1

Chapter ................................................................................................................................. 7
Introduction to Equity Research ............................................................................................ 7
Global Markets: Insights and Perspectives ...................................................................... 10
Chapter ............................................................................................................................... 21
Valuing Investments: Investment Management Approach ................................................... 21
Valuing Investments ........................................................................................................ 21
Asset classes ..................................................................................................................... 21
Compounding and Discounting ........................................................................................ 21
Valuation of Investments .................................................................................................... 22
Valuing Equity Investments ................................................................................................ 24
Standalone or Consolidated? ............................................................................................... 32
Alternative Methods of Valuing Equity Shares ...................................................................... 35
Management Quality .......................................................................................................... 44
Portfolio Sizing, Diversification versus Concentration ............................................................ 61
Chapter ............................................................................................................................... 65
Behavioural Finance ........................................................................................................... 65
Introduction to Behavioural Finance ................................................................................ 65
Introduction to Heuristics & Biases .................................................................................. 66
Types of Heuristics & Biases ........................................................................................... 67
Chapter ............................................................................................................................... 84
Introduction To Value Investing – Basic Principles .............................................................. 84
What is Value Investing? .................................................................................................... 86
Types of Investors .............................................................................................................. 88
Market Fluctuation ............................................................................................................. 91
Intrinsic Value ................................................................................................................... 97
Margin of Safety .............................................................................................................. 102
Chapter ............................................................................................................................. 110
Economic And Industry Analysis –Equity Research Perspective ............................................... 110
What Is Fundamental Analysis ...................................................................................... 110
Economic Analysis ........................................................................................................ 110
Significance Of Economic Analysis ................................................................................ 110
Economic Forecasting Techniques ................................................................................ 110
Summary Of Indicators .................................................................................................. 112
Economic Cycle/ Business Cycle Study......................................................................... 113
Impact Of FIIs, DIIs & FDI.............................................................................................. 113
Exogenous Shocks ........................................................................................................ 114
 2

Current Turmoil In Global Financial Markets .................................................................. 114

Integration of Market Segments ................................................................................. 114
Linkages of Financial Instruments .............................................................................. 114
Appropriate Strategies ............................................................................................... 114
Bubbles and Crises .................................................................................................... 114
Headwinds ................................................................................................................. 114
Tailwinds in India ....................................................................................................... 115
Industry Analysis ........................................................................................................... 115
Industry Classification By Product ................................................................................. 115
NIC Classification .......................................................................................................... 115
Industry Classification According To Business Cycle ..................................................... 116
Industry Life-Cycle Theory ............................................................................................. 116
Structure-Conduct-Performance Paradigm .................................................................... 118
Structure Of An Industry ................................................................................................ 120
Industry Structure, Competitive Advantage and Value Chain ................................................ 122
Porter’s Five Forces Model ............................................................................................ 124
Threat of New Entrants .............................................................................................. 125
Determinants of Substitution Threat ........................................................................... 126
Bargaining Power of Suppliers ................................................................................... 126
Bargaining Power of Buyers ....................................................................................... 126
Rivalry amongst Existing Firms .................................................................................. 127
Three Generic Strategies............................................................................................... 127
Cost Leadership ......................................................................................................... 128
Differentiation Advantage ........................................................................................... 128
Focus ......................................................................................................................... 129
Global and National Events – PESTEL .......................................................................... 129
Boston Matrix ................................................................................................................. 130
Important Factors for Select Sectors: .................................................................................. 131
Factors affecting Auto Sector ..................................................................................... 131
Factors affecting Finance Sector ................................................................................ 132
Factors affecting FMCG Sector .................................................................................. 132
Factors affecting Energy Sector ................................................................................. 133
Factors affecting IT Sector ......................................................................................... 133
Factors affecting Pharma Sector ................................................................................ 133
Factors affecting Metals Sector .................................................................................. 134
Factors affecting Media Sector................................................................................... 134
 3

Factors affecting Construction, Cement and Realty Sector ........................................ 135

Factors affecting Telecom Sector ............................................................................... 135
Factors affecting Manufacturing Sector ...................................................................... 135
Top Down and Bottom Up Approach ............................................................................. 136
Regulatory Framework .................................................................................................. 137
Points To Be Considered In Industry Analysis ............................................................... 139
Sources of Information .................................................................................................. 140
Primary Sources ........................................................................................................ 140
Secondary Sources.................................................................................................... 141
Composition of Indices .................................................................................................. 141
Appendices.................................................................................................................... 142
Appendix 1: Nifty 50 – Methodology and Fact Sheet .................................................. 142
Appendix 2: Nifty Midcap 50 ...................................................................................... 142
Appendix 3: Nifty Smallcap 100 ................................................................................. 142
Appendix 4: Nifty Bank ............................................................................................... 142
Appendix 5: Nifty Financial services ........................................................................... 142
Appendix 6: Nifty IT .................................................................................................... 142
Appendix 7: Nifty Consumer Goods ........................................................................... 142
Appendix 8: Nifty Auto................................................................................................ 142
Appendix 9: Nifty Pharma .......................................................................................... 142
Appendix 10: BSE Sensex ......................................................................................... 142
Appendix 11: BSE 100 ............................................................................................... 142
Appendix 12: BSE 200 ............................................................................................... 142
Appendix 13: BSE Dollex 30 ...................................................................................... 142
Appendix 14: MSCI India Index .................................................................................. 142
Questions ...................................................................................................................... 142
Assignments .................................................................................................................. 143
Suggested Websites...................................................................................................... 146
Chapter .............................................................................................................................. 149
Company Analysis: Stock Selection and Fundamental Concepts of Valuation for Equity
Research .......................................................................................................................... 149
Preliminary Screening as a Basis for Stock Selection .................................................... 149
Non-Financial Analysis .................................................................................................. 149
Vision, Mission and Goals .......................................................................................... 149
Management Quality .................................................................................................. 149
Organisation Structure ............................................................................................... 150
 4

Production, Technology and R & D ............................................................................ 150

Purchasing ................................................................................................................. 151
Marketing ................................................................................................................... 151
Human Resource Management ................................................................................. 152
Wealth Creation and Other Aspects ........................................................................... 152
CSR Activities ............................................................................................................ 153
SWOT Analysis and the 7-S Framework .................................................................... 153
Financial Analysis .......................................................................................................... 154
Annual Report ............................................................................................................ 154
Adjusted Financial Statements ................................................................................... 159
Financial Ratio Analysis ............................................................................................. 162
DuPont System .......................................................................................................... 168
Considerations about Financial Strength, Capital Structure and Dividends ........................... 171
Analysis of Expenses with respect to Sales ...................................................................... 171
Trend Analysis ............................................................................................................. 171
Comparative Statement Analysis .................................................................................... 171
Common-size Analysis ................................................................................................. 172
Analysis of Cash Flow Statement ................................................................................... 172
Interrelationships between Certain Parameters ................................................................. 172
Other Important Financial Parameters ............................................................................. 172
Cost Advantage ............................................................................................................ 173
Leverage .................................................................................................................... 175
Earnings Estimates........................................................................................................ 179
Valuation ....................................................................................................................... 181
Philosophy of valuation .............................................................................................. 181
Concept of fair value .................................................................................................. 181
Core principles ........................................................................................................... 182
Myths about valuation ................................................................................................ 184
The role of valuation .................................................................................................. 185
Valuation and fundamental analysts........................................................................... 185
Valuation and chartists ............................................................................................... 185
Valuation and information traders .............................................................................. 185
Valuation and market timers ...................................................................................... 185
Valuation and efficient marketers ............................................................................... 185
Valuation models ....................................................................................................... 186
Determining cash flows .............................................................................................. 187
 5

Estimating growth ...................................................................................................... 188

Estimating terminal value ........................................................................................... 190
Dividend discount models .......................................................................................... 191
Free cash flow to equity discount models ................................................................... 192
Free cash flow to the firm ........................................................................................... 193
Estimating equity value per share .............................................................................. 194
Valuation Matrices ....................................................................................................... 194
Relative valuation: fundamental principles ................................................................. 195
Questions ...................................................................................................................... 197
Chapter ............................................................................................................................. 199
Company Analysis: Financial Modelling, Risk and Return ................................................. 199
What Financial Modelling Is ........................................................................................... 199
Tools for Financial Modelling ......................................................................................... 199
EXCEL Functions ............................................................................................................ 199
Application of EXCEL Functions .................................................................................... 200
Financial Appraisal of Historical Performance ............................................................ 200
Financial Forecasting .................................................................................................... 201
Valuation .................................................................................................................... 201
Statistical Functions for Risk Management ...................................................................... 201
Performance Measurement: ........................................................................................... 201
Risk and Return............................................................................................................. 201
Return ........................................................................................................................ 201
Risk in holding securities............................................................................................ 202
Measuring Return ......................................................................................................... 203
Measuring Risk ............................................................................................................ 203
Valuation and Risk-Return Theory ..................................................................................... 204
Comparing Price with Value ....................................................................................... 204
Cootner’s Price-Value Interaction Model .................................................................... 204
The Dynamics of Valuation and Investment ............................................................... 205
Management of Risk by Investors with Different Risk Aversion...................................... 205
Questions ...................................................................................................................... 209
Assignment(s) ............................................................................................................... 210
Chapter ............................................................................................................................. 211
Financial Markets –Research Perspective -Others............................................................ 211
What are Derivatives? ...................................................................................................... 211
Cash and Futures Arbitrage ............................................................................................... 215
 6

Call and Put Options: Payoffs ........................................................................................ 216

Purchase of Call Option: Payoffs ............................................................................... 216
Purchase of Put Option: Payoffs ................................................................................ 216
Straddle ......................................................................................................................... 217
Strangle ......................................................................................................................... 219
Hedging with Futures and Options ..................................................................................... 219
Hedging Using Futures ................................................................................................. 219
Hedging Using Put Options ........................................................................................... 219
History of Indian & Global Markets ................................................................................ 220
BSE ........................................................................................................................... 220
National Stock Exchange ........................................................................................... 220
London Stock Exchange ............................................................................................ 220
NYSE ......................................................................................................................... 220
NASDAQ ................................................................................................................... 220
Other International Exchanges ................................................................................... 221
Accounting Framework Affecting Equity Research ........................................................ 221
Regulatory Requirements .................................................................................................. 221
Questions ........................................................................................................................ 222
 7

Chapter

Introduction to Equity Research

Wealth Creation is the goal of Investors and many finance professionals, financial
planners, wealth managers, fund managers globally and in India .Wealth creation is sought to
be done for oneself or clients and Financial Markets provide a major opportunity. Financial
Markets are dynamic globally and changing rapidly with the opening up of Financial Markets
of many countries including developed country to external investments. Development is
coming on top of the agenda of most countries including India requiring huge investments.

Trillions have been invested in Equities. Equity is becoming a very important Asset
Class along with other Asset Classes like Real Estate, Gold, Fixed deposits, Saving Accounts
and Saving Products, Debt, Bonds, Commodities, Currencies ,Alternative Investments and
other financial instruments.

Equities are owned directly or through Sovereign Funds, Pension Funds, Mutual
Funds, Institutions (Foreign and Domestic) and Portfolio Investors including Foreign
Portfolio Investors. Private Equity also plays a major role in initial mobilisation of
Investments by Entrepreneurs particularly with the increasing role of Start-ups. Tax benefits
encourage investments in Equities through various fiscal incentives to encourage Savings and
Investments. Major Investments are in long term holdings in Equities. Trading Volumes in
Stock Exchanges show a high proportion of trading volumes and also volatility in Equity
Markets which need to provide liquidity.

Recent data shows growing Retail participation with the highest number of investor
accounts in Mutual Funds in India at 46 million as at 31 St December 2015 out of which
Equities constitute a lion’s share at 34 million investor accounts showing a growth of 13.3%
annually.
 8

Equity Research Role is to provide information to the investor. Lack of information

creates inefficiencies. Research is very important in filling the information gaps so that each
individual investor does not need to analyse every stock. There is a difference between
Researches by different entities for various purposes. Institutional Equities Research is
generally provided by major brokerage firms. Other Equities Research is now being provided
by Independent Research firms and small brokerage firms. Research is also being done by
Investment Managers including Mutual Funds, Institutions and Portfolio Investors depending
on their requirements. They also use the Research provided by others and may also outsource
Research for specific areas. Research is also done for Private Equity and Investment Banking
Deals in private placements and for Initial Public Offers, Follow on Public Offers and Offer
for Sale.

All Institutions and Service providers have realized that Research is an integral part of
making a successful Investment decision. They often hire Equity Analysts to have a
competitive edge over others. Institutions tend to focus on Large Caps or Mid-Caps while a
majority of stocks are small caps. Independent Research firms or finance professionals are
becoming the main source of information on majority of stocks.

Equity Research Analysts are required use their knowledge, insights and expertise to
spend time analysing a stock. Analysis includes Company Analysis, Price History,
Movements and Volumes, Industry Analysis, Economic Analysis, comparisons with peers
and competitors, competitive advantages and provides reports which also include earnings
and valuation estimates and risk evaluation. Analysts accordingly give recommendations and
advice to Investors.

Investments are done in Equities on the basis of Fundamental or Technical Analysis.

A new trend is doing Investments in Equities based on Analysis of Companies with strong
fundamentals and long term investment potential and trying to time the market and Buy / Sell
 9

investment decisions. Also there is a high degree of volumes in the market which is often
referred to trading in stocks or speculation. This is also increasingly being done through use
of Equity Research inputs like Fundamental or Technical Analysis.

Equity Research has evolved into a discipline within the financial services industry.
Finance professionals doing equity research are known most generally as ‘Research Analysts’
or ‘Securities Analysts’. As a growing field of specialization, Equity Research Analysts are
further sub divided into industry specialization on different sectors. Some large firms have up
to 20 Analysts including Associate Analysts responsible for analysing various sectors and
various companies within the sectors, Technical Analysts, Derivative Analyst , ‘Economist ‘
and a ‘Strategist’ .They usually report to the ‘Head of Research’ . The ‘Strategist’ and the
Head of Research need to have deep and wide knowledge and experience in Fundamental
Analysis, Technical Analysis, Investment Management and Markets.

