(For Private Circulation only) (Copy Rights Reserved) BHARATHIDASAN UNIVERSITY = TIRUCHIRAPALLI - 620 024, CENTRE FOR DISTANCE EDUCATION . M SECURITY ANALYSIS AND B PORTFOLIO MANAGEMENT A THIRD SEMESTER (Full Package)Code Number : MBA BHARATHIDASAN UNIVERSITY TIRUCHIRAPPALLI - 620 024. CENTRE FOR DISTANCE EDUCATION MBA SECURITY ANALYSIS & PORTFOLIO MANAGEMENT Full Package Third Semester Copy right reserved For Private Circulation Only‘SYLLABUS SECURITY ANALYSIS & PORTFOLIO MANAGEMEN’ OBJECTIVE: This course provides (a) an understanding of the conceptual framework underlying Security Analysis & Portfolio Management; (b) an appreciation of the regulatory and tax framework circumscribing investment in securities: and (c) some insights into the operations of the Indian Stock Market. UNITE: Valuation of Buus: Measures or Yield, Duration & Convexity, Measures of Kisk, Determinants of Interest Rates and Theories on ‘Term Structure, Bond Swaps UNIT Il: Derivative Securities : Equity Options: Concept, Applications & Valuation. Economic Analysis, Industry Analysis, UNIT III: Valuation of Equity Stocks: Approaches to Equity Stock Valuation, Index Futures: Concept. Applications & Valuation. UNITIV: Valuation of Equity Stocks: Company Analysis, Technical Analysis, Efficient Markets Hypothesis UNITY: Portfolio Management - The Conceptual Framework: Modern Portfolio Theory, Portfolio Management, Performance Evaluation of Portfolio, Applications of Options & Futures in Portfolio Management. Suggested Reading: 1. “Investment Management’ by V.K Bhalla Management of Investments’ by Francis 3. "Security Analysis and Portfolio Management’ by Fisher and Jordan versity tsa nol, by way’ of trade or otherwise be lon esol, No par oF 8 the prior writen permission ofthe University. No'pat ts form or by any means (electronic, mechanical photocopying ‘© Copy right ofthis book belongs to Bharaihidasan Ur hired others cused in any fonn without ublication may be reproduced, stored in oF transmitted inary bay raeaing or eterwiae) iho te prior writen peniasn ofthe Unies Reprint /600/ Oct 2013, This Book has been printed in 13,7 Seshayee paper Printed at : United Bind Graphics, Chennal - 10‘Lesson - 1 SECURITY ANALYSIS - AN OVERVIEW The objective of this lesson isto introduce the subject Security Analysis and Portfolio Management to the readers. The lesson is organised as follows: > Investments Risk and returns, Financial markets, ‘The Indian capital market vvvy Investment avenues > — Sccurity analysis 1.1 INVESTMENTS Investments may be defined as postponed consumption. The following arc some examples for investments. > —Ayoung couple buying a house for Rs.10 lakh. > A farmer buying piece of agricultural land for Rs.2 lakhs > Acticket fan betting on the outcome ofa cricket match for Rs.1000. > — Agovernment employee buying mutual fund units worth Rs.10,000 > — Anofficerbuying 100 shares of CMC Ltd for R8.500 each. Inall these cases money is sacrificed now for the prospects of something in the future. The prospects expected are always greater than what they sacrifice now. ‘Thus, investments may also be defined as commitment ‘of fonds made in the expectation of some positive rate of rerum, The investment process may be divided into five steps as follows. 1. ‘Setting goals and objectives 2. Determining the appropriate risk level 3. Estimating the risk and return characteristics of individual securities 4, Forming optimal portfolios 5. Performance review: ‘The first step in the investment process is to identify one’s goals and ébjectives. The typical investment objectives are current income, capital appreciation, and safety of principal. Determining the amount of risk one is willing to assume to achieve the investment objective is one of the ~ most critical and difficult aspects of the investment process. This decision will determine the mix of assets to be held in the investment portfolio.Seth auntie arly ony wena thse erin casa: hi the third step in the investment process. Given the estimates of return and risk for individual securities and the relationships between securities, portfolios can be formed. Finally, investors should monitor the results of their portfolio in order to determine whether the goals and objectives are being met. In addition, reviewing their portfolio's performance may provide some insights Which “will improve their security analysis and portfolio selection techniques. 1.2 RISK AND RETURN Everying held constant, individuals generally prefer current consumption to future consumption, In onder to motivate individuals to invest, a potential investment must offera positive rate of return. This will result in the investor having greater future wealth and therefore greater future consumption opportunities than the current consumption opportunities. It isan incentive for the investor to postpone consumption. ‘Three major factors which determiné the retum investors require in order to invest. They are: 1. The time preference for consumption as measured by the risk-free real rate of return. 2. Theexpected rate of inflation 3. Therisk associated with the investment. Required return may thus be stated a8 follows Required retum =risk-free real rate + expected inflation + risk premium ‘Thi first two factors (the risk-free real rate of return and rate of inflation) are common to all investments (Only the third factor, risk premium is unique to each investment. Risk The risk ofan investmentrefers to the volatility ofits rate of retum. The volitilty ie the returns results inthe possibility that the realised retums will be less than the returns that were expected. The source of such risk is the failure of dividends or interest and or the security’s price to materilise as expected Investment risk is associated with the variability ofrates of return. The more variable the retum, the more risky the investment. The standard deviation is commonly used as the measure of risk. Factors contributing to risk Forces that contribute to variations in zetum are the elements of tisk. Some factors are extemal tothe fitm, not controllable and affecta large numberof securities. ‘There are some other factors which are mternal to the firm,and are controllable to @ large degree. ‘Those factors which are extemal, not controltable and affect many securities are called sources of systematic risk. Internal factors which are controllable and peculiar to an industry and ora firm are referred to as sources of unsystematic risk Systematic Risk Systematic risk refers to that portion of risk affecting all the securities, It may arise due to economic, political and sociological factors. These factors cause the prices of almost all the securities to rise or fall. This will result in the security prices to move in the same direotion as the stock market index (for instance theSensex), Systematic isk is also referred to as market risk or undiversifiable risk. Elements of systematic tisk are 1 Market risk 2. Imeresterate risk 3. Purchasing power risk 1. Market risk ‘Variability in retum on most common stocks that is due to basic sweeping changes in investor expectations iscalled as marketrisk. The basis for the changes in investors expectations may be political, social, oreconomic. For instance, he’change of government or government policies may affect the security prices across the board. + Vanability in return may also arise due so the market psychology. The emotional reaction of investors may result in the security prices to overteact. Italso isa cause for market risk. 2. Interest Rate Risk ‘The Variation inthe returns caused by fluctuations inthe general level of interest rates is referred tos the imterest rate risk, As the interest rate goes up, the market price of existing fixed income-securities falls, and vice versa, The root cause for this fluctuation is that as the rate of interset on government securities rises or falls, the rates of retumn demanded on other alternative investments such as bonds and equity shares rise or fall. While the changes in the iterestrates have a direct impact on the prices of bonds, they affect equity prices indirectly. 3. Purchasing Power Risk While market risk and interset rate risk are associated with the uncertainities in the amount of money to be received by an investor, purchasing power risk is the uncertainty of the purchasing power 6f the money to he received. Itrefers to the impactof inflation or deflation on an investment. Rising prices on goods and services are normally associated with inflation and falling prices on goods and services are referred to as deflstios Generally, purchasing power risk is identified with inflation, because declining prices is very rare. The wholes price index (WPI) and consumer price index (CPI) are the commonly used measures of inflation. Ratins! investors should include inflation rate in theit estimate of expected return, Unsystematic Risk Unsystematic risk is thatportion of total risk that is unique to a firm or an industry, above and beyond the systematic risk. Unsystematic risk may also be referred to as diversifiable risk: The two major elements of unsystematic risk are: 1. Business risk 2. Financial risk 1, Business Risk Business risk arises due to the variations in the operating income and the dividends. Factors such a> mariagement capability, consumer proferences, competition, about strikes, and so on cause the business risk ‘Business sisk can be divided into two broad categories: intemal and extemal. Internal business tisk is assoviated with the efticieney with which. firm conducts its business.External business risk is assuciated withthe external environment within which a firm has to operate. The ‘extemal factors may be the cost of capital, the business cycle, demographic factors, goverment policies, economic factors, monetary and creditpolicies, political - legal factors and so on. 2, Financial Risk ‘The way in which a company finances its activities influences the return to the equity shareholders. This ‘can be ascertained from the capital structure of the firm. The ust of debt finance creates payment of fixed interest and hence it affects the residual profit available to the equity shareholders. The use of debt capital, called financial leverage, increases the variability of equity returns, affects the expectations of return by the equity shareholders and increases thei risk 1.3 FINANCIAL MARKETS Financial markets are the markets in which securities are bought and sold. Securities market play an extremely important ole in an economy. An efficient and integrated financial market isan important infrastructure thet facilitates savings, investments and consequent economic growth. Classification of Financial Markets Financial markets may be classified in several ways. The following three type of classifications are discussed, > — Bymaturity ofclaims By the type of financial claim > — Bythetype ofissue (On the basis of maturity of claims, the market may be classified into money market and capital market. Money market is the market for short-term securities with a maturity period of one year or less. Short-term securities are always debt securities and hence the money market is the market for short-term debt securities. Capital market on the otherhand isthe market for long-term securities. Long term securities include the debt securities with maturity of more than one year and equity stocks, “The second way of classifying financial markers is by the type of financial claim, A Cuucial clan say be 4 fixed claim ora tesidual claim, Debt securities have a fixed claim and equity shares have a residual claim. Hence, the market may be classified into debt market and equity market. ‘The third way of classifying a financial market ison the basis of type of issue i.e. new issues or outstanding, sssues. The market for the new issues is referred to as primary market and the market for the outstanding 1ssues is referred to as secondary market, Ina primary market a company is the seller and the transaction leads to raising capital for the company. Companies generally engage in two types of primary market transactions Public issues and private placéments. A public issue. as the name suggests, involves selling securities tothe teneral public. Whereas, private placement isa negotiated sale involving a specific buyer. Public issues can be made afier the consent of Securities and Exchange Board of India (SEBI) and as per the SEBI regulations. The cost of public issues is considerable. Private placements are made to large financial institutions such as LIC. GIC or mutwal funds. The cost of private placements is significantly less. Ina secondary market transaction one owner of equity or debt securities sells his holdings to another. ‘Therefore, a secondary market provides the means for transferring ownership in financial securities. 