become more organizationally decentralized and geographically diversified.

Major retailers use bar-code scanning, which speeds the checkout process and allows the firm to

track inventory. Use of customer credit cards allows firms to track customer purchases and send

50

custom-made sales announcements. Electronic data interchange (EDI) allows the retailer to

electronically communicate with suppliers to order new inventory and pay accounts payable.

Electronic funds transfer allows retailers to move funds quickly and easily between local banks

and headquarters.

Politics and Regulations:

As political change reflects social values, today‘s social trend may be tomorrow‘s law,

regulation, or tax. The industry analyst needs to project and assess political changes relevant to

the industry under study. Some regulations and laws are based on economic reasoning. Due to

utilities‘ positions as natural monopolies, their rates must be reviewed and approved by a

regulatory body. Some regulation involves social ends. For example, the Food and Drug

Administration protects consumers by reviewing new drugs. Public and worker safety concerns

spurred creation of the Consumer Protection awareness which lead to Consumer Protection Act,

1986, and the various Environmental Protection Acts and the like. Notably, heavy regulation of

an industry can result in increasing a firm‘s costs and restricting entry into the industry.

Understanding Industry Life Cycle:

An insightful analysis when predicting industry sales and trends in profitability is to view the

industry over time and divide its development into stages similar to those that human‘s progress

through as they move from birth to adolescence to adulthood to middle age to old age. The

number of stages in this industry life cycle analysis can vary based on how much detail one want.

Exhibit No.2.2

Source: Adopted from Reilly and Brown, 8th

Edition.

51

A five-stage model would include:

1. Pioneering development

2. Rapid accelerating growth

3. Mature growth

4. Stabilization and market maturity

5. Deceleration of growth and decline

ExhibitNo.2.2shows the growth path of sales during each stage. The vertical scale in logs reflects

rates of growth, whereas the arithmetic horizontal scale has different widths representing

different, unequal time periods. To estimate industry sales, you must predict the length of time

for each stage. This requires answers to such questions as: How long will an industry grow at an

accelerating rate (Stage 2)? How long will it be in a mature growth phase (Stage 3) before its

sales growth stabilizes (Stage 4) and then declines (Stage 5)?

Besides being useful when estimating sales, this analysis of an industry‘s life cycle also can

provide some insights into profit margins and earnings growth, although these profit measures do

not necessarily parallel the sales growth. The profit margin series typically peaks very early in

the total cycle and then levels off and declines as competition is attracted by the early success of

the industry. To illustrate the contribution of life cycle stages to sales estimates, let us see these

stages and their effects on sales growth and profits:

Examine the biotechnology industry and you will find many firms with high rates of investment,

high rates of return on investment, and very low dividends as a percentage of profits. Do the

same for the electric utility industry and you will find lower rates of return, lower investment

rates, and higher dividend payout rates.

Why should this be?

The biotech industry is still new. Recently available technologies have created opportunitiesfor

the highly profitable investment of resources. New products are protected by patents, and profit

margins are high. With such lucrative investment opportunities, firms find it advantageousto put

all profits back into the firm. The companies grow rapidly on average.Eventually, however,

growth must slow. The high profit rates will induce new firms to enter the industry. Increasing

competition will hold down prices and profit margins. New technologies become proven and

more predictable, risk levels fall, and entry becomes even easier. As internal investment

opportunities become less attractive, a lower fraction of profits is reinvested in the firm. Cash

dividends increase.

FIGURE 12.11

Ultimately, in a mature industry, we observe ―cash cows,‖ firms with stable dividends and cash

flows and little risk. Their growth rates might be similar to that of the overall economy.

Industries in early stages of their life cycles offer high-risk/high-potential-return investments.

Mature industries offer lower risk, lower return combinations. This analysis suggests that a

typical industry life cycle might be described by four stages: a start-up stage characterized by

extremely rapid growth; a consolidation stage characterized by growth that is less rapid but still

52

faster than that of the general economy; a maturity stage characterized by growth no faster than

the general economy; and a stage of relative decline, in which the industry grows less rapidly

than the rest of the economy, or actually shrinks. This industry life cycle is illustrated in Exhibit

No.2.2. Let us turn to an elaboration of each of these stages.

Pioneering development:

The early stages of an industry are often characterized by a new technology or product, such as

VCRs or personal computers in the 1980s, cell phones in the 1990s, or flat-screen televisions

today. At this stage, it is difficult to predict which firms will emerge as industry leaders. Some

firms will turn out to be wildly successful, and others will fail altogether. Therefore, there is

considerable risk in selecting one particular firm within the industry.

For example, in the flat-screen television industry, there is still a battle among competing

technologies, such as LCD versus plasma screens, and it is still difficult to predict which firms

or technologies ultimately will dominate the market. At the industry level, however, sales and

earnings will grow at an extremely rapid rate since the new product has not yet saturated its

market.

For example, in 1990 very few households had cell phones. The potential market for the product

therefore was huge. In contrast to this situation, consider the market for a mature product like

refrigerators. Almost all households in India already have refrigerators, so the market for this

good is primarily composed of households replacing old refrigerators. Obviously, the growth rate

in this market in the next decade will be far lower than for flat-screen TVs.

Rapid accelerating growth:

After a product becomes established, industry leaders begin to emerge. The survivors from the

start-up stage are more stable, and market share is easier to predict. Therefore, the performance

of the surviving firms will more closely track the performance of the overall industry. The

industry still grows faster than the rest of the economy as the product penetrates the marketplace

and becomes more commonly used.

Mature growth:

At this point, the product has reached its potential for use by consumers. Further growth might

merely track growth in the general economy. The product has become far more standardized, and

producers are forced to compete to a greater extent on the basis of price. This leads to narrower

profit margins and further pressure on profits. Firms at this stage sometimes are characterized as

“cash cows,” firms with reasonably stable cash flow but offering little opportunity for profitable

expansion. The cash flow is best “milked from” rather than reinvested in the company.

We pointed to VCRs as a start-up industry in the 1980s. By the mid-1990s it was a mature

industry, with high market penetration, considerable price competition, low profit margins, and

53

slowing sales. By the late 1990s, VCR sales were giving way to DVD players, which were in

their own start-up phase. By today, one would have to judge DVDs as already having entered a

maturity stage, with standardization, price competition, and considerable market penetration.

Deceleration of growth and decline:

In this stage, the industry might grow at less than the rate of the overall economy, or it might

even shrink. This could be due to obsolescence of the product, competition from new products,

or competition from new low-cost suppliers, as illustrated by the steady displacement of VCRs

by DVDs.

At which stage in the life cycle are investments in an industry most attractive? Conventional

wisdom is that investors should seek firms in high-growth industries. This recipe for success is

simplistic, however. If the security prices already reflect the likelihood for high growth, then it is

too late to make money from that knowledge. Moreover, high growth and fat profits encourage

competition from other producers. The exploitation of profit opportunities brings about new

sources of supply that eventually reduce prices, profits, investment returns, and finally, growth.

This is the dynamic behind the progression from one stage of the industry life cycle to another.

The famous portfolio manager Peter Lynch makes this point in One Upon Wall Street. He says:

Many people prefer to invest in a high-growth industry, where there‘s a lot of sound and fury.

Not me. I prefer to invest in a low-growth industry. . . . In a low-growth industry, especially one

that‘s boring and upsets people [such as funeral homes or the oil-drum retrieval business], there‘s

no problem with competition. You don‘t have to protect your flanks from potential rivals . . . and

this gives [the individual firm] the leeway to continue to grow.

In fact, Lynch uses an industry classification system in a very similar spirit to the lifecycle

approach we have described. He places firms in the following six groups:

1. Slow Growers:

Large and aging companies that will grow only slightly faster than the broad economy. These

firms have matured from their earlier fast-growth phase. They usually have steady cash flow and

pay a generous dividend, indicating that the firm is generating more cash than can be profitably

reinvested in the firm.

2. Stalwarts:

Large, well-known firms like Coca-Cola or Colgate-Palmolive. They grow faster than the slow

growers but are not in the very rapid growth start-up stage. They also tend to be in noncyclical

industries that are relatively unaffected by recessions.

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3. Fast Growers:

Small and aggressive new firms with annual growth rates in the neighborhood of 20 to 25%.

Company growth can be due to broad industry growth or to an increase in market share in a more

mature industry.

4. Cyclicals:

These are firms with sales and profits that regularly expand and contract along with the business

cycle. Examples are auto companies, steel companies, or the construction industry.

5. Turnarounds:

These are firms that are in bankruptcy or soon might be. If they can recover from what might

appear to be imminent disaster, they can offer tremendous investment returns. A good example

of this type of firm would be Chrysler in 1982, when it required a government guarantee on its

debt to avoid bankruptcy. The stock price rose fifteen-fold in the next five years.

6. Asset Plays:

These are firms that have valuable assets not currently reflected in the stock price. For example,

a company may own or be located on valuable real estate that is worth as much or more than the

company‘s business enterprises. Sometimes the hidden asset can be tax-loss carry forwards.

Other times the assets may be intangible. For example, a cable company might have a valuable

list of cable subscribers. These assets do not immediately generate cash flow and so may be more

easily overlooked by other analysts attempting to value the firm.

Porter’s Five Forces:

Let us understand Porter‘s concept of competitive strategy is described as the search by a firm

for a favorable competitive position in an industry. To create a profitable competitive strategy, a

firm must first examine the basic competitive structure of its industry because the potential

profitability of affirm is heavily influenced by the profitability of its industry. After determining

the competitive structure of the industry, you examine the factors that determine the relative

competitive position of a firm within its industry. In this section, we consider the competitive

forces that determine the competitive structure of the industry. In the next chapter, our discussion

of company analysis will cover the factors that determine the relative competitive position of a

firm within its industry.

Porter believes that the competitive environment of an industry (the intensity of competition

among the firms in that industry) determines the ability of the firms to sustain above-average

rates of return on invested capital. As shown in Exhibit No.2.3, he suggests that five competitive

forces determine the intensity of competition and that the relative effect of each of these five

factors can vary dramatically among industries.

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Exhibit No.2.3

1. Rivalry among the existing competitors.

For each industry analyzed, you must judge if the rivalry among firms is currently intense and

growing, or if it is polite and stable. Rivalry increases when many firms of relatively equal size

compete in an industry. When estimating the number and size of firms, be sure to include foreign

competitors. Further, slow growth causes competitors to fight for market share and increases

competition. High fixed costs stimulate the desire to sell at the full capacity, which can lead to

price cutting and greater competition. Finally, look for exit barriers, such as specialized facilities

or labor agreements. These can keep firms in the industry despite below-average or negative

rates of return.

2. Threat of new entrants.

Although an industry may have few competitors, you must determine the likelihood of firms

entering the industry and increasing competition. High barriers to entry, such as low current

prices relative to costs, keep the threat of new entrant slow. Other barriers to entry include the

need to invest large financial resources to compete and the availability of capital. Also,

substantial economies of scale give a current industry member an advantage over a new firm.

Further, entrants might be discouraged if success in the industry requires extensive distribution

channels that are hard to build because of exclusive distribution contracts. Similarly, high costs

of switching products or brands, such as those required to change a computer or telephone

system, keep competition low. Finally, government policy can restrict entry by imposing

licensing requirements or limiting access to materials (lumber, coal). Without some of these

barriers, it might be very easy for competitors to enter an industry, increasing the competition

and driving down potential rates of return.

3. Threat of substitute products:

Substitute products limit the profit potential of an industry because they limit the prices firms in

an industry can charge. Although almost everything has a substitute, you must determine how

close the substitute is in price and function tithe product in your industry. As an example, the

56

threat of substitute glass containers hurts the metal container industry. Glass containers kept

declining in price, forcing metal container prices and profits down. In the food industry,

consumers constantly substitute between beef, pork, chicken, and fish. The more commodity like

the product, the greater the competition and the lower the profit margins.

4. Bargaining power of buyers:

Buyers can influence the profitability of an industry because they can bid down prices or demand

higher quality or more services by bargaining among competitors. Buyers become powerful

when they purchase a large volume relative to the sales of a supplier (e.g., Wal-Mart, Home

Depot). The most vulnerable firm is a one customer firm that supplies a single large

manufacturer, as is common for auto parts manufacturers or software developers. Buyers will be

more conscious of the costs of items that represent a significant percentage of the firm‘s total

costs. This consciousness increases if the buying firm is feeling cost pressure from its customers.

Also, buyers who know a lot about the costs of supplying an industry will bargain more

intensely—for example, when the buying firm supplies some of its own needs and buys from the

outside.

5. Bargaining power of suppliers:

Suppliers can alter future industry returns if they increase prices or reduce the quality of the

product or the services they provide. The suppliers are more powerful if they are few and if they

are more concentrated than the industry to which they sell and if they supply critical inputs to

several industries for which few, if any, substitutes exist. In this instance, the suppliers are free to

change prices and services they supply to the firms in an industry. When analyzing supplier

bargaining power, be sure to consider labor‘s power within each industry. An investor needs to

analyze these competitive forces to determine the intensity of the competition in an industry and

assess the effect of this competition on the industry‘s long-run profit potential. One should

examine each of these factors and develop a relative competitive profile for each industry. You

need to update this analysis of an industry‘s competitive environment overtime, because an

industry‘s competitive structure can and will change over time.

Company Analysis:

At this point, you have made two decisions about your investment in equity markets. First, after

analyzing the economy you have decided what percent of your portfolio should be invested in

common stocks. Second, after analyzing various industries, you have identified those that appear

to offer above-average risk-adjusted performance over your investment horizon. The final

questions in the fundamental analysis procedure are:

(1) Which are the best companies within these desirable industries? and

(2) Are their stocks underpriced?

In order to answer the question number one, we need to understand the concept of SWOT

analysis and related aspects.

57

SWOT ANALYSIS:

This is the most renowned tool for audit and analysis of the overall strategic position of the

business and its environment. Its key purpose is to identify the strategies that will create a firm

specific business model that will best align an organization‘s resources and capabilities to the

requirements of the environment in which the firm operates. In other words, it is the foundation

for evaluating the internal potential and limitations and the probable/likely opportunities and

threats from the external environment. It views all positive and negative factors inside and

outside the firm that affect the success. A consistent study of the environment in which the firm

operates helps in forecasting/predicting the changing trends and also helps in including them in

the decision-making process of the organization.

SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats. By definition,

Strengths (S) and Weaknesses (W) are considered to be internal factors over which you have

some measure of control. Also, by definition, Opportunities (O) and Threats (T) are considered

to be external factors over which you have essentially no control.

An overview of the four factors (Strengths, Weaknesses, Opportunities and Threats) is given

below:

Strengths:

Strengths are the qualities that enable us to accomplish the organization‘s mission. These are the

basis on which continued success can be made and continued/sustained. Strengths can be either

tangible or intangible. These are what you are well-versed in or what you have expertise in, the

traits and qualities your employees possess (individually and as a team) and the distinct features

that give your organization its consistency. Strengths are the beneficial aspects of the

organization or the capabilities of an organization, which includes human competencies, process

capabilities, financial resources, products and services.

Weaknesses:

Weaknesses are the qualities that prevent us from accomplishing our mission and achieving our

full potential. These weaknesses deteriorate influences on the organizational success and growth.

Weaknesses are the factors which do not meet the standards we feel they should meet.

Weaknesses in an organization may be depreciating machinery, insufficient research and

development facilities, narrow product range, poor decision-making, etc. Weaknesses are

controllable. They must be minimized and eliminated. For instance - to overcome obsolete

machinery, new machinery can be purchased. Other examples of organizational weaknesses are

huge debts, high employee turnover, complex decision making process, narrow product range,

large wastage of raw materials, etc.

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Opportunities:

Opportunities are presented by the environment within which our organization operates. These

arise when an organization can take benefit of conditions in its environment to plan and execute

strategies that enable it to become more profitable. Organizations can gain competitive

advantage by making use of opportunities. Organization should be careful and recognize the

opportunities and grasp them whenever they arise. Selecting the targets that will best serve the

clients while getting desired results is a difficult task. Opportunities may arise from market,

competition, industry/government and technology. Increasing demand for telecommunications

accompanied by deregulation is a great opportunity for new firms to enter telecom sector and

compete with existing firms for revenue.

Threats:

Threats arise when conditions in external environment jeopardize the reliability and profitability

of the organization‘s business. They compound the vulnerability when they relate to the

weaknesses. Threats are uncontrollable. When a threat comes, the stability and survival can be at

stake. Examples of threats are - unrest among employees; ever changing technology; increasing

competition leading to excess capacity, price wars and reducing industry profits, etc.

SWOT Analysis Framework:

Exhibit No.2.4

Limitations of SWOT Analysis:

SWOT Analysis is not free from its limitations. It may cause organizations to view

circumstances as very simple because of which the organizations might overlook certain key

strategic contact which may occur. Moreover, categorizing aspects as strengths, weaknesses,

opportunities and threats might be very subjective as there is great degree of uncertainty in

market. SWOT Analysis does stress upon the significance of these four aspects, but it does not

tell how an organization can identify these aspects for itself.

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There are certain limitations of SWOT Analysis which are not in control of management. These

include:

a. Price increase;

b. Inputs/raw materials;

c. Government legislation;

d. Economic environment;

e. Searching a new market for the product which is not having overseas market due to

import restrictions; etc.

Internal limitations may include:

a. Insufficient research and development facilities;

b. Faulty products due to poor quality control;

c. Poor industrial relations;

d. Lack of skilled and efficient labour and the like.

Understanding Financial Statements and Analysis:

What is the need to understand and analyze financial statements?

To answer this very reasonable question, we need to recall the process of investing. Early on, the

point was made that our ultimate goal is to construct a portfolio of investments that will provide

rates of return that are consistent with the risk involved with the portfolio. In turn, to determine

the expected rates of return on alternative assets, it is necessary to estimate the future value of

the asset since a major component of the rate of return is the change in value for the asset over

time. Therefore, the crux of investments is valuation! While we will consider alternative

valuation models in the next chapter, you are already aware from prior coursework that the value

of any earning asset is the present value of the expected cash flows generated by the asset.

Therefore, to estimate the value of an asset, you must derive an estimate of

(1) the discount rate for the asset (your required rate of return) and

(2) its expected cash flows.

The point is, the main source of information that will help you make these two estimates is the

financial statements. To derive an estimate of your required rate of return, you need to

understand the business and financial risk of the firm, which is specifically considered in this

chapter. To estimate future cash flows, you must understand the composition of cash flows and

what will contribute to the short-run and long-run growth of this series. Financial statements are

also the main source of information when deciding whether to lend money to a firm (invest in its

bonds) or to buy warrants or options on a firm‘s stock. We will also discuss about the financial

ratios and how to use them effectively. Financial statements are intended to provide information

60

on the resources available to management, how these resources were financed, and what the firm

accomplished with them.

Corporate shareholder annual and quarterly reports include three required financial statements:

the balance sheet, the income statement, and the statement of cash flows. In addition, reports that

must be filed with the Securities and Exchange Board of India (SEBI) carry detailed information

about the firm, such as information on loan agreements and data on product line and subsidiary

performance. Information from the basic financial statements can be used to calculate financial

ratios and to analyze the operations of the firm to determine what factors influence a firm‘s

earnings, cash flows, and risk characteristics.

Major Financial Statements:

The Income Statement

The income statement or profit and loss account is a summary of the profitability of the firm

over a period of time, such as a year. It presents revenues generated during the operating period,

the expenses incurred during that same period, and the company‘s net earnings or profits, which

are simply the difference between revenues and expenses. It is useful to distinguish among four

broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing

the product sold by the firm; general and administrative expenses, which correspond to overhead

expenses, salaries, advertising, and other costs of operating the firm that are not directly

attributable to production; interest expense on the firm‘s debt; and taxes on earnings owed to

federal and local governments.

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Table No.2.1 presents a 2012 income statement for Tata Steel Ltd.

Table No.2.1

Tata Steel Ltd

Income Statement for the year ended

31st March 2012

Mar 12

(Rs.in Crs) 

  INCOME :

 Sales Turnover 37,005.71

   Excise Duty 3,072.25

  Net Sales 33,933.46

  Other Income 1,397.44

 Stock Adjustments 220.72

   Total Income 35,551.62

  EXPENDITURE :

 Raw Materials 8,223.89

  Power & Fuel Cost 1,990.16

 Employee Cost 3,047.26

  Other Manufacturing Expenses 4,555.30

 Selling and Administration Expenses 3,240.10

  Miscellaneous Expenses 2,038.93

 Less: Pre-operative Expenses Capitalised 478.23

   Total Expenditure 22,617.41

  Operating Profit 12,934.21

  Interest 1,925.42

  Gross Profit 11,008.79

  Depreciation 1,151.44

  Profit Before Tax 9,857.35

  Tax 3,115.11

 Fringe Benefit tax 0

  Deferred Tax 45.82

  Reported Net Profit 6,696.42

  Extraordinary Items 603.66

  Adjusted Net Profit 6,092.76

  Adjst. below Net Profit -174.17

  P & L Balance brought forward 16,639.46

 Appropriations 2,016.67

   P & L Balance carried down 21,145.04

  Dividend 1,165.46

   Preference Dividend 0

  Equity Dividend % 120

   Earnings Per Share-Unit Curr 67.07

  Earnings Per Share(Adj)-Unit Curr

   Book Value-Unit Curr 541.7

Source: www.capitaline.com

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At the top are revenues from standard operations. Next come operating expenses, the costs

incurred in the course of generating these revenues, including a depreciation allowance. The

difference between operating revenues and operating costs is called operating income. Income

from other, primarily nonrecurring, sources is then added to obtain earnings before interest and

taxes (EBIT),which is what the firm would have earned if not for obligations to its creditors and

the tax authorities. EBIT is a measure of the profitability of the firm‘s operations abstracting

from any interest burden attributable to debt financing. The income statement then goes on to

subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax due

the government is subtracted to arrive at net income, the ―bottom line‖ of the income statement.

The Balance Sheet

While the income statement provides a measure of profitability over a period of time, the

balance sheet provides a ―snapshot‖ of the financial condition of the firm at a particular time.

The balance sheet is a list of the firm‘s assets and liabilities at that moment. The difference in

assets and liabilities is the net worth of the firm, also called stockholders‟ equity or, equivalently,

shareholders‟ equity. Like income statements, balance sheets are reasonably standardized in

presentation. Table No.2.2 is Tata Steel‘s balance sheet for year-end 2012.

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Table No.2.2

Tata Steel Ltd

Balance Sheet as on 31st March 2012

Rs in Cr

  SOURCES OF FUNDS :

 Share Capital 971.41

  Reserves Total 51,649.95

  Equity Share Warrants 0

   Equity Application Money 0.17

  Total Shareholders Funds 52,621.53

  Secured Loans 1,915.47

 Unsecured Loans 24,256.78

   Total Debt 26,172.25

  Other Liabilities 4,342.35

   Total Liabilities 83,136.13

  APPLICATION OF FUNDS :

 Gross Block 23,485.63

  Less : Accumulated Depreciation 11,986.17

  Less:Impairment of Assets 133.2

  Net Block 11,366.26

  Lease Adjustment 0

  Capital Work in Progress 16,058.49

 Investments 50,282.52

   Current Assets, Loans & Advances

  Inventories 4,858.99

 Sundry Debtors 904.08

  Cash and Bank 3,946.99

 Loans and Advances 1,950.27

   Total Current Assets 11,660.33

  Less : Current Liabilities and Provisions

 Current Liabilities 10,018.18

  Provisions 2,066.24

  Total Current Liabilities 12,084.42

   Net Current Assets -424.09

 Miscellaneous Expenses not written off 0

   Deferred Tax Assets 1,017.27

  Deferred Tax Liability 1,987.78

   Net Deferred Tax -970.51

  Other Assets 6,823.46

   Total Assets 83,136.13

 Contingent Liabilities 4,861.47

source:www.capitlaline.com

64

The first section of the balance sheet gives a listing of the assets of the firm. Current assets are

presented first. These are cash and other items such as accounts receivable or inventories that

will be converted into cash within one year. Next comes a listing of long-term or ―fixed‖ assets,

which usually consists primarily of the company‘s property, plant, and equipment. The liability

and shareholders‘ equity section is arranged similarly. Listed first are short-term or ―current‖

liabilities, such as accounts payable, accrued taxes, and debts that are due within one year. Long-

term debt and other liabilities due in more than a year follow. The difference between total assets

and total liabilities is shareholders‘ equity. This is the net worth or book value of the firm.

Shareholders‘ equity is divided into par value of stock, capital surplus (additional paid-in

capital), and retained earnings, although this division is usually unimportant. Briefly, par value

plus capital surplus represents the proceeds realized from the sale of stock to the public, while

retained earnings represent the buildup of equity from profits plowed back into the firm. Even if

the firm issues no new equity, book value will increase each year due to reinvested earnings.

The Statement of Cash Flows

The income statement and balance sheets are based on accrual methods of accounting, which

means revenues and expenses are recognized at the time of a sale even if no cash has yet been

exchanged. In contrast, the statement of cash flows recognizes only transactions in which cash

changes hands. For example, if goods are sold now, with payment due in 60 days, the income

statement will treat the revenue as generated when the sale occurs, and the balance sheet will be

immediately augmented by accounts receivable, but the statement of cash flows will not

recognize the transaction until the bill is paid and the cash is in hand.

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Table No.2.3 shows the statement of cash flows for Tata Steel for the year 2012.

Table No.2.3 Tata Steel Ltd

Cash Flow Statement For the Year Ended 31-03-12

Cash and Cash Equivalents at Beginning of the year     4102.52

Net Cash from Operating Activities     10256.47

Cash Flow From Operating Activities

Net Profit before Tax & Extraordinary Items 9857.35

Adjustment For

Depreciation 1151.44

Interest (Net) 1061.59

Dividend Received -117.5

P/L on Sales of Assets 52.98

P/L on Sales of Invest -511.01

Prov. & W/O (Net) 1.7

P/L in Forex 283.59

Others 48.82

Total Adjustments (PBT & Extraordinary Items) 1971.61

Op. Profit before Working Capital Changes 11828.96

Adjustment For

Trade & 0th receivables 1425.86

Inventories -905.23

Trade Payables 1205.36

Total (OP before Working Capital Changes) 1725.99

Cash Generated from/(used in) Operations 13554.95

Direct Taxes Paid -3298.48

Total-others -3298.48

Cash Flow before Extraordinary Items 10256.47

Net Cash Used in Investing Activities     -2859.11

Cash Flow from Investing Activities

Investment in Assets :

Purchased of Fixed Assets -7059.2

Sale of Fixed Assets 9.19

Financial/Capital Investment :

Purchase of Investments -2597.33

Sale of Investments 2802.29

Interest Received 447.5

Dividend Received 117.5

Inter Corporate Deposits 3420.94

Net Cash Used in Financing Activities     -7599.35

Cash Flow From Financing Activities

Proceeds:

Proceeds from Issue of shares (incl share premium) 536.12

Proceed from 0ther Long Term Borrowings 2317.43

Payments:

Of the Long Tem Borrowings -8212.56

Dividend Paid -1151.06

Interest Paid -1593.2

Others 503.92

Net Cash Used in Financing Activities -7599.35

Net Inc/(Dec) in Cash and Cash Equivalent     -201.99

Cash and Cash Equivalents at End of the year     3900.53

Source:www.capitaline.com

(Rs in Crs)

66

The first entry listed under cash flows from operations is net income. The following entries

modify that figure for components of income that have been recognized but for which cash has

not yet changed hands. Increases in accounts receivable, for example, mean income has been

claimed on the income statement, but cash has not yet been collected. Hence, increases in

accounts receivable reduce the cash flows realized from operations in this period. Similarly,

increases in accounts payable mean expenses have been incurred, but cash has not yet left the

firm. Any payment delay increases the company‘s net cash flows in this period.

-Another major difference between the income statement and the statement of cash flows

involves depreciation, which accounts for a substantial addition in the adjustment section of the

statement of cash flows in Table No.2.3. The income statement attempts to ―smooth‖ large

capital expenditures over time. The depreciation expense on the income statement is a way of

doing this by recognizing capital expenditures over a period of many years rather than at the

specific time of those expenditures. In contrast, the statement of cash flows recognizes the cash

implication of a capital expenditure when it occurs. It will ignore the depreciation ―expense‖

over time but will account for the full capital expenditure when it is paid.