Having a detailed study of Fundamental Analysis including price movements of

Stocks through Charts and Patterns becomes highly useful at arriving at a well-informed
investment decision. While preparing Research Reports, besides regulatory requirements, use
of financial modelling and software packages are often done to Analyse a company and its
peers to build various scenarios and sensitivity analysis in doing financial projections with a
view to arriving at earnings estimates and valuations and target price based on various
methodologies. The Equity Analyst, in the Research Report, also seeks to develop and
communicate to investors, insights regarding the Value, Risk and Volatility in the covered
stock to enable or assist investors to decide whether to Buy, Sell, Hold, Short or Avoid or its
Derivative. To be able to guide investors in making give a recommendation and the target price
needs years of experience and insights and not just an arithmetic exercise. To gather the
information required to do so, it is essential for the Analyst to review the Annual Report and
Accounts to Shareholders in detail along with periodic disclosures by the company as may be
required by Regulations and Listing Agreement. Analyst must also participate in management
conference calls, Analyst Meets if allowed and General Meetings if allowed , read industry
news and use industry information database ,understand key drivers, trading history, interview
management and other important stakeholders and do channel checks with customers,
suppliers, bankers, etc. and if required do own primary research.
 10

Limitations for an Analyst may be lack of complete information needed for

appropriate decision making. The company may have Forensic issues and risk of Fraud which
may not be known for several years”

Analyst produces reports and recommendations like ‘Buy (Overweight)’, Hold or

‘Sell (Underweight)’ etc. These are done based on various benchmarks, which are disclosed
to various investors

The Industry now has ‘Buy-side Analysts’ and ‘Sell-side Analysts’. It has become
imperative to look at Analysis Perspective both from the ‘Buy-Side’ (Investment Manager/
Mutual Fund Manager / Wealth Manager / PMS Manager) perspective as well as ‘Sell-Side’
(preparing research reports from a Brokerage Research / Independent Research perspective.)
Retail research is evolving into a new growth area with many retail investors requesting for
research. Media (print, electronic and internet) is having its own research or intelligence units
doing research.

Any finance professional in Financial Markets including an Analyst must look at Global
Markets Realities and wisdom of Global Investment Gurus like Benjamin Graham, Warren
Buffet, George Soros, Peter Lynch, and Sir John Templeton any many others from different
perspectives to get insights in the world of investing.

It takes years of practical experience for an Analyst to be able to guide investors in

making a successful investment decision in dynamic Global Markets. A good Analyst must
THINK, remain focussed, a needs a MENTOR for guidance to be on the right path and play
an effective role in the process of Wealth Creation. In the process of wealth creation, whether
the payoff is through research, fundamental and technical analysis, or not or about
randomness ultimately the decision is of the respective class of investors.

Global Markets: Insights and Perspectives

Benjamin Graham (1894 - 1976)

 11

You are neither right nor wrong because other people agree with you. You are right because
your facts are right and your reasoning is right - and that's the only thing that makes you
right.

At the present time, when the outlook is so clouded with uncertainty, the trader might well
turn his attention for a while to the unspectacular, but safely profitable business of hedging.

Warren Buffet

What a company's stock sells for today, tomorrow, next week, or next year doesn't matter.
What counts is how a company does over a 5 year or 10 year period.

I have often felt there might be more to be gained by studying business failures than business
successes.

Unfortunately what happens in business and investments is that people know better, but when
they hear a rumour - particularly when they hear it from a higher place - they just can't resist
the temptation to go along.

Philip Fischer

For the conservative investor, the test of all actions is whether the management is truly
building up the long range profits of the business than just seeming so.

A large company's need to bring in a new Chief Executive from the outside is a damning sign
of something basically wrong with the existing management.

The company with real investment merit is the company that usually promotes from within.

The first dimension of a conservative investment consists of outstanding managerial

competence.
 12

George Soros

Analysts generally regard the stock market as the passive reflection of investor’s
expectations. But in fact, it is an active force in shaping them.

Jim Rogers

The smart investor learns to buy fear and panic and to sell greed and hysteria.

It does not take esoteric knowledge or an MBA degree or some mystical skill. Read the
newspapers, watch the television news - and think.

The smart investor learns to listen to the popular press with an ear tuned for panic extremes.
At market tops, the tune will run “This time it’s different from all other times. This is an
investment you put money in and forget."

It is learning to listen to the gloom and doom at bottoms and question it, and to the exaltation
at tops and question this as well, that makes a sharp investor.

Peter Lynch - Fidelity

Though people who buy stocks about which they are ignorant may get lucky and enjoy great
rewards, it seems to me they are competing under unnecessary handicaps.

A great patient's drug is one that cures an affliction once and for all, but a great investor's
drug is one that the patient has to keep buying.
 13

So often we struggle to pick a winning stock, when all the while a winning stock has been
struggling to pick us.

You don't have to be a Vice President at Exxon to sense a growing prosperity in that
company .You can be a roustabout ,a geologist ,a driller, a supplier, a gas - station owner, a
grease monkey, or even a client at the gas pumps.

Edward C Johnson, II (1898 to 1984) - Fidelity

Operation in securities is not mainly a matter of reasoning at all .The talented operators I
know don't really reason things out (although they often pretend to).

The Stock Market represents everything that anybody has ever hoped, feared, hated, or loved.
It is all of life.

Crowds, when they carry often sound ideas to foolish extremes, tend to commit suicide.

Sir John Templeton

For all long term investors, there is only one objective - “maximum total real return after
taxes”

Achieving a good track record takes much study and work, and is a lot harder than most
people think.

It is impossible to produce a superior performance unless you do something different from

the majority

The time of maximum pessimism is the best time to buy, and the time of maximum optimism
is the best time to sell.

In the stock market the only way to get a bargain is to buy what most investors are selling.
 14

To buy when others are selling and to sell when others are greedily buying requires the
greatest fortitude, even while offering the greatest reward.

Bear Markets have always been temporary .Share prices turn upwards from one to twelve
months before the bottom of the business cycle.

If a particular industry or type of security becomes popular with investors, that popularity
will always prove temporary and, when lost, won't return for many years.

In the long run, the stock market indexes fluctuate around the long term upward trend of
earnings per share.

In free - enterprise nations, the earnings on stock market indexes fluctuate around the
replacement book value of the shares of the index.

If you buy the same securities as other people, you will have the same results as other people

The time to buy a stock is when the short term owners have finished their selling, and the
time to sell a stock is often when short term owners have finished their buying.

Share prices fluctuate much more widely than values. Therefore, index funds will never
produce the best total return performance.

Too many investors focus on “Outlook” and "Trends ". Therefore, more profit is made by
focussing on Value.

If you search worldwide, you will find more bargains and better bargains than by studying
only one nation. Also, you gain the safety of diversifications.

The fluctuations of share prices are roughly proportions to the square root of its price.

The time to sell an asset is when you have found a much better bargain to replace it.
 15

When any method for selecting stocks becomes popular, then switch to unpopular methods.
Too many investors can spoil any share selection or any market timing formula.

Never adopt permanently any type of asset or any selection method. Try to stay flexible,
open-minded and sceptical. Long term top results are achieved only by changing from
popular to unpopular the types of securities you favour and your methods of selection.

The skill factor in selection is largest for the common stock part of your investments.

The best performance is produced by a person, not a committee.

If you begin with a prayer, you can think more clearly and make fewer stupid mistakes.

Adam Smith

Some Analysts should not manage their own money, some portfolio managers should be
running funds with other characteristics, and some investors should be cutting flowers in their
garden and letting smart people run the money.

There is one requirement that is absolute in money managing .If you don't know who you are;
this is an expensive place to find out.

The Analyst really wants to be right; his ego needs the pleasure of being right, but he would
almost rather be right than make money.

If you really know what's going on, you don't even have to know what's going on to know
what's going on.

Portfolio managers used to have the same sort of profile as a CPA, because portfolio
managers were usually trust officers, safe, sound Prudent Men who wore free eye-shades,
sleeve garters, and said “My Good man ".

John Moody (1868-1958) - Moody's

 16

The investor, theoretically at least, is placing his capital to work more or less permanently.

The speculator is almost invariably one who is looking for quick profits.

More money is probably lost by people who attempt to invest their money conservatively and
sanely, but conservatively and sanely, but ignorantly, than is lost by those who enter into
frank speculations.

John C Bogle (Vanguard Group)

Despite overpowering evidence to the contrary, investors seem to believe that past
performance is the precursor to future performance.

One major area in which shareholders should make their opinions known is the quality of the
communications they receive from the fund.

The right to vote proxies is significant, since management fee increases must be approved by
mutual fund shareholders .Each shareholder must vote, and vote intelligently.

If mutual fund investors become more cognizant of the costs they are paying in the form of
sales loads, management fees, and other fund expenses, and then act on this awareness, these
costs will surely decline.

For the long term investor, knowing the fund's objectives, investment policies, returns, risks,
and total costs is probably sufficient.

While it seems trivial to suggest that the canny investor begins by reading fund prospectus,
that is where it really does begin.

In considering exactly what is in your best interests as a mutual fund investor 1 Be Canny 2.
Be thrifty 3 Be active and 4 Be skeptical
 17

Charles H Dow (1851-1902)

There is good similarity in all “booms” and in all periods of depression. The character of
these movements is like a snowball running down an inclined plane and gathering snow as it
runs.

Experience has shown that it takes about five years for one of these cycles to complete itself.

There is always a disposition in people's minds to think that existing conditions will be
permanent.

When the public mind has a well-defined tendency, either bullish or bearish, it is not easily
changed. Scores of hundreds of people may change, but the mass press on in the same
direction.

William Peter Hamilton (1867-1929) - Editor of Wall Street Journal and Barron's

It seems to be a fact that a primary movement in the market will generally have a secondary
movement in the opposite direction of at least three-eights of the primary movement.

A prophet, especially in Wall Street, takes his life in his hands.

The market represents everything everybody knows, believes, anticipates, with all that
knowledge sifted down to the bloodless verdict of the market place.

What we need are soulless barometers, price indexes and averages to tell us where we are
going and what we may expect.

Panics, at least, show a variable interval between them, from ten to fourteen years, with the
intervals apparently tending to grow longer.
 18

B C Forbes (1880-1954)

The trouble is that the crazy exploits of the besmirch the reputation of the many, when a Wall
Street plutocrat runs amuck it makes a spicy front page story.

The term “Wall Street" embraces anything from the get rich thievishly fraternity to the
strongest of our financiers and banking institutions.

Abby Joseph Cohen - Goldman Sachs

Share repurchases have been used as a tax efficient alternative to paying cash dividends
which is often preferred by taxpaying investors.

Joseph E Granville

One cannot expect to become a good market diagnostician overnight any more than one could
become a good doctor without the necessary years of practice and training.

Technical Analysis of the stock market is largely based on many repetitive observations and
the truths revealed often can be shown to have parallels in such things as music, medicine,
physics, etc.

Stanley Kroll

We do not trade for the action, the excitement or to entertain friends with wild and woolly
stories. We accept the accompanying risks for one reason only - to make a big score...a home
run...lots and lots of money!

Bibliography /Suggested readings/acknowledgements:

1) Competitive Advantage: Creating and Sustaining Superior Performance by

Michael E. Porter
2) Security Analysis: Principles and Techniques by Graham and Dodd
3) The Intelligent Investor by Benjamin Graham
4) Security Analysis and Portfolio Management by Fischer and Jordan
 19

5) Investment Valuation - Aswath Damodaran

6) Mastering Financial Modelling – Alastair L. Day
7) Value Investing and Behavioural Finance by Parag Parikh
8) Technical Analysis of Stock Trends by Robert D. Edwards and John Magee
9) Complete Guide to Technical Analysis – An Indian Perspective by Martin Pring
10) Japanese Candlestick Charting Techniques by Steve Nison

11) Super economies America, India, China and The Future of The World by Raghav
Bahl
12) Emerging India: Economics, Politics, and Reforms by Dr. Bimal Jalan
13) Keys to Reading an Annual Report (Barron's Business Keys Ser.) by George T.
Friedlob Ph.D., Ralph E. Welton
14) Damodaran on Valuation by Aswath Damodaran
15) Valuation: Measuring and Managing the Value of Companies: McKinsey
16) Investments by William Sharpe, Gordon Alexander & Jeffery Bailey
17) Modern Investments and Security Analysis by Rusell Fuller and James Farrell
18) The Warren Buffet Way by Robert Hagstrom Jr.
19) A Random Walk Down Wall Street by Burton Malkiel
20) One Up on Wall Street by Peter Lynch
21) Beating The Street by Peter Lynch
22) The Alchemy of Finance by George Soros
23) Light Reading : Reminisces of Stock Operator by Jesse Livermore
24) Art of Contrary Thinking by Humphrey Neill’s
25) Behavioural Finance Paperback – by William Forbes
26) Psychology of Investing (4th Edition) (Prentice Hall Series in Finance) – by John
R. Nofsinger
27) Extraordinary Popular Delusions & the Madness of Crowds by Charles Mackay
28) The Winner’s Curse by Richard H. Thaler’s
29) Technical Analysis of the Financial Markets by John Murphy
30) Technical Analysis And Derivatives Book by Ashwini Gujral
31) Options, Futures and Other Derivatives by John Hull
32) How It Make Money Trading Derivatives by Ashwini Gujral
33) Elliott Wave Principle by A.J. Frost and Robert Prechter How to read a Financial
Report – John A. Tracy Tage C. Tracy
 20

34) Using Excel for Business Analysis: A Guide to Financial Modelling Fundamentals
- Danielle Stein Fairhurst
35) Financial Modelling and Valuation: A Practical Guide to Investment Banking and
Private Equity - Paul Pignataro
36) Business Analysis with Microsoft Excel (3rd Edition) - Conrad Carlberg
37) Spreadsheet Check and Control - Patrick R. O'Beirne
38) Building Financial Models - John Tjia
39) The House of Nomura – Al Alletzhauser
40) Book of Leadership Wisdom – Peter Crass
41) Book of Investment Wisdom – Peter Crass
42) The Black Swan - The Impact of the Highly Improbable – Nassim Nicholas Taleb
43) Fooled by Randomness – Nassim Nicholas Taleb
44) Antifragile – Nassim Nicholas Taleb
45) Revolutionary Wealth – Alvin & Hedi Toffler

Additional readings:

1) Financial Newspapers
2) Financial Journals and Magazines
3) Letters to Shareholders – Warren Buffet
4) S & P, Moody’s, CRISIL, ICRA, CARE Ratings, News & Analysis
5) RBI Bi-monthly Reports
6) Reuters, Bloomberg, Newswire Updates
 21

Chapter

Valuing Investments: Investment Management Approach

Valuing Investments

Investing

The act of investing is commonly understood as an act of parting with funds by the investor
with the expectation of getting the principal plus returns in the future. It means that the
investor is willing to postpone her consumption in order to get more in the future.