4Functions of financial markets The primary role of a financial markets is to allocate the resources in an economy. They perform the following three important functions: 1. Facilitating price discovery Financial markets facilitate continual interaction among a large number of buyers and sellers. Thereby the prices of financial securities are established. The faimess inthe pricing of a security depends on the efficiency of the market. 2. Providing Liquidity ‘The most important function of financial markets is to provide liquidity for the securities. Liquidity refers to the ease and convenience with which a financial security can be sold or bought ata reasonable price. In the absence of financial markets the investors would not like to hold securities. 3. Reduce the cost of transaction ‘The two major costs associated with buying and sellirig an asset are search costs and information.costs. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell ‘an asset and implicit costs such as the effort and time one has to putin to find out a buyer orseller. Information costs refer to costs incurred in evaluating the merits ofan asset. 1.4 INDIAN CAPITAL MARKET ‘The origin of stock market in India goes back to the later part of the eighteenth century. The earliest security dealings were transactions in loan securities of the East India Company. The first stock exchange in India was started as an informal association which later gave birth to the Native Stock Brokers Association in 1887. Itis now knownas the Bombay Stock Exchange. The Bombay Stock Exchange grew in stature and size of operations and became the nerve centre of all financial activity. This is the first ever stock exchange to be recognised by the Government of India, “The Ahmedabad Share and Stock Brokers Association was formed in 1894, which later came to be known as the Ahmedabad Stock Exchange. The next stock exchange to be.started was the Calcutta Stock Exchange 1n 1908. Atpresent there are 23 recognised stock exchanges in India including the OTCEI and NSE. The list of these exchanges are given in Table 1.1Table 1.1 Recognised Stock Exchanges in India National Stock Exchange Name of the Exchange Location ‘Year of Recognition The Stock Exchange, Bombay (BSE) Mumbai 1957 ‘The Stock Exchange, Ahmedabad Abimedabad 1957 3 The Calcutta Stock Exchange Association Ltd., Kolkata 1987 a Madras Stock Exchange Ltd., Chennai 1957 5. The Delhi Stock Exchange Association Ltd, ‘New Delhi 1957 The Hyderabad Stock Exchange Ltd,, Hyderabad 1958 Madhyapradesh Stock Exchange Ltd., Indore 1958 Bangalote Stock Exchange Ltd., Bangalore 1963 Cochin Stock Exchange Ltd., Cochin 1979 Uttarpradesh Stock Exchange Association Ltd, Kanpur 1982 Pune Stock Exchange Ltd., Pune 1982 Ludhiana Stock Exchange Association Ltd, Ludhiana 1983 ‘The Gauhati Stock Exchange Ltd.. Gaubati 1984 Kanara Stock Exchange Lud, Mangalore 1985 Magadha Stock Exchange Association Patna 1980 Jaipur Stock Exchange Ltd,, Jeipur 1989 Bhubaneswar Stock Exchange Association Ltd., Bhubaneswar 1989 Saurashtra Stock Exchange Ltd., Rajkot 1989 ‘The Vadodra Stock Exchange Ltd., Baroda 190 ‘The Coimbatore Stock Exchange Ltd., Coimbatore 1991 ‘The Meerut Stock Exchange Ltd., Meentt 1991 Over the Counter Exchange of India Murai 1994 Mumbai 1993There has been a phenomeral growth in the operations of the stéck market in India over the last four decades particuarly, during the last one decade. Table 1.2 shows the pattem of growth in the Indian securities market in terms ofnumber of companies listed, market capitalisation and tumover. Table 1.2 Growth of Secondary Marketin India (Amount in Rs. Crores) Year No.of listed companies | Marketcapitalisation | Turnover 1990-91 629 110279 = 1991-92 6480 354,106 - 1992.93 6925 228,780 i 1993.94 7811 400077 203,703 1994.95 907 473,349 162,905 1995.96 9,100 372257 227,368 1996.97 9890 448,332 646,116 1997898 9833 589,816 908,681 1998-99 9877 574.064 1,023,382 999-00 9871 1,192,630 2,067,031 2000-01 9.954 s 768,863 2,880,990 2001-02 904 749,248 895,826 1,SINVESTMENT AVENUES Investments generally involve real usseis or Financial assets. Real assets arc tangible, material things such as land, buildings, and car. Financial assets are pieces of paper representing an indirect claim toreal asscts held by someone else, These pieces of paper represent debt or equity securities Debt Securities ‘Debt securities may be issued by the governments, companies and individuals. Government securities include the Treasury bills, Central government dated securities and semi-government dated securities. Semi-government dated securities are the debt instruments issued by organisations set up by sate/central govemmments, such as, municipal corporations, electricity boards, financial institutions, and housing boars. Corporate Debt Securities Corporate bonds/debentures are the promisory notes issued by the joint stock companies in the private sector. They are the debt obligations ofthe issuing companies. The bonds have an issue price, interest rate, and a specified maturity period. There isa variety of subclassifications in bonds. iEquities The investors in the equity shares of a company are the owners of the company and is thus entitled to the residual share of profits. The equity shareholders have voting right. The equity shares are considered to be the rishiest investment ‘Mutual Funds Mutual funds permit investment in equities and/or bonds issued by companies indirectly. Mutual firids require less supervision by the investors and it facilitates the sviall investors to invest in a well diversified portfolio. The three broad types of mutual funds are: % — Growth schemes » — Incomeschemes » — Balanced schemes Options and Futures Options and futures derive their value fom an underlying security. Therefore, they are called derivatives, ‘An option 1s a contract in which the writer of the option grant’ the buyer of the option the right to puirchase from or sell to the writera designated instrument ata specified price within a specified period of time. Call options are _ options to buy. Put options are options to sell Futures represent a firm legal commitment between a buyer and seller, where they agree to exchange something ata specified price at the end of a specified period of time. Preference shares Preference shares carry a fixed rate of dividend and is payable outof distributable profits: All preference shares issued in India are redeemable. There are different types of preference shares. The other investment alternatives are the real estates, bank deposits, employees provident fund, public provident fund, national savings vertificates, life insurance, and bullion, 1.0 SECURITY ANALYSIS ‘Security analysis involves the process of estimating the future cash flows which will accrue to the owners of ‘particular security. and the risk associated with these prospective cash flows. Security analysis also involves the estimation of the future price of the security Security analysis serves the investor by identifying the fairly priced or mispriced securities whcih are most to produce the desired returns, While valuing the securities, the analyst apphes consistently a process which will achieve the following: > Ate picture ofa company asa going concem over a representative time span % — Acarefully prepared estimate of current normal earning power. + Aprojection of furure profitability and growth, — Atranslation of these conclusions into a valuation of the company and its securities. 8A security analyst has to do a great deal of preparatory work which includes gathering data about the economy and the industry the firm operates in, assvell as data unique to the firm. These data then be carefully analysed before projections can.be made. ‘These aspects of security analysis and much more are discussed in the subsequent chapters. Review Questions : 1. Define investments 2 Investments are postponed constimption. Justicy with examples. 3. Explain the various steps in the investment process. 4, What may be the possible objectives of investing? . What factors determine the rate of return expected by investors? Explain. 6. Inflaction influences the rates of retum on investments? How? 7, Whats risk-free rate of return? 8, Define risk. Explain the factors influencing risk. ‘9, What is systematic tisk? Why systematic risk cannot be diversified? 10 Describe the different types of risk, 11. Whatis the relationship between leverage and investment nsk? Explain with an example. 12. What isa financial market? Explain its functions? 13, Discuss the different types of financial markets. 14 Explain the features of equity shares. 15, Discuss the various investment altematives. PteLesson - 2 STOCK RETURN AND VALUATION ‘The lesson is organised into the following three section: > — Elements ofretum, > Valuation of equity shares > Valuation of preference shares People have many motives for investing. Some people invest in order to gain a sense of power or prestige. Investors want to maximize expected retuims subject to their tolerance for risk. Returns the motivating force and the principal reward in the investment process, and itis the key method available to investors in comparing alternative investments, Measuring historical retums allows investors to assess how well they have done. and it plays a part in the estimation of future, unknown retums. The return might be realised retum or . expected rerum. Realized return is historical return that was eamed. Expected return is the return ftom an asset that investors anticipate they will earn over some future period. Itisa predicted retum. Itmay or may not occur, Investors should be willing to purchase a particular asset ifthe expected retum is adequate, but they must understand that their expectation may not materialize. 