Rather than smooth or allocate expenses over time, as in the income statement, the statement of

cash flows reports cash flows separately for operations, investing, and financing activities. This

way, any large cash flows such as those for big investments can be recognized as such without

affecting the measure of cash flow generated by operating activities. The second section of the

statement of cash flows is the accounting of cash flows from investing activities. These entries

are investments in the assets necessary for the firm to maintain or enhance its productive

capacity.

Accounting Vs Economic Earnings

Stock valuation models (which we will discuss shortly) require a measure of economic earnings

or sustainable cash flow that can be paid out to stockholders without impairing the productive

capacity of the firm. In contrast, accounting earnings are affected by several conventions

regarding the valuation of assets such as inventories (e.g., LIFO versus FIFO treatment) and by

the way some expenditure such as capital investments are recognized over time (as depreciation

expenses). We will discuss problems with some of these accounting conventions in greater detail

later in the chapter. In addition to these accounting issues, as the firm makes its way through the

business cycle, its earnings will rise above or fall below the trend line that might more accurately

reflect sustainable economic earnings. This introduces an added complication in interpreting net

income figures. One might wonder how closely accounting earnings approximate economic

earnings and, correspondingly, how useful accounting data might be to investors attempting to

value the firm.

In fact, the net income figure on the firm‘s income statement does convey considerable

information concerning a firm‘s products. We see this in the fact that stock prices tend to

increase when firms announce earnings greater than market analysts or investors had anticipated.

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Profitability measures focus on the firm‘s earnings. To facilitate comparisons across firms, total

earnings are expressed on a per-dollar-invested basis. So return on equity (ROE), which

measures profitability for contributors of equity capital, is defined as (after-tax) profits divided

by the book value of equity. Similarly, return on assets (ROA), which measures profitability for

all contributors of capital, is defined as earnings before interest and taxes divided by total assets.

Not surprisingly, ROA and ROE are linked, but as we will see shortly, the relationship between

them is affected by the firm‘s financial policies.

Let us focus more into the Ratio Analysis and its relevance:

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values

taken from a company‘s financial statements. Often used in accounting, there are many standard

ratios used to try to evaluate the overall financial condition of a corporation or other

organization. Financial ratios may be used by managers within a firm, by current and

potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use

financial ratios to compare the strengths and weaknesses in various companies. If shares in a

company are traded in a financial market, the market price of the shares is used in certain

financial ratios.

Ratios are classified differently by different experts in the literature. Let us discuss few

interesting classification which are essential for research analysts.

Activity Ratios:

Companies will typically try to turn their production into cash or sales as fast as possible because

this will generally lead to higher revenues. Such ratios are frequently used when performing

fundamental analysis on different companies. The total assets turnover ratio and inventory

turnover ratio are two popular examples of activity ratios used widely across most industries.

Average collection period:

The above ratio basically measures in an average within how many days the credit sales are

being collected from the customers. For example, the average credit periods of credit given to

customers are 40 days and average collection period shows 60 days, it shows some deficiency

with our collection process or mechanics.

Average payment period:

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Average payment period basically measures in average how many days of credit being given by

our suppliers to pay their bills.

Asset turnover ratio:

This ratio measures how effectively the assets were being used by the company for generating

sales. For instance if the asset turnover ratio is 10x, which means that with an asset base Rs.10,

sales were generated to the tune of 10 times i.e.Rs.100.

Stock turnover ratio:

This is a ratio showing how many times a company's inventory is sold and replaced over a

period. This ratio should be compared against industry averages. A low turnover implies poor

sales and, therefore, excess inventory. A high ratio generally implies strong sales.

Solvency Ratio:

One of many ratios used to measure a company's ability to meet long-term obligations. The

solvency ratio measures the size of a company's after-tax income, excluding non-cash

depreciation expenses, as compared to the firm's total debt obligations. It provides a

measurement of how likely a company will be to continue meeting its debt obligations.

The measure is usually calculated as follows:

Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a

solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the

lower a company's solvency ratio, the greater the probability that the company will default on its

debt obligations.

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial

leverage.

69

Debt Ratio:

In the above ratio, generally the term ‗liabilities‘ means and includes only liabilities payable to

the outsiders (external liability). This ratio indicates how much is the value of the assets that the

company holds against the liabilities payable to the outsiders.

Long-term Debt to Equity Ratio:

The above ratio indicates the company‘s long term debt (including the value of leases) to the

average share-holders equity.

Interest Coverage Ratio:

This ratio basically explains how many times a company‘s earnings covers its interest expenses.

Normally, this ratio is considered by the lenders in order to assess the financial soundness of the

company with reference it repayment capacity.

Or

Market ratios or Valuation Ratios:

Market ratios measure investor response to owning a company's stock and also the cost of

issuing stock. These are concerned with the return on investment for shareholders, and with the

relationship between return and the value of an investment in company‘s shares.

Earnings Per Share (EPS)

70

Earnings per share are generally considered to be the single most important variable in

determining a share's price. It is also a major component used to calculate the price-to-earnings

valuation ratio. For example, assume that a company has a net income of Rs25 million. If the

company pays out Rs1 million in preferred dividends and has 10 million shares for half of the

year and 15 million shares for the other half, the EPS would be Rs1.92 (24/12.5). First, the

Rs1million is deducted from the net income to get Rs24 million, then a weighted average is

taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the

earnings (net income) in the calculation. Two companies could generate the same EPS number,

but one could do so with less equity (investment) - that company would be more efficient at

using its capital to generate income and, all other things being equal, would be a "better"

company. Investors also need to be aware of earnings manipulation that will affect the quality of

the earnings number. It is important not to rely on any one financial measure, but to use it in

conjunction with statement analysis and other measures.

Dividend Payout Ratio:

The percentage of earnings paid to shareholders in dividends. calculated as:

The payout ratio provides an idea of how well earnings support the dividend payments. More

mature companies tend to have a higher payout ratio.

Price Earning Ratio or P/E Ratio:

A valuation ratio of a company's current share price compared to its per-share earnings.

It is calculated as:

Market Value per Share

Earnings per Share (EPS)

For example, if a company is currently trading at Rs43 a share and earnings over the last 12

months were Rs1.95 per share, the P/E ratio for the stock would be 22.05 (Rs43/Rs1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the

71

estimates of earnings expected in the next four quarters (projected or forward P/E). A third

variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

This ratio is also sometimes known as "price multiple" or "earnings multiple".

Forward P/E Ratio:

A measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation.

While the earnings used are just an estimate and are not as reliable as current earnings data, there

is still benefit in estimated P/E analysis. The forecasted earnings used in the formula can either

be for the next 12 months or for the next full-year fiscal period. This is also referred to as

"estimated price to earnings".

The estimated P/E of a company is often used to compare current earnings to estimated future

earnings. If earnings are expected to grow in the future, the estimated P/E will be lower than the

current P/E. This measure is also used to compare one company to another with a forward-

looking focus.

Trailing P/E Ratio:

The sum of a company's price-to-earnings, calculated by taking the current stock price and

dividing it by the trailing earnings per share for the past 12 months. This measure differs from

forward P/E, which uses earnings estimates for the next four quarters.

The trailing P/E ratio is calculated as follows:

This is the most commonly used P/E measure because it is based on actual earnings and,

therefore, is the most accurate. However, stock prices are constantly moving while earnings

remain fixed. As a result, forward P/E can sometimes be more relevant to investors when

valuating a company.

Dividend Yield:

A financial ratio that shows how much a company pays out in dividends each year relative to its

share price. In the absence of any capital gains, the dividend yield is the return on investment for

a stock. Dividend yield is calculated as follows:

72

Dividend yield is a way to measure how much cash flow you are getting for each dollar invested

in an equity position - in other words, how much "bang for your buck" you are getting from

dividends. Investors who require a minimum stream of cash flow from their investment portfolio

can secure this cash flow by investing in stocks paying relatively high, stable dividend yields.

To better explain the concept, refer to this dividend yield example: If two companies both pay

annual dividends of Rs1 per share, but ABC company's stock is trading at Rs20 while XYZ

company's stock is trading at Rs40, then ABC has a dividend yield of 5% while XYZ is only

yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement

his or her income would likely prefer ABC's stock over that of XYZ.

Price to Book Ratio (P/B) or Price to Book Value (PBV) Ratio:

A ratio used to compare a stock's market value to its book value. It is calculated by dividing the

current closing price of the stock by the latest quarter's book value per share. This is also known

as the "price-equity ratio". It is computed as below:

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that

something is fundamentally wrong with the company. As with most ratios, be aware that this

varies by industry. This ratio also gives some idea of whether you're paying too much for what

would be left if the company went bankrupt immediately.

Price Earnings to Growth (PEG) Ratio:

A ratio used to determine a stock's value while taking into account earnings growth. The

calculation is as follows:

PEG is a widely used indicator of a stock's potential value. It is favored by many over the

price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG

means that the stock is more undervalued. Keep in mind that the numbers used are projected and,

therefore, can be less accurate. Also, there are many variations using earnings from different

time periods (i.e. one year vs. five year). Be sure to know the exact definition your source is

using.

73

Table No.2.4

Tata Steel Ltd - Key Financial Ratios

Mar-12

Leverage Ratios:

Debt-Equity Ratio 0.55

Long Term Debt-Equity Ratio 0.46

Liquidity Ratio:

Current Ratio 0.85

Turnover Ratios:

Fixed Assets 1.6

Inventory 8.4

Debtors 55.73

Interest Cover Ratio 6.12

Return on Capital Employed (%) 14.51

Return On Net Worth (%) 13.45

Valuation Ratios:

Price Earning (P/E) 7.01

Price to Book Value ( P/BV) 0.87

Price/Cash EPS (P/CEPS) 5.96

EV/EBIDTA 5.25

Market Cap/Sales 1.23

Source: www.capitaline.com

End of the Chapter Questions:

1. Why would you expect a relationship between economic activity and stock price

movements?

2. At a lunch with some business associates, you discuss the reason for the relationship

between the economy and the stock market. One of your associates contends that she has

heard that stock prices typically turn before the economy does. How would you explain

this phenomenon?

3. Explain the following statements:

(a) There is a strong, consistent relationship between money supply changes and stock

prices,

(b) Money supply changes cannot be used to predict stock price movements.

4. You are informed of the following estimates: nominal money supply is expected to grow

at a rate of7 percent, and GDP is estimated to grow at 4 percent. Explain what you think

will happen to stock prices during this period and the reason for your expectation.

74

5. The current rate of inflation is 3 percent, and long-term Treasury bonds are yielding 7

percent. You estimate that the rate of inflation will increase to 6 percent. What do you

expect to happen to long term bond yields?

6. Some observers contend that it is harder to estimate the effect of a change in interest rates

on common stocks than on bonds. Discuss this contention.

7. Prepare a table showing the percentage change for each of the last 10 years in

(a) the Consumer Price Index (all items),

(b) nominal GDP,

(c) real GDP (in constant dollars), and

(d) the GDP deflator.

8. Discuss how much of nominal growth was due to real growth and how much was due to

inflation.

9. There has been considerable growth in recent years in the use of economic analysis in

investment management. Further significant expansion may lie ahead as financial

analysts develop greater skills in economic analysis and these analyses are integrated

more into the investment decision-making process. The following questions address the

use of economic analysis in the investment decision making process:

a. Differentiate among leading, lagging, and coincident indicators of economic

activity, and give an example of each.

b. Indicate whether the leading indicators are one of the best tools for achieving

above-average investment results.

Briefly justify your conclusion.

10. Interest rate projections are used in investment management for a variety of purposes.

Identify three significant reasons why interest rate forecasts may be important in reaching

investment conclusions.

11. Assume you are a fundamental research analyst following the automobile industry for a

large brokerage firm. Identify and briefly explain the relevance of three major economic

time series, economic indicators, or economic data items that would be significant to

automotive industry and company research.

12. What monetary and fiscal policies might be prescribed for an economy in a deep

recession?

13. Unlike other investors, you believe the Government is going to dramatically loosen

monetary policy. What would be your recommendations about investments in the

following industries?

a. Gold mining

75

b. Construction

14. If you believe the U.S. dollar is about to depreciate more dramatically than do other

investors, what will be your stance on investments in Indian auto producers?

15. According to supply-side economists, what will be the long-run impact on prices of a

reduction in income tax rates?

16. Consider two firms producing DVDs. One uses a highly automated robotics process,

while the other uses human workers on an assembly line and pays overtime when there

is heavy production demand.

a. Which firm will have higher profits in a recession? In a boom?

17. Here are four industries and four forecasts for the macro economy. Choose the industry

that you would expect to perform best in each scenario.

Industries: Housing construction, health care, gold mining, steel production.

Economic Forecasts:

i) Deep recession: Falling inflation, falling interest rates, falling GDP.

ii) Superheated economy: Rapidly rising GDP, increasing inflation and

interest rates.

Iii) Healthy expansion: Rising GDP, mild inflation, low unemployment.

iv) Stagflation: Falling GDP, high inflation.

18. In which stage of the industry life cycle would you place the following industries?

a. Oil well equipment.

b. Computer hardware.

c. Computer software.

d. Genetic engineering.

e. Railroads.

19. For each pair of firms, choose the one that you think would be more sensitive to the

business cycle.

a. General Autos or General Pharmaceuticals.

b. Friendly Airlines or Happy Cinemas.

20. Choose an industry and identify the factors that will determine its performance in the next

three years. What is your forecast for performance in that time period?

76

Problems for Practice:

The Balance Sheet of

ABC Co is given below

Rs (000) Rs (000)

Cash & Near Cash 1648 Accounts Payable 3141

Marketable Securities 159 Short term Borrowings 4462

Accounts Receivable 1666 Other Short term liabilities 1037

Other Current Assets 2017 Current Liabilities 8640

Current Assets 6380 Long term Borrowings 687

Long term investments 1863 Other long term Liabilities 1415

Depreciable Fixed Assets 5486 Non-current liabilities 2102

Non-depreciable Fixed Assets 199

Accumulated Depreciation 2016 Share Capital (Paid-in) 3060

Net Fixed Assets 3669 Retained Earnings 5343

Other Assets 7233 Shareholder Equity 8403

Total Assets 19145 Total Liabilities & Equity 19145

1. Consider the assets on ABC‘s balance sheet and answer the following questions:

a. Looking at the assets that ABC has on its balance sheet, which assets are likely

to be assessed closest to market value? Explain.

b. ABC has net fixed assets of Rs.3,669 million. Can you estimate how much ABC paid

for these assets? Is there any way to know the age of these assets?

c. ABC seems to have far more invested in current assets, rather than fixed assets.

