Securities Analysis & Investment Management

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SECURITIES ANALYSIS&

INVESTMENT MANAGEMENT

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Capital Market – An Overview

Securities Market

Equity Market

Debt Market

Derivatives Market

Govt. Securities

Market

Corporate Debt

Market

Money Market

Options Market

Futures Market

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Participants In Securities MarketRegulators – 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

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Participants In Securities MarketStock 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.

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Participants In Securities MarketBrokers – 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.

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Participants In Securities MarketRegistrars – 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.

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Capital Market – An OverviewPrimary 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.

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Nature ofPrimary 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.

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Nature ofSecondary 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.

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Trading

• Only listed & permitted securities traded on Stock Exchange.

• Investors need to place their orders with the members / brokers of the exchange.

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Ways of TradingOpen 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.

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Ways of TradingScreen-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.

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REGULATORYMECHANISM

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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.

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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.

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UNIT – 2

RISK & RETURN

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• Some people invest in a business to acquire control and enjoy the prestige associated with it.

• Desire to earn return leads to bearing some risk.

• Risk and Return are center points of investment decisions.

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The Concept

• Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.

• A mix of danger and opportunity.• The wider the range of possible outcomes, the greater

the risk.• Biggest risk – Not investing at all.• Also known as reward for understanding towards

investments.• Risk – averse means willing to sacrifice some return to

reduce risk.

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The Concept

The three types of Risk:

1) Business Risk2) Interest Rate Risk3) Market Risk

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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.

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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.

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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.

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COMPONENTS OF RISK

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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.

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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.

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Measuring Historical Return

Cash payment received Price change over

during the period + the period Price of Investment at the beginning

Total Return =

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OR

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Measuring Historical Return

C + (PE – PB)PB

where,R is the total return over the period,C is the cash payment received during the period,PE is the price of investment at the end of period, &PB is the price of investment at the beginning of period.

R =

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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.

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OR

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• 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 -

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State of Economy Probability of Occurrence

Rate of Return (%)Stock A Stock B

Boom 0.30 16 40

Normal 0.50 11 10

Recession 0.20 6 -20

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• Expected Rate of Return is weighted average of all possible returns multiplied by their respective probabilities.

• The formula – n

E(R) = ∑ Ri Pi i=1

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.

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Expected return of Stock A shall beE(R) = (0.30)(16)+(0.50)(11)+(0.20)(6) = 11.5%

Expected return of Stock B shall beE(R) = (0.30)(40)+(0.50)(10)+(0.20)(-20) = 13.0%

State of Economy Probability of Occurrence

Rate of Return (%)

Stock A Stock B

Boom 0.30 16 40

Normal 0.50 11 10

Recession 0.20 6 -20

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σ² = ∑ pi (Ri – E(R))²Whereσ² is the varianceRi is the return for the ith possible outcomePi is the probability with the ith possible

outcome, &E (R) is the expected return

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Hence,

Standard Deviation σ = (σ²)½

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Calculation of Standard DeviationStock A

i. State of Economy

pi Ri piRi Ri – E(R) (Ri – E(R))² Pi(Ri-E(R))²

1. Boom 0.30 16 4.8 4.5 20.25 6.075

2. Normal 0.50 11 5.5 -0.5 0.25 0.125

3. Recession

0.20 6 1.2 -5.5 30.25 6.050

E(R) = ∑piRi = 11.5 σ² = ∑pi(Ri – E(R))² = 12.25

σ = [∑pi(Ri-E(R))²]½ = (12.25)½ = 3.5%

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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.

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Valuation of Equity

Two approaches to Equity Valuation are -

1. Fundamental Analysis2. Technical Analysis

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Valuation of Equity

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

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Valuation of Equity

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

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Valuation of Equity

Fundamental Equity Valuation

Balance Sheet Technique

•Book Value•Liquidation Value•Replacement Cost

Discounted Cash Flow Technique

•Dividend Discount Model•Free Cash Flow Model

Relative Valuation Techniques

•Price – Earnings Ratio•Price – Book Value Ratio•Price – Sales Ratio

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Balance Sheet Technique

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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

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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

L V = 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.

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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.

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Discounted Cash Flow Techniques

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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.

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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 (1 + r) (1+r)

P0 = +

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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∞

(1+r) (1+r)² (1+r)∞P0 = + +-----+

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1) Dividend Discount Model: c. Zero Growth Model: It is the case where

dividend per share remains constant year after year.

D r

P0 =

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1) Dividend Discount Model: d. Constant Growth Model: It is the case where

the dividend grows at a constant rate (g).

D1 r - g

P0 =

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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 InvestmentNOPAT = Net Operating Profit after adjusting for taxes

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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)

WACC - gVH =

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e) Estimating the Enterprise Value: FCF1 FCF2 ...... FCFH VH

(1+WACC) (1+WACC) 2 (1+WACC)H (1+WACC)H

f) Deriving the Equity Value:Equity Value = Enterprise Value – Preference Value – Debt

Valueg) Computing the value per share: It is the equity value

divided by the no. of outstanding equity shares.

EV = + ++ +

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Relative Valuation Technique

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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

r rWhere r is the Expected Return.

P0 = OR

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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 Book Value Per Share at time t

ORP0

BV0

PBV Ratio=

PBV Ratio=

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

P0

S0P S Ratio =

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Valuation of Debentures / Bonds

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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.

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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.

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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 flowsAn estimate of the required return

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Valuation

Bond with Annual InterestAssuming thato 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 (1+r)t (1+R)n

P = ∑ +

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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.

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Valuation

OR

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Valuation

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

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Valuation

Bond with Semi-Annual InterestValue of Bond shall be

C/2 M(1+r/2)t (1+r/2)2n

P = ∑ +

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Valuation

OR

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Valuation

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

Securities Analysis & Investment Management

Economy & Finance

Transcript of Securities Analysis & Investment Management