2.1 ELEMENTS RETURN ‘The retum fiom the security includes both current income and capital gain caused by the appreciation of the Price. The current income and capital gain are expressed as a percentage of money invested in the beginning. The return is defined as, Price change + Current income 2100 Total return = Purchase Price Pasy—PytD RB x10 where, R = Total return on security at time. P, = Priceattimet Pri = Priceattimet+1 D = Gurrentincome (Dividend or interest) To find out the expost or historial average return of the stock, the common arithmetic mean is used Re(utttr, ate) fn where Re average retum 101 Ty wane, ate the returns that occur in different periods ofthe stock. ‘Now let us consider the following example. The return of stock A for four quarter is as follows: Quarter 73 10%, I >8%, IIT > ~4%,1V + 20% ‘The average return for the year is, 10+8: ‘The Anticipated Return The historical retum can be calculated by a direct method. The calculation ofthe anticipated or expected retumis different. The ex-ante or future returns are calculated with the help of probability. Probability describes the likelyhood of occurence ofan event. ‘The expected rate of returns of any stock i the weighted average rate of return. Probabilities ofthe rate of returns aré used as weights. a E(R)= DPR, a where F(R) = _ Expected returnon security. mR Probability of occurance of return t R Return on the security at timet This can be explained with the help of the following example. Returu(R) Probability(h) (RY 10% oO. 10 11% 02 22 12% 04 “48 13% ae) a 14% on 14 DOE WR) = 120 2.2 VALUATION OF EQUITY SHARES An investorholds shares of TVS Suzuki for a period of one year. The beginning and end period prices are 1Rs.335 and Rs 421 respectively. The dividend paid is Rs 3.5. Now, the yield and retum can be expressed easilyDividend Yield == Pp 100 = 421-335 1499-95. 7% 335 -P 421-335+3.5 + x100 =2x100 = 26.7% 335 ‘The return occurs at the end of the period. If tis to be expressed as the value of the security at the beginning of the holding period, ithas to be given in terms of the present value puDtk eo ey P.,= Present value of the security P. = Selling price at the end of one year period D, = The dividend received during the one year holding period. r= Investor's required rate of return, ‘With the help of the above equation the investors can find out whether the price he has to pay will yield the Fequired rate of retum, Now, ifthe investor wants to get 20% retum by holding TVS Suzuki stock fora year, he ould find whether the purchase price is high or low. Utilising the details given in the previous example the present value is calculated as follows. _ 3.54421 . A100 153.75 The value of te stock is Rs.353.75. This isthe intrinsic value of TVS Suzuki shares. This value may be compared with the market price for share. If the market: price is lower than the intrinsic value buy the shares, ifthe market price is greater than the intrinsic value sell the shares, and if they are equal hold the shares. In our csample.the market price in lower than the intrinsic value (i.e, 335 < 353.75). So itis recommended to buy the shaves, The investor can also find out the anticipated selling price for the stock with his expected rate of retum trom holding the stock. Ifthe expected return is 20% the price at the end of the year is puPth “ler SP, = P,(IH)+D, *, 335x 1.2+3.5 = 398.5 12‘Multiple holding period Itis easy to calculate the present value of the stock for a year. Ifthe holding period is more than one year. theapproach is different, Valuation of equity stocks when the holding period is more than one year is diseussed ‘under the following headings - Zero growth model = Constant dividend growth mode} - Tworstagemodel = Threephase model Zero- growth model a: Bp R= 7 e Laer (ery where D, = dividend forperiodt P_ =. selling price atthe end of period n r - rate of return required Example : Supposing ABC Ltd pays. dividend of Rs 2 per annum, An investor wishes to hold the share for five years. The price at the end ofthe fifth year is expected to be Rs.250. Ifthe investor expects a return of 16 percent, what isthe price at which the share may be purchased? f° D2 é , . aD Gen Gen 2 2 2 2 2 ot St at ot 1.16 (1.16)? (1.16)' 1.16)" (1.16) =Rs.125.57 ‘The value of the share is Rs.125.57 and hence the share may be purchased if the market price is Rs.125.57 orless. Constant Dividend growth Model For definite period ' ‘The simplest extension ofthe above model is to assumie that the dividends will grow constantly overtime Under this assumption the value ofa share, ifthe holding period isa definite period, is 13R => Pltay, A “ES “asery any = Rate of growth in the dividend income D,=Recent dividend paid For Indefinite Holding Period ‘When the holding period approaches to infinity the equation takes the form P, =valne of the stock D,=Thenext year dividend =D, 0+ 9] T=required rate of return g= growth rate This model is applicable when the: analyst is able to predict two variables in the ‘equation namely, 1. next year’s dividend, and 2. the firm’s long term growth rate Another advantage of this model is that with the present selling price, next year's dividend and growth fate, the rate of return of the stock can be estimated as follows: D, r=Dy 2, & Example Anil gota dividend of Rs.4 from his investment during the last year, He expects a growth rate of 10% in dividend and he has a plan to hold the share for 5 ‘years. Atthe end of Sth year the shares will be sold for Rs. 150. His expected rate of retum is 18%: Therefore, the value of the share is : aay Ate A (+r) (ery Where, D,=Rs.4 B= 10% 144d. 150 (14.18) (1.18)* =Rs 81.85 Example: Suppose ABC’s next year dividend per share is expected to be Rs.3.50. The dividend in subsequent yearsis expected to grow ataiate uf 10% per year. The required rate ofretum is 15%. lfthe prevailing market price ofthe share is Rs.75 will you buy the share? Sohimon as 015-01 =Rs.70" ‘Smee the market price is greater than its intrinsic value the share will not be bought. Two stage growth model The constant growth model is extended to two stage growth model. Here, the growth stages are divided inte two, namely, a period of extraordinary growth (or decline) and a constant growth period of infinite nature. he extiaordinary growth period will continue for some period followed by the constant growth rate. The information echnolgy industry is at present experiencing an extraordinary growth rate, it ay continue for sometime and aftenwords it may grow at a constant growth rate, “The model is, PA+ gy. a. Ue gy Dollz). : x (sry where D, =D, (14g) 15mal growth rate & g,~above normal growth rate r= required rate of retum n=period of above - normal grovith D, = Dividend for the most recent period Example The growth rate of Nagarjuna Fertilizer stock for the past S years is 18.58%. This rate is assumed to continue for the next 5 years and after that itis expected to grow at the rate of 10% indefinitely. The dividend paid for the previous yearis Rs.1.80. The réquired rate of retum is 20%. Estimate the stock price according to tthe 2 stage model. ‘Solution 3 Doll+g, Rod (ery D,=Rs.1.80 Step (1.1858) 1.8(1.1858)* 1858)" _ 8 686 +02" +02" "+027 +02)" Step2 D, isthe fifth year’s dividend D,= 1.8 (1.1858)5=4.2201 164.2201(1.10) R5.46.42 02-01 D, (+ 8) 1 & +r) = 46.42 “G2 =Rs.18.65 Step4 R=S, Padre) , Buds.) Oe Gay r-g, (1+r)" = 8.686 + 18.65 = Rs.27.34 ‘The computed value, Rs.27.34 is higher than the marketprice, Rs.14. The three-phase model Here three phases of dividend growth pattern is assumed. Dividends are assumed to grow at a constant rate g, foraperiod of A’ years. After the phase A’, the growth rate of dividend declines throughout the phase B. Aflerwords, there would be perpetual growth rate g,”. Sometimes the "g,’ would be less than 'g, ‘and in the second phase there would be linear growth rate, The perpetual growth rate is known as the firm's Jong run normal growth rate. The following figure illustrates the three stage growth model. Figure 2.1 Earnings growth (%) Three phase model of stock returns and valuation 7Example 1 _Da(i+g,) ¢ Di(l+g,) Dy (1+) | 8 tan, “Gent r=g,0+r* - a, (ler) mi (try D, he previous year dividend g,=Theperiod A’ growth rate 18> The period "B" growth rate The growth rate in the third phase 1D, = The dividend atthe end of the second phase D, ~The dividend at the eutl of the fist phase. Forthe first four years XYZ firm is assumed to grow ata rate of 10%. After 4 years the growth rate of. dividend is assumed to decline tinearly to 6%. After 7 years, the firm is assumed to grow at a rate of 6% infinitely, The previous year dividend is Rs.2 and the required rate of return is 14%. Find out the value of the stock. Solution (l+g,) +g.) Da +e) soo ee re ee eer eg (ery retry" D,=2 r=0.14 g=0.1 D,= declining rate of retum from 10% 10 6% .¢. 0.09, 0,08; 0.07, and 0.06 B, = 0.06 Die.) > (1+ 84) vy (l+ry 2-2, 201), 20.0" 20.0" 1.14” (Lay (14 14)" =1.754+ 1,693 + 1.633 + 1.576 =Rs.6.656 3Da+ 8) Deol 8) 2 d+ry x. (+r), 2(0.1)*(1.09) | 20.1)*(..09)(.08) , 2¢1.1)*(.09)(.08)0 O7y (uray 14° ara)" tay =Rs4.2746x 0.5921 =2.703 Dl +g,) or=g, +r) _ 2(1.1)" (1.09)(1.08)1.07)(1.06) (0.14-0.06)x(1.14)" 5.2088 = 2088 _ 26.006 2001 Sup Add all the components of the equation P, = Rs.6.656 + 2.703 + 26.006 P,=Rs.35.365 The present value of the stock is Rs.35,365 2.3 VALUATION OF PREFERENCE SHARES Preferred stocks provide a fixed retum. Generally the preferred stock are not redeemable and hence the fixed income will be eamed infinitely. Therefore, the income from preferred stocks are perpenial and hence the ‘equation for valuation is ixed dividendincome r= Required rate of retum, ‘Suppose a preferred stock's face valut is Rs.100 and the rate of dividend is 12%, The requited rate of returnis 13%. What isit worth today? 19_ R82 13 = Rs.92.31 Ifthe preference shares are redeemable, then value of preference shares may be calculated as follows: & D, B % Lan Gr Where D,=dividend at timet _p, =selling price at the end of the holding petiod or the redemption value. r= required rate of return n=holding period Review Questions: 1. Which of the following is worth more at 14 percent? a) Rs.1000 today b) Rs.2000 after'six years. 2. Your required rate of return is 16 percent. An investment gives Rs.5000 every year forever. How much will you pay forthis iovestment? 3. The valuation of equity shares is difficult compared to the valuation of bonds. Why? 4. Agrotech Lid share is currently selling at Rs.45 per share, The company is expected to pay a dividend of Rs.3 pershare at the end of the next yeaf. The stock price is expected to be Rs.50 at the end of next year. If your expected rate of return is 15 percent, will you buy the share at Rs.45.now? 5. You wish to buy 100 shares of Tata Motors with the intention of selling them after four years. You estimate that the company will pay a dividend of Rs.4 per share each year inthe foreseable future and that the price of the share after four years will be Rs.750. If your expected return is 18 percent, how much will you be willing to pay for each share now? . 6. Deming Ltd paid a dividend of Rs.2 per share last year. It is forecast that the company’s earnings and dividends will grow at the rate of 8 percent indefinitely. You expect a return of 15 percent from these shares. Whats the value of Deming Ltd share? 