SECURITIES ANALYSIS & INVESTMENT MANAGEMENT

Capital Market An Overview

Securities Market
Equity Market Debt Market Derivatives Market

Govt. Securities Market

Corporate Debt Market

Money Market

Options Market

Futures Market

Capital Market An Overview

Participants In Securities Market Regulators Agencies having direct or indirect influence over the securities market. Company Law Board Reserve Bank of India Securities & Exchange Board of India Department of Economic Affairs Department of Company Affairs

Capital Market An Overview

Participants In Securities Market Stock Exchanges A place where old securities are bought & sold. Listed Securities Securities registered with stock exchanges for trading. Depositories - An institution where physical certificates are dematerialised and ownership is transferred by Electronic Book Entries.

Capital Market An Overview

Participants In Securities Market Brokers Registered members of stock exchanges through whom investors transact. E. g., Sharekhan, Indiabulls. Foreign Institutional Investors Institutions from abroad registered with SEBI to invest in Indian capital market.

Capital Market An Overview

Participants In Securities Market Registrars Agencies responsible to handle investor-related services, e.g. Karvy, Cams. Underwriter A person or agency that guarantees for public subscription to a given no. of shares.

Capital Market An Overview Primary Equity Market

o Working in India since late nineteenth century. o Remained dull & inactive till 1991. o Control of Capital Issues Act abolished & SEBI formed as governing body to regulate the primary market. o Companies now free to fix price of their shares & interest on debt securities. o Disclosure of Investor Protection Guidelines made compulsory. o New shares to be issued only in dematerialised form.

Nature of Primary Market

1) Market for New Equity Capital Deals only with securities sold for the first time. Also called the New Issues Market. 2) Direct Issuance of Securities The securities are issued directly to the investors in a Primary Market. 3) Used by Companies Helps companies to raise funds to set up new business or expanding & modernising the existing business. 4) Capital Formation Facilitates the flow of idle money in the market for economic growth & development. 5) Private going Public Used to raise funds by converting private capital into public capital. 6) Sale of Securities Securities can only be sold by original investors.

Nature of Secondary Market

1) Transfer of Securities Securities can be sold & transferred from one person to another. 2) Liquidity Availability of fixed place & presence of large no. of investors makes the securities easily sellable.

Trading
Only listed & permitted securities traded on Stock Exchange. Investors need to place their orders with the members / brokers of the exchange.

Ways of Trading Open Outcry System

There are several trading posts for different securities. Traders or their representative shout and respond to signals on these posts. Sellers quote their rates and buyers make their bids. Bargains are closed at a mutually agreed prices.

Ways of Trading Screen-based System

Used widely around the globe. Trading floor is replaced by the computer screen. Trading carried on at a very fast speed. Traders sitting at distant places can buy or sell securities through network of computers.

REGULATORY MECHANISM

SEBI
Came into existence in 1989 by the Ministry Of Finance. Prime objective is to control & regulate the Primary & Secondary Markets to protect the interests of the investors.

SEBI s Guidelines
1. Regulating the Securities Markets. 2. Register & regulate the market intermediaries, like Brokers, Investment Bankers, etc. 3. Register & regulate working of Mutual Funds. 4. Promote & regulate self-regulatory organisations. 5. Prohibit unfair trade practices in securities market. 6. Promote investor education. 7. Training of intermediaries. 8. Prohibit insider trading. 9. Regulate acquisitions & take-overs.

UNIT 2
RISK & RETURN

The Concept
The three types of Risk: 1) Business Risk 2) Interest Rate Risk 3) Market Risk

Business Risk
Associated with poor business performance. May be due to high competition, new technology, substitute products, change in consumers preferences, change in govt. policies, etc. Affects the interests of equity shareholders who have claim on income and wealth of the company. May also affect the interests of debentureholders sometimes.

Interest Rate Risk

Affects the welfare of investors. Market price of existing fixed income securities fall, when the interest rate goes up. When the prevailing interest rate is lower than fixed rate, buyer would not buy it at its face value. Also affects the equity shares price indirectly.

Market Risk
Associated greatly with the sentiments of the investors. When the investors are bullish & optimistic, share prices tend to rise high. Similarly, when the investors are bearish & pessimistic, share prices tend to decline.

COMPONENTS OF RISK

Systematic Risk
Associated with firm-specific factors like, emergence of new products, labour strike, etc. Affects a specific firm and not the sector generally. Can be washed away by diversifying portfolio (combining with other stocks). A favourable development in one firm may offset an adverse happening in another.