Is this significant? Explain.

d. In the early 1980s, ABC sold off its bottling operations, with the bottlers becoming

independent companies. How would this action have impacted the assets onABC‘s

balance sheet? (The manufacturing plants are most likely to be part of the bottling

operations)

2. Examine the liabilities on ABC‘s balance sheet.

a. Based upon the balance sheet, how much interest-bearing debt does ABC have

outstanding. (You can assume that other short term liabilities represent sundry

payables, and other long term liabilities represent health care and pension obligations.)

b. Based upon the balance sheet, how much did ABC obtain in equity capital

when it issued stock originally to the financial markets?

c. Is there any significance to the fact that retained earnings is much larger than the

original paid-in capital?

77

d. The market value of ABC‘s equity is Rs140 billion. What is the book value of

equity in ABC? Why is there such a large difference between the market value of

equity and the book value of equity?

3. ABC‘s most valuable asset is its brand name. Where in the balance sheet do yousee its value?

Is there any way to adjust the balance sheet to reflect the value of this asset?

4. Assume that you have been asked to analyze ABC‘s working capital management.

a. Estimate the net working capital and non-cash working capital for ABC.

b. Estimate the firm‘s current ratio.

c. Estimate the firm‘s quick ratio.

d. Would you draw any conclusions about the riskiness of ABC as a firm by

looking at these numbers? Why or why not?

ABC's income statements for 2009 and

2010 are summarized below

2009

Rs (000)

2010

Rs (000)

Net Revenues 18868 18813

Cost of Goods Sold 6,105 5,562

Selling, G & A Expenses 7,852 8,284

Earnings before interest and taxes 5,001 4,967

Interest Expenses 258 277

Non-operating Gains 1,312 508

Income Tax Expenses 1,926 1,665

Net Income 4,129 3,533

Dividends 1,387 1,480

The following questions relate to ABC‘s income statement.

5. How much operating income did ABC earn, before taxes, in 1998? How does this

compare to how much ABC earned in 1997? What are the reasons for the differences?

6. The biggest expense for ABC is advertising, which is part of the selling, general and

administrative expenses. A large portion of these expenses are designed to build up

ABC‘s brand name. Should advertising expenses be treated as operating expenses or are

they really capital expenses? If they are to be treated as capital expenses, how would you

capitalize them? (Use the capitalization of R&D as a guide.)

7. What effective tax rate did ABC have in 1998? How does it compare with what they paid

in 1997 as an effective tax rate? What might account for the difference?

78

8. You have been asked to assess the profitability of ABC, as a firm. To that end, estimate

the pre-tax operating and net margins in 1997 and 1998 for the firm. Are there any

conclusions you would draw from the comparisons across the two years.

9. The book value of equity at ABC in 1997 was Rs7,274 million. The book value of

interest-bearing debt was Rs3,875 million. Estimate:

a. the return on equity (beginning of the year) in 1998

b. the pre-tax return on capital (beginning of the year) in 1998

c. the after-tax return on capital (beginning of the year) in 1998, using the effective tax

rate in 1998.

10. SeeSaw Toys reported that it had a book value of equity of Rs1.5 billion at the end of

1998 and 100 million shares outstanding. During 1999, it bought back 10 million shares

at a market price of Rs40 per share. The firm also reported a net income of Rs150 million

for1999, and paid dividends of Rs50 million.

a. Estimate the book value of equity at the end of 1999

b. Estimate the return on equity, using beginning book value of equity.

c. Estimate the return on equity, using the average book value of equity.

79

CHAPTER NO.III

Valuation of Stocks and

Firms

ANALYSIS OF FINANCIAL RATIOS

80

This chapter is titled ―Valuation of Stocks and Firms‖ to convey the idea that the common stocks

of good companies are not necessarily good investments. The point is, after analyzing a company

and deriving an understanding of its strengths and risks, you need to compute the fundamental

intrinsic value of the firm‘s stock and compare the intrinsic value of a stock to its market value to

determine if the company‘s stock should be purchased. The stock of a wonderful firm with

superior management and strong performance measured by sales and earnings growth can be

priced so high that the intrinsic value of the stock is below its current market price and should

not be acquired. In contrast, the stock of a company with less success based on its sales and

earnings growth may have a stock market price that is below its intrinsic value. In this case,

although the company is not as good, its stock could be the better investment. The classic

confusion in this regard concerns growth companies versus growth stocks. The stock of a growth

company is not necessarily a growth stock. Recognition of this difference is absolutely essential

for successful investing.

What is a Growth Company?

Observers have historically defined growth companies as those that consistently experience

above-average increases in sales and earnings. This definition has some limitations because

many firms could qualify due to certain accounting procedures, mergers, or other external events.

In contrast, financial theorists define a growth company as a firm with the management ability

and the opportunities to make investments that yield rates of return greater than the firm‘s

required rate of return. This required rate of return is the firm‘s weighted average cost of capital

(WACC). As an example, a growth company might be able to acquire capital at an average cost

of 10 percent and yet have the management ability and the opportunity to invest those funds at

rates of return of 15 to 20 percent. As a result of these investment opportunities, the firm‘s sales

and earnings grow faster than those of similar risk firms and the overall economy. In addition, a

growth company that has above-average investment opportunities should, and typically does,

retain a large portion of its earnings to fund these superior investment projects (i.e., they have

low dividend payout ratios).

What is a Growth Stock?

Growth stocks are not necessarily shares in growth companies. A growth stock is a stock with a

higher rate of return than other stocks in the market with similar risk characteristics. The stock

achieves this superior risk-adjusted rate of return because at some point in time the market

undervalued it compared to other stocks. Although the stock market adjusts stock prices

relatively quickly and accurately to reflect new information, available information is not always

perfect or complete. Therefore, imperfect or incomplete information may cause a given stock to

be undervalued or overvalued at a point in time. If the stock is undervalued, its price should

eventually increase to reflect its true fundamental value when the correct information becomes

available. During this period of price adjustment, the stock‘s realized return will exceed the

required return for a stock with its risk, and, during this period of adjustment, it will be

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considered a growth stock. Growth stocks are not necessarily limited to growth companies. A

future growth stock can be the stock of any type of company; the stock need only be undervalued

by the market.

The fact is, if investors recognize a growth company and discount its future earnings stream

properly, the current market price of the growth company‘s stock will reflect its future earnings

stream. Those who acquire the stock of a growth company at this correct market price will

receive a rate of return consistent with the risk of the stock, even when the superior earnings

growth is attained. In many instances, overeager investors tend to overestimate the expected

growth rate of earnings and cash flows for the growth company and, therefore, inflate the price

of a growth company‘s stock. Investors who pay the inflated stock price will earn a rate of return

below the risk-adjusted required rate of return, despite the fact that the growth company

experiences the above-average growth of sales and earnings. Several studies that have examined

the stock price performance for samples of growth companies have found that their stocks

performed poorly—that is, the stocks of growth companies have generally not been growth

stocks.

What is a Defensive Company?

Defensive companies are those whose future earnings are likely to withstand an economic

downturn. One would expect them to have relatively low business risk and not excessive

financial risk. Typical examples are public utilities or grocery chains—firms that supply basic

consumer necessities. There are two closely related concepts of a defensive stock. First, a

defensive stock‘s rate of return is not expected to decline during an overall market decline, or

decline less than the overall market. A stock with low or negative systematic risk (a small

positive or negative beta) may be considered a defensive stock according to this theory because

its returns are unlikely to be harmed significantly in a bear market.

What is a cyclical company?

A cyclical company‟s sales and earnings will be heavily influenced by aggregate business

activity. Examples would be firms in the steel, auto, or heavy machinery industries. Such

companies will do well during economic expansions and poorly during economic contractions.

This volatile earnings pattern is typically a function of the firm‘s business risk (both sales

volatility and operating leverage) and can be compounded by financial risk.

A cyclical stock will experience changes in its rates of return greater than changes in overall

market rates of return. In terms of the CAPM, these would be stocks that have high betas. The

stock of a cyclical company, however, is not necessarily cyclical. A cyclical stock is the stock of

any company that has returns that are more volatile than the overall market—that is, high-beta

stocks that have high correlation with the aggregate market and greater volatility.

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What is a speculative company?

A speculative company is one whose assets involve great risk but that also has a possibility of

great gain. A good example of a speculative firm is one involved in oil exploration. A

speculative stock possesses a high probability of low or negative rates of return and a low

probability of normal or high rates of return. Specifically, a speculative stock is one that is

overpriced, leading to a high probability that during the future period when the market adjusts

the stock price to its true value, it will experience either low or possibly negative rates of return.

Such an expectation might be the case for an excellent growth company whose stock is selling at

an extremely high price/earnings ratio—i.e., it is substantially overvalued.

Some analysts also divide stocks into ―growth‖ stocks and ―value‖ stocks. As we have discussed,

growth stocks are companies that will have positive earnings surprises and above-average risk

adjusted rates of return because the stocks are undervalued. If the analyst does a good job in

identifying such companies, investors in these stocks will reap the benefits of seeing their stock

prices rise after other investors identify their earnings growth potential.

Value Stocks Vs Growth Stocks

Value stocks are those that appear to be undervalued for reasons other than earnings growth

potential. Value stocks are usually identified by analysts as having low price-earning or price-

book value ratios. Notably, in these comparisons between growth and value stocks, the

specification of a growth stock is not consistent with our preceding discussion. In these

discussions, a growth stock is generally specified as a stock of a company that is experiencing

rapid growth of sales and earnings (e.g., Intel and Microsoft). As a result of this company

performance, the stock typically has a high P/E and price-book-value ratio. Unfortunately, the

specification does not consider the critical comparison between intrinsic value and market price.

Apart from the above this chapter describes the ways stock market analysts try to uncover

mispriced securities. The models presented are those used by fundamental analysts, those

analysts who use information concerning the current and prospective profitability of a company

to assess its fair market value. Fundamental analysts are different from technical analysts, who

essentially use trend analysis to uncover trading opportunities. We start with a discussion of

alternative measures of the value of a company. From there, we progress to quantitative tools

called dividend discount models that security analysts commonly use to measure the value of a

firm as an ongoing concern.

The purpose of fundamental analysis is to identify stocks that are mispriced relative to some

measure of ―true‖ value that can be derived from observable financial data. Of course, true value

can only be estimated. In practice, stock analysts use models to estimate the fundamental value

of a corporation‘s stock from observable market data and from the financial statements of the

firm and its competitors. These valuation models differ in the specific data they use and in the

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level of their theoretical sophistication. But at their heart, most of them use the notion of

valuation by comparables: They look at the relationship between price and various determinants

of value for similar firms, and then extrapolate that relationship to the firm in question.

The Internet makes it convenient to obtain relevant data. For Indian companies, the Securities

and Exchange Board of India provides information available to the public at its web site

www.sebi.gov.in. The SEBI requires all public companies to file registration statements, periodic

reports, and other forms electronically through. Many Web sites, such as finance.yahoo.com,

also provide analysis and data derived from the SEBI reports.

Before moving into the theory of valuation, let us understand some important terms such as cost

of capital, weight average cost of capital popularly known as WACC, cost of preferred stock,

cost of debt, and computing expected rate of return through universally agreed model known as

capital asset pricing model.

Cost of Capital (Kc):

The cost of capital determines how a company can raise money (through a stock issue,

borrowing, or a mix of the two). This is the rate of return that a firm would receive if it

invested in a different vehicle with similar risk.

Weighted Average Cost Of Capital – WACC:

A calculation of a firm's cost of capital in which each category of capital is proportionately

weighted. All capital sources - common stock, preferred stock, bonds and any other long-term

debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the

beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation

and a higher risk. The WACC equation is the cost of each capital component multiplied by its

proportional weight and then summing:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Cost of Debt (Kd):

The effective rate that a company pays on its current debt is known as cost of debt. This can be

measured in either before- or after-tax returns; however, because interest expense is deductible,

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the after-tax cost is seen most often. This is one part of the company's capital structure, which

also includes the cost of equity.

Kd = Interest * (1-Tax Rate)

A company will use various bonds, loans and other forms of debt, so this measure is useful for

giving an idea as to the overall rate being paid by the company to use debt financing. The

measure can also give investors an idea as to the riskiness of the company compared to others,

because riskier companies generally have a higher cost of debt. To get the after-tax rate, you

simply multiply the before-tax rate by one minus the marginal tax rate (before-tax rate x (1-

marginal tax)). If a company's only debt were a single bond in which it paid 5%, the before-tax

cost of debt would simply be 5%. If, however, the company's marginal tax rate were 40%, the

company's after-tax cost of debt would be only 3% (5% x (1-40%)).

Cost of Equity (Ke):

In financial literature, the return that stockholders require for a company. The traditional formula

for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for

owning the asset and bearing the risk of ownership. Let‘s look at a very simple example: let's say

you require a rate of return of 10% on an investment in TI Cycles. The stock is currently trading

at Rs10 and will pay a dividend of Rs0.30. Through a combination of dividends and share

appreciation you require aRs1.00 return on your Rs10.00 investment. Therefore the stock will

have to appreciate by Rs0.70, which, combined with the Rs0.30 from dividends, gives you your

10% cost of equity.

Capital Asset Pricing Model (CAPM):

The capital asset pricing model, or CAPM, was developed by Treynor, Sharpe, Lintner, and

Mossin in the early 1960s, and further refined later. The model predicts the relationship between

the risk and equilibrium expected returns on risky assets. We will approach the CAPM in a

simplified setting. Thinking about an admittedly unrealistic world allows a relatively easy leap to

the solution. With this accomplished, we can add complexity to the environment, one step at a

time, and see how the theory must be amended. This process allows us to develop a reasonably

realistic and comprehensible model.