7. Nila Ltd. has paid Rs.2 as dividend tast year to its equity shareholders. The earnings and dividends of the company are expected to grow at 20 percent over the next five yearsand thereafter at the rate of 10 percent. Ifthe investors expect a retum of 20 percent on those shares what is the present value of Nila Ltd shares? 8. Marutham Ltd. has issued 14% preference shares. If the investors expect 13 percent return from these shares, what is its value? eee 20Lesson 3 ECONOMIC ANALYSIS “The intinsic value of'an equity share depends on a multitude of factors. ‘The earnings of the company, the ‘growth rate and the risk exposure of the company have a direct bearing on the price ofthe share, These factors inturn rely on host of other factors like economic environment in which they function, the industry they belong ‘to and finally companies’ own performance. The approach used for analysing these factors is known as economic- industry-company approach or the E-I-C framework. ‘This approach is'sometithes referred to as a “top- down’ method of analysis. ‘The lesson is organised as follows: — Economic analysis > © Macroeconomic factors > — Beonomic forecasting 3.1 ECONOMIC ANALYSIS King observed that, on the average, over 50 percent of the variation ina stock's price could be attributed to.amarket influence that affects all the stocks. The stocks are also subject to an industry influence, over and above the influence common to all stocks. King noted that this industry influence, explained, on the average, ‘about 13% of the variation ina stock's price. The level of economic activity has an impact on investment in many ways. Ifthe economy grows rapidly. the industry can also be expected to show rapid growth and vice versa. When the level of economic activity is low, stock prices arc low, and when the level of economic activity is high, stock prices are high reflecting the positive outlook for sales and profits ofthe firms. Hence analysis of macro economic environment is essentis! {o understand the behaviour of the stock prices. 3.2 MACRO ECONOMIC FACTORS- ‘The commonly analysed macro economic factors arcas follows: 1. Gross domestic product (GDP) GDP indicates the rate of growth of the ecoriomy. GDP represents the aggregate value of the goods and services produced in the economy. GDP consists of personal consumption expenditure, gross private domestic investment and government expenditure on goods and services and net export of goods and services. The estimates of GDP arc available on an annual basis. The growth rate of economy points out the prospects for the industrial sectorand the return investors can expect from investment in shares. The higher growth rate is more favourable tothe stock market. 2. Savings and investment Itis obvious that growth requires investment which in tum requires substantial amount of domestic savings, ‘Stock markets a cliannel ihrough which the savings of the investors are made available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual find units, real estate and bullion. auThe savings and investment pattems of the public affect the stock to.a great extent. Therefoie, it is essential to know about the attitude of the public towards savings and investment. 3. Inflation Along with the growth of GDP, ifthe inflation rate also increases, then the real rate of growth would be very little. The demand in the consumer product industry is significantly affected by inflation. The industries which come under the government price control policy may lose the marke, for example sugar. The government control over this industry, affects the price ofthe sugar and thereby the profitability of the industry itself Ifthere isa mild level of inflation, itis good tothe stock market but high rate of inflation is harmful tothe stock market. 4, Interest rates The interest rate affects the cost of financing of the firms, A decrease in interest rate implies lower cost of finance for firms and more profitability. More money is available at a lower interest rate for the borrowers, Availability of cheap fund, encourages speculation and rise in the price of shares. 5. Budget The budget provides an claborate account of the government revenues and expenditures. A deficit budget may lead o high rate of inflation and adversely affect the cost of production. Suirplus budget may result indeflation. Hence, balanced budget is highly favourable to the stock market. 6. The tax structure Every year in March, the business community eagerly awaits the government's announcement regarding, the tax policy. Concessions and incentives given to a certain industry encourages investment in that particular industry. Tax reliefts given to savings encourage savings. The Minimum Altemative Tax (MAT) levied by the finance ministry in 1996 adversely affected the stock market. Then years of tax holiday for all industries to be selupin the Northeast was provided in the 1999 budget. The tax rates have their impact on the profitability of the industries. *. The balance of payment The balance of payment is the record of a country’s money recelpts from and payments abroad. The differcuee between receipts and payments may be surplus or deficit. Balance of payment is a measure of the strength of rupee on the external account, Ifthe deficit increases, the rupee may depreciate against other ‘currencies, thereby, affecting the cost of imports, The industries involved in the export and import are considerably affected by the changes in foreign exchange rate. The volatility of the foreign exchange rate affects the investment ofthe foreign institutional investors in the Indian stock market. vA favourable balance of payment renders a positive effect on the stock marker. 8 Monsoon and agriculture Agriculture is directly and indirectly linked with the industries, For example, Sugar, Cotton, Textile and Food Processing industries depend upon agriculture for raw material. Fertilizer and insecticide industries are supplying inputs to the agriculture. A good monsoon leads to higher demand for input and results in bumper cro This would lead to buoyancy in the stock market, When the monsoon is bad, agricultural and hyydel power production would suffer. They casta shadow on the share market. 229. Infrastructure facilities {Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide net work of communigation system is a must forthe growth of the economy. Regular supply of power without power cut would boost the production, Banking and financial sectors also should be sound enough to provide adequate support to the industry and agriculture. Good infrastructure facilities affect the stock market faveurably. In India even though itfrastructure facilities have been developed, still they are not adequate. The government has liberalised its policy regarding the communication, transport and power sector. For example, power sector has been opened up to the foreign investors with assured rates of returns. 10. Demographic factors The demographic data provides details about the population by age, occupation, literacy and geographic location. This is needed to forecast the demand for the corisumer goods. ‘The population by age indicates the ‘availability of able work force. The cheap labout force in India has encouraged many multinationals to start their venturesin India, Indian labour is cheapet compared to the westem labour force, Population, by providing labour and demand for products, affeets the industry and stock market. 3.2 ECONOMIC FORECASTING To estimate the stock price changes, an analyst has to analyse the macro economic environment and the factors peculiar to the industry he is concemed with. The economic activities affect the corporate profits, investors’ attitude end the share prices. For the purpose of economic analysis, an analyst should be familiar with the forecasting techniques. He should know the advantages and disadvantages of various techniques. The common techniques used are analysis of key economic indicators, diffusion index, survey and econometric ‘model building. These techniques help him to decide the right time to invest and the type of security he has to purchase ie. stocks and bonds or some combination of stocks and bonds. 1. Anticipatory surveys ‘The most logical step to starta forecast is to ask prominent people in government and industry what theit plans are with respect to construction, plant arid equipment expenditure, and inventory adjustments, and to ask ‘consumers what their future spending plansare. Surveys of intentions consitute a valuable input inthe forecasting proves. A survey of intention must be based upon elaborate statistical sampling procedures. Furthermore, adequate {acilities must be provided for the processing and tabulation of the results of the questionnaires. “The greatest shortcoming oF intention surveys is that the forecasts has no guarantee that the intentions ‘will be carried out. For this reason, the survey approach is most realiable for short-term forecasts that are continually monitored, External shocks such as strikes, political turmoil, ot government action can caust sudden changes in intentions. But to the extent the intentions are translated into final action, this survey approach provides a most valuable insight into the business environment Despite the shortcomings of anticipatory surveys, a great plus is their abundance and easy availability even toa non institutional investor. 2B2. Barometric or indicator approach ‘The economic indicators are factors that indicate the present status, progress or slow down in the economy. They are capital investment, business profits, moriey supply, GNP, interest rate, unemploymentrate.ete. The ‘economic indicators are grouped in to leading, coincidental and lagging indicators. * Leading indicators : The leading indicators indicate what is going to happen in the economy. Ithelps the investor to predict the path ofeconomy. Forexample, monetary policy, rainfall, and capital investment. Coineidental indicators . ‘The coincidental indicators indicate what the economy is. Forexample, GDP, industrial production. interest, rates ete Lagging Indicators ‘The changes thatare occuring in leading and coincidental indicatorsare reflected in the lagging indicators. | agging indicators are identified as unemployment rate, consumer price index and flow of foreign funds etc ‘These leading, coincidental and lagging indicators provide an insight into the economy's current and future position Diffusion index Diffusion index isa composite or consensus index. The diffusion index conisists of leading, coincidental and lagging indicators. Diffusion index is complex in nature to calculate and the irregular movements thatocetir 1nindividual indicators cannot be completely eliminated. 3. Econometric Model Building Beonometrics is the field of study that applies mathematical and statistical techniques to economic theory. Formodel building several economic variables are taken into consideration, The assumptions underlying the analysis are specified. The relationship between the independent and dependent variables is given mathematically. While using a model, the analyst has to think clearly about the inter-relatioriship between the variables, when these inter relationships are specified, he can forecast not only the dircotion but also the magnitude. Buthis prediction depends on his understanding of economic theory and the assumptions on which the model has been butlt, The models mostly use simultaneous equations. Some of the problems with the econometric approach are: 1. Latge computer facilities and vast amounts of clerical and programming support are needed to maintain and update the system, 2. - Frequently, the overall forecast is more reliable than the individual components of the forecast. 