Asset classes

Investments can be in various asset classes, broadly these can be

1. Fixed income asset classes / lending money like

(a) Fixed deposits
(b) Corporate / Government Bonds
(c) Small savings instruments
(d) Commercial Paper / Treasury Bills
2. Owning businesses / Equities
(a) Investing in listed equity shares
(b) Private equity / Venture capital
(c) Investing in own /closely held business
3. Physical assets
(a) Real Estate
(b) Equipment leasing etc.

Compounding and Discounting

The basics of interest rates / returns and the compound interest formula are introduced to
students in high school. As it turns out, this is the basic principle on which high finance is
based.

The compound interest formula is given below

 22

Amount on Maturity A

Principal P

Annual Rate of return in percentage terms r

Number of years of investment n

A = P ( 1 + r)

This same formula can be used to calculate future value from the present value or vice versa.
The version given above calculates the future value A.

If one were to calculate present value, we could use

P= -----------------------

(1+r)

Valuation of Investments

All investors need to be able to value the investments in order to be able to decide whether
the purchase / sale price is appropriate. For example Government / Corporate Bonds, Equity
Shares, Real Estate etc. need to be valued to see whether the prices at which they are quoting
are appropriate or not.

Process of Valuation
 23

The first step involved is to project cash flows for the future periods.

For example, in the case of a Corporate Bond, we would project the future payouts by the
borrower in terms of interest and principal payments.

The second step would be to discount all the future cash flows to the present by using the
appropriate discount rate (interest rate). The appropriate discount rate would depend upon the
prevailing interest rates and the risk associated with the investment. The higher the risk the
higher the discount rate required.

After discounting the cash flows to the present, the discounted values are added up and that is
the true (intrinsic) value of the investment. This intrinsic value is compared with the market
price of the investment to decide whether the investment should be made or not. Obviously, if
the market price is higher than the true / intrinsic value, the investment should be rejected.
 24

Valuing Equity Investments

Which Cash Flow?

Usually, when investors talk about cash flows, it means cash flows that they get paid. In the
case of bonds it is the interest paid out to investors, in the case of property, it means the rent
paid to the owner of the property.

By extension, cash flow to the investor of equity shares would mean dividends.

A. Cash flow to shareholders (dividend method of valuation)

To value equity shares like any other asset on the basis of dividends, we use the following

Di refers to the dividend received in year i

r required rate of return

V0 Value of the equity share at year 0

D1 D2 D3

V0 = ----------- + ---------- + ----------- + .....................................

1 2 3

(1+r) (1+r) (1+r)

 25

In short, all the dividends over the life of the company are to be discounted to the present
value.

Surely, such a calculation is tedious and requires a lot of assumptions regarding the future
dividends.

In order to simplify calculations somewhat, we have the following formulae.

Gordon's Dividend Discount Model

In a simplified (but somewhat unrealistic) world, the dividend discount formula would look
like

D1 refers to the dividend received in year 1

g refers to the constant rate of growth in dividend each year

r required rate of return

V0 Value of the equity share at year 0

D1 D1 (1+g) D3 (1+g)

V0 = ----------- + ----------------- + ---------------- + .....................................

1 2 3

(1+r) (1+r) (1+r)

 26

Those who remember their mathematics well will recognise this is as a geometric series and
it simplifies to

D1

Vo = ----------------

(r - g)

This formula is also called the Gordon's Dividend Discount Model.

Problems with the Gordon's Dividend Discount Model

The appeal of the Gordon's Dividend Discount Model is its simplicity in application. One has
to just estimate the dividend for the forthcoming year (not too difficult), arrive at a discount
rate or required rate of return and estimate the growth rate of dividend. The calculations are
not too difficult.

For example, take Company X with an estimated dividend of ₹ 5 in one years time and a
required rate of return of 15% and a growth rate of dividends at 8% will have an intrinsic
value as follows

V0 = ------------- = ₹ 71.43

(0.15-0.08)

The problem however is that the real world scenario is significantly different as compared to
the idealised situation required by the Gordon's Dividend Discount Model.
 27

Most businesses are susceptible to a life cycle. One way of classifying stages would be

1. Inception and Start-up stage

2. Survival and growth stage
3. Expansion stage
4. Mature stage
5. Decline / Exit stage

Obviously an assumption of a steady state growth indefinitely is not compatible with the life
cycle observed for most real world companies.

An alternative to the Gordon's model is the use of multistage dividend discount model. As an
example we consider a two stage growth model.

D1 refers to the dividend received in year 1

g1 refers to the constant rate of growth in dividend for the first

stage

g2 refers to the lower constant growth rate after the end of the first
stage

r required rate of return

V0 Value of the equity share at year 0

Let us say dividend at the end of year one is ₹ 5. The first stage of growth will be for 5 years.
The growth in the first stage is 12% and the growth after the first stage is 3%. Required rate
of return is 15%.
 28

In such a case

2 3 4

D1 D1( 1+ g1) D1 (1+g1) D1(1+g1) D1(1+g1)

Terminal
Value

V0 = --------- + ---------------- + --------------- + --------------- + -------------- + ---------

---

2 3 4 5
5

(1+r) (1+r) (1+r) (1+r) (1+r)

(1+r)

Where the Terminal Value can be calculated using the Gordon's Model.

D1(1+g1) (1+g2)

Terminal Value = ---------------------------

(r-g2)

In our example, Terminal Value will be

5 (1 + 0.12) (1+0.03)

= -------------------------------

(0.15 – 0.03)
 29

= ₹ 67.53

2 3 4

5 5 (1.12) 5 (1.12) 5 (1.12) 5 (1.12) 67.53

V0 = ----------- + -------------- + --------------+ --------------+ --------------+ --------------

2 3 4 5 5

(1.15) (1.15) (1.15) (1.15) (1.15) (1.15)

V0 = ₹ 54.21
 30

B. Cash flow to the firm (More real world method of valuation)

Those who are familiar with Companies, Investors and Equity markets know this. Not all of
the companies profits / cash flows are paid out to investors.

There are various reasons for companies to keep cash and not pay out dividends. These can
be

1. The company has better investment opportunities (projects) as compared to

shareholders and hence can create more wealth by re-investing the cash.
2. Even in the absence of good investment opportunities with the company, shareholders
may prefer returns in the form of share buy-backs rather than dividends from a tax
efficiency point of view.

Indeed there are many companies like Berkshire Hathaway run by the legendary Warren
Buffett and new age technology companies like Google which do not pay dividends.
Obviously, these are valuable companies and do not have a zero value in the absence of
dividends.

An alternative method to value equity shares is to value the company based on free cashflow
to the firm and then divide the total value by the number of shares outstanding to arrive at the
per share value. The methods applied when using the dividend discount model can also be
applied while valuing a company on the basis of cash flow to the firm.

Unlike the dividend discount model, where the cash flow to the shareholders is unambiguous,
in the case of cash flow to the firm, some care is required to calculate the true free cash flow
to the firm. Sometimes there is no unanimity on the true number of free cash flow to the firm.

Generally, to the profit after tax number reported, various adjustments are made to eliminate
non cash expenses like depreciation (which is added back). At the same time cash outflows
(additional deployment in working capital) are reduced from the profit amount. Also capital
expenditure in the nature of maintenance capex (capital expenditure which will just maintain
capacity and profits rather than grow them) is reduced from profits to arrive at cash flow to
the firm.
 31

It is to be noted that growth capex (capital expenditure that is voluntary on the part of the
company and which will grow future earnings) is not reduced from the profits to arrive at the
free cash flow.

Caution on Capital Allocation

When one is using cash flow to the firm to value companies, it is vey important to keep in
mind the way the management is using the cash. Unlike cash flow to the shareholders model
where the shareholders can decide how they want to use the cash, here the cash is at the
disposal of the management. If one holds the company long enough, the allocation decision
will in many cases have the maximum impact on the returns to the shareholders.

Real Life Examples

WIPRO and Titan created enormous wealth for shareholders by allocating capital to the IT
and jewellery business respectively while the UB group has had to go through enormous
difficulty on account of its foray into civil aviation.
 32

Standalone or Consolidated?

In the current age, most large corporations have a holding company and a subsidiary
structure.

This may be driven by various considerations. Law may require it, for example a financial
conglomerate is required by law to have a separate company for banking operations,
insurance operations, stock brokerage, asset management, investment banking and so on. In
some cases, subsidiaries may be required for foreign operations. Whatever be the reasons,
given the fact that most companies have numerous subsidiaries the question arises as to how
to value companies that have subsidiaries. This is especially the case where many a times (in
the case of US listed companies for example) only consolidated financials may be disclosed.

In general, it is acceptable to use the consolidated cash flow, profit and book value numbers.
However there are a lot of special considerations which have to be kept in mind while valuing
companies with subsidiaries.

In the case of loss making subsidiaries, where the parent has decided not to pump in more
money even at the cost of the subsidiary going into bankruptcy, one has to ignore losses
beyond the investment put in by the holding company.

Real Life Examples

Today we have numerous Indian companies like Bharti Airtel, Tata Steel, Tata Motors,
Hindalco and so on which have overseas subsidiaries.

If an overseas subsidiary is making continuous losses, and the parent decides not to put in
additional capital, while valuing the parent company, one should ideally restrict the aggregate
losses to the total investment made in the subsidiary and not beyond that. We should resist
the temptation to blindly forecast unending losses into the future.

In the case of cash holdings of subsidiaries, it may be prudent to discount a portion of that
cash as it may not be easily accessible by the parent. This is on account of the fact that many
 33

a time, these cash holdings are in companies in low tax jurisdictions and there may be tax
implications of moving the cash to the parent company. Also there may be currency
fluctuations to take into account.

Real Life Examples

For example Apple Inc. is a company with sizeable cash balances. However it is not able to
use all of that cash either to pay out dividends our do significant share buy backs as a lot of
the cash is in low tax jurisdictions and bringing the money back to the USA will result in a
huge tax bill.
 34

Problems with estimating Future Cash Flows

So far the process has been very neat and simple. Most theories are like that.

Even in practice, as far as investments in instruments like government bonds, the application
of this theoretical framework is simple. The future cash flows on government bonds are
known with precision and this framework can be applied precisely.

Even when it comes to instruments like Corporate Bonds, where there is some possibility of
default, one can keep the forecasted cash flows constant and increase the discount rate to take
into account the higher risk associated with corporate bonds as compared to government
bonds and the method of valuation does not change much.

With assets like Real Estate, one has to estimate future rental income, account for vacancy
periodically and also take into account repairs, renewals, insurance, maintenance, property
taxes and so on. The process of estimating the cash flows is somewhat more difficult but it is
doable.

However when it comes to equity investments, almost nothing is certain as far as future
cashflow go. Hence there is a whole host of factors to be considered when valuing equity
shares. It is on account of this that many a times, equity valuation is considered to be a
combination of an art and a science. It is not just a blind application of formulae.

SOURCES OF VARIABILITY OF CASH FLOWS

In a Corporate Bond, bondholders have to be paid the interest and principal that is promised
to them and in case of a default the bondholder can drag the company to liquidation.
However in case of equity shares, there is no explicit or implicit promise to give any
cashflow to shareholders. The cashflows to the shareholders vary from company to company
and from time to time.
 35

The number and variety of factors that can affect cash flows for equity shareholders are
numerous. Some of them are listed as examples.

External factors

1. Uncertain demand from customers

2. Competitor actions
3. Introduction of substitutes / technological disruption
4. Fluctuating raw material prices
5. Fluctuating currencies
6. Government and regulatory policies
7. Changing taxation policies
8. Changes in interest rates
9. Stoppages on account of labour issues, floods, earthquakes etc.

Internal factors

10. Changes in dividend payout policies by the Board of Directors

11. Mergers and acquisitions carried out by the company
12. Diversification / entering new geographies
13. Corporate governance issues like excessive managerial compensation, related party
transactions and so on.

Alternative Methods of Valuing Equity Shares

Given the difficulty associated with predicting cash flows many years into the future for
equity shares, many time alternative methods of valuation are used. Indeed in many cases as
we will see, the alternative methods may give better valuation indicators as compared to the
Discounted Cash Flow Method that we have seen.

Price to Earnings Ratio (P/E Ratio)

Price to Earnings Ratio has two variants. One is the ratio of Price per share divided by the last
twelve months Earnings Per Share. This is called the trailing Price Earnings Ratio.
 36

The other variant is where the Price per share is divided by the estimated Earnings Per share
in the next year and it is called a Forward Price Earnings Ratio.

A key advantage of the ratio is simplicity. Anyone familiar with division can arrive at it! It
also gives a very rough indication of the cheapness or expensiveness of a stock, sector or
market. The higher the P/E Ratio the more expensive the stock is relative to earnings. Hence
a 50 P/E is considered to be more expensive than say a 10 P/E.

P/E Ratio can be used as an absolute measure as well as a relative measure across companies,
sectors or markets.

The inverse of the P/E Ratio also gives a rough indication of what is referred to as the
“Earnings Yield”

For example, if the P/E Ratio is 5, it means that Earning / Price X 100 is 20%. This gives a
rough indication as to how much are the current profits “yielding” on the purchase price.

It is to be noted that P/E Ratio cannot be used in isolation to value companies. The trailing or
the forward P/E does not give any indication as to what the future holds for the company. The
accounting EPS is also not equivalent to cash flow and many companies showing good
accounting profits have got into trouble if the cash flows were not managed properly.

Price to Book Value ratio (P/B Ratio)

All accountants are familiar with the concept of Book Value. Book Value is the sum of
Equity Capital and the accumulated Reserves. Book Value per share is simply the total book
value divided by the outstanding number of equity shares.

Price to Book Value is the ratio of the current market price of an equity share divided by the
book value per share. Book value can be considered to be the amount that shareholders have
put in the company plus the retained profits over the years.
 37

Like P/E ratio, the lower the P/B ratio the cheaper the stock or the company is considered to
be.

The advantage of P/B ratio is that it is easily understood. Also the P/B Ratio does not
fluctuate too much as compared to the P/E Ratio since the Book Value is generally more
stable than the EPS. A P/B ratio can be calculated even for loss making companies whereas a
P/E Ratio for a loss making or a very low profit company is meaningless.