A number of simplifying assumptions lead to the basic version of the CAPM. The fundamental

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idea is that individuals are as alike as possible, with the notable exceptions of initial wealth and

risk aversion. The list of assumptions that describes the necessary conformity of investors

follows:

1. Investors cannot affect prices by their individual trades. This means that there are

many investors, each with an endowment of wealth that is small compared with

the total endowment of all investors. This assumption is analogous to the perfect

competition assumption of microeconomics.

2. All investors plan for one identical holding period.

3. Investors form portfolios from a universe of publicly traded financial assets, such

as stocks and bonds, and have access to unlimited risk-free borrowing or lending

opportunities.

4. Investors pay neither taxes on returns nor transaction costs (commissions and

service charges) on trades in securities. In such a simple world, investors will not

care about the difference between returns from capital gains and those from

dividends.

5. All investors attempt to construct efficient frontier portfolios; that is, they are

rational mean-variance optimizers.

6. All investors analyze securities in the same way and share the same economic

view of the world. Hence, they all end with identical estimates of the probability

distribution of future cash flows from investing in the available securities. This

means that, given a set of security prices and the risk-free interest rate, all

investors use the same expected returns, standard deviations, and correlations to

generate the efficient frontier and the unique optimal risky portfolio. This

assumption is called homogeneous expectations.

Obviously, these assumptions ignore many real-world complexities. However, they lead to some

powerful insights into the nature of equilibrium in security markets. A model that describes the

relationship between risk and expected return and that is used in the pricing of risky securities.

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The general idea behind CAPM is that investors need to be compensated in two ways: time value

of money and risk. The 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. The security market line plots the results of the

CAPM for all different risks (betas).Using the CAPM model and the following assumptions, we

can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the

beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the

stock is expected to return 17% (3%+2(10%-3%)).

CAPM and its Limitations:

The CAPM has two limitations: It relies on the theoretical market portfolio, which includes all

assets (such as real estate, foreign stocks, etc.), and it deals with expected as opposed to actual

returns. To implement the CAPM, we cast it in the form of an index model and use realized, not

expected, returns. An index model uses actual portfolios, such as the S&P 500, rather than the

theoretical market portfolio to represent the relevant systematic factors in the economy. The

important advantage of index models is that the composition and rate of return of the index is

easily measured and unambiguous.

In contrast to an index model, the CAPM revolves around the ―market portfolio.‖ However,

because many assets are not traded, investors would not have full access to the market portfolio

even if they could exactly identify it. Thus, the theory behind the CAPM rests on a shaky real-

world foundation. But, as in all science, a theory may be viewed as legitimate if its predictions

approximate real-world outcomes with a sufficient degree of accuracy. In particular, the reliance

on the market portfolio shouldn‘t faze us if we can verify that the predictions of the CAPM are

sufficiently accurate when the index portfolio is substituted for the market.

We can start with one central prediction of the CAPM: The market portfolio is mean variance

efficient. An index model can be used to test this hypothesis by verifying that an index chosen to

be representative of the full market is a mean-variance efficient portfolio. Another aspect of the

CAPM is that it predicts relationships among expected returns, while all we can observe are

realized (historical) holding-period returns; actual returns in a particular holding period seldom,

if ever, match our initial expectations.

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Multifactor Models and CAPM

The index model introduced earlier in the chapter gave us a way of decomposing stock

variability into market or systematic risk, due largely to macroeconomic factors, versus firm

specific effects that can be diversified in large portfolios. In the index model, the return on the

market portfolio summarized the aggregate impact of macro factors. In reality, however,

systematic risk is not due to one source, but instead derives from uncertainty in many economy

wide factors such as business-cycle risk, interest or inflation rate risk, energy price risk, and so

on. It stands to reason that a more explicit representation of systematic risk, allowing for the

possibility that different stocks exhibit different sensitivities to its various facets, would

constitute a useful refinement of the single-factor model. It is easy to see that models that allow

for several systematic factors— multifactor models—can provide better descriptions of security

returns.

The Fama-French Three-Factor Model

Fama and French (1996) proposed a three-factor model that has become a standard tool for

empirical studies of asset returns. Fama and French add firm size and book-to-market ratio to the

market index to explain average returns. These additional factors are motivated by the

observations that average returns on stocks of small firms and on stocks of firms with a high

ratio of book value of equity to market value of equity have historically been higher than

predicted by the security market line of the CAPM. This observation suggests that size or the

book-to-market ratio may be proxies for exposures to sources of systematic risk not captured by

the CAPM beta, and thus result in return premiums. For example, Fama and French point out

that firms with high ratios of book to market value are more likely to be in financial distress and

that small stocks may be more sensitive to changes in business conditions. Thus, these variables

may capture sensitivity to macroeconomic risk factors.

How can we make the Fama-French (FF) model operational? To illustrate, we will follow the

same general approach that we applied for General Motors earlier, but now using the more

general model.

Collecting and processing data To create portfolios that track the size and book-to-market

factors, one can sort industrial firms by size (market capitalization or market ―cap‖) and by book-

to-market (B/M) ratio. The size premium is constructed as the difference in returns between

small and large firms and is denoted by SMB (―small minus big‖). Similarly, the book-to-market

premium is calculated as the difference in returns between firms with a high versus low B/M

ratio, and is denoted HML (―high minus low‖ ratio).

Taking the difference in returns between two portfolios has an economic interpretation. The

SMB return, for example, equals the return from a long position in small stocks, financed with a

short position in the large stocks. Note that this is a portfolio that entails no net investment.

Davis, Fama, and French (2000) follow this sorting procedure.

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CAPM and the Real World:

In limited ways, portfolio theory and the CAPM have become accepted tools in the practitioner

community. Many investment professionals think about the distinction between firm specific and

systematic risk and are comfortable with the use of beta to measure systematic risk. Still, the

nuances of the CAPM are not nearly as well established in the community. For example, the

compensation of portfolio managers is not based on appropriate performance measures.

What can we make of this?

New ways of thinking about the world (that is, new models or theories) displace old ones when

the old models become either intolerably inconsistent with data or when the new model is

demonstrably more consistent with available data. For example, when Copernicus overthrew

the age-old belief that the Earth is fixed in the center of the Universe and that the stars orbit

about it in circular motions, it took many years before astronomers and navigators replaced old

astronomical tables with superior ones based on his theory. The old tools fit the data available

from astronomical observation with sufficient precision to suffice for the needs of the time. To

some extent, the slowness with which the CAPM has permeated daily practice in the money

management industry also has to do with its precision in fitting data, that is, in precisely

explaining variation in rates of return across assets. Let‘s review some of the evidence on this

score.

The CAPM was first published by Sharpe in the Journal of Finance (the journal of the American

Finance Association) in 1964 and took the world of finance by storm. Early tests by Black,

Jensen, and Scholes (1972) and Fama and MacBeth (1973) were only partially supportive of the

CAPM: average returns were higher for higher-beta portfolios, but the reward for beta risk was

less than the predictions of the simple theory.

While this sort of evidence against the CAPM remained largely within the ivory towers of

academia, Roll‘s (1977) paper ―A Critique of Capital Asset Pricing Tests‖ shook the practitioner

world as well. Roll argued that since the true market portfolio can never be observed, the CAPM

is necessarily untestable. The publicity given the now classic ―Roll‘s critique‖ resulted in

popular articles such as ―Is Beta Dead?‖ that effectively slowed the permeation of portfolio

theory through the world of finance. This is quite ironic since, although Roll is absolutely correct

on theoretical grounds, some tests suggest that the error introduced by using a broad market

index as proxy for the true, unobserved market portfolio is perhaps not the greatest of the

problems involved in testing the CAPM.

Fama and French (1992) published a study that dealt the CAPM an even harsher blow. They

claimed that once you control for a set of widely followed characteristics of the firm, such as the

size of the firm and its ratio of market value to book value, the firm‘s beta (that is, its systematic

risk) does not contribute anything to the prediction of future returns.

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Fama and French and several others have published many follow-up studies of this topic. We

will review some of this literature later in the chapter, and the nearby box discusses recent

controversies about the risk-return relationship. However, it seems clear from these studies that

beta does not tell the whole story of risk. There seem to be risk factors that affect security returns

beyond beta‘s one-dimensional measurement of market sensitivity. In fact, in the next section of

this chapter, we will introduce a theory of risk premiums that explicitly allows for multiple risk

factors.

Liquidity, a different kind of risk factor, has been ignored for a long time. Although first

analyzed by Amihud and Mendelson as early as 1986, it is yet to be accurately measured and

incorporated in portfolio management. Measuring liquidity and the premium commensurate with

illiquidity is part of a larger field in financial economics, namely, market structure. We now

know that trading mechanisms on stock exchanges can affect the liquidity of assets traded on

these exchanges and thus significantly affect their market value.

In limited ways, portfolio theory and the CAPM have become accepted tools in the practitioner

community. Many investment professionals think about the distinction between firm specific and

systematic risk and are comfortable with the use of beta to measure systematic risk. Still, the

nuances of the CAPM are not nearly as well established in the community. For example, the

compensation of portfolio managers is not based on appropriate performance measures.

Theory of Valuation:

You may recall from your studies in accounting, economics, or corporate finance that the value

of an asset is the present value of its expected returns. Specifically, you expect an asset to

provide a stream of returns during the period of time you own it. To convert this estimated

stream of returns to a value for the security, you must discount this stream at your required rate

of return. This process of valuation requires estimates of

(1) the stream of expected returns and

(2) the required rate of return on the investment.

An estimate of the expected returns from an investment encompasses not only the size but also

the form, time pattern, and the uncertainty of returns, which affect the required rate of return.

Form of Returns:

The returns from an investment can take many forms, including earnings, cash flows, dividends,

interest payments, or capital gains (increases in value) during a period. We will consider several

alternative valuation techniques that use different forms of returns. As an example, one common

stock valuation model applies a multiplier to a firm‘s earnings, whereas another valuation model

computes the present value of a firm‘s operating cash flows, and a third model estimates the

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present value of dividend payments. Returns or cash flows can come in many forms, and you

must consider all of them to evaluate an investment accurately.

Time Pattern and Growth Rate of Returns:

You cannot calculate an accurate value for a security unless you can estimate when you will

receive the returns or cash flows. Because money has a time value, you must know the time

pattern and growth rate of returns from an investment. This knowledge will make it possible to

properly value the stream of returns relative to alternative investments with a different time

pattern and growth rate of returns or cash flows.

Uncertainty of Returns (Cash Flows):

You will recall from Chapter 1 that the required rate of return on an investment is determined by

(1) the economy‘s real risk-free rate of return, plus

(2) the expected rate of inflation during the holding period, plus

(3) a risk premium that is determined by the uncertainty of returns.

All investments are affected by the risk-free rate and the expected rate of inflation because these

two variables determine the nominal risk-free rate. Therefore, the factor that causes a difference

in required rates of return is the risk premium for alternative investments. In turn, this risk

premium depends on the uncertainty of returns or cash flows from an investment. We can

identify the sources of the uncertainty of returns by the internal characteristics of assets or by

market-determined factors. Earlier, we subdivided the internal characteristics for a firm into

business risk (BR), financial risk (FR), liquidity risk (LR), exchange rate risk (ERR), and country

risk (CR). The market-determined risk measures are the systematic risk of the asset, its beta, or

its multiple APT factors.

To ensure that you receive your required return on an investment, you must estimate the intrinsic

value of the investment at your required rate of return and then compare this estimated intrinsic

value to the prevailing market price. You should not buy an investment if its market price

exceeds your estimated value because the difference will prevent you from receiving your

required rate of return on the investment. In contrast, if the estimated value of the investment

exceeds the market price, you should buy the investment.

In summary:

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Don‟t Buy

For example, assume you read about a firm that produces athletic shoes and its stock is listed on

the National Stock Exchange (NSE). Using one of the valuation models we will discuss and

making estimates of earnings, cash flow, and growth based on the company‘s annual report and

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other information, you estimate the company‘s stock value using your required rate of return as

Rs. 20 a share. After estimating this value, you look in the paper and see that the stock is

currently being traded at Rs.15 a share. You would want to buy this stock because you think it is

worth Rs.20 a share and you can buy it for Rs. 15 a share. In contrast, if the current market price

were Rs.25 a share, you would not want to buy the stock because, based upon your valuation, it

is overvalued.

The theory of value provides a common framework for the valuation of all investments.

Different applications of this theory generate different estimated values for alternative

investments because of the different payment streams and characteristics of the securities. The

interest and principal payment son a bond differ substantially from the expected dividends and

future selling price for a common stock. The initial discussion that follows applies the discounted

cash flow method to bonds, preferred stock, and common stock. This presentation demonstrates

that the same basic model is useful across a range of investments. Subsequently, because of the

difficulty in estimating the value of common stock, we consider two general approaches and

numerous techniques for the valuation of stock.

Valuation of Bonds:

Calculating the value of bonds is relatively easy because the size and time pattern of cash flows

from the bond over its life are known. A bond typically promises:

1. Interest payments every six months equal to one-half the coupon rate times the face value

of the bond;

2. The payment of the principal on the bond‘s maturity date

As an example, in 2003, a Rs.10,000 bond due in 2018 with a 10 percent coupon will pay Rs.500

every six months for its 15-year life. In addition, the bond issuer promises to pay the Rs.10,000

principal at maturity in 2018. Therefore, assuming the bond issuer does not default, the investor

knows what payments (cash flows) will be made and when they will be made.

Applying the valuation theory, which states that the value of any asset is the present value of

its cash flows, the value of the bond is the present value of the interest payments, which we can

think of as an annuity of Rs. 500 every six months for 15 years, and the present value of the

principal payment, which in this case is the present value of Rs.10,000 in 15 years. The only

unknown for this asset (assuming the borrower does not default) is the required rate of return that

should be used to discount the expected stream of returns (cash flows). If the prevailing nominal

risk-free rate is 9 percent and the investor requires a 1 percent risk premium on this bond because

there is some probability of default, the required rate of return would be 10 percent. The present

value of the interest payments is an annuity for 30 periods (15 years every six months) at one-

half the required return (5 percent):

Rs.500 × 15.3725 = Rs7,686 (Present Value of Interest Payments at 10 Percent)

The present value of the principal is likewise discounted at 5 percent for 30 periods:

Rs.10,000 × 0.2314 = Rs.2,314 (Present Value of the Principal Payment at 10 Percent)

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This can be summarized as follows:

Present Value of Interest Payments Rs.500 × 15.3725 = Rs.7,686

Present Value of Principal Payment Rs. 10,000 × 0.2314 = 2,314

Total Value of Bond at 10 Percent = Rs.10,000

This is the amount that an investor should be willing to pay for this bond, assuming that the

required rate of return on a bond of this risk class is 10 percent. If the market price of the bond

is above this value, the investor should not buy it because the promised yield to maturity at this

higher price will be less than the investor‘s required rate of return.