3. Because of the vast amount of data that must be collected, processed, and prepared for inclusion in the model, delays occur in making the results available tothe public. 4, — Generally, these models are useful only for very short-term forecasts. 24Review Questions |. Explain the significance of economic analysis in valuation of securities. 2. Desoribe the macro economic factors that may influence the value of shares, 3, Whats the link between monsoon and the stock markets? 4, How do infrastructure facilities affect the share prices? 5, Discuss the various techniques of economic forecasting? 6. What isa lagging indicator? RaandLesson 4 INDUSTRY ANALYSIS After assessing the outlook of the economy, the analyst must do the industry analysis, Recessions or growth in the economy may result in falling or rising stock markets with different relative price changes among different industry groupings. Therefore, an analyst should gain insight into 1 the key sectors or subdivisions of overall economic activity that influence particular industries, and 2. the relative strength or weakness ofa particular industry or other groupings under specific sets of assumptions about the economic activity. This lesson is organised as follows: > Classification of industry © Classification by product © Classification according to business cyele > Industry Life Cycle Analysis 7 Analysis of the structure and characteristics of an industry > Michael Porter's model -Profit Potential Analysis rOther factors 4.1 CLASSIFICATION OF INDUSTRY An industry isa group of firms that have similar technoligical structure of production and produce similar products CLASSIFICATION BY PRODUCT . Companies are distinctly classified to givea clear picture about their manufacturing process and producis, Following is the industry wise classification given by the Reserve Bank of India (RBD), S.No. Industries 1 Food products 2 Beverages, Tobacco and tobacco products 3 Textile 4 Wood and wood products 5 Leather and leather products 6 7 8 9, Rubber and plastic products (Chemical and chemical products Non-metallic mineral products ) Basic mnetals, alloys and metal products 10. Machinery and machine tools 1 ‘Transport equipment and parts 12, Other miscellaneous manufacturing industries 26Classification According to Business Cycle Industries can also be classified on the basis of the business cycle ie. classified according to their reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive and cyclical growth industry. 1. Growth industry The growth industries have special features of high rate of earnings and growth in size, independent of the businesscycle. The expansion of the industry mainly depends on the technological change. For instance, inspite ofthe recession in the Indian economy in 1997-98, there was a spurt in the growth of information technology industry. It defied the business cycle and continued to grow. Likewise in every phase of the history certain industries like colour televisions, pharmaceutical and telecommunication industries have shown remarkable growth, During the 1990s 1'T Indusiry was growing ata very high rate. In the 2000s, it may be the Biotechnology and related industies. 2. Cyclical industry. The growth and the profitability of the cyclical industry move along with the business cycle: During the ‘bom period they enjoy growth and during depression they suffera set back. For example, the white goods like fridge, washing machine and kitchen products command a good market in the boom period and the demand for them slackens during the recession, 3. Defensive industry Defensive industry defies the movement of the business cycle. For example, food and shelter are the basic requirements of humanity. The food industry withstands recession and depression. The stocks of the defensive industries can be held by the investor forincome, They expand and earn income in the depression period 100, under the government's umberella of protection and are counter cyclical in natire, 4, Cyclical growth industry ‘This is anew type of industry that is cyclical and atthe same time growing. For example, the automobile industry experience periods of stagnation and decline but they grow tremendously. The changes in technology and introduction of new models help the automobile industry to resume their growth path. 4.2 INDUSTRY LIFE CYCLE ANALYSIS ‘Many industrial economists believe that the development of almost every industry may be analysed in terms ofa life cycle. There are four well-defined stages in the life cycle of an industry. © Pioneering stage © Rapid growth stage © Maturity and stabilisation stage © Declinestage Pioneering Stage During this stage, the technology and/or the product is relatively new. Lured by promising prospects, ‘many entrepreneurs enter the field. As a result, there is keen, and often chaotic, competition. Only a few. entrants may survive this stage.Rapid Growth Stage (Once the period of chaotic developments is over, the rapid growth stage arrives. Thanks to a elatively orderly ‘growth during this period, firms which survive the intense competition of the pioneering stage witness significant growth in their sales and profits Maturity and Stabilisation Stage After enjoying an above-average rate of growth during the rapid growth, the industry enters the maturity and stabilisation stage. During this stage, when the industry is more or less fully developed, 1s growth rate is comparable to that of the economy asa whole, Decline Stage ‘With the satiation of demand, encroachment of new products, and changes in consumer preferences, the industry eventually enters the decline stage. In this stage, which may continue indefinitely, the industry may ‘grow slightly during prosperous periods, stagnate during normal periods, and decline during recessionary periods. Evaluation and Investment Implications The experience of most industries suggest that they go through the four phases of the industry life'cycle, though there are considerable variations in terms of the relative durations of various stages and the rates of ‘growth during these stages. Because of these variations it may not be easy to’define what the current stage is, how long will it ast, and what whould be its precise growth rate, ‘The broad validity ofthis theory and its gencral message that there isa definite trend towards retardation of growth rates has several implications for you as an investor. 1, Give industry analysis prior attention in your investment selection process. 2, Display caution during the pioneering stage. 3. Respond quickly and expand your commitments during the rapid growth stage. 4. Moderate your investment during the maturity stage. 5, Sénsibly disinvest when signals of decline are evident. 4.3 ANALYSIS OF THE STRUCTURE AND CHARACTERISTICS OF AN INDUSTRY Since each industry is unique, a systematic study ofits specific features and characteristics must be an integral part of security analysis. Industry analysis should focus on the following: 1 Structure of the Industry and Nature of Competition © Thenumber of firms in the industry and the market share ofthe top few (four to five) firms inthe industry. Licensing policy of the govemment Entry barriers, ifany Pricing policiesof the firm Degree of homogeneity or differentiation among productsCompetition fiom foreign firms ‘Comparison of the products of the industry with substitutes in terms of quality, price, appeal, sind fumetional performance. Ll. Nature and Prospectus of Demand ‘Major customers and their requirements Key determinants demand Degree of eyclicality indemand “Expected rate of growth in the foreseable future. IIL. Cost, Efficiency, and Profitability eevee Proportions of'the key cost elements, namely, raw materials, labour, utilities, and fuel Productivity of labour Turonver of inventory, receivables, and fixed assets Control over prives of outpats and inputs Behaviour of prices of inputs and outputs in response to inflationary pressures Gross profit, operating profit, and net profit margins Return on assets, earning power, and retum on equity. IV, Technology and Research Degree of technological stability Important technological changes on the horizon and their implications Research and development outlays sa percentage of industry sales Proportion of sales growth attributable to new products. 4.4 MICHAEL PORTER'S PROFIT POTENTIAL ANALYSIS ‘Michael Porter has argued that the profit potential of an industry dépends on the combined strength of the following five basic competitive forces: Threat of new entrants Rivalry among existing fitms Pressure from substitute products Bargaining power of buyers Bargaining power of sellers ‘The following figure shows diagrammatically the forces that drive competition and determine industry profit potential. 29FORCES DURING INDUSTRY COMPETITION Bargaining Power of Suppliers Figure 4.1 Potential Entrants Suppliers Buyers Threat of New Entrants New entrants add capacity, inflate costs, push prices down, and reduce profitability. Hence, ifan industry faces the threat of new entrants, its profit potential would be limited. The threat from new entrants is low ifthe ‘entry barriers confer an advantage on existing firms and deterinew entrants, Entry bastiers ae high whed Substitutes © Thenew entrants have to invest substantial resources to enter the industry. © Economies of scale are enjoyed by the industry. © Existing firms control the distribution channels, benefit from product differentiation in the form of brand image and customer loyalty, and enjoy some kind of proprietary experience curve, © Switching costs are high - These are essentially one-time costs of switching from the products, of one supplier to another. © The government policy limits or even prevents new entrants, Rivalry Among Existing Firms Firms in an industry compete on the basis of price, quality, promotion, service, waitantics, and soon. Generally, a firms attempts to improve its competitive position provoke retaliatory action from others. Ifthe rivalry between the firms inan industry is strong, competitive moves and countermoves dampen the average profitability ofthe industry, The intensity of rivalry in an industry tends to be high whei: 30The number of competitors in the industry is large ‘Atleast a few firms are relatively balanced and capable of engaging ina sustained competitive battle © Theindustry growth is slugaish, prodding firms to strive fora higher market share. © Thelevel of fixed costs is high, generating strong pressures forall firms to achieve higher capacity utilisation level © Theres chronic overcapacity in the industry. 