Unsystematic Risk
Associated with national economic factors like GDP growth rate, level of govt. spending, interest rates, inflation, etc. Cannot be avoided, as these factors affect all the firms.

Measuring Expected Return

Investment in a stock can take various possible values and the chances of these possible values can vary. If we say there is 3 to 1 chance that the price of a stock will rise in a certain period say, one month, it means that there is a 75% chance of price rise & 25% chance of price decline.

OR

Measuring Expected Return

If we say Stock A may provide return of 6%, 11% or 16% with certain probabilities based on state of economy, & Stock B may provide return of -20%, 10% or 40% with same probabilities based on state of economy. Their probability distribution of returns shall be as -

Measuring Expected Return

State of Economy
Boom Normal Recession

Probability of Occurrence
0.30 0.50 0.20

Rate of Return (%)

Stock A 16 11 6 Stock B 40 10 -20

Measuring Expected Return

Expected Rate of Return is weighted average of all possible returns multiplied by their respective probabilities. The formula E(R) = Ri Pi Where E(R) is the expected return, Ri is the return under state i, Pi is the probability that state i occurs, & n is the no. of possible states of the economy.

State of Economy
Boom Normal Recession

Probability of Occurrence
0.30 0.50 0.20

Rate of Return (%)

Stock A 16 11 6 Stock B 40 10 -20

Expected return of Stock A shall be E(R) = (0.30)(16)+(0.50)(11)+(0.20)(6) = 11.5% Expected return of Stock B shall be E(R) = (0.30)(40)+(0.50)(10)+(0.20)(-20) = 13.0%

Measuring Expected Return

= pi (Ri E(R)) Where is the variance Ri is the return for the ith possible outcome Pi is the probability with the ith possible outcome, & E (R) is the expected return

Measuring Expected Return

Hence, Standard Deviation = ()

Calculation of Standard Deviation

Stock A i. State of Economy 1. Boom pi 0.30 Ri 16 piRi 4.8 Ri E(R) 4.5 (Ri E(R)) Pi(RiE(R)) 20.25 6.075

2. Normal
3. Recession

0.50
0.20

11
6 E(R) = piRi = 11.5

5.5
1.2

-0.5
-5.5

0.25
30.25

0.125
6.050

= pi(Ri E(R)) = 12.25

= *pi(Ri-E(R))] = (12.25) = 3.5%

Valuation of Equity
Fixed income securities have limited life & fixed returns. Equity shares have unlimited life & uncertain returns. The valuation of equity is complex due to growth & risk factors.

Valuation of Equity
Two approaches to Equity Valuation are 1. Fundamental Analysis 2. Technical Analysis

Valuation of Equity
1) Fundamental Analysis: Examines the assets, earning prospects, cash flow projections & dividend potential to assess fair market value of equity shares.

Valuation of Equity
2) Technical Analysis: Focuses on price trends, volume trends & other market indicators to assess fair market value of equity shares.

Valuation of Equity
Balance Sheet Technique Book Value Liquidation Value Replacement Cost

Fundamental Equity Valuation

Discounted Cash Flow Technique Dividend Discount Model Free Cash Flow Model Relative Valuation Techniques Price Earnings Ratio Price Book Value Ratio Price Sales Ratio

Balance Sheet Technique

Balance Sheet Valuation

1) Book Value: Net worth of a company divided by the no. of outstanding equity shares. Net worth = Paid-up Equity Shares + Reserves & Surplus Book Value = Net Worth / No. of Equity Shares

Balance Sheet Valuation

2) Liquidation Value: It is the value realised after liquidating all the assets of the firm & amount paid to creditors and shareholders divided by the no. of outstanding equity shares.
Value realised from Amt. to be paid to creditors

LV=

all assets of firm - & Preference Shareholders No. of Outstanding Equity Shares

Although liquidation value appears more realistic, it is very difficult to estimate the amounts to be realised after liquidation of assets. Also, it does not reflect the earning capacity.

Balance Sheet Valuation

3) Replacement Cost: It is the cost of replacement of assets less liabilities. It is assumed here that market value of a firm cannot deviate much from its replacement cost. The ratio of market price to replacement cost is called Tobin q. Limitation of Replacement Cost is that organisational capital is not shown in the balance sheet. Organisation capital is the group of people associated with the firm, directly or indirectly, such as employees, customers, suppliers, etc in a mutually beneficial and productive relationship.