Alternatively, assuming an investor requires a 12 percent return on this bond, its value

would be:

Rs.500 × 13.7648 = Rs.6,882

Rs.10,000 × 0.1741 = 1,741

Total Value of Bond at 12 Percent = Rs.8,623

This example shows that if you want a higher rate of return, you will not pay as much for an

asset; that is, a given stream of cash flows has a lower value to you. As before, you would

compare this computed value to the market price of the bond to determine whether you should

invest in it or not.

Valuation of Preferred Share:

The owner of a preferred share receives a promise to pay a stated dividend, usually each year,

for an infinite period. Preferred stock is perpetuity because it has no maturity. As was true with

a bond, stated payments are made on specified dates although the issuer of this stock does not

have the same legal obligation to pay investors as do issuers of bonds. Payments are made only

after the firm meets its bond interest payments. Because this reduced legal obligation increases

the uncertainty of returns, investors should require a higher rate of return on a firm‘s preferred

stock than omits bonds. Although this differential in required return should exist in theory, it

generally does not exist in practice because of the tax treatment accorded dividends paid to

corporations. Since, preferred stock is perpetuity, its value is simply the stated annual dividend

divided by the required rate of return on preferred stock (kp) as follows:

V = Dividend / Kp

Assume a preferred stock has a Rs.100 par value and a dividend of Rs.8 a year. Because of the

expected rate of inflation, the uncertainty of the dividend payment, your required rate of return

on this stock is 9 percent. Therefore, the value of this preferred stock to you is:

V = 8/.09 = Rs.88.89

Given this estimated value, you would inquire about the current market price to decide whether

you would want to buy this preferred stock. If the current market price is Rs.95, you would

decide against a purchase, whereas if it is Rs.80, you would buy the stock. Also, given the

market price of preferred stock, you can derive its promised yield. Assuming a current market

price of Rs.85, the promised yield would be:

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Kp= Dividend / Price

= Rs.8/Rs.85

= 0.09411

Approaches to the Valuation of Equity Share:

Valuation of Bonds and Preferred Shares are relatively easy when comparing with that of equity

shares. Owing to the complexity and importance of valuing common stock, various techniques

for accomplishing this task have been devised over time. These techniques fall into one of two

general approaches:

(1) the discounted cash flow valuation techniques, where the value of the stock is estimated

based upon the present value of some measure of cash flow, including dividends, operating cash

flow, and free cash flow; and

(2) the relative valuation techniques, where the value of a stock is estimated based upon its

current price relative to variables considered to be significant to valuation, such as earnings, cash

flow, book value, or sales.

Exhibit No.3.1 provides a visual presentation of the alternative approaches and specific

techniques.

Exhibit No.3.1

Source: Adopted from Reilly and Brown, 8

th Edition

An important point is that both of these approaches and all of these valuation techniques have

several common factors. First, all of them are significantly affected by the investor‘s required

rate of return on the stock because this rate becomes the discount rate or is a major component of

the discount rate. Second, all valuation approaches are affected by the estimated growth rate of

the variable used in the valuation technique—for example, dividends, earnings, cash flow, or

sales. As noted in the efficient market discussion, both of these critical variables must be

estimated. As a result, different analysts using the same valuation techniques will derive different

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estimates of value for a stock because they have different estimates for these critical variable

inputs.

The following discussion of equity valuation techniques considers the specific models and the

theoretical and practical strengths and weaknesses of each of them.

Discounted Cash Flow Valuation Approach- Why and When?

Discounted cash flow valuation techniques are obvious choices for valuation because they are

the epitome of how we describe value—that is, the present value of expected cash flows. The

major difference between the alternative techniques is how one specifies cash flow—that is, the

measure of cash flow used. The cleanest and most straightforward measure of cash flow is

dividends because these are clearly cash flows that go directly to the investor, which implies that

you should use the cost of equity as the discount rate. However, this dividend technique is

difficult to apply to firms that do not pay dividends during periods of high growth, or that

currently pay very limited dividends because they have high rate of return investment

alternatives available. On the other hand, an advantage is that the reduced form of the dividend

discount model (DDM) is very useful when discussing valuation for a stable, mature entity

where the assumption of relatively constant growth for the long term is appropriate.

The second specification of cash flow is the operating free cash flow, which is generally

described as cash flows after direct costs (cost of goods and S, G & A expenses) and before any

payments to capital suppliers. Because we are dealing with the cash flows available for all capital

suppliers, the discount rate employed is the firm‘s weighted average cost of capital

(WACC).This is a very useful model when comparing firms with diverse capital structures

because you determine the value of the total firm and then subtract the value of the firm‘s debt

obligations to

arrive at a value for the firm‘s equity.

The third cash flow measure is free cash flow to equity, which is a measure of cash flows

available to the equity holder after payments to debt holders and after allowing for expenditures

to maintain the firm‘s asset base. Because these are cash flows available to equity owners, the

appropriate discount rate is the firm‘s cost of equity. Beyond being theoretically correct, these

models allow a substantial amount of flexibility in terms of changes in sales and expenses that

implies changing growth rates over time. Once you understand how to compute each measure of

cash flow, you can estimate cash flow for each year by constructing a pro forma statement for

each year or you can estimate overall growth rates for the alternative cash flow values as we will

demonstrate with the DDM.

A potential difficulty with these cash flow techniques is that they are very dependent on the two

significant inputs—(1) the growth rates of cash flows (both the rate of growth and the duration

of growth) and (2) the estimate of the discount rate. As we will show in several instances, a small

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change in either of these values can have a significant impact on the estimated value. This is a

critical realization when using any theoretical model: Everyone knows and uses the same model,

but it is the inputs that are critical—GIGO: garbage in, garbage out!

Relative Valuation Techniques: Why and When to Use?

As noted, a potential problem with the discounted cash flow valuation models is that it is

possible to derive intrinsic values that are substantially above or below prevailing prices

depending on how you adjust your estimated inputs to the prevailing environment. An advantage

of the relative valuation techniques is that they provide information about how the market is

currently valuing stock at several levels—that is, the aggregate market, alternative industries,

and individual stocks within industries. Following this chapter, which provides the background

for these two approaches, we will demonstrate the alternative relative valuation ratios for the

aggregate market, for an industry relative to the market, and for an individual company relative

to the aggregate market, to its industry, and to other stocks in its industry. The good news is that

this relative valuation approach provides information on how the market is currently valuing

securities. The bad news is that it is providing information on current valuation.

The point is, the relative valuation approach provides this information on current valuation, but it

does not provide guidance on whether these current valuations are appropriate—that is, all

valuations at a point in time could be too high or too low. For example, assume that the market

becomes significantly overvalued. For example, if you compare the value for an industry to the

very overvalued market, you might contend based on such a comparison that an industry is

undervalued relative to the market. Unfortunately, your judgment may be wrong because of the

benchmark you are using—that is, you might be comparing a fully valued industry to a very

overvalued market. Put another way, the relative valuation techniques are appropriate to consider

under two scenarios:

1. You have a good set of comparable entities—that is, comparable companies that are similar

in terms of industry, size, and, it is hoped, risk.

2. The aggregate market and the company‘s industry are not at a valuation extreme—that is,

they are not either seriously undervalued or overvalued.

Discounted Cash Flow (DCF) Valuation Techniques:

All the DCF valuation techniques are based on the basic valuation model, which asserts that the

value of an asset is the present value of its expected future cash flows as follows:

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As noted, the specific cash flows used will differ between techniques. They range from dividends

(the best-known model) to operating free cash flow and free cash flow to equity. We begin with a

fairly detailed presentation of the present-value-of-dividend model, referred to as the dividend

discount model (DDM), because it is intuitively appealing and is the best-known model. Also, its

general approach is similar to the other discounted cash flow models.

The Dividend Discount Model (DDM):

The dividend discount model assumes that the value of a share of common stock is the present

value of all future dividends as follows:

A technique for valuing the price of a stock by using predicted dividends and discounting them

back to present value. The idea is that if the value obtained from the DDM is higher than what

the shares are currently trading at, then the stock is undervalued. This technique has many

variations, and it doesn't work for companies that don't pay out dividends. For example one

variation is the supernormal dividend growth model which takes into account a period of high

growth followed by a lower, constant growth period. The principal behind the model is the net

present value of the cash flows. To get a growth number, one option is to take the return

on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio).

Present Value of Operating Free Cash Flows:

In this model, you are deriving the value of the total firm because you are discounting the

operating free cash flows prior to the payment of interest to the debt holders but after deducting

funds needed to maintain the firm‘s asset base (capital expenditures). Also, because you are

discounting the total firm‘s operating free cash flow, you would use the firm‘s weighted average

cost of capital (WACC) as your discount rate. Therefore, once you estimate the value of the total

firm, you subtract the value of debt, assuming your goal is to estimate the value of the firm‘s

equity.

The total value of the firm is equal to:

where:

Vj= value of firm j

n = number of periods assumed to be infinite

OFCFt= the firm‘s operating free cash flow in period t.

WACCj = firm j‟s weighted average cost of capital

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Present Value of Free Cash Flows to Equity:

The third discounted cash flow technique deals with ―free‖ cash flows to equity, which would be

derived after operating free cash flows have been adjusted for debt payments (interest and

principle).Also, these cash flows precede dividend payments to the common stockholder. Such

cash flows are referred to as ―free‖ because they are what is left after meeting all obligations to

other capital suppliers (debt and preferred stock) and after providing the funds needed to

maintain the firm‘s asset base (similar to operating free cash flow).Notably, because these are

cash flows available to equity owners, the discount rate used is the firm‘s cost of equity (k) rather

than the firm‘s WACC.

where:

Vj= value of the stock of firm j

n = number of periods assumed to be infinite

FCFEt= the firm‘s free cash flow to equity in period t.

Again, how an analyst would implement this general model depends upon the firm‘s position in

its life cycle. That is, if the firm is expected to experience stable growth, analysts can use the

infinite growth model. In contrast, if the firm is expected to experience a period of temporary

supernormal growth, analysts should use the multistage growth model similar to the process used

with dividends and for operating free cash flow.

Relative Valuation:

In contrast to the various discounted cash flow techniques that attempt to estimate a specific

value for a stock based on its estimated growth rates and its discount rate, the relative valuation

techniques implicitly contend that it is possible to determine the value of an economic entity(i.e.,

the market, an industry, or a company) by comparing it to similar entities on the basis of several

relative ratios that compare its stock price to relevant variables that affect a stock‘s value, such as

earnings, cash flow, book value, and sales.

In relative valuation, we value an asset based upon how similar assets are priced in the market. A

prospective house buyer decides how much to pay for a house by looking at the prices paid for

similar houses in the neighborhood. A baseball card collector makes a judgment on how much to

pay for a Mickey Mantle rookie card by checking transactions prices on other Mickey Mantle

rookie cards. In the same vein, a potential investor in a stock tries to estimate its value by looking

at the market pricing of ―similar‖ stocks. Embedded in this description are the three essential

steps in relative valuation.

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The first step is finding comparable assets that are priced by the market, a task that is easier to

accomplish with real assets like baseball cards and houses than it is with stocks. All too often,

analysts use other companies in the same sector as comparable, comparing a software firm to

other software firms or a utility to other utilities, but we will question whether this practice really

yields similar companies is an another question!.

The second steps scaling the market prices to a common variable to generate standardized prices

that are comparable. While this may not be necessary when comparing identical assets

(MickeyMantle rookie cards), it is necessary when comparing assets that vary in size or units.

Other things remaining equal, a smaller house or apartment should trade at a lower price than a

larger residence. In the context of stocks, this equalization usually requires converting the market

value of equity or the firm into multiples of earnings, book value or revenues.

The third and last step in the process is adjusting for differences across assets when comparing

their standardized values. Again, using the example of a house, a newer house with more updated

amenities should be priced higher than a similar sized older house that needs renovation. With

stocks, differences in pricing across stocks can be attributed to all of the fundamentals that we

talked about in discounted cash flow valuation. Higher growth companies, for instance, should

trade at higher multiples than lower growth companies in the same sector. Many analysts adjust

for these differences qualitatively, making every relative valuation a story telling experience;

analysts with better and more believable stories are given credit for better valuation.

There is a significant philosophical difference between discounted cash flow and relative

valuation. In discounted cash flow valuation, we are attempting to estimate the intrinsic value of

an asset based upon its capacity to generate cash flows in the future. In relative valuation, we are

making a judgment on how much an asset is worth by looking at what the market is paying for

similar assets. If the market is correct, on average, in the way it prices assets, discounted cash

flow and relative valuations may converge. If, however, the market is systematically over pricing

or under pricing a group of assets or an entire sector, discounted cash flow valuations can deviate

from relative valuations.

Reasons for Popularity and potential pitfalls:

Why is the use of relative valuation so widespread? Why do managers and analysts relate so

much better to a value based upon a multiple and comparables than to discounted cash flow

valuation? In this section, we consider some of the reasons for its popularity.

a. It is less time and resource intensive than discounted cash flow valuation:

Discounted cash flow valuations require substantially more information than relative valuation.

For analysts who are faced with time constraints and limited access to information, relative

valuation offers a less time intensive alternative.