The problem with P/B ratio is that it always seems high for companies which expense out
important business property. This is true of companies with a lot of advertising spend on
brand building and companies with a lot of spend on Research and Developments. Brands
and Patents are valuable property but do not usually figure on the balance sheet.

Despite limitations P/B ratio is popular especially for companies in the financial sector like
Banks.

Dividend yield

This is a very simple method of valuation. The yield from dividends as a percentage of the
market price of the shares is calculated and this is used to value companies.

The advantage is its simplicity and the flexibility it gives in ignoring factors like capital
allocation decisions of the company.

The disadvantage is that it ignores many growing and promising companies which are
retaining a lot of cashflow for further wealth creation opportunities.

Dividend yield may be an appropriate valuation metric for mature companies which are not
distributing bulk of their cash profits to shareholders and which do not have further projects
on hand.

Asset Realisation Based

 38

In the case of some companies, rather than value them on a Discounted Cash Flow method, it
may make sense to value them on an asset realisation basis.

This may make sense if one or more of the following factors are going to result in a
significant change in the way the company is run as opposed to the present way of
functioning.

1. Low promoter holding

2. Activist investors / lenders pushing for change in management or divesture of some
units
3. Generational change in promoters resulting in split of companies into various
segments

Real Life Examples

With the Mukesh Ambani and Anil Ambani group separating, Reliance Industries Ltd.
shareholders got shares in various companies of the group resulting in each company being
valued on its own accord.

Replacement Cost method

In many cyclicals, the selling price, input costs and demand go all over the place. A well
know example is crude oil the price of which has fluctuated from $ 25 a barrel to $ 150 a
barrel over a span of may be a few years.

In such volatile businesses, estimating the cashflows over the years is fraught with risk.
However there is a factor called mean reversion which comes to the rescue.

The basic premise of mean reversion in cyclicals is that there are no entry and exit barriers.
When there is supernormal profit in the sector a lot of players will enter the sector and
increase supply. At the same time if profits are depressed for a long time, fresh capacity
addition will stall and some existing marginal players will exit the field.
 39

Hence replacement cost or the cost which would have to be incurred to create the existing
capacity of the company serves as a very useful anchor for valuation.

If the market price is valuing a company at say 25% of its replacement cost, in all likelihood
the industry is going through tough times. No new capacity will be created, some loss making
player will exit and the industry economics will improve and the company should trade closer
to replacement cost sometime in the future.

On the other hand, if the market price is valuing the company at 4X its replacement cost and
the company is showing supernormal profits, it is very likely that new players will enter the
market and set up new capacity. In some time, the industry economics will deteriorate and the
company will soon be valued closer to its replacement cost.

Real Life Examples

In India it is said that Cement Plants cost $120 to $140 per tonne to set up. Many analysts use
this metric to value cement companies.

Caution

While such rough and ready measure give some anchor and indication of value, they should
not be used indiscriminately. For example, in the case of cement companies, the quality of
limestone deposits, the region, the brand of the company's product, whether a captive power
plant is available and so on would have a role to play and one cannot indiscriminately use a
number across companies.

Revenue Based
 40

In many cases, especially when a company is entering a new segment or there are exceptional
expenses there is absence of profits and free cash flow. In such cases, sometimes, revenue is
used as a proxy for valuing companies.

For example and FMCG company spending a lot of money on advertising and promotions
will not have reportable profits and cash flows. Here sales numbers can be used to value a
segment / company.

Real Life Examples

ITC is entering new FMCG categories given that cigarette business is frowned upon by the
government and society. Given the elevated ad spends, a good way to value that segment
would be on Price to Sales basis.

Business metric based

In many cases, especially in the early days of a business, there may not be profits or
cashflows for the shareholders. Indeed in many cases, the plan may be to lose money for a
few years in order to gain market share or customer loyalty. Again, the business will not have
zero value and at the same time predicting cash flows with precision into the future may be
difficult.

These kind of valuation metrics are especially popular in the startup / venture capital space in
new age businesses.

Here, many a time some business metrics are used to value companies. These metrics may be
in terms of number of customers signed up for a taxi hailing company, Gross Merchandise
Value for an e-commerce company, number of daily users and time spent on the site for a
social networking site and so on.

Care should be taken however while using these metrics as these are rough indicators and
prone to gaming by the companies (a company for example may just ramp up user base even
though it is known that those users will never be profitable customers just to shore up
 41

valuations). Ultimately the value of any investment depends on the cash flows the investment
can give to the investors

Real Life Examples

Companies like Flipkart are being valued on metrics like Gross Merchandise Value of
products sold.

Strategic Valuation

In many cases, the value that an investor derives from an investment would be very different
from the value that another business would derive from adding that business to enhance the
effectiveness of its existing business.

Hence a minority shareholder would value a company based on say the discounted cash flow
method while a potential acquirer will look at the before and after cashflows from her
existing business and value a company.

Real Life Examples

Say there is a company which has a mobile phone application which can be used for maps
and navigation. For this company the value for investors will be only what the company can
get by making its customers pay for using the application.

However if the company were to be acquired by let us a consortium of car companies, they
will be able to use the data for developing self driving cars and will not need to depend on
companies like Google.

This is precisely what happened to the maps division of Nokia which was acquired by a
consortium of Audi, BMW and Daimler for about $ 2.8 billion. A minority shareholder
would never put such a value on a standalone maps and navigation business.
42
 43

WARREN BUFFETT AND HIS INVESTING PRINCIPLES

The valuation methods and techniques discussed in the preceding pages is the “science” of
investing. However stock investing is part art and part science. It is the art part that is more
difficult to teach.

In this regard, it will be helpful to understand the investing principles of Warren Buffett who
is considered by many as the most successful investor in the world.

Broadly, Buffett wants to invest in businesses

1. Which are run by honest, competent and passionate managers

2. Which have demonstrated earning power. Businesses which have a economic moat
around its castle
3. Which generate high returns on equity while employing little or no debt.
4. Which can be understood
5. Finally at prices which offer a margin of safety

We will look at each of the factors in detail to understand the success of Warren Buffett and
Berkshire Hathaway.
 44

Management Quality

Equity investing is an act of looking into the future. Buying equity shares is in effect
partnering with the promoters and management of a company. In this regard it is of utmost
importance to partner with the right promoters and management.

Warren Buffett is famous for saying “Price is what you pay, value is what you get”. This
statement has been modified by some for the Indian context as saying “Price is what you pay,
Value is what Promoters / Management will let you get.”

Real Life Examples

Infosys Technologies and Satyam Computer Services were both companies offering IT
services. However while Infosys Technologies created huge wealth for shareholders it turned
out that Satyam Computer Services played a huge fraud on shareholders.

As of January 2016, HDFC Bank has a market capitalisation exceeding the sum of all public
sector banks.

These example show the importance of management quality and how it can affect
profitability, growth and capital allocation of companies.

Things to look for in Management / Promoters

1. Honesty and Integrity

 45

As with a business partnership, stock investing also requires that your partners “Promoters /
Management” have honesty and integrity. In fact, I would argue that this factor is more
important in stock investing than in business partnership because of the fact that when you
are a minority shareholder in a company you have effectively no say in what the company
does and how it is run unlike a partnership where you have part of the management control.

Honesty and Integrity is not just in terms of interactions with owners (partners / shareholders)
but with all stakeholders namely customers, employee, suppliers, government and society.

A lot of people think that as long as promoters / management do not cheat minority
shareholders it is ok if they cheat on taxes or if they cheat customers. That is not true. As
Thomas Phelps, an author has said “Remember that a man who will steal for you will steal
from you”.

Real Life Examples

Recently Volkswagen was caught cheating on the emission limits for its diesel vehicles in the
USA. This caused a lot of losses to the company besides loss of reputation in the eyes of the
consumers, society and the government.

2. Competence

Competence refers to deep understanding of the industry structure, its dynamics, competitive
scenarios, customer insights and so on. It is to be noted that people who have competence in
one area are not necessarily competent in other areas.

Real Life Examples

The UB group had experience in running the alcoholic beverages business in India. They had
no past experience or managerial expertise in the airline business and they have floundered.
Indigo airlines which has been promoted by professionals with years of experience in the
airline business has had far greater success than others in the business.
 46

3. Passion

While many people are honest and competent, addition of passion for what one does really
brings out excellence.

Real Life Examples

A recent example from India is that of Siddhartha Lal who has turned around the fortunes of
an almost defunct business of Royal Enfield motorcycles.

Internationally, Steve Jobs and his passion for technology and devices is well known.
 47

Demonstrated earning power

People invest in various kinds of companies.

There are angel investors, venture capital investors, etc. who invest in early stage companies.
They realise that many of the investee companies will fail. However the ones that survive and
make it big hopefully will make outsize returns even accounting for the companies that fail.

Buffett is not an early stage investor. Typically he wants to invest in companies with a long
track record and in sectors where things do not change very quickly.

In these kind of companies the future is based in the past and the visibility of business even
for a decade is not difficult.

Turnaround companies refer to companies which have had a troubled past especially in recent
times but where investors expect a change in fortunes. Buffett stays away from turnarounds.
His quote “Turnarounds seldom turn”.

Economic Moats and Porter's Five Forces Analysis

As part of the demonstrated earning power Warren Buffett refers to a concept of an economic
moat around a castle. What he means by economic moat is that the business has some
competitive advantage over other players such that the company can protect and grow its
earnings / cash flows to the shareholders.

These moats can come in one or more of the following forms. Please note that this list is not
exhaustive.

1. Brands
 48

We all are aware of the power of brands. Brands like Coca Cola, Cadbury,Dabur, Parachute,
Amul and so on are well entrenched in peoples minds and when one is in a store on
automatically asks for products with these brands.

2. Patents

Companies in certain sectors have legally enforceable patents which prevent competitors
from coming out with similar products / copies. An example of this is the pharmaceutical
sector.

3. Licences / Regulation

In some sectors, the government / regulator restricts entry to licensed players and many times
getting these licences is difficult. For example in India Bank licences are very difficult to
come by.

4. Network effects / Survival of the fattest

In many businesses, as the customer base increases, so does the unassailable nature of the
enterprise. There are many such instances. For example social networking sites like facebook,
stock exchanges like the National Stock Exchange, newspapers in any particular city and so
on.

Let us look at the newspaper example in detail. It is seen that the newspaper with the most
content will get the most readers and will get the most advertisers and in turn will be able to
provide more content. This creates a virtuous cycle which is almost impossible to break for a
new entrant. For example Times of India in Mumbai.

Warren Buffett in the context of the newspaper with the most content / readership base /
advertiser base winning has humorously called it the “Survival of the fattest”

5. Technology
 49

Many companies have at their disposal unique technologies which enable them to keep a lead
over their competitors.

For example a company like Bosch has technological leadership in some diesel engine
technologies which enables it to keep competitors away. Companies like Google which has
technology led products like Android operating system, Google Maps, Search Engine and so
on have a definite advantage over competitors.

6. Distribution network

Companies with huge distribution, service network and so on have a huge advantage over
competition and they cannot be easily displaced by competitors.

Hindustan Unilever which has a huge distribution reach is very difficult to dislodge as a
market leader in most categories where it plays.

7. Scale

If a company achieves a significant scale in a particular business segment, it becomes very

difficult for suppliers or customers to negotiate favourable terms from the company.

For example Amazon in the case of books has a huge bargaining power vis a vis publishers as
no publisher can afford to antagonise Amazon.

Porter's Model

It is not be noted however that the moats are not constant. At some times moats may be
strengthening, meaning that the company is increasing it strength over competition. At other
times it may be weakening.
 50

Porter's model is an important framework to see in which direction the company's business is
moving.

This to be monitored according to this model are

1. Industry rivalry
2. Bargaining power of suppliers
3. Threat of new entrants
4. Threat of substitutes
5. Bargaining power of buyers
 51

Importance of Return on Capital Employed / Return on Equity

Say you were approached to invest in a private business which would require an investment
of ₹ 1 crore and the business is likely to generate annual pre tax profits of ₹ 6 lacs on a
consistent basis. Question is would you invest in such a business.

Most people are likely to answer no and logically so given the fact that banks / government
pay interest at a rate higher than 6%. If you were to invest in a business with its attendant
risks, you would expect to be paid far better returns.

Hence the return on Capital Employed on an overall basis and especially Return on Equity
for equity shareholders is of great importance. This may seem to be a very obvious
conclusion for most people. However the stock exchange is littered with examples of
companies and sectors which have consistently generated very low returns on capital and still
manage to get investors.

As a group, airlines have lost money for investors over many decades (there are a few
exceptions). Still they have managed to raise capital and be in business for many years.
Buffett is not interested in investing in businesses which do not have attractive return
characteristics.

Reason for preference for low debt companies

As is well known, bond holders / lenders have a priority in payment over equity shareholders.
Most borrowing agreements have a clause where the lenders can realise the assets of a
company in case of a default in payment of interest or principal.

High debt companies run the risk that in case of a downturn in fortune, the lenders can force
the company into liquidation. Here the equity shareholders would be left with nothing (or
very little). Also even in the case of high debt companies not having trouble, most of the cash
 52

flows in initial years would go to the lenders in the form of interest payments and principal
repayments leaving little cash flow for shareholders.

Given this situation, Buffett does not prefer highly leveraged businesses. There are however
exceptions to the rule. Utility companies usually have very predictable cashflows and it is
acceptable for them to have some leverage. Also banks and financial companies by the very
nature of their business have to borrow money.

Given that banks and financial companies are highly leveraged entities, Buffett places
management quality above all else in the case of banking companies.
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BREAKUP OF RETURN ON EQUITY / DUPONT ANALYSIS

Net Profit

Return on Equity (ROE) = --------------------------------

Networth of the company

This can be broken down as

Net Profit Pre Tax Income EBIT Sales Assets

ROE = --------------------- X ------------------- X --------- X-------- X ---------

Pre Tax Income EBIT Sales Assets Equity

This breakdown is useful for analysts in trying to understand the levers and make get some
insight into the future of the company.

Net Profit / Pre Tax Income would be governed by the applicable tax rate for the company
and how it is expected to move in the future. Pre Tax Income / EBIT would depend on the
level of interest payment made by the firm. For zero debt companies, this ratio would be
equal to one. EBIT / Sales indicates the margins that the company makes on sales. Sales /
Assets is the asset turnover ratio. This ratio going up and down based on capacity utilisation
can have significant impact on ROE. Assets / Equity indicates the extent to which the
company is debt financed.

It is to be noted that this analysis is not static.