5 © Theindustry’s producti regarded as a commodity or near-commodity, stimulating strong price and service competition, © Theindustry confronts high exit barriers. Pressure from Substitute Products Ina way, all firms in an industry face competition from indusries producing substitute products. Performing. the same function as the product of industry, substitute products may limit the profit potential ofthe industry by imposing a ceiling on the prices that can be charged by the firms in the industry. The threat from substitute products is high when © Theprice-performance tradeoff offered by the substitute products is attractive © Theswitching costs for prospective buyers are minimal. © The substitute products are being produced by industries earning superior profits. Bargaining Power of Buyers Buyers area competitive force. They can bargain for price cut, ask for superior quality and better service, and induce rivalry among competitors. If they are powerful, they can depress the profitability of the supplier industry. The bargaining power ofa buyer group is high when: © Its purchases are large relative to the total sales of the seller. © Itsswitching costs are low © = “Itposes a strong threat of backward integration. Bargaining Power of Suppliers ‘Suppliers, like buyers, can exeit a competitive force in an industry as they can raise prices, lower quality, and curtail the range of free services they provide. Powerful suppliers can hurt the profitability of the buyer industry. Suppliers have strong bargaining power when 7 © Few suppliers dominate and the supplier group is more concentrated than the buyer group ‘There are hardly any viable substitutes for the products supplied. ‘The switching costs for the buyers are high. Suppliers do presenta real threat of forward integration. at4.5 OTHER FACTORS ‘The following are some of the factors that are to be analysed as part of industry analysis. J. Cost strueturé and profitability ‘The cost structure, thatis the fixed and variable cost, affects the Cost of production and profitability of the firm. Higher the fixed cost component, greater sales volume is required to reach the firm's break even point. Once the break even point is reached and the production is on the track, the profitability can be increased by utilising the capacity to full. In the case of oil and natural gas iuctustry and iron and steel industry the fixed cost portion ishigh and the gestation period is also !-"gthy. 2. Nature of the product The products produced by the industries are demanded by the consumets and other industries. [industrial {goods like iron, iron sheets and coils ere produced, the demand for them depends on the construction industry. Likewise, textile maching tools industry produces tools or the textile industry and the entire demand depends upon the health of the textile industry. Several such examples can be cited. The investor has to analyse the condition of related goods producing industry and the end user industry to find out the demand for industrial ‘goods, Incase of consurher goods industry, the change in the consumers” preference, technoligical innovations and substitute products affect the demand, A simple example is that the demand forthe ink pen is affected by the ball pomnt pen. 3. Nature of competi n ts Nature of competition is an essential factor that determines the dernaind for the particular product profitability and the price of the concerned company scrips. If too many firms are present in the organised sector, the competition would be severe. The competition would lead to a decline in the price of the product. The investor before investing in the scrip of a company, should analyse the market share of the particular ‘company’s product and should compare it with the top five companies. 4. Government policy ‘The govemment policies affect the very herve of the industry and the effects differ from industry to industry. Tax subsidies and tax holidays are provided for export oriented products. Government regulates the size of the production and the pricing of certain products. In some cases entry barriers are placed by the government, When selecting an industry, the government policy regarding the particular industry should be carefully evaluated. Liberalisation and delicensing have brought immense threat to the existing domestic industries In several sectors. 5. Labour The analysis of labour scenario in « particular industry is of great importance. The number of trade unions and their operating mode have impact on the labour productivity and modemisation of the industry. Textile industry isknown for its militant trade unions. Ifthe rade unions are strong and strike oceur frequently, it would. lead to fallin the production, In an industry of high fixed cost, the stoppage of production may lead to heavy loss. ‘Skilled labour is needed for certain industries. In the case of Indian labour market, even in computer teelmology or in any other industry skilled and well-qualified labour isavailableata cheaper rate. Thisis one of ‘ie many reasons atracting multinationals to set up companies in India 326. Research and development Forany industry to survive the competition in the national and intemational markets, product and production process have to be technically competitive. This depends on the R&D in the particular company or industry. Economies of scale and new market can be obtained only through R&D. The percentage of expenditure made on R&D should be studied diligently before making an investment, 7. Pollution standards Pollusion standards aré very high and siict inthe industrial sector, For some industries it may be heavier thanothers, Forexample, in leather, chemical and pharmaceutical industries the industrial effluents are more. SWOT analysis ‘The above mentioned factors themselves would become strength, weakness, opportunities and threats (SWOl) for the industry. Hence, the investor should carry out a SWOL analysis for the chosen industry take forinstance. increase in demand for the industry's product becomes its strength, presence of numerous players in the market i.e. competition becomes the threat to a paiticular company in the respective industry. The progress in the research and development in'that particular industry isan oppotunity and entry of multinationals in the industry and cheap imports of the particular product are threat ofthat industry. In this way the factors have to be arranged and analysed. REVIEW QUESTIONS |. Explain what is industry analysis 2, Discuss the classfication of industries, 3. Explain the classification of industries based on the business cycle. 4. What do you mean by eyelical industry? 5. Explain the nature of detensive industry stocks. 6, Discuss industry life cycle analysis and its role in valuation of equity stocks. 7. Whar investment decision will you recommend if an industry isin its pioneering stage? 8 Take an example af'an industry in rapid growth stage and disenss its features 9, Analyse the factors to be considered in evaluating the structure of an industry. 10, What factors determine the intensity of competition inan industry? 11. Explain the relationship between the cost structure in an industry and the value of securities 12. Discuss Michael Porters model. 13. Whatdo you mean by entry bartiers? 14, How do the bargaining power of buyers influence the eaming power of company? 15. Explain when will the entry barriers be high? What are implications of very high entry barriers for the indusary? 16, Explain SWOT analysis. briefly. 17, Do you thing the labour and their bchaviour will affect the value of stocks? Explain with examples. rete 33Lesson 5 : COMPANY ANALYSIS ‘The last and crucial stage in security valuation is the company analysis. The lesson is organised into the following sections. > Analysing the competitive edge > > Analysingthe earings > Financial analysis Manipulation ofthe bottom line — Keynumbers Qualitative analysis >” Evaluation of management Inthe company analysis the investors assimilate the several bits of information related to the company and evaluates the present and future values ofthe stock. The risk and return associated with the purchase of the stock is analysed to take better investment decisions. The valuation process depends upon the investors’ ability to elicit information from the relationship and inter-relationship among the company related variables. ‘The true test ofan analyst's worth lies in his ability to develop a system of secuitity analysis that couples original insight and unique ways of forming expectations about the prospects forindividual companies. The following are the factors to be evaluated by the analyst. 5.1 ANALYSING THE COMPETITIVE EDGE OF THE COMPANY z ‘Major industies in India are composed of hundreds of individual companies. In the information technology industry even though the number of companies is large, few companies like Tata Infotech, Satyam computers. Infosys, NIIT ete, control major market share. Likewise inal industries, some companies rise to the position of eminence and dominance. Once the companies obtain the leadership position in the market. they seldom lose it. The competitiveness of'a company can be studied with the help of © Marker share © Growth insales © Stability ofsales _ © Sales forecast The Market share The market share of a compiany helps to determirie a company’ relative competitive position within the industry, Ifthe market share ishigh, the compainy would beable to meet the compeition sucessfully, The market leaders will continue to lead atleast in the near future, ‘The companies in the market should be compared with like product groups. Otherwise, the results wll be misleading, 34Growth in sales ‘The company may be a leading company, but if the growth in sales is comparativel}'iower than another ‘company, it indicates the possibility of the company losing the leadership. The rapid growth in sales would keep the company in a better position than one with the stagnant growth rate, Growth in sales isusually followed by growth in profits. Investors genetally prefer size and grows in sales because the large companies may be able to withstand the business cycle rather than a company of smaller size. ‘The growth in sales ofa company is analysed both in rupee terms and in physical terms. Physical term is very essential because it shiows the growth in real terms. The rupee valuc is affected by inflation. Stability of sales Ifa firm has stable soles revenue, other things remaining constant, will have more stable eamings. Wide vvanation in sales leads to variations in capacity utilisation, financial planning and dividend. Periodically the financial newspapers provide information about the market share of different companies in an industry. The fall in the market share indicates the declining trend of the company, even if the sales are stable in absolute terms. Hence, the stability of sales also should be compared with its market share and the competitors’ market share. Sales forecast A company may be in a superior position commanding more’sales both.in monetary terms and physical terms but the investorstiould have an idea whether itwill continue in the future or not. For this purpose, forecast ofsales has to be done. He can forecast the sales in different ways: 1. Trendline 2. Simple least square technique 3. Sales growth can be compared with macro economic variables like GDP, per capital incor ete 4, The demand for the substitutes and.competitior’s product also should be analysed) square techniques. if 5.2 ANALYSING