Discounted Cash Flow Techniques

Discounted Cash Flow Techniques

1) Dividend Discount Model: According to this model, the value of a share is equal to the present value of dividends expected plus the present value of share expected when it is sold. It is assumed here that dividends are paid annually and the first dividend is received after one year of buying the share.

Discounted Cash Flow Techniques

1) Dividend Discount Model: a. Single Period Valuation: It is the case where the investor is expected to hold the share for one year. D1 P1 P0 = + (1 + r) (1+r)

Discounted Cash Flow Techniques

1) Dividend Discount Model: b. Multi-Period Valuation: It is the case where the investor is expected to hold the shares for more than one year. D1 D2 D P0 = + +-----+ (1+r) (1+r) (1+r)

Discounted Cash Flow Techniques

1) Dividend Discount Model: c. Zero Growth Model: It is the case where dividend per share remains constant year after year.
D P0 = r

Discounted Cash Flow Techniques

1) Dividend Discount Model: d. Constant Growth Model: It is the case where the dividend grows at a constant rate (g).

D1 P0 = r-g

Discounted Cash Flow Techniques

2) Free Cash Flow Model: This model involves the following procedure: a) Dividing the future into Explicit Forecast Period & Balance Period: This is the period during which the firm is expected to grow & reach a steady state. b) Forecasting the Free Cash Flow (cash available for distribution to shareholders & debtholders after providing for investment in fixed assets & net working capital required) during the Explicit Forecast Period:

FCF = NOPAT Net Investment NOPAT = Net Operating Profit after adjusting for taxes

Discounted Cash Flow Techniques

c) Calculating the weighted average cost of capital: WACC = Were + Wprp + Wdrd (1-t) Where w is the weight associated with equity, preference & debt; r is the cost associated with equity, preference & debt. d) Establishing the Horizon Value of the firm: It is the value placed on the firm at the end of explicit forecast period (H). FCF (1+g)
VH =

WACC - g

Discounted Cash Flow Techniques

e) Estimating the Enterprise Value:
FCF1 VH + FCF2 + ...... + FCFH + EV = (1+WACC) (1+WACC) 2 (1+WACC)H (1+WACC)H
f) Deriving the Equity Value: Equity Value = Enterprise Value Preference Value Debt Value g) Computing the value per share: It is the equity value divided by the no. of outstanding equity shares.

Relative Valuation Technique

Relative Valuation Technique

1) Price Earning Ratio: It is the value after dividing dividend per share by the share price or earning per share divided by the share price. D1 E1 OR P0 = r r Where r is the Expected Return.

Relative Valuation Technique

2) Price to Book Value Ratio: Book value is the net worth of the company divided by the no. of equity shares. Market Price Per Share at time t PBV Ratio= Book Value Per Share at time t OR P0 PBV Ratio= BV0

Relative Valuation Technique

3) Price to Sales Ratio: It is calculated by dividing current market value of equity capital by annual sales of the firm. P S Ratio = P0 S0

Valuation of Debentures / Bonds

Meaning & Characteristics of Bonds

A Bond is a security issued that obligates the issuer to make specified payments, i.e., interest & principal, to the bondholder. It may be characterised in terms of par value, coupon rate & maturity date.

Meaning & Characteristics of Bonds

Par Value is the value that is stated on the face of the bond and represents the amount the issuer promises to pay at the time of maturity. Coupon Rate is the rate at which the interest is payable to the bondholder. Maturity Date is the date at which the principal amount is payable to the bondholder.

Valuation
Value of a Bond is equal to the present value of the cash flows expected from it. Determining the value of a bond requires An estimate of expected cash flows An estimate of the required return

Valuation
Bond with Annual Interest Assuming that o The coupon rate is fixed for the entire term, o The coupon payments are made every year, & o The bond will be redeemed at par on maturity. Value of a bond shall be; C M P= + t (1+r) (1+R)n

Valuation
Where, P is the value; n is the number of years to maturity; C is the annual coupon payment; r is the periodic required return; M is the maturity value; & t is the time period when the payment is received.

Valuation

OR

Valuation

P = C X PVIFA r,n + M X PVIF r,n

Valuation
Bond with Semi-Annual Interest Value of Bond shall be C/2 M P= + (1+r/2)t (1+r/2)2n

Valuation

OR

Valuation

P = C/2 (PVIFA r/2,2n) + M(PVIF r/2,2n)