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An analyst will have to watch each component of this analysis to figure out the future path of
the Return on Equity and the cash flows that will be available to the shareholders. Changing
tax rates, changing margins on account of competitive factors, changing capital intensity on
account of outsourcing of manufacturing, changing financial leverage..... all of these have an
impact on the return profile of the company.

It is also a very useful tool to compare various companies in the same sector and compare and
contrast the business models of various companies.
 55

Businesses which can be understood

Here broadly there are two aspects

1. Not all businesses can be understood and valued (this is true for everybody, meaning
no one in the world can accurately value the business).
2. Circle of Competence. This means that it takes some understanding of a particular
business, process, technology, market, country etc. to value certain businesses and not
everybody can value the business. Only a few possess the capability to value the
business.

Taking the first factor into account, let us take the example of a newly set up company to
research and develop drugs to cure a rare disease. The company has not track record, no
existing products or business assets and so on. It has a bunch of employees, some research
facility in rented premises and cash to meet business expenses for 2 years. It has spent efforts
in screening some molecules and results of early stage clinical trials are awaited. If results are
promising, further trials will be needed and there is no known probability of success in later
trials.

In such a scenario, things are so uncertain that most valuations will be akin to guesses, gut
feels, bet on the management and so on. Buffett steers clear of such things.

The second factor called circle of competence by Buffett refers to the fact that each person
has different experience, educational background, interests, aptitude and temperament. These
factors come into play while evaluating different businesses. Hence for example, a shipping
sector veteran will have deeper understanding of shipping cycles as compared to say a rookie
MBA or that a pharmacologist is better capable to understand a Pharmaceutical company but
may not have the expertise to evaluate a mining company.

Buffett as per his statements does not understand technology and hence tries to steer clear of
most technology companies and investments.

Real Life Examples

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A lot of people in the years leading upto 2007 bought into a lot of financial companies like
AIG not understanding how they were generating “profits.” It is only in the crisis that it
became clear that Insurance was not the main profit generating source for AIG. It was their
dabbling in exotic derivatives that was showing near term profits while at the same time
raking up a lot of risk which would eventually blow up.

Similarly not many people understood what Enron did exactly and paid the price when the
company blew up.
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Margin of Safety

Warren Buffett calls Margin of Safety as the three most important words in investing.

Margin of safety means that an investor should estimate intrinsic value of shares and buy
them only when they are trading at substantial discount to the intrinsic value.

Benjamin Graham and Warren Buffett refer to this as buying a dollar bill for 50 cents
(Buying ₹ 1 for 50 paise).

Reasons for seeking Margin of Safety especially in equity investing

1. We have seen in the earlier pages how cash flows from equity shares vary a lot. Most
companies rather than having a single point estimate for intrinsic value will have a
base case value, a pessimistic scenario value and an optimistic value. Experienced
investors will know that many a times the true value turns out to be even lower than
the pessimistic value on account of various developments. Hence buying shares at a
discount gives us protection against adverse market / economic / corporate
developments.
2. As we shall see in the material on Behavioural Finance, human beings are prone to
overconfidence and are not very good forecasters. The concept of Margin of Safety
helps in giving us some protection against our own errors in estimating the intrinsic
value give our outlook for the future.
3. The concept of Mr. Market and the boom and bust cycles. Mr. Market will be
discussed in the coming pages. It has to be noted that the equity markets go through
cycles of boom and bust also referred to as Bull markets and Bear markets. When all
round optimism prevails markets tend to overvalue the entire market or favoured
sectors. Similarly when pessimism abounds, shares get sold down to absurdly low
levels. Waiting for adequate level of Margin of Safety is also financially rewarding in
that if the purchase price is very low, the subsequent returns are higher in percentage
terms.
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Mr. Market

Mr. Market is an imaginary person created by Benjamin Graham. This imaginary person is
prone to mood swings and has mercurial temperament. On some days Mr. Market is in a very
buoyant mood and offers to buy from the investors, shares are very high prices. On other
days, the same Mr. Market is in a depressive mood and offers to sell shares at throwaway
prices.

Investors are not forced to deal with Mr. Market. He can be safely ignored. Graham tells us to
take advantage of Mr. Market. The right way of dealing with him is to ignore him on most
days. On days when he is extremely pessimistic, one should buy from him and on days when
he is very optimistic, one should sell to him.
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20 Punch Rule

Buffett says that imagine you have a card on which you can punch holes. The card can be
punched 20 times. You have to punch a hole each time you buy a stock. Over your lifetime
you cannot punch more than 20 holes.

This mental exercise throws up many interesting points.

1. If say an investor starts at age 20 and invests till age 60, the total number of years the
investor has is 40. If only 20 stocks can be bought, on an average, not more than 1
stock every 2 years. If the investing period is longer, the average goes down further!
2. If the total number of stocks ever bought is 20, obviously the portfolio will not have
too many stocks. Obviously Buffett does not seem to be a big believer in very
diversified portfolios. (More on this later)
3. Since investment ideas do not come steadily (they are plenty when markets are very
low and scarce when valuations and market levels are very high), there can be many
years without any new stock being bought.

Obviously if fewer decisions are to be made by an investor, more thought and effort will go
into those decisions. My neighbour told me about the stock in the elevator is not a valid
reason to buy a stock any more.

Given that fewer decisions are made, the holding period for those stocks also increases. The
longer the holding period, the lower the costs like brokerage, STT, demat charges and so on.
Further taxation is also lower if the holding period is long.

Does Buffett actually follow this?

A lot of people berate Warren Buffett for preaching one thing and practicing something else.
Obviously over his investing career, Buffett has bought an number of companies and that
number far exceeds the 20 that he recommends.
 60

Firstly, given the scale of Berkshire's operations, it is very difficult to deploy capital over just
20 companies. Also, this is more of a mental model and something to be aware of rather than
taking it as a cast in stone rule.
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Portfolio Sizing, Diversification versus Concentration

There are various views on diversification vs. concentration in investment portfolios. While
academicians and some market practitioners would have people invest in very diversified
portfolios (almost invest in the entire market or buy broad based index funds) at the other end
of the spectrum are entities like hedge funds and even renowned investors / traders like
Charlie Munger / George Soros who have made or recommend extremely concentrated
positions.

Academicians like Harry Markowitz have created a modern portfolio theory whereby the
objective is to maximise the portfolio return for a given level of risk (volatility) or to
minimise the risk (volatility) for a given level of return.

Buffett and Munger do not look at volatility as risk. The also do not subscribe to the view that
the markets are efficient at all points in time and that market participants are perfectly
rational and act in their own economic interest at all points in time.

Leaving aside the academic argument, let us look at the diversification vs concentration
argument from a practical and empirical point of view.

It cannot be denied that if one has say a single stock in a portfolio, the portfolio would be
extremely risky. Hence any fluctuations in the fortunes of that single company would
completely translate into a full impact on the portfolio. If that stock were to go to zero. The
portfolio would be wiped out.

Now consider another portfolio of 10 stocks A, B, C, D, E, F, G, H, I and J each having a

10% weightage in the portfolio. Now if say stock A were to move to zero while other stocks
are unaffected, the impact on the portfolio would be to the extent of 10%.

Hence having more number of securities in a portfolio surely brings down the overall risk of
the portfolio. Apart from the number of securities in a portfolio, what matters is also the
correlation between the securities. Hence for example, if all the 10 securities are those of
mining companies, a commodity downturn would affect all of them simultaneously or if all
10 of them are in the same business group / house, some adverse development in that
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business group would affect all companies simultaneously. Hence for most benefits, the
securities in the portfolio should have very little correlation with one another.

We have seen the benefits of diversification. However a question arises, “If diversification is
good should be go on increasing the number of securities in a portfolio?” The answer to that
is no. Empirically it has been seen that most of the benefits of diversification come at the
initial stages of increasing the number of companies. For example the reduction in risk of the
portfolio will be far greater when the number of stocks moves up from 1 to 2 while the
reduction will be insignificant when the number of stocks moves from 50 to 51. It has been
seen that most of the benefits are achieved when the number of stocks reach 15 to 20. Beyond
this number, the benefits in terms of risk reduction are not that high while the dilution of the
best investment ideas would in fact harm portfolio returns.

For example if your best idea has only a 1% portfolio weight in a 100 stock portfolio, the
portfolio return even if the stock doubles will be go up by only 1%
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Pithy Quotes of Warren Buffett

 Rule No. 1, Do not lose money. Rule No. 2, Do not forget Rule No. 1

 Its far better to buy a wonderful company at a fair price than a fair company at a
wonderful price.

 Time is the friend of a wonderful business, enemy of the mediocre.

 Our favourite holding period is forever.

 Be greedy when others are fearful. Be fearful when others are greedy.

 Price is what you pay. Value is what you get.

 No matter how great the talent or the efforts. Some things just take time. You cannot
get a baby in one month by getting nine women pregnant.

 If you are in a chronically leaking boat, energy spent on changing boats is more
fruitful than energy spent on fixing the leak. (In the context of bad businesses or being
in partnership with bad management, it is wiser to quit such investments rather than
trying to fix things).

 Don't do calculations with Greek letters in them. Volatility is not risk. Risk arises
from not knowing what you are doing. (Buffett and Munger are not fans of measuring
risk in terms or portfolio Beta and things like that. For them, risk is the risk of
permanent loss of capital).

 I would be a bum with a tin cup on the street if the markets were always efficient.
(You can figure out that Buffett is not a fan of the Efficient Market Theory)

 You only figure out who is swimming naked when the tide goes out. (In the context of
risk taking / cooking books and so on, bad behaviour comes to fore only in tough
times. Otherwise people can hide things)

 There never is just one cockroach in the kitchen. (If one sees small problems in terms
 64

of corporate governance or integrity issues, they are symptoms of bigger problems

which have not yet come out).

 You only have to do a very few thing right as long as you do not do too many wrong
things. (Most returns for successful investors come from a few good investments)

 Never ask a barber is you need a haircut. (The answer would always be yes. People
respond to incentives. If your incentives are aligned one way, it is very difficult for
you to recommend going the other way)

Bibliography

1. The Intelligent Investor - Benjamin

Graham
2. Common Stock and Uncommon Profits - Philip Fisher
3. Warren Buffett's letters to Shareholders of Berkshire Hathaway (available online as
well as in print form).
4. Poor Charlie's Almanack - Peter D Kaufman
5. Security Analysis - Graham & Dodd
6. The Outsiders - William
Thorndike
7. One up on Wall Street - Peter Lynch
8. Beating the Street - Peter Lynch
9. A short history of financial euphoria - John Kenneth
Galbraith
10. Extraordinary Popular Delusions and Madness of Crowds - Charles Mackay
11. Manias, Panics and Crashes - Charles
Kindleberger
12. The Smartest Guys in the room - Bethany McLean
13. When Genius Failed - Roger
Lowenstein
 65

Chapter

Behavioural Finance

Introduction to Behavioural Finance

Any Economics or Finance model / theory starts with an assumption that all participants in
the economic / financial system are rational and work to maximise their financial well being.

However people outside of academia have known for ages that this assumption is not true.
Human beings think logically some of the time while at other times their decisions are driven
by various emotions and are at a significant variance to what economic / financial theory
would state.

There are numerous examples of such behaviour by people, some of them are given below

 People buying lottery tickets and gambling in casinos (the expected value after all for
these activities is negative)
 People giving to charity, celebrating and giving parties (these are not wealth
maximising activities, they benefit others)
 People saving for their retirement / child's education while at the same running credit
card debts (the returns on the former are lower than the costs of the latter).
 People rushing to buy stocks at overvalued levels and then panicking when prices fall
and rushing to sell even at a loss.

Behavioural Finance tries to fill the huge void between economic and financial theory and the
practical observations in the market place.
 66

Behavioural Finance combines Psychology with Finance. It looks at people as they are and
not as they should be if they were economic creatures looking to maximise financial wealth.

Introduction to Heuristics & Biases

In a lay person's language, heuristics are mental shortcuts. These shortcuts enable
people to arrive at decisions quickly and can be seen something akin to rules of thumb. They
can also be seen as something akin to reflex actions where not too much “thought” is put in
before acting. They can also be seen as habits which come out of repeated behaviour over
time.

Heuristics are many times beneficial to people and it is argued that in some form they may
have an evolutionary basis. For example when we pull away our hand on touching something
very hot or run away on hearing a lions roar, it is for our own protection. If we had to think
for a long time before pulling our hand, our hand would get scalded and if we waited to think
before running we would become a lion's lunch.

Similarly after learning new things or after forming habits, we undertake actions without
active thought. A person who knows how to ride a bicycle can ride a bicycle while listening
to music or while thinking about family or work and does not need to put in conscious
thought to the act of riding a bicycle.

Every person has to go through numerous decisions everyday (such as which brand of soap or
toothpaste to buy) and heuristics help us by allowing us to take many decisions without
conscious thought (you end up buying your favourite brand of soap and toothpaste out of
habit) and in not getting overwhelmed by the life's numerous decisions.
 67

However in many cases these quick decisions are sub-optimal and sometimes downright
harmful to our well being. We will restrict our examination and look at heuristics which are
sub-optimal and harmful to our financial well being.

For example you may be buying soap of brand A out of habit but it may be the case that a
recently introduced brand B is 30% more cost effective while at the same time having better
cleansing and sensorial properties. If you would have made a conscious decision, may be you
would have chosen brand B.

Heuristics which are not logical and which have a potential to cause harm are called biases.

Types of Heuristics & Biases

There are numerous kinds of heuristics and biases. In fact Behavioural Finance is an evolving
field and new biases are being discovered. However we will look at the better known and
significant biases that affect human financial decision making.

(a) Anchoring bias

The anchoring bias was first discovered by psychologists Amos Tversky and Daniel
Kahneman. Anchoring bias is the tendency of the human mind to latch on to the first
information that comes to our notice and then not being able to move away from that
information.

There have been numerous studies on this effect and the strong anchoring effect on
participants has been proven beyond doubt.
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For example if 1,000 random participants are chose and split into two groups A & B.

Group A of 500 participants is asked the following two questions

 Whether the length of river Ganga is more or less than 1,000 Kms.?
 What is the guess of the correct length of river Ganga?

Group B of 500 participants is asked the following two questions

 Whether the length of river Ganga is more or less than 5,000 Kms.?
 What is the guess of the correct length of river Ganga?