THE EARNINGS OF THE COMPANY Sales alone do not increase the earnings but the cost and expenses of the company also influence t= «rnings of the company. Eamings do not always increase with the increase in sales: The company’s sales might have increased but its eamings per share may decline due to rise in costs.. Sometimes, the volume of sales ‘may dectine but the earings may improve due to rise in the unit price ofthe product. Hence, the investorshou!s not depend only on the sales, but should analyse the earings of the company. leas The income for the company is generated through operating sources and non-operating sources. The sources of operating income vary from industry to industry. The operating income are generated from sales. ‘The non-operating income may be generated from interest or dividend from investments rentals from lease, etc. The investor should analyse the income source diligently. The investor should be aware that incomte of the company may vary due tothe following reasons. , > — Change in sales > — Change in costs> Depreciation method adopted > Depletion of resources in the case of oil, mining, forest products, gas etc. > Inventory accounting method > Replacement cost of inventories > Income taxes and other taxes. Oper: g efficiency ‘The operating efficiency of company directly affects the camings ofa company. An expanding Company that maintains high operating efficiency with a low break-even point earns more than the company with high ‘break-even point. A growing company should have low operating leverage to meet the growing demand fbr its product. Operating leverage Leverage means the use of lever to raise a heavy object with a small force. [the firm’s fixed cost is, high in the total cost the firm is said to havea high degree of operating leverage. ‘Toa large extent, operating leverage is determined by technology. For example, telephone companies, iron and steel companies and electric utilities have heavy investments in fixed assets leading to high fixed costs and operating leverage. On the other hand cosmetics companies, and constimer goods producing companies may need significantly lower fixed costs. and hence lower operating leverage: Higher the operating leverage higher the risk and vice versa, 5.3 FINANCIAL ANALYSIS The best source of information abouta company is its own financial statements. Historical financial statements help to predict the future. ‘The current information aids to analyse the present status of the comp: ny. The two main statements used in the analysis are: > Balance sheet >. _ Profitand loss account The Balance sheet The balance sheet shows all the company’s sources of funds (liabilities and stock holders’ equity) and uses of funds ata given point of time. The balance sheet shows the financial position of the company as ona particulardate, Balance sheet is prepared in the prescribed format. The major items appearing in the balance sheet ofa typical inanufacturing company are listed below:Balance sheet Liabilities Assets Stockholders equity: Fixed tangible assets Share Capital Buildings Retained earnings Land Long-term Liabi ‘Lonjgterm loans “Machinery and equipments Bonds Furniture and fixtures Currentliabilities: Patents Accounts payable Investments ‘Accrued wages and salaries Current assets, ‘Taxes payable Receivables Provisions: Inventories Prepaid expenses y Cash and bank balances Total Total Assets From the balance sheet, liquidity position of the company'can also be assessed with the information on current assets and current liabilities. The Profit and loss account ‘The income statement reports the flow of furs from business operations that takes place in between tw points of time. I lists down the items of income and expenditure. The difference between the income an ‘expenditure represents profit ur luss fos te petiod. Itis alse called inicome and expenditure statement. ‘Th investor should be aware of the limitations of the financial statements, 1. The financial statements contain historical information. This information is useful, but an investor should be concerned more about the present and future. 2. Financial statements are prepared on the basis of certain accounting concepts at’ “onventions ‘An investor should know them. 3. The statements contain only information that can be measured in monetary units. 4, Sometimes management may resort to manipulation of data and window dressing Analysis of Financial statements ‘The investor determines the financial position and the performance of thecompany through analysis The investor is interested in the yiekd and safety of his capital. He cares much about the profitability and the ‘management's policy regarding the dividend, Towards this end, he can use the following techniques: 7> Comparative financial statements > — Common size statements > — Trendanalysis > Cash flowanalysi > — Ratioanlaysis Comparative financial statements In the comparative batance sheets figures are provided for more than one year. The comparative financial statement provides time perspective to the balance sheet figures. The annual data are compared with similar data of previous years, eithsr in absolute terms or in percentages. Similarly, comparative income stitement can also be prepared, Common size statement ‘Common size balance sheet shows the percentage of each asset item to the total assets and each liability item to the total liabilities. Similarly, a common size income statement shows cach item of expenseas.apercentage ‘fet sales. With common size statements comparison can be made between firms of different size belonging tothe same industry. ‘Trend analysis In trend analysis, all the items of balance sheet and the income statement. in the base year. are taken to be 100. The items in the other years are expressed asa percentage of the base year value. This would provide insight into the growth or decline in each item over the years. Sometimes, sales may have an increasing trend but profits may remain the same. Here the investor has to look into the cost and management efficiency of the company Cash flow statement Accash flow statement is prepared with the help of balance sheet, income statement and some additional information. The statement shows the causes of changes in cash balance between two balance sheet dates. With the help of cash flow statement the investor can review the cash movements overan operating cycle. The factors responsible for the reduction of cash balances inspite of increase in profits or vice versa can be found out Ratio analysis Financial ratio provides numerical relationship between two relevant financial data. Financial ratiosare calculated from the balance sheet and profit and loss account. The relationship can be either éxpressed asa percent or asa quotient, Ratios summarise the data for easy understanding, comparison and intrepretation, Financial ratios may be divided into six groups. They ate listed below: 1. Liquidity ratios 2. Turnover ratios 3. Leverage ratios 384, Profitmargin ratios 5, Retumon investment ratios 6. Valuation ratios. 5.4 MANIPULATION OF THE BOTTOM LINE Financial statements refleot revenues, costs, expenses, assets, and liabilities. Corporate managements have some discretion in influencing the occurrence, measurement, and reporting of these items, They often use this latitude to manipulate the reported profits, referred to as the "bottom line’. The devices commonly employed for this purpose are: 1. Inflate the sales for the current yearby advancing the sales from the following year. Alter the otherincome’ figure by playing with non-operational items like sale of fixed assets, ‘Change the method and rate of depreciation. ‘Change the method of stock valuation to minimise the cost of goods sold. Capitalise certain revenue expenses, 6, Defer certain discretionary expenditures (like repairs, advertising, research and development) to the following year. ‘Make inadequate provision for certain known liabilities (gratuity, etc) and treat certain likely liabilities as ‘contingent liabilities’ after getting suitable ‘legal opinion’ from obliging lawyers. & Make extra provisions during prosperous years and write them back in lean years. 9. Use otally unacceptable accounting practices. 10. Revalueassets to create the impression of substantial reserves. 11, Lengthen the accounting year in an attempt to cover poor performance. ‘An investorshall take the following stepsso that he will not be misled by the manipulations ofthe bottomline ofa company: 1. Acquite greater knowledge of how accountants prepare financial statements and what are the current financial reporting practices. : 2. Carefully peruse the notes to accounts and a) discover changes in accounting policies; b) learn about the nature and magnitude of contingent liabilities. 3, Read the auditor's report and understand the implications ofthe qualifications in that report. 4. Lookat the performance of the company over a period of time and do not attach much importance to the figure for one year, Remember that while manipulation may pay fora year or two, it tends to bea self-defeating exercise in the long run. This indeed is your greatest consolation against window dressing. 395.5 THE KEY NUMBERS ‘Asan equity investor, you would be interested in the following key numbers: 4) eamings level; ) growth rate, and ) risk exposure. Earning Level To assess the earnings level, you should look at earnings per share, book value per share, and return on. equity. These may be measured 2s follows: Profit after tax, less preference dividends, ifany mings per share :~ ; Number of outstanding equity shares, Paid up capital + Reserves & Surplus = Book value per share Number of outstanding equity shares Profitafter tax less preference dividend = Return on Equity ~ Equity capital + Reserves & Surpluses Growth Rate Toassess the growth characteristics, you may look at the compound annual growth rate (CAGR) of sales and earnings per share over a certain period (which may be 5 years, 10 years, or whatever). These measures are defined hereunder, Sales for theending year] Win CAGR of Sales Sales forthe beginning year EPS forthe ending year] Vin “1 CAGR of Earnings per share (EPS)= EPS for the beginning year 40Risk Exposure Riskis the most significant aspectin investment analysis, You may find the following measures helpful volatility ‘ofreuin on equity and beta. These measures are defined below. Range of retum on equity over 5 years ‘Volatility of retum on equity Average return on equity over 5 years peta is a measure shoving how sensitive isthe return on the stock to variations inthe market return 5.6 QUALITATIVE ANALYSIS ‘Analysis of tinancialstarsties must be supplemented with an appraisal, mostly ofa qualitative nature, ofthe company's present situation and prospects and the quality of ts management FAVOURABLE AND UNFAVOURALB FACTORS Favourable factors Unfavourable factors TamunygsLevel @ — High book valueper share © Lowbook value per share © Highretumon equity © Lowretumonequity Growth Rate © ~—-Highgrowthrateinsales © Low growth rate in sales © High growth rate in © Low growthratein earnings pershare earnings per share RiskExposure @ — Lowvolatilty ofretum © Highvolatitiyofretum oneauity onequity . © Lowbew © Highbera Tio size up the company’s preset situation and prospects, you may ask questions along the following! lines: Availability and Cost of Inputs Is the company well-placed with respect tothe availability ofbasic raw materials, Power, fuel, and other production inputs? Whatare the cost avantages/disadvantages ofthe company vis s-Vis its competitors? Order position ‘what isthe order position ofthe company? How many months or years of production does t represent? Is the order position improving or deteriorating? 