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b. It is easier to sell:

In many cases, analysts, in particular, and sales people, in general, use valuations to sell stocks to

investors and portfolio managers. It is far easier to sell a relative valuation than a discounted cash

flow valuation. After all, discounted cash flow valuations can be difficult to explain to clients,

especially when working under a time constraint – many sales pitches are made over the phone

to investors who have only a few minutes to spare for the pitch. Relative valuations, on the other

hand, fit neatly into short sales pitches. In political terminology, it is far easier to spin a relative

valuation than it is to spin a discounted cash flow valuation.

c. It is easy to defend:

Analysts are often called upon to defend their valuation assumptions in front of superiors,

colleagues and clients. Discounted cash flow valuations, with their long lists of explicit

assumptions are much more difficult to defend than relative valuations, where the value used for

a multiple often comes from what the market is paying for similar firms. It can be argued that the

brunt of the responsibility in a relative valuation is borne by financial markets. In a sense, we are

challenging investors who have a problem with a relative valuation to take it up with the market,

if they have a problem with the value.

d. Market Imperatives:

Relative valuation is much more likely to reflect the current mood of the market, since it

attempts to measure relative and not intrinsic value. Thus, in a market where all internet stocks

see their prices bid up, relative valuation is likely to yield higher values for these stocks than

discounted cash flow valuations. In fact, by definition, relative valuations will generally yield

values that are closer to the market prices than discounted cash flow valuations, across all stocks.

This is particularly important for those investors whose job it is to make judgments on relative

value and who are themselves judged on a relative basis. Consider, for instance, managers of

technology mutual funds. These managers will be judged based upon how their funds do relative

to other technology funds. Consequently, they will be rewarded if they pick technology stocks

that is under-valued relative to other technology stocks, even if the entire sector is over

valued.

Advantages and Disadvantages:

The strengths of relative valuation are also its weaknesses. First, the ease with which a relative

valuation can be put together, pulling together a multiple and a group of comparable firms can

also result in inconsistent estimates of value where key variables such as risk, growth or cash

flow potential are ignored.

Second, the fact that multiples reflect the market mood also implies that using relative valuation

to estimate the value of an asset can result in values that are too high, when the market is over

valuing comparable firms, or too low, when it is under valuing these firms.

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Third, while there is scope for bias in any type of valuation, the lack of transparency regarding

the underlying assumptions in relative valuations make them particularly vulnerable to

manipulation. A biased analyst who is allowed to choose the multiple on which the valuation is

based and to choose the comparable firms can essentially ensure that almost any value can be

justified.

Relative valuation is not as straightforward as it might appear on the surface. Which companies

are chosen as comparable companies and which multiples are used to determine value will have

a significant outcome on a company's relative valuation. When performing a relative valuation, a

company's sector should be used to determine the most logical multiple to use. For example,

price to cash flow for real estate and price to sales for retail.

Further Classification of Relative Valuation Models:

Analysts and investors are endlessly inventive when it comes to using relative valuation. Some

compare multiples across companies, while others compare the multiple of a company to the

multiples it used to trade in the past. While most relative valuations are based upon comparables,

there are some relative valuations that are based upon fundamentals.

I.Fundamentals versus Comparables

In discounted cash flow valuation, the value of a firm is determined by its expected cash flows.

Other things remaining equal, higher cash flows, lower risk and higher growth should yield

higher value. Some analysts who use multiples go back to these discounted cash flow models to

extract multiples. Other analysts compare multiples across firms or time, and make explicit or

implicit assumptions about how firms are similar or vary on fundamentals.

1. Using Fundamentals

The first approach relates multiples to fundamentals about the firm being valued –growth rates in

earnings and cash flows, payout ratios and risk. This approach to estimating multiples is

equivalent to using discounted cash flow models, requiring the same information and yielding

the same results. Its primary advantage is to show the relationship between multiples and firm

characteristics, and allows us to explore how multiples change as these characteristics change.

For instance, what will be the effect of changing profit margins on the price/sales ratio? What

will happen to price-earnings ratios as growth rates decrease? What is the relationship between

price-book value ratios and return on equity?

2. Using Comparables

The more common approach to using multiples is to compare how a firm is valued with how

similar firms are priced by the market, or in some cases, with how the firm was valued in prior

periods. As we will see in the later chapters, finding similar and comparable firms is often a

challenge and we have to often accept firms that are different from the firm being valued on one

dimension or the other. When this is the case, we have to either explicitly or implicitly control

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for differences across firms on growth, risk and cash flow measures. In practice, controlling for

these variables can range from the naïve (using industry averages) to the sophisticated

(multivariate regression models where the relevant variables are identified and we control for

differences.).

II. Cross Sectional versus Time Series Comparisons

In most cases, analysts price stocks on a relative basis by comparing the multiple it is trading to

the multiple at which other firms in the same business are trading. In some cases, however,

especially for mature firms with long histories, the comparison is done across time.

a. Cross Sectional Comparisons

When we compare the price earnings ratio of a software firm to the average price earnings ratio

of other software firms, we are doing relative valuation and we are making cross sectional

comparisons. The conclusions can vary depending upon our assumptions about the firm being

valued and the comparable firms. For instance, if we assume that the firm we are valuing is

similar to the average firm in the industry, we would conclude that it is cheap if it trades at a

multiple that is lower than the average multiple. If, on the other hand, we assume that the firm

being valued is riskier than the average firm in the industry, we might conclude that the firm

should trade at a lower multiple than other firms in the business. In short, you cannot compare

firms without making assumptions about their fundamentals.

b. Comparisons across time

If you have a mature firm with a long history, you can compare the multiple it trades today to the

multiple it used to trade in the past. Thus, Ford Motor company maybe viewed as cheap because

it trades at six times earnings, if it has historically traded at ten times earnings. To make this

comparison, however, you have to assume that your firm has not changed its fundamentals over

time. For instance, you would expect a high growth firm‘s price earnings ratio to drop and its

expected growth rate to decrease overtime as it becomes larger. Comparing multiples across time

can also be complicated by changes in the interest rates over time and the behavior of the overall

market. For instance, as interest rates fall below historical norms and the overall market

increases, you would expect most companies to trade at much higher multiples of earnings and

book value than they have historically.

Applicability of multiples and limitations

The allure of multiples is that they are simple and easy to work with. They can be used to obtain

estimates of value quickly for firms and assets, and are particularly useful when there are a large

number of comparable firms being traded on financial markets and the market is, on average,

pricing these firms correctly. They tend to be more difficult to use to value unique firms, with no

obvious comparables, with little or no revenues and negative earnings.

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By the same token, they are also easy to misuse and manipulate, especially when comparable

firms are used. Given that no two firms are exactly similar in terms of risk and growth, the

definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a

group of comparable firms to confirm his or her biases about a firm‘s value. An illustration of

this is given below. While this potential for bias exists with discounted cash flow valuation as

well, the analyst in Discounted Cash Flow valuation is forced to be much more explicit about the

assumptions which determine the final value. With multiples, these assumptions are often left

unstated.

The other problem with using multiples based upon comparable firms is that it builds in errors

(over valuation or under valuation) that the market might be making in valuing these firms. For

instance, if the market has overvalued all computer software firms, using the average PE ratio of

these firms to value an initial public offering will lead to an overvaluation of its stock. In

contrast, discounted cash flow valuation is based upon firm-specific growth rates and cash flows,

and is less likely to be influenced by market errors in valuation.

Asset Based Valuation Models

There are some who add a fourth approach to valuation to the three that we describe in this

chapter. They argue that you can argue the individual assets owned by a firm and use that to

estimate its value – asset based valuation models. In fact, there are several variants on asset

based valuation models. The first is liquidation value, which is obtained by aggregating the

estimated sale proceeds of the assets owned by a firm. The second is replacement cost, where

you evaluate what it would cost you to replace all of the assets that a firm has today.

While analysts may use asset-based valuation approaches to estimate value, we do not consider

them to be alternatives to discounted cash flow, relative or option pricing models since both

replacement and liquidation values have to be obtained using one or more of these approaches.

Ultimately, all valuation models attempt to value assets – the differences arise in how we identify

the assets and how we attach value to each asset. In liquidation valuation, we look only at assets

in place and estimate their value based upon what similar assets are priced at in the market. In

traditional discounted cash flow valuation, we consider all assets including expected growth

potential to arrive at value. The two approaches may, in fact, yield the same values if you have a

firm that has no growth assets and the market assessments of value reflect expected cash flows.

Contingent Claim Valuation

Perhaps the most significant and revolutionary development in valuation is the acceptance, at

least in some cases, that the value of an asset may not be greater than the present value of

expected cash flows if the cash flows are contingent on the occurrence or non-occurrence of an

event. This acceptance has largely come about because of the development of option pricing

models. While these models were initially used to value traded options, there has been an

attempt, in recent years, to extend the reach of these models into more traditional valuation.

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There are many who argue that assets such as patents or undeveloped reserves are really options

and should be valued as such, rather than with traditional discounted cash flow models.

To conclude, there are three basic, though not mutually exclusive, approaches to valuation. The

first is discounted cash flow valuation, where cash flows are discounted at a risk-adjusted

discount rate to arrive at an estimate of value. The analysis can be done purely from the

perspective of equity investors, by discounting expected cash flows to equity at the cost of

equity, or it can be done from the viewpoint of all claimholders in the firm, by discounting

expected cash flows to the firm at the weighted average cost of capital. The second is relative

valuation, where the value of the equity in a firm is based upon the pricing of comparable firms

relative to earnings, cash flows, book value or sales. The third is contingent claim valuation,

where an asset with the characteristics of an option is valued using an option pricing model.

There should be a place for each among the tools available to any analyst interested in valuation.

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Table No.3.1

International Comparison of Accounting Principles

Accounting Principle UK USA France Germany Netherlands Sweden

1. Consistence – accounting principles and methods are applied on the

same basis from period to period Yes Yes Yes Yes Yes PP

2. Realization – revenue is recognized when realization is

reasonably assured Yes Yes Yes Yes Yes Yes

3. Fair presentation of the financial statement is required Yes Yes Yes Yes Yes Yes

4. Historical cost convention – departures from the historical

cost convention are disclosed Yes Yes Yes Yes Yes Yes

5. Accounting policies – a change in accounting principles

and methods without a change in circumstances

is accounted for by a prior year adjustment Yes No Yes MP RF MP

6. Fixed assets – revaluation – in historical cost statements,

fixed assets are stated at an amount in excess

of cost which is determined at irregular intervals. MP No Yes No RF PP

7. Fixed assets – revaluation – when fixed assets are stated,

in historical cost statements, at an amount in

excess of cost, depreciation based on the revaluation amount

is charged to income. Yes No Yes No Yes Yes

8. Goodwill amortized MP Yes Yes Yes M Yes

9. Finance leases capitalized Yes Yes No No No Yes

10. Short-term marketablse securities at the lower of

cost or market value Yes Yes Yes Yes Yes Yes

11. Inventory values at the lower of cost or market value Yes Yes Yes Yes Yes Yes

12. Manufacturing overhead allocated to year-end inventory Yes Yes Yes Yes Yes Yes

13. Inventory costed using FIFO PP M M M M PP

14. Long-term debt included maturities longer than one year Yes Yes Yes No Yes Yes

15. Deferred tax recognized where accounting income and

taxable income arise at different times Yes Yes Yes No Yes No

16. Total pension fund assets and liabilities excluded from

a company‘s financial statements Yes Yes Yes No Yes Yes

17. Research and development expensed Yes Yes Yes Yes Yes Yes

18. General purpose (purely discretionary) reserves allowed No No Yes Yes Yes Yes

19. Offsetting-assets and liabilities are offset against each

other in the balance sheet only when a legal right

of offset exists Yes Yes Yes Yes Yes Yes

20. Unusual and extraordinary gains and losses are taken in

the income statement Yes Yes Yes Yes Yes Yes

21. Closing rate method of foreign currency translation employed Yes Yes Yes Yes Yes No

22. Currency translation gains or losses arising from trading

are reflected in current income Yes Yes MP MP MP MP

23. Excess depreciation permitted Yes No Yes Yes Yes Yes

24. Basic statements reflect a historical cost valuation

(no price level adjustment) Yes Yes Yes Yes M Yes

25. Supplementary inflation – adjusted financial statements

adjusted MP MP No NO MP Yes

(a) less than 20% ownership - cost method Yes Yes Yes Yes No Yes

(b) 20 - 50% ownership -equity method Yes Yes Yes No Yes MP

(c) More than 50% full consolidation Yes Yes Yes Yes Yes Yes

27. Both domestic and foreign subsidiaries consolidated Yes Yes Yes M Yes Yes

Source: Adopted from Investment Valuation – Damodaran, 2nd Edition

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CHAPTER NO.IV

Report Writing and Presentation

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Equity research is a report written by a brokerage or securities firm for its clients as a way to

help investors make decisions about where to invest resources. A written or electronic

communication that includes an analysis of equity securities of individual companies or

industries, and that provides information reasonably sufficient upon which to base an investment

decision. Readers of Equity Research, more so than anything else, are looking for you to identify

trends that make investment decisions easier to justify.

Points to be kept in mind while preparing an equity research report:

The report should be simple and to the point. It may seem obvious, but portfolio, pension-

fund managers and investors do not want to read something they don't understand. If your

research has identified a trend or a buy/sell opportunity, keep the communication simple

and easy to understand, but don't be condescending.

Issue the report in a timely manner. Late investment advice is of no value.

Concentrate on 5 main areas: 1) the company, 2) the industry, 3) government interest, 4)

market interest, and 5) investment ideas for clients. You can find this information in the

annual report and official SEBI and Exchange filings, company press releases, company

visits, industry studies, relevant government sources and the press.

Report the basics on the cover. The reader should know, immediately, the reason to read

the report. Include a paragraph that gives the client a reason to read your analysis, what

investors should think about the stock. What is the investment conclusion? What is new

and different from consensus estimates (read: other analysts).

Keep your audience engaged with a clear report design. The report should never be more

than 30 pages; always use charts and graphs to support your arguments, and use message

headings to help the reader navigate the document. Also edit the text for industry jargon

and passive verbs.

Discuss risks. This usually goes at the end of an equity research report, but you are

obligated as a research analyst to provide information on the risks involved in taking your

advice. Readers expect this section.

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Template for the Equity Research Report:

Following is the proforma Equity research report. There may be slight changes with between the

research analysts, but by and large this is the template which is followed by many of the analysts

across the world.

Highlights

Investment summary

Historical financial

Industry analysis

Valuation

Business description

Other headings

Industry description and competitive position

Estimates

Investment risks

Disclosures

Under the Highlights section:

Tells the reader why they should read the report.

1-2 sentences per bullet.

Be clear and concise.

Investment summary section

Make a longer statement about your recommendation.

Make assertions that back up your recommendation.