It would be seen that the first group of participants will give answers as to their estimate of
the length of river Ganga which are closer to 1,000 kms while the second group will give
answers which are closer to 5,000 kms. (The correct answer is 2,525 Kms. in case you are
wondering)

What is interesting is that people get anchored to even irrelevant pieces of information.

For example if the groups have questions as follows

Group A of 500 participants is asked the following

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 The length of Chenab river is 960 Kms.

 What is the guess of the correct length of river Ganga?

Group B of 500 participants is asked the following

 the length of the Amazon river is 6,259 Kms

 What is the guess of the correct length of river Ganga

Now here the participants know (or should know) that the length of a different river has
nothing to do with the length of the river Ganga. Still the first group will give low estimates
whereas the second group will give high estimates.

Real Life Examples

In the financial world too, investors and analysts get anchored to numbers. For example if a
company has been growing at 20% for 3 years, investors will keep predicting numbers close
to 20% event though the business environment has changed. It is only after a significant
period of time has elapsed that they will adjust to the new reality.

(b) Availability bias

The Availability bias is exactly what the name suggests. It means that people tend to over
weigh information that is readily available (or recallable) and under weigh or ignore
information that is not available. For example people tend to overestimate people dying due
to airplane crashes / bird flu / shark attacks / terrorism since they get covered in the media
and movies while deaths due to car crashes / tuberculosis / dog attacks and individual gun
shootings are underestimated.
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Real Life Examples

When media is full of stories of promise of technology companies, there tends to be a bubble
in technology stocks (late 90s and 2000) similarly when the media is full of stories of the
promise of real estate companies, investors overestimate the prospects of such companies
(2007).

(c) Base rate fallacy

Base rate fallacy takes some thinking to understand but at root it is not that difficult a
concept. It is a mistake made by many people a lot of times and knowledge of this concept
can prevent a lot of problems in investing as well as in life.

Let us look at an example.

Suppose you are given the following information.

1. You are told that a person A is a shy and introverted person and likes to read.
2. 90% of Librarians in the city are shy and introverted and like to read.
3. Only 10% of Salespersons in the city are shy and introverted and like to read.

You have to guess whether A is a librarian or a salesperson.

Most people would guess that A is a librarian. However the above information is only partial.
It is not all the information that you need. In addition to the above information, you need the
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base rates (which you neglected if you chose librarian as an answer). The base rates relate to
how many librarians are there in the city and how many salespersons are there in the city.

Now say you have the following additional information.

Total number of Librarians in the city 10

Total number of Salespersons in the city 10,000

Would your answer change now? It should change.

If 90% of librarians are shy and introverted and like to read, it means that we have a total of 9
librarians in the city who are shy and introverted and like to read.

If only 10% of salespersons are shy and introverted and like to read, it means that we have
1,000 salespersons in the city who are shy and introverted and like to read.

Hence the chances that a person who is shy and introverted and like to read is a librarian is 9 /
1009 (assuming there are only two professions in the city) while the chances of the person
being a sales person is 1000/1009

Real Life Examples

A lot of analysts see successful companies internationally and try and poject the same on
Indian companies. For example an Indian company is projected to be the next Walmart or the
 72

next Southwest Airlines. However analysts ignore the unsuccessful retailing and airline
companies in the west when they make the projections and thus ignore the base rates.

(d) Confirmation bias

Although Charles Darwin is know for his work in the field of biology, he his this interesting
thing to say regarding human nature:

“I had also, during many years, followed a golden rule, namely, that whenever a published
fact, a new observation or thought came across me, which was opposed to my general results,
to make a memorandum of it without fail and at once; for I had found by experience that such
facts and thoughts were far more apt to escape from the memory than favourable ones.”

Confirmation bias refers to the fact that human being tend to overweigh facts and
observations which support their prior conclusions and beliefs and tend to ignore facts and
observations which are contrary to their conclusions and beliefs.

Real Life Examples

If an analyst or an investor is positive on a company, she will tend to ignore the risks and
negative news relating to that company.

(e) Contrast effect

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Contrast effect refers to the fact that human beings evaluate things on a relative basis rather
than on an absolute basis.

Hence if you walk into a clothing store looking to buy a shirt for ₹ 500 and all the shirts that
you see first are in the range of ₹ 3,000 and then you come across a few shirts costing ₹
1,000, you will find the ₹ 1,000 shirts attractive and reasonably priced in contrast to the ₹
3,000 shirts you have seen earlier. You will tend to forget that you original price point was
only ₹ 500.

Again let us say you are buying a shirt. You choose a shirt costing ₹ 1,000 and are about to
purchase it when you get to know that the same shirt is selling for ₹ 500 in a store 15 minutes
walk away. Would you not buy and go to the other store? Most people would.

However if you were buying a car for ₹ 500,000 and you were told that another dealer was
selling it for ₹ 500 cheaper and that the other dealer was 15 minutes walk away would you go
to the other dealer? Most people would not in this case.

If we were strictly rational we would calculate that the worth of 15 minutes of time and effort
was the same in both cases and the amount of savings of ₹ 500 was also the same in the two
cases.

Real Life Examples

In case of a frenzy in the stock market for say technology shares. You come across various
tech companies. Most are quoting at P / E multiples exceeding 100. You come across a
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company trading at a multiple of 50. You may find that attractive forgetting the fact that a
P/E Ratio of 50 would be considered expensive form most companies at most times.

(f) Endowment effect

Endowment effect refers to the bias that creeps in when we own something. Repeated
psychological studies have shown this effect.

For example a large set of participants were split into pairs of two. One person in a pair was
given a vase while the other person had money. They two, if they agreed on a price could
exchange the vase for the money. However it was seen that the person who had the vase
placed a far higher value on it while the buyer was prepared to pay only a much lower price.

Real Life Examples

Once an investor owns a stock, sub-consciously she starts valuing the stock higher. A good
financial result is given great importance whereas a bad result is seen as a one off random
event.

(g) Framing effect

Consider the following two situations

Situation A
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You are given ₹ 1,000 for free. In addition you are told that you have two choices.

In the first choice you can choose to call a coin flip. If you win you get an additional ₹ 1,000
giving you a total of ₹ 2,000. If you call incorrectly on the coin flip, you get to keep the first ₹
1,000 and get nothing more.

In the second choice, you get to take an additional ₹ 500 taking the total cash with you to ₹
1,500 risk free.

It has been seen that most people take the second choice and are happy to get ₹ 1,500 for free.

Situation B

In Situation B, you are given ₹ 2,000 for free. In addition you are told that you have two
choices.

In the first choice you can choose to call a coin flip. If you win you get to keep the first ₹
2,000 giving you a total of ₹ 2,000. If you call incorrectly on the coin flip, you lose and
amount of ₹ 1,000 and get to keep only ₹ 1,000.

In the second choice, you will lose a fixed amount of ₹ 500 taking the total cash with you to
₹ 1,500.
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It has been seen here that most people take the first choice and will gamble to try and retain
the ₹ 2,000.

Careful readers will note that in both cases, the choices are the same in financial term. Get ₹
1,500 risk free or get ₹ 2,000 or ₹ 1,000 which is dependent on a coin flip.

The question that then arises is this. Why are people more willing to gamble in the second
case and not in the first.

The answer is this. In the second case the same financial amount is “framed” as a loss. In
their minds people already start thinking that they own the ₹ 2,000 and are being asked to
lose ₹ 500 and hence they are willing to take a risk whereas in the first situation, the financial
amount is “framed” as a gain leading to a different result.

As we will see in the section on Loss Aversion, people hate losses.

Real Life Examples

Say your client has purchased shares of company A at 100 and now the price is only 50. If the
client is asked to sell the shares and make a loss, it is likely that the client will refuse. On the
other hand if the sale transaction is framed as resulting in a tax loss which will save the client
taxes, it is likely to meet with the client's approval.

(h) Hindsight bias

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Our minds play games with us. Everything is crystal clear in hindsight and we have a perfect
20/20 vision. After the event, we feel that we say the 2008 and 2009 financial crisis coming
and that we saw all the symptoms. It is just that on account of some strange inexplicable
reason we did not act on what was clear to us.

This bias affects not just lay persons but even so called experts.

(i) Hyperbolic discounting

Ask a child whether the child would like to have one chocolate after 30 days or two
chocolates after 31 days.

Most children would choose to have two chocolates after 31 days. After all the wait is only
one day and the payoff is double.

Now try the same thing with a difference. Ask the child whether the child would like one
chocolate right now or two chocolates after 24 hours. (Note that the delay period is the same
– 1 day in both examples). In the second case most children will be unable to resist the
temptation to have the chocolate right now.

What is true for children and chocolates is also true for adults in different circumstances. Ask
a student whether he would like to save 20% of her salary after she starts working one year
from now and the answer will likely be yes. But on the other hand asking once she has started
working and earned her first salary whether she would like 20% to be deducted from her
salary right now the answer is likely to be no.
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This phenomenon is referred to as hyperbolic discounting.

(j) Illusion of control

Illusion of control refers to the fact that many a times people have an illusion that they can
control the outcome of a random event. This has significant consequences in investing as
people estimate the future earnings and cash flows of random events assuming that they have
control.

In the case of many research experiments, people were willing to pay a higher amount for
lottery tickets where they could choose the number rather than randomly assigned lottery
numbers even though the chances of winning are the same in both cases.

Again in research experiments, people assigned a far lower probability to their being in a car
accident if they were driving as compared to a situation where they were passengers. This is
as a result of illusion of control.

(k) Loss aversion

Consider the following situation

You have two choices.

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In the first choice you can choose to call a coin flip. If you win you lose nothing. If you call
incorrectly on the coin flip, you lose an amount of ₹ 1,000 giving you a loss or ₹ 1,000 net.

In the second choice, you lose an assured sum of ₹ 500.

Most people chose to gamble rather than take the certain loss of ₹ 500. People hate to lose
and undertake risky behaviour to avoid losses.

Real Life Examples

Investors will not sell shares of companies where prices have come down. They will keep
hoping for the price to return to their original purchase price in order to sell the shares. This is
even if they know for a fact that the company is doing badly and is unlikely to recover. Peter
Lynch a renowned investor call this the disease of “Get evenitis”

(l) Mental accounting

Mental accounting refers to the fact that people do not treat all money as being equal. In their
minds people have different mental accounts into which different sums are put in and how
that money is treated depends on the type of that mental account.

For example, most people would spend their salary money rather carefully but if they have
some lottery money or an unexpected bonus, they would not hesitate in blowing up that
money.

People will take child education plans sold by insurance companies earning 6% – 7% returns
while at the same time they will have housing loans on which they would be paying 12%
interest.
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Again, say you have bought a movie ticket for ₹ 500 and you lose the ticket. You will feel
guilty and feel that you have blown your entertainment budget and may not buy another
ticket. On the other hand if you have lost a wallet with ₹ 500, that ₹ 500 may be deducted
from an general purpose mental account and you may not feel that bad buying a movie ticket
for ₹ 500.

These are examples of mental accounts.

(m) Overconfidence bias

A lot of research studies have proven overconfidence bias.

In quizzes having a numerical answer many a times participants are asked to give a range of
values within which the correct answer would lie with a 90% probability. It is seen that not
more than 20% to 30% answers are correct when the expected value of correct answers
should be 90%.

When people are asked whether they themselves are above average, average or below
average in their driving skills a very large majority of drivers rate themselves as above
average.

Overconfidence has severe consequences both for investors as well as for company
management when they enter new products or markets.
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(n) Representativeness heuristic

Representativeness is a heuristic where based on a small sample and based on readily

recallable information a judgement is made.

Real Life Examples

For example if the years 2000 and 2008 were years of recession, it is assumed that it is very
likely that 2016 will be a year of recession and that recession comes like clockwork after 8
years.

(o) Sample size neglect

Sample size neglect happens when people draw mistaken inferences from an small set of data
or a few random observations.

Real Life Examples

Lets look at the example of a chronically loss making company. Say because of an unusual
shortage of the company's product in the market the selling price for the product has gone up
10 fold. In such a scenario, the company reports 2 quarterly financial reports where it has
turned around and now has reported profits.
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Bidding up the share prices of the company on two quarterly earnings and an unusual short
term shortage of the company's product would be a case of sample size neglect. As soon as
the market returns to normalcy, the company will be back to making losses.

(p) Sunk cost fallacy

In lay persons terms, Sunk cost fallacy refers to the tendency of throwing good money after
bad. We have already seen in Loss Aversion that we do not like to lose money.

In Sunk cost fallacy we take this one step further. Not only do we fail to recognise the losses,
we in fact invest more in our efforts to make things right and recoup the losses.

Real Life Examples

 A bank lending more to a defaulter so that NPAs need not be recognised and maybe
with the additional funds the company will be able to turnaround.
 Investors averaging costs on the shares which have declined in price.
 Paying more and more on repairs to a second hand car which has turned out to be a
bad purchase.
 A successful business group going on putting money in a new business which has
turned out to be bad (eg. UB group pouring money into Kingfisher Airlines).

(q) Survivorship bias

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Survivorship bias reflects the problem where people only see the successes (i.e. the survivors
and not those who are no longer around to tell the story).

For example many a young person leaves home to come to Mumbai to achieve the dream of
becoming a successful movie actor or a model and they look at the success stories of a few
who made it big but they do not realise that there have been many failures and on an average
leaving home to pursue movie dreams is not that great an idea.

Real Life Examples

Many people would look at successful e-commerce companies like Amazon and think that
starting a similar company is a way to wealth. However they fail to look at the statistics and
do not realise that thousands of companies have failed in this endeavour.

Bibliography

1. Nudge - Richard Thaler

2. Think Twice - Michael Mauboussin
3. Predictably Irrational - Dan Ariely
4. Beyond Greed and Fear - Hersh Shefrin
5. Heuristics and Biases - Daniel Kahneman
6. The Folly of Forecasting - James Montier
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Chapter

Introduction To Value Investing – Basic Principles

“Value Investing” as a concept first originated in the studies of legendary investor and
investment guru Benjamin Graham. The phrase “Value Investing” was not coined as such in
his writing but rather he introduced the conceptual framework which was then popularized by
Warren Buffet and came to be known as “Value Investing”. To understand Value Investing
concept, it is pertinent to understand in right perspective what does the term “Value” and
“Investing” mean. In one his first books titled “The Intelligent Investor” Benjamin Graham
defines “Investment” as

“An investment operation is one which, upon thorough analysis, promises safety of
principal and a satisfactory return. Operations not meeting these requirements are
speculative”

• Thorough Analysis - means ‘Study of facts in light of established standards of safety

and value’.