41Regulatory Framework What is the licensing policy applicable tothe industry to which the firm belongs? Are there any price and’ or distribution contiols applicable to the company? Ifo, what are their implications for profitability? Technological and Production Capabilities What is the technological competence of the firm? What is the state ofits plant and machinery? Does the company have unutilisiéd capacity to exploit favourable market developments? Marketing and Distribution What is the image of the company in the market place? How strong i the loyalty of its customersiclients? Whats the reach of the distribution network? Finance and Accounting What are the intemal accruals? How much access does the company have to external financing? How ‘conservative or liberal are the accounting policies ofthe firm? Does the company take great offorts to maintain and increase its profits. Is the depreciation charge adequate? What are the prospects of'a bonus issue? Product Portfolio ‘What are the relative shares (sales-wise) of various products of the company? What are the prospects of these products? How competitive is the position of the company in these products? What are the overall prospects of the company? Human Resources and Personnel How competent and skilled is the work force of the company? Is the company over-staffed or under- staffed? What,s the extent of employee tumover and absenteeism? How high is employee productivity? ‘What is the state of industrial relations? What is the level of employee motivation and morale? Sore information relating to the above questions may be available in the annual report of the company. some can be gathered from the financial press, and the rest may be obtained from the officials ofthe company. 5.7 EVALUATION OF MANAGEMENT. ‘Many financial analysts believe that there is no need to consider management as an independent factor in company analysis because the quality of management is reflected in sales growth, profit margins, retum on equity and so forth., Management experts, however, argue that management and the numbers should be regarded as separate aspects. Peter F. Drucker, for example, observed that “The performance of a business, today is largely a result of the performance, or lack of it, of earlier managements. Good management means doing a good job in preparing today’s business forthe future”, Echoing a similar thought, Theodore Levitt wrote that“"The mark of good management is not simply how well itruns (its) business buthow well it changes them.” Hence, the quality of rianaginentis an important factor shaping the success ofthe firm and retums to shareholders, ‘and hence calls for a separate evaluation. In this context, the analyst should ask questions like: © What isthe grand design of management? Does it believe in “staying close to the knitting” oriunrelated diversification? © Whats the calibre, motivation, integrity, dynamism, and commitment ofthe top management ‘personnel? 42Does the management have specific objectives, plans, and time-bound programmes? ‘What emphasis is accorded to research and development? How effective is the organisational structure? How sound are the management systems of the company? What is the importance assigned to management development? © How investor-fiendly is the management? ‘The information relating to the above questions is hard to come by. Yet, the determined investorcan form some judgement by perusing published material, participating in annus} general meetings, and attending investor conferences, REVIEW QUESTIONS 1. How significant is company analysis is valuation of secutities? Explain, 2. Describe company analysis. 3. What factors are to be examined to ascertain the competitive position ofa company? 4. What do you mean by market share? Explain eamings analysis. (6, In what are all the ways the profit of company may be manipulated? What steps an investor may take to protect himself from such manipulation? 7. What is operating leverage? In what way itis related to a security analysis? 8. Discuss the various tools available for analysing the financial statements 9, What is trend analysis, What are its merits? 10.How will youcaleulate earnings per share? Book value per share? 11 -Digenas the relevance and importance of qualitative analysis in company analysis. 12, How will you evakiate the management of company?- eee 43Lesson 6 VALUATION OF BONDS Bonds pay a fixed interest and one expects that their price will not be subject to wide Muctuations. Vinancial institutions, banks and corporate bodies are offering attractive bonds like retirement bonds, floating rate bonds, deep discount bonds, encash bonds, money multiplier bonds index bonds and soon. Government and goverment organisations like public sector undertakings also issue a variety of bonds. Not with standing the fact that the bonds offer fixed income, several factors make bond valuation a very challenging topic. This lesson deals with valuation of bonds and is organised into the following five sections. Meaning of bond Bond risk > Bond return > — Bond value theorems > Theterm structure of interest rate 6.1 MEANING OF BONDS ‘A bond is a contract that requires the borrower to pay the interest to the lender. Ii resembles the promissory note and issued by the government and corporate. The par value of the bond indicates the face value of the bond ice. the value stated on the bond paper. Most of the bonds make fixed interest payment till the imsturity period. ‘This specitic rate of interst is known a8 coupon rate. Coupons are paid quarterly, semi-annually ad annually, Atthe end ofthe maturity period, the face value is repaid. In India, comporate bonds are popularly known as debentures 6.2 BOND RISK Generally stocks are considered to be risky but bonds are not. This is because the bonds promise a well defined stream of interest payments and principal repayment, and hence investors generally perceive bonds to be risk-free. Bonds do have risk but the nature and types of risks may be different. Bonds are subject to the followingrisks: Interest rate risk Interest rate risk refers to the possiblity that income and/or capital loss will result because of change in the level of interest rates. This is the major risk element for most of the debt secutities. Bond prices move inversely with interest rate, An inctease in interest rate will result in decrease in prices of outstanding bonds and vice versa There isa second dimension to interest rate risk. This aspect is referred to as reinvestment risk. Suppose, after you purchase a bond, interest rates decline. In this case, the interest income can be invested only at a lower rate of interest and hence the proposed yield to maturity cannot be achicved. For example, you purchase 412% one year bond for Rs, 100 today. The interest on the bond are payable quarterly. [the interest income canbe reinvested ut the same coupon rate of 12% then the investor will get Rs.112.55at the end of one year trom the bond (100 x (1+.12/4)'] Supposing the interest rate falls to say 10%, then even though the bond will continue to yield 12% p.a. the interest income can be reinvested only at 10% and hence, the end value of the ivond will be Rs.112.46 which is lower than Rs.112,55. This loss has arise because ofthe decline in the general interest rate level in the market. 44Default risk The failure to pay the agreed value of the debt instrument by the issuer in full, on time orboth are the default risk, Treasury bills and bonds issued by the central government are devoid of this risk. ‘The same cannot be assured of bonds/debentures issued by any corporate firm. The default risk occurs because of macto ‘economic factors or firm specific factors, in order to avoid the default tisk, the capacity to serve the debt by the company is rated by rating ayencies. Regulators like Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBD) often use credit rating to determine the eligibility of the fixed income instruments. Credit Rating Information Services of India Limited (CRISIL), livestment Information and Credit Rating Agency of India Ltd (ICRA) and Credit Analysis and Research Limited (CARE) are rating tlie bonds and other fixed income securities. In the international bond market, Moody’s Investor Service and Standard and Poor's ratings are famous. Marketability risk ‘Variation in return caused by the difficulty in selling the bonds quickly without having to makea substantial price concession is known as marketability risk. This risk is different from the market risk that affects all securities in the market, Marketability risks specific risk. The'marketability or liquidity of the particular bond ‘depends on the firm who issues the bond. The managerial inefficiencies and fall in the profits may create a fear in the minds of investors aid they may not be willing to buy such bonds in the secondary market. fan investor has to séll such illiquid investments, he may be forced to sell it at a high discount. idity, but the same may For example, the bonds/debentures issued by Reliance Industries enjoy high not be true ofthe debentures issued by the smaller companies. Thus liquidity ofthe particular bond or debenture depend may on the corporate image. Callability risk The uncertainty created in the investors return by the issuer's right to call the bond atany time is known, ais callabiliy risk. Debt mstruments may carry call option. The call option provides the issuer the nightto call back the instruments by redeeming them. This facility provides a way out for the issuer if the interest rate ieotines, The issuer can call the bond with high interest rate and again raise funds at a lower interset rate. Since, the bond or debenture can be called at any time there is an uncertainty regarding the maturity period and coupon. This feature of the bond may depress the price level of the bond and the uncertainty element attached swith the callable bonds make the investors to ask for higher yields. Purchasing Power Risk i ‘When commodity prices are perecived to rise, lenders require higher rates of interest to protect depreciating purchasing power of the debt payments, Some also theorize that rising commodity pricés raise the level of interest rates because rising commodity prices inerease nominal credit demands, thereby boosting interst rates. “The necessity to adjust the rate of interest for price changes can be understood better with an example, Suppose you invest Rs, 1000 on a bond which promises to pay Rs.1100 after one year. ‘The rate of interest ‘onthe bond is 10%. Assume that the inflation rate during the coming year is expected to be 12%. Because of snilanion, the Rs.1100 received after one year will have the purchasing power of only Rs.968 (i.e. Rs.1100x 8%), ‘Therefore, if'you wish to earn a eal return of 10 percent you must demand an interest of 22 percent (i.c 10% overthe inflation rate). 45