Leave support of assertions to the body of report.

Valuation section

Used to justify your price target

Each of the models that you use should be presented.

Do not reiterate textbook material.

Risks to the price target should be included

Incorporate a sensitivity analysis of the valuation based on your computations.

Under Business Description Section:

• Describe business, products, finances, and strategy of company.

• Relative importance of segments and products.

• Highlight important assets or liabilities.

• Special situations/earnings interruptions

• Mergers &Acquisitions if any

• Restructurings – effects/pay back expectations

• Discontinued operations

• What is the leverage?

• Operating, fixed and variable costs

• Value added

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• How to manage downturn

Other headings

• Use to make points that do not fit in the rest of the report

• Contains for example:

• Cost of capital calculations.

• Dilution of shares analysis.

• Large insider share-holdings details.

Industry description and competitive position:

Describe the industry

• Where in cycle does

• Who are the competitors

• Describe how the industry excel

• How has it performed in the previous cycles

• Cyclical, Continuous growth

• Industry Maturity

• Effects of recession/ slow

• What are the factors that affects the company the most

• Demand Environment recovery

• Forces affecting the industry

• Elasticity of Demand

• Speed of Product

• Innovation

• Rate of growth

Historical financial analysis

• Must be ratio based using a bottoms-up using the DuPont and the leverage formulas.

• Historical and comparison with industry.

• How as the company performed and how well in comparison with industry.

• Operating Performance

• Analyze the company using the DuPont formula

• Financial Performance

• Comparing the company with its components.

• Total Performance

Estimates section

• Must be ratio based following leverage and DuPont-formula.

• The analysis of the future should be done relating the company to its peers in the

industry.

• Justify the assumptions made

• Short run Total Performance

• Long-run Performance

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Sources of Information:

Having discussed the proforma research report, you should know where is the relevant

information available for writing the report in the manner as described above.

Public information

• Returns / documents filed with SEBI and the stock exchanges

• Annual Reports

• Press Releases

Conversations with company management for detailed information

• Establish relationships with new companies

• Most meetings with companies done via phone; some in-person meetings

• Obtain a better understanding of:

• Trends

• Leverage/margins

• Efficiency programs

• Costs - current, changes

• Management team

Validation:

The information collected from multiple sources must be validated before doing any further

analysis. The validation could be done by confirming and reconfirming the data collected from

various sources.

Expert / Legal Opinion:

Whenever, the analysts fees that the data obtained is technical or if he feels that he is not

understanding the things in a proper manner, he should seek the help of the expert in the

respective field. For instance, when an analyst is writing a report about an oil company where in

lot of technical details regarding oil upstream, downstream, refining, transportation and the like

he should seek the help of an expert in this field in order to better understand and absorb.

Further, before releasing the final report the analyst should ensure that no legal issues should

arise out of the report. He should also seek a legal opinion and also write the caveat very clearly

stating that the contents of the reports are purely based on the personal opinion of the analyst

based on the information collected from multiple sources and assumptions.

A model Equity Research Report of Kotak Securities is appended below for your reference and

understanding:

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Source:http://www.kotaksecurities.com/pdf/morninginsightsample.pdf

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References:

Bodie, Kane and Marcus, Essentials of Investments, 7th

Edition, McGrwa Hill Irwin Series.

Reilly and Brown, Investment Analysis and Portfolio Management, 8th

Edition, Thomson, South

Western.

Damodaran A, Investment Valuation – Tools and Techniques for determining the value of any

asset – 2nd

Edition, Wiley & Sons, New York.

Websites:

www.nseindia.com accesses on 20th

November 2012

www.baseindia.com accessed on 20th

November 2012

www.investopedia.com accessed on 21st November 2012

www.ssrn.com accessed on 21st November 2012

www.ncaer.org accessed on 25th

November 2012

www.tatasteeel.com accessed on 28th

November 2012

www.accclimited.com accessed on 28th

November 2012

www.capitaline.com accessed on 28th

November 2012

www.kotaksecurities.com/pdf/morninginsightsample.pdf accessed on 1st December 2012

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Useful Formulas

Nominal Rate

Interest rate is the price for using someone’s money. In simple terms, if money is kept idle,

its value would get eroded by at least the rate of inflation. Anyone having surplus money

would try to earn at least the rate of inflation to be at par, but to grow in real terms of

wealth his money should increase beyond the rate of inflation. Thus, a lender would quote a

nominal rate, of interest, which would be;

N = R + I

Where,

N = Nominal Rate of Interest

R = Real Rate of Interest

I = Inflation

Assuming an inflation rate of 3% and a desired real rate of 4%, the nominal rate of interest

would be;

N = R + I

N = 4% + 3%

N = 7%

Effective Rate

Effective rate of interest is the rate which takes the effect of compounding. To put in simple

terms when the year is broken into smaller units like quarterly, monthly, etc and

compounding frequency is more than 1, than the nominal rate and effective rate starts

differing. The investor / borrower effectively starts receiving / paying more than what was

quoted (nominal rate).

Where,

i = Effective rate of interest

i(p) = Nominal rate if interest

p = Number of periods broken in a year (frequency)

Illustration-1

State Bank of India is quoting car loan at the rate of 12.5% for a period of 5 years. The loan

has to be repaid in equated monthly installments. Calculate the effective rate.

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Flat Rate

The rate at which interest is calculated on the original loan amount, irrespective of the

principal repayment, is called flat rate of interest. Unlike the effective rate which calculates

the interest on the reduced principal, the flat rate ignore the principal repayment and thus

the interest figure calculated turns out to be same as the first period interest.

Flat rate of interest is a gimmick used by the market to show a lower rate and charge a

higher rate. The flat rate can be converted into an effective rate by the following thumb

rule:

E = F x 2 x (n / n+1)

Where,

E = Effective rate on interest

F = Flat rate of interest

n = Number of installements

Illustration-2

Citi Bank offers personal loan for 5 years at a flat rate of 9.5% p.a. Calculate the effective

rate of interest if the loan is to be paid in equated monthly installments.

E = F x 2 x (n / n+1)

= 9.5 x 2 x (60 / 61)

E = 18.69%

Rule of ‘72’

The rule of ‘72’, is a simple thumb rule used for doubling period calculation.

For example what is the interest rate earned if the money is doubled in 5 years.

r = 72 / n

= 72 / 5

r = 14.4% (aprox)

or

For example, in how many years the money can be doubled if the rate of interest is 9%.

n = 72 / r

= 72 / 9

n = 8 years (aprox)

Rule of ‘69’

Very similar to the rule of 72, a rule stating that an amount of money invested at r percent

per period will double as:-

n = 69/r (in percent) + .35 periods

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Continuous Compounding

Compounding is a process of calculating interest on interest at some intervals. Continuous

compounding is the process of calculating interest on interest for infinite times during the

life of investment. For calculating the continuous compounded value of investment we would

need the continuous compounding factor (CCF(r%,t))

CCF(r%,t) = ert

Where,

CCF(r%,t) =Continuous compounding factor for Rs 1 invested at the rate ‘r’ for time ‘t’

e = Base to natural log (ln)

If the money is invested at any rate for a particular time period and compounded

continuously, the resultant would be highest future value. Therefore, an investor should

always insist on getting his money compounded continuously.

FV = PV x CCF(r%,t)

Illustration-14

Rahul wants to invest Rs 100000 for 5 years. The bank offers him an interest rate of

8.25%p.a. compounded continuously. Calculate the amount Rahul would get after 5 years.

FV = PV x CCF(8.25%,5)

= PV x ert

= 100000 x e0.0825 x 5

= 100000 X 1.5106

= 1,51,058.95

Hence, rahul would get an amount of Rs 1,51,058.95 after 5 years.

Continuous Discounting

Discounting is a process of calculating the reduction of interest at some intervals.

Continuous discounting is the process of calculating the reduction of interest for infinite

times during the life of investment. For calculating the continuous discounted value of future

cash flow we would need the continuous discounting factor (CDF(r%,t))

CDF(r%,t) = e-rt

Where,

CDF(r%,t) = Continuous compounding factor for Rs 1 invested at the rate ‘r’ for time ‘t’

e = Base to natural log (ln)

If present value is calculated at any rate for a particular time period and discounted

continuously, the resultant would be lowest present value. Therefore, if you have to pay a

lump sum against some future liability, you should insist on getting this future value of

money discounted continuously.

PV = FV x CDF(r%,t)

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Illustration-15

Sushmita has to pay Kaveri Rs 3,65,000 after 4 years. Kaveri is in need of money and

wants the money now. Sushmita agrees but after continous discounting the money at the

rate of 14%p.a. calculate the amount of money that sushmita can pay now.

PV = FV x CDF(14%,4)

= FV x e-rt

= 365000 x e-0.14 x 4

= 365000 x 0.5712

= 2,08,491.31

Hence, Sushmita would only pay Rs 2,08,491.31 today.

DuPont analysis

DuPont analysis (also known as the dupont identity, DuPont equation, DuPont Model

or the DuPont method) is an expression which breaks ROE (Return On Equity) into three

parts.

The name comes from the DuPont Corporation that started using this formula in the 1920s.

Basic formula

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net

profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)

Profitability (measured by profit margin)

Operating efficiency (measured by asset turnover)

Financial leverage (measured by equity multiplier)

ROE analysis

The Du Pont identity breaks down Return on Equity (that is, the returns that investors

receive from the firm) into three distinct elements. This analysis enables the analyst to

understand the source of superior (or inferior) return by comparison with companies in

similar industries (or between industries).

The Du Pont identity, however, is less useful for some industries, such as investment

banking, that do not use certain concepts or for which the concepts are less meaningful.

Variations may be used in certain industries, as long as they also respect the underlying

structure of the Du Pont identity.

Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is

by definition true.

Examples

High Turnover Industries

Certain types of retail operations, particularly stores, may have very low profit margins on

sales, and relatively moderate leverage. In contrast, though, groceries may have very high

turnover, selling a significant multiple of their assets per year. The ROE of such firms may

be particularly dependent on performance of this metric, and hence asset turnover may be

studied extremely carefully for signs of under-, or, over-performance. For example, same

store sales of many retailers is considered important as an indication that the firm is

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deriving greater profits from existing stores (rather than showing improved performance by

continually opening stores).

High margin industries

Other industries, such as fashion, may derive a substantial portion of their competitive

advantage from selling at a higher margin, rather than higher sales. For high-end fashion

brands, increasing sales without sacrificing margin may be critical. The Du Pont identity

allows analysts to determine which of the elements is dominant in any change of ROE.

High leverage industries

Some sectors, such as the financial sector, rely on high leverage to generate acceptable

ROE. In contrast, however, many other industries would see high levels of leverage as

unacceptably risky. Du Pont analysis enables the third party (relying primarily on the

financial statements) to compare leverage with other financial elements that determine ROE

among similar companies.

ROA and ROE ratio

The return on assets (ROA) ratio developed by DuPont for its own use is now used by

many firms to evaluate how effectively assets are used. It measures the combined effects of

profit margins and asset turnover.[1]

The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2]

Decomposing the ROE into various factors influencing company performance is often called

the Du Pont system.[3]

Where

Net income = net income after taxes

Equity = shareholders' equity

EBIT = Earnings before interest and taxes

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This decomposition presents various ratios used in fundamental analysis.

The company's tax burden is (Net income ÷ Pretax profit). This is the proportion of

the company's profits retained after paying income taxes. [NI/EBT]

The company's interest burden is (Pretax income ÷ EBIT). This will be 1.00 for a firm

with no debt or financial leverage. [EBT/EBIT]

The company's operating income margin or return on sales (ROS) is (EBIT ÷

Sales). This is the operating income per dollar of sales. [EBIT/Sales]

The company's asset turnover (ATO) is (Sales ÷ Assets).

The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt

to equity ratio + 1. This is a measure of financial leverage.

The company's return on assets (ROA) is (Return on sales x Asset turnover).

The company's compound leverage factor is (Interest burden x Leverage).

ROE can also be stated as:[4]

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor

Profit margin is (Net income ÷ Sales), so the ROE equation can be restated:

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Time series analysis comprises methods for analyzing time series data in order to extract

meaningful statistics and other characteristics of the data. Time series forecasting is the

use of a model to predict future values based on previously observed values. While

regression analysis is often employed in such a way as to test theories that the current

value of one time series affects the current value of another time series, this type of

analysis of time series is not called "time series analysis".

Time series data have a natural temporal ordering. This makes time series analysis distinct

from other common data analysis problems, in which there is no natural ordering of the

observations (e.g. explaining people's wages by reference to their respective education

levels, where the individuals' data could be entered in any order). Time series analysis is

also distinct from spatial data analysis where the observations typically relate to

geographical locations (e.g. accounting for house prices by the location as well as the

intrinsic characteristics of the houses). A stochastic model for a time series will generally

reflect the fact that observations close together in time will be more closely related than

observations further apart. In addition, time series models will often make use of the

natural one-way ordering of time so that values for a given period will be expressed as

deriving in some way from past values, rather than from future values (see time

reversibility.)

Methods for time series analyses may be divided into two classes: frequency-domain

methods and time-domain methods. The former include spectral analysis and recently

wavelet analysis; the latter include auto-correlation and cross-correlation analysis.

Additionally time series analysis techniques may be divided into parametric and non-

parametric methods. The parametric approaches assume that the underlying stationary

stochastic process has a certain structure which can be described using a small number of

parameters (for example, using an autoregressive or moving average model). In these

approaches, the task is to estimate the parameters of the model that describes the

stochastic process. By contrast, non-parametric approaches explicitly estimate the

covariance or the spectrum of the process without assuming that the process has any

particular structure.

Additionally methods of time series analysis may be divided into linear and non-linear,

univariate and multivariate.

Time series analysis can be applied to:

real-valued, continuous data

discrete numeric data

discrete symbolic data (i.e. sequences of characters, such as letters and words in

English language)

Cross series analysis comprises methods for analyzing the financial data across the

industry. Selection of a good company does not only qualify improvement over a period of

time (Time series analysis) but also a relatively better performance over the peer group

companies (Cross section analysis).

Thus, cross section analysis or vertical analysis serves an important filter to select a

company considered for investment for a long period.

Models like ROE and DU PONT can be used as structures to perform Time series analysis

and Cross section analysis.

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