• Safety of Principal - The safety sought in investment is protection against loss under
all normal or reasonably likely conditions or variations. Safe stock is one which holds
every prospect of being worth the price paid except under unlikely contingencies.
Please note that while defining “safe stock” there is no reference to the potential
upside. The only characteristic it should have is it is bought at a price which is worth
its value.

• A satisfactory return is a wider expression than adequate income, since it allows for
capital appreciation or profit as well as current interest or dividend yield.

An investment operation is one that can be justified on both qualitative and quantitative
grounds. Hence what is required is, any investor who is looking to invest in stock/ equity
markets need to perform a thorough analysis of the stock, which is based on facts. In today’s
time analyst and investors alike have started focusing only on arbitrary arrived future
projections which end up confirming the analysts/ investor’s own assumptions. Instead of
looking at discomforting evidence which will act as true due diligence, investor end of
focussing on confirming their own prejudices. After thorough study of the stock, it may not
yet necessarily become an investible idea. For an Idea to become investible two other criteria
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need to be met. The stock selected should provide protection against loss of capital. Loss
does not mean notional loss on market price, it means loss of intrinsic value of the stock.
Market price would on its own end up converging with value over a period of time cause in
the long run, the market price of the stock only reflects the intrinsic value of the business.
Many professional investors would further extend the concept of loss of capital by also
including the implied loss of opportunity and add it to the capital cost. Even after Thorough
Analysis is performed and it has been determined that the stock idea provides reasonable
safety of capital, it still may not still be the right time to buy the stock at price levels
prevailing in the market. The current price level of stock provides the base value for future
returns and hence an act of investment is complete only when the buy price provides
satisfactory return. It translates that if the despite the opportunity which may be presented to
the investor, if the buy price is not right, it is almost certain to end up with unsatisfactory
returns. In extreme cases, investor may also end up bearing significant loss of capital. Note,
the word used is satisfactory return. A true measure of satisfactory return is based on current
inflation rate, risk taken by the investor and after considering the tax regulations and tax rate
in relation to that investment. All that a value investor seeks is a return which satisfactorily
compensates him against inflation on a post-tax basis.

What does “Value” mean?

Benjamin Graham framework for investing lays two values for every stock, the first being the
current market price, and the second what the share would be worth if the entire company
were acquired by a knowledgeable buyer or if the assets are liquidated, the liabilities paid off
and proceeds paid to stockholders. Let us look at some more aspects of value:

 Some investors also believe that Value accrues by buying “Growth at Reasonable Price
(GARP)”.
 Price is what you give and Value is what you get.

Generally most investment community relates the concept of value to cheap prices. Cheap
prices itself may mean different to different investors. For some absolute stock level of say
less than Rs.20 is cheap, while for some the price fall relative to its 52-week high or some
historical high price is cheap, while for some others cheap is relative to the value it offers.
Benjamin Graham looked at Value as stocks which were quoting as discount to Book Value
while Warren Buffet looks at Value as significant discount to intrinsic value of quality stocks
rather than those that were quantitatively cheap.
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Investors Buy and Sell decisions are increasingly driven by greed and fear rather on rational
and prudent process. In the book titled “The Art of Value Investing” by John Heins and
Whitney Tilson, the authors have suggested that

“For Value Investors core belief is that equity markets regularly offer – for a variety of
different but predictable reasons – opportunities to buy stake in companies at significant
discounts to conservative estimates of what those businesses are actually worth. Further, like
fingerprints, no two value investing strategies are exactly alike. Its perfectly normal for
equally talented and accomplished investors to assess the landscape of investment
opportunities or a specific idea and come to diametrically opposed conclusions”.

To Summarize, value may mean differently to different investors. The most rational
framework to look at value should be the price paid to acquire the stock in relation to its
intrinsic value. Intuitively, when investors look for low price stock (say stocks lower then
Rs.20 or so) or 52-week low prices, they actually want to believe that they are buying cheap
in relation to intrinsic value. It is just that investors rely on adhoc mental models driven by
greed to buy the stock immediately rather than waiting patiently for price to get attractive
based on thorough analysis.

What is Value Investing?

Having looked at Investing and Value differently let us understand how people practice
Value Investing

 In the publication “Value Investing Perspectives” by Value Research, Nimish Shah

of ICICI Prudential Mutual Fund says “Value Investing is simple, unpretentious art
of investing that revolves around two key tenets. First, buy as inexpensively as
possible; second, wait patiently for your assets to deliver returns. One has to seek out
really inexpensive assets compared to their future earnings potential”.
 Value investing means avoiding companies that can wipe out – with too much debt,
unproven business models, secularly challenged end markets or no durable
competitive advantages.”
 Buying at low prices relative to intrinsic value (rigorously and conservatively
arrived) holds the key to earning dependably high returns, limiting risk and
minimizing losses. There is no substitute for this process and without which
“investing” moves closer to “speculating” which is not a dependable activity.
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 Making money in a rising market is easy but because in future there is no certain way
to predict how markets will behave and hence one must follow a value philosophy at
all times. Extensive fundamental analysis and with strict discipline and patience,
investors can not only control risk and limit losses but also can expect good results.
Its not as important to make money as much as it not to lose money and maintain
what one has already made.

A corollary aspect to business quality is the emphasis value investors place on company’s
ability to grow. Growth not just for the sake of growth but quality growth where Cash flows
and Return on Capital either improve or do not deteriorate at the cost of topline and bottom-
line growth. Sales and Profits are mere accounting reality and for analyst/ investor cash flows
and return ratios should play more emphasis.

Value Vs Growth

Positioning value vs growth sets up a false comparison. Warren Buffet in his Annual Letter to
Shareholders have summarized this very aptly as

“Most Analyst feel they must choose between two approaches customarily thought to be in
opposition: ‘value’ and ‘growth’. In our opinion, the two approaches are joined at hip:
Growth is always a component in the calculation of value, constituting a variable whose
importance can range from negligible to enormous and whose impact can be negative as well
as positive”.

Other important framework for successful value investing requires an understanding of

Intrinsic value, Circle of Competence, Margin of Safety, Delayed Gratification and also
Behavioral Finance. Students shall be exposed to these topics in further detail in this module
as well as elsewhere. The objective of this module is to introduce these concepts at the
elementary level which helps shapes the correct understanding of equity investing. Given the
depth of the topics, students are expected to do significant reference studies.
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Types of Investors
In the book “The Intelligent Investor” Benjamin Graham lays down the fundamental principle
of expected return from an investor’s perspective. He emphasizes that the rate of return which
the investor expects should be dependent on the amount of intelligent effort, the investor is
willing and able to put. The minimum return should go to the most passive investor while the
maximum return should be realized by investor who puts maximum intelligence and skill. He
has suggested two categories of investors viz. a Defensive Investor and an Enterprising
Investor.

A Defensive Investor according to him is “One who selects stocks once for all and detaches
from the fluctuations and volatility in stock market” and he further adds by describing that
“how defensive an investor can be depends less on the tolerance for risk and more on his
willingness to allot time and effort into the stock investment”. So defensiveness does not stem
from the amount of risk one takes in securities market or the amount of capital one puts,
neither does it come from the nature of securities one buys. It rather stems from the extent of
time and effort an investor is willing to put in to securities investment. The aspect of effort
indicates the manner of investors’ participation in the securities market. The description
“buying stocks once for all” lays the foundation of investor approach to securities market, the
kind of securities he should buy and most importantly the amount of return one should
expect.

Investors need to understand and keep in mind the fact that stock picking is not possible
without thorough analysis. A defensive investor is not expected to be competent in the above,
he should take help of market intermediaries such as hiring a broker, financial planner,
investment management companies. However, before he selects whom to deal and transact
with, he should investigate whether the adviser is trustworthy.

Second important aspect is of Investment period and the role it plays in investment return.
Investor has to stick to his investment period without getting influenced by the stock market
fluctuations. Often defensive investor find it challenging to desist himself from the stock
market shocks. This results in a tendency to sell or stop investing when the market falls or
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instead start buying when the market goes up. Most investors end up buying high and selling
low. This activity keeps him away from letting the power of compounding work in his favor
over long periods.

Finally, the aspect of asset allocation holds the key. A defensive investor needs to be
disciplined in maintaining his asset allocation, mix between stocks and bonds, depending
upon how much risk he can accommodate. David Swensen, in his classic book “Pioneering
Portfolio Management” has mentioned a study which proves that 90% of investment returns
are explained by asset allocation decisions. It is required that an investor follows its asset
allocation in a disciplined manner.

To avoid making the mistake of buying high and selling low, investors can follow a simple
mathematical model which also helps him maintain his asset allocation decision. Let’s say an
investor has decided to allocate 70% of his portfolio in stocks and 30% in bond. If the stock
prices rise by 25%, the investor (Rs. 100 portfolio will become Rs.117.5 and stock portfolio
will become Rs.87.5) shall have 75% in stocks and 25% in bonds. The best way is to
rebalance his portfolio mix is by reducing stock and adding to bond composition, to return
back to the original position of 70:30. This in turn will mean investor will book profits when
stocks rise, hence sell high. On the contrary when the stock prices fall 25%, investors’ stock
portfolio will fall to ~63% and to rebalance his asset allocation back to 70:30, he needs to add
stocks, resulting in buying during market fall. This shall help investor focus on his strategy
and portfolio instead of getting into the predictive game of volatile stock markets and macro-
economic conditions in market.

Based on the above, Graham has laid down that a Defensive Investor should have a) limited
Diversification in portfolio of stocks (E.g.: minimum 10 and maximum 30) and b) Company
selected should be large, well known/prominent, conservatively financed and has consistent
dividend policy. Also investments through Mutual Funds are well suited for such investors
who want to capture the upside potential and yet limit the downside risk from not being able
to give time to their stock portfolio.

An Enterprising Investor according to Graham is “the one who is actively involved in

researching, selection, and monitoring the mix of portfolio on continuous basis”. As noted
before, the difference between enterprising investor and defensive investor is that the former
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is willing to put in extra time and effort in researching his/her portfolio investment as
compared to the later.

Additional avenues for an Enterprising Investor

 Investing in growth stocks. “The term “growth stock” is applied to the one which has
increased its per share earnings in the past as well above the rate for common stocks
generally and is expected to continue to do so in future”. Such stocks are attractive to buy
provided they are bought at low prices. Risks associated with growth stocks are many:
- One risk associated with growth stocks is how much general public is enthusiastic
about the stock and speed of rise in stock price as compared with actual growth in
earnings. If the stock price increases far ahead of the actual growth in earnings,
investment can turn risky. The more the stock has gone up, the more it seems likely to
keep going up. However this belief is often contradicted by the fundamental law of
finance i.e. the bigger the company gets the slower they grow. An intelligent investor
gets interested into big growth stock not when they are most popular but when there
are certain unpopular events and when things are wrong or some unsatisfactory
development temporary in nature is leading to trading at discounted prices.
- Common stock with good records and good prospects mostly sell at comparatively
high price. Hence, there is a risk of buying growth stocks at extremely high valuation.
- Growth is not permanent in nature and rapid growth in past cannot be expected to
continue going forward. Thus at some point of time growth curve may flatten and
even turn downwards.
- The defensive investor should keep in mind the downside risk associated with growth
stocks and not get carried away with an aim of beating the market.
 Investing in special situations like merger, demerger, acquisitions, sale, take over etc.
 IPOs - Investors should also note that not all IPO’s are big winners but only few give the
expected results. Irrespective of the euphoria around the IPO, an intelligent investor
should buy only when it is available at a discounted price as compared to the value of the
business.
 The enterprising investor can earn substantial profits from purchase stocks when the
dividend return on stock is high and the incremental return on capital employed is
substantial as compared to the price paid for the stock. Over an average of 5-7 years this
can yield great benefits in terms of price rise of stock.
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Thus an enterprising investor as against defensive must have considerable knowledge of

security values and should look after his security investment as he would have if that was his
own business. Just like in case of business, risk is accounted by the chance of losing money;
often risk in case of stock market is associated with the possible decline in market price of
stock. However investor should note that real risk is associated with the decline in value of
the stock or complete wipe out of company’s actual worth and position and not merely
fluctuations in market prices, which are generally termed risky in common parlance. Being
Defensive while investing can act as cushion against market’s power to upset because of the
typical characteristics of refusal to be active and inbuilt nature of resistance to predict the
future, in case of defensive investor.

Thus it is suitable and optimal for an investor to be a defensive as most of the investors do
not have the time, expertise and mental equipment to embark upon quasi business. They
should choose to be satisfied with excellent return obtainable from a defensive portfolio and
should control their expectation of increasing the return.

Market Fluctuation
How should an Investor look at Market Fluctuation?

The Risk Curve

Fluctuation

91-D Tbill Long Term G-Sec Corp. Bonds Equity Shares

Risk

A bond faces multiple risks. Most of this risk are directly related to its tenor. For e.g. Interest
rate risk and credit risk are higher for the long maturity bonds. An investor who has parked its
fund in bond which has smaller period to maturity will be significantly less affected by
changes in market price as maturity is near. On the contrary, for investor in longer period
remaining for bond maturity, say 20 years, will see higher fluctuations/ swings in market
price. So is the case with the common stock portfolio. Since common stocks are designed as
long term investment products more the chances for its value to fluctuate.

It is important for investors to develop an ability to digest these possibilities financially and
psychologically. One is tempted to exploit price swings despite the risk involved in the
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activity, which leads into speculation. Graham says, “It is easy to advice people not to
speculate but the hard part is to follow that advice. If you want to speculate do so with your
eyes open, knowing that you will probably lose money in the end; be sure to limit the amount
at risk and keep it separate from the investment program.”

All stocks, be it low quality or high quality, are subject to price fluctuations. One can profit
from these price swings by either taking decisions on timing or either by way of pricing.
Timing means entering the market before it is about to get into uptrend and exiting before the
downtrend begins. Pricing means to buy the stock when they are below their fair value and
sell when they reach above their fair value. In other words for pricing it can also mean one
does not pay a very high price while buying.

This forms the basis of differentiating an investor from a speculator. An investor derives
satisfactory results from pricing the market whereas speculator will look at forecasting timing
and most often will also end up with speculator’s result. In an investment decision the
probability of gain is higher than the probability of loss whereas for speculator probabilities
of gains and losses are equal. This distinction is not commonly accepted by market
participants across, whether stock brokers or investors, and hence makes them believe that
future forecasts is key to investment performance. All forms of daily media via newspapers,
online, TV etc are filled with forecasts and predictions. The investor notices them and
sometimes acts upon it, for he is persuaded by these market players, who are in the business
of forecasting or have ulterior motive in persuading the crowd by an information which is
projected to be very important. Investor’s believe these forecasts as dependable and accept to
act upon it at their own peril.

Some people do make good money being a good stock market analyst but it is absurd to think
that general public will be able to make money from market forecasts. Its irony of the market
mechanism that for forecasts to work there need to be a buyer and seller both present in the
market and if the forecast signals sell everyone will rush to sell but who will buy!! If
following such forecasts one is following a herd mentality but actually to become successful
one must act differently than the herd. It would be absurd to think that an investor can
anticipate market movement more successfully than general public, for he himself is a part of
general public.
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There is a typical behavior that some trading formulae or models exhibit becomes popular for
a period of time and then going obsolete. This is because as they gain popularity, adoption of
these formulae increases and as adoption grows the reliability decreases. There are two
reasons, first being that gradually as time progresses new events surface which the old
models don’t fit and second that popularity of a theory is itself a hindrance as it takes away
the profit making possibilities. Hence investors will do well ignoring the latest fancy which
would normally be described as the most successful strategy ever. In true sense it is just one
more bull market syndrome, albeit named differently.

BUY LOW SELL HIGH

When we know forecasting the market adds no value to investor, is there still any worthwhile
use an investor can make of these forecasts? History shows us that an investor can
substantially from these forecasts after the event has played out i.e. one who bought in a bear
market when everyone was selling and sold in bull market when everyone was buying.

Nearly all bull markets have some common characteristics such as a historically high price
level, high P/E ratios, low dividend yield against bond yields, heightened speculative activity
even by non-market participants significant number of IPO’s mainly poor quality and so on.
With such defined characteristics, it probably appears simple to identify peak of bull markets
or reverse situation as bear markets. However, market behavior keeps changing at every cycle
and occasion which makes it complex to look through these signals with clarity.

To buy low and sell high, market should give such opportunities at frequent intervals. The
real challenge comes when bull market lasts very long and an investor who wants to deploy
cash keeps waiting on the sidelines in the hope for market correction. Hence, the longer a bull
market lasts, the more severely investors forget; after 4-5 years, that a bear market is even
possible. Since, it is hard to decide high and lows, Benjamin Graham proposes a classic
approach which helps follow this principle. The approach requires investor to make provision
for changes in proportion of stocks and bonds in the portfolio based on stocks price levels by
value standard. In investing parlance, it is also “Dollar Cost Averaging” or a in more simple
words a Balancing approach.

There are “Formula Investment Plans” which enables investors to sell some equity when
market is substantially high. At every high levels investors would sell equity holdings and
shift money to bond portfolio. Investor can either decide to completely sell equity holdings or
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may choose to retain minor proportions. Generally, these model would show satisfactory
results but most often these bull markets or bear markets see extended period and if these
formulas are applied over shorter duration, investors will find themselves on the sidelines
while stocks keep rallying or unable to buy additional quantity as value keeps falling. Hence
it is important to build scenarios and spread the formulas over longer period with flexibility
to change the pace of shifting.

A serious investor should be more concerned with about the long term scenario rather than
daily fluctuations. This is the most rational and prudent way to approach market volatility.
However, the human mind for what it is gets distracted and starts weighing different
situations and outcomes. It is for this reason the investment plans are built to take actions as
mandated and planned before. To protect from getting lured with short term temptations,
these plans chart out the defined strategy and gives the investor limited independence.

Fundamentally, there is relation between business valuation and stock market valuation. For
example an investor holding shares in a private company and another investor holding shares
in a public company. In the private company he values the shares based on profits and assets
and his interest in the company as a proportion of the net worth seen on the balance sheet of
the company. In the other case, the shares are held by the investor which are tradable in the
market and its value depends on market activity of other investor and is often removed from
the balance sheet values. Assuming both the companies have similar profitability and net
assets and both are doing reasonably well, the public company will result in enterprises
selling above their net asset value. Some premium would surely be justified given the listing
advantages of public company. The paradox of current market is that companies with good
prospect and record have little relationship between their book value and market value and
higher the premium it gets the less certain it becomes to find its intrinsic value because it will
depend upon the changing moods of the participating public and their changing parameters to
judge the price. Hence, can we say that more successful a company is the more speculative its
price will be as compared to average performing companies?

Hence, conservative investors should pay special attention while choosing stocks in portfolio
concentrating on reasonable priced securities trading closer to their tangible asset value. In
the past premium on net tangible assets in the region of 1.33 to 1.5 would have been
considerate appropriate, in the world of extremely low interest rates and excess liquidity,
such investors may find it difficult to find such stocks. Irrespective of the challenges posed by
market valuations, stocks at these prices have support of the book value independent of
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market price fluctuation and should remain the preferred choice. Only looking at stock
valuations in relation to its books value or tangible value may not be sufficient, an investor
should also look at reasonable price to earnings ratio, stable financial position over long term
and a fair estimate that the company will be able to main its future profitability. Further,
investor need to gauge the company’s performance from time to time to reassess his thesis. If
investment is done based on these parameters, investors would develop more objective view
towards market fluctuations than those who have paid a high premium to invest in
companies.

In the words of Benjamin Graham “The true investor scarcely ever is forced to sell his shares,
and at all other times he is free to disregard the current price quotation. He need pay attention
to it and act upon it only to the extent that it suits his book, and no more. Thus, the investor
who permits himself to be stampeded or unduly worried by unjustified market declines in his
holdings is perversely transforming his basic advantage into a basic disadvantage. That man
would be better off if his stocks had no market quotation at all, for he would then be spared
the mental anguish caused him by other persons’ mistakes of judgment”. He urges investors
to look at Mr. Market as your partner who everyday tells you the worth of your interests in
businesses you own. Mr. Market also gives you opportunity to either buy you out or sell you
additional interest. Often, this quotation is driven by his enthusiasm and fear and seldom its
justified by the business developments. Investors should act only when he wants to trade with
him while other times he will do better if he forgets about the market and concentrate on
operating results of the company.

SUMMARY

The difference between speculator and investor is their attitude towards the market. The
speculators hope to profit from market fluctuations while the investors’ motive lies in buying
securities at attractive prices and profit from them as the business grows in the long term. A
typical investor should not hold buying in the hope of lower market levels because this may
result in loss of income, unless the general market level is much higher than can be justified
by well-established standards of value.

Many market experts engage not only in forecasting the market movement but also on
selecting the stocks that are expected to do better in terms of price. However, investors
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should not fall into this trap as in doing so he will be competing with analysts and traders and
given the resource they have it would be difficult to excel over them.

Market prices are available for investor’s convenience and it’s his decision to ignore it or use
it the way he likes it. An investor should never buy a stock immediately after a substantial
rise or sell one after a substantial drop.

Since the shareholder judges the success of his investment by the earning he receive be it in
terms of dividend or price appreciation, the same parameter should be used to judge the
competitiveness of the management and its attitude towards business. Management may state
that it is not responsible for the share value or price but the market prices the share based on
the business performance which are directly in control of these management.
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Intrinsic Value
Intrinsic Value is a concept which is hard to define and determine easily. The word gained
prominence with its usage in “Security Analysis” by Benjamin Graham and David Dodd, by
far one of the best written till date on the subject of fundamental and security analysis.
Graham defines it as:

“Intrinsic Value is justified by facts like assets, earnings, dividends, definite prospects.”

It is a concept which is a product of multiple variables like Earnings, Assets, Dividends and
Capital Structure. It is not as definite as a market price but is rather a range of fair values.
These value may significantly be different for two people looking at the same set of facts.
According to Graham, Security Analysis is just an enabling tool to an investor for arriving at
an intrinsic value.

Occasionally securities trade either below the intrinsic value or above it. This creates a
window of opportunity for the investor to enter into buy or sell transactions. The basic
premise behind this is the faith that such securities will revert to their intrinsic value. If the
intrinsic value is above the current market price of an asset, investor will buy the asset and if
such value is less than the current market price investor might choose to sell the asset.

As seen above, Intrinsic value is more about calculating a fair range of prices rather than a
single determinate price and hence, precision in determining intrinsic value is unnecessary.
Even an imperfect intrinsic value would be useful in making an investment decision, as the
purpose of estimating this range of values is to take advantage of mispricing of securities i.e.
paying much less than the intrinsic value so as to provide a margin of safety. Since the value
is an estimate range there is a degree of uncertainty attached to the value. Investor need a
sufficient margin of safety to compensate for the uncertainty involved. It is important to
establish whether the value provides safety of the principal or is it much higher or lower than
market price of the security. To use a simple example – A visual inspection of the boy will
provide a fair idea whether he is old enough to marry without trying to find his exact age.
Hence, a very broad judgement of the intrinsic value may still be a good enough reason to
justify whether the security provides an opportunity to buy or sell.

Estimating the Intrinsic Value

 98

It is important to understand the fundamental difference between Price and Value and most
often these are interchangeably used. Graham gave a classic example of Voting machine as
different from Weighing Machine to explain what is price.

“Market Price is a voting machine where the result is an outcome of numerous people’s
decision and not a weighing machine where the value that appears is accurate. On the other
hand, Intrinsic Value is an estimate of the fundamental worth of a security based on the
analysis done by one person and is not a derivative of multiple people’s understanding/
expectation”.

Intrinsic value is neither equivalent to the book value nor is determined by the future earnings
power alone. Earning power, despite being subjective, is a fairly confident expectation of
future results. And is very closely determined from predicting future earnings. To value the
business, future earnings are normally projected using the past trend. Investor/ Analyst should
exercise caution and note that past average only supplies a rough index to what may be
expected of the future and to that extent future earnings are only an assumption based on past
trend facts. There is no certainty over the outcome and that past may not necessarily repeat
itself. Overdependence on past numbers may result in error or overvaluation or
undervaluation. The projection appears to be a mathematical process but is in fact a
psychological and arbitrary process influenced by many qualitative factors. The central
objective of estimating the future value is more of protecting against the unforeseen rather
than expecting to gain out of the above.

Analysing a security involves two most important factors viz. Time and Price. The question
relating to which security to be bought and for whom is relatively easy to answer.
- Timing depends on a lot of conditions like market situation, overall; respective industry
performance, financials of the security at the time of analysing the decision. All the
parameters need to be looked from the perspective of security in question sought to be
bought.
- Price is another important aspect. The mistake of paying the wrong price is as big as
selecting a wrong stock for investment. Even if the choice of security is right, if the price
is wrong (high) then the investor may end up with making no profits on the investment or
even running the risk of making losses. This is nothing but margin of safety which is a
central aspect in determining the price at which action needs to be taken.
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Process of Analysis

Analysis as defined in the book “Security Analysis” is the “careful study of available facts
with an attempt to draw conclusions therefrom based on established principles and sound
logic”. Analyzing a security and assessing its intrinsic value involves primarily analyzing the
business and the management. Assessing the value may be relevant after the security passes
these two filters. The legendary Warren Buffet has always preferred a great business at fair
price over a fair business at great price. The analysis of process for any security, irrespective
of its objective will entail:

Step A – It consists of systematically gathering and assembling all important facts relating to
the security which should be presented in a logical and understandable manner.

Step B – After collection of all such information, corporate policies and accounting standards
on the basis of which results have been published, needs to be critically evaluated. These
policies and standards are a representation of philosophy and policies of top management.

Step C – Post the above two process, investors begins the process of decision making i.e.
decide about the action to buy or sell, the security.

Fundamental analysis involves a study of both quantitative and qualitative aspects of the
security. The quantitative factors are normally leading indicators of the qualitative aspects. A
good quantitative measure may sometimes substitute the assessment of qualitative factors
separately. E.g. A higher gross margin relative to industry or lower working capital are strong
indicators of the competitive advantage or the bargaining power of a company.

Quantitative Factors
Benjamin Graham laid more focus on Quantitative factors while practitioners of Value
Investing philosophy post Graham, are tilted more towards the qualitative factors. Graham
have talked about consideration of qualitative parameters also, however the bias appeared
more on the quantitative. These factors refers to financial and statistical results of the
company.
- Capitalisation structure, Earnings, dividends, assets and liabilities and operating statistics.
- Operating statistics would include Return on Invested Capital (and whether it is more
than weighted average cost of capital), the level of Free Cash flow, working capital
intensity and host of other parameters.
 100

- Post 2008 and 2009, money managers across the world have started focussing on
analysing the macro environment too given the level of globalization and its impact at
each company level. The assessment is done with a view to minimize future
unpleasantness. It is not about only looking at the trees (each company) but also looking
at the forest (global environment). The macro forecasts are considered to make sure that
the boat will be strong enough rather than to judge whether to go sailing.

Qualitative Factors
Qualitative factors deals with matters like nature of the business, relative position of the
company in the industry, operating characteristics, character of the management and outlook
for the industry and business in general.
- Tests of the management quality do not fall into an exhaustive list but are broader based
encompassing various factors. The most reliable proof of management quality is a strong
track record in terms of business and financials. Consistency over a longer period of time
is what describes management quality in a better way. E.g. of Sales consistency, Return
on Capital Employed, Cash Flow. Many a times an investor ends up valuing management
factor twice in the valuations. Once with the strong financial earnings the stock has
demonstrated and second giving a separate value to management quality. The strong
earnings are an outcome of good management and hence valuing the management
separately may lead to overvaluing the stock. What is important to analyse is
Management Integrity, intelligence, attitude towards minority shareholders, compensation
package and whether top management is knowledgeable and energetic? Many of these
things can be assessed only on face to face meetings by attending conferences, plant
visits, reading shareholder letters and on conference calls. Management quality should
also be assessed by talking to competitors, its own sales people, ex-employees and its
customers.
- Few other important questions apart from management which should be ascertained are:
What are the key drivers of the business? How efficient is management in allocating
capital? What steps company is taking to de-risk its business from future uncertainty? Is
there a definite competitive advantage which will drive away competition? What are the
catalyst for value creation? Are there frequent changes in focus areas of business?

Preparation of a checklist for assessing whether qualitative or quantitative factors brings

consistency to the results of the process. The entire process (which may be more detailed than
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mentioned above) is essentially a part of second-level thinking rather than looking at just the
primary information. Primary information may help only highlight the fact that a security
may be undervalued but second level thinking helps to reach the answers as to why the
security may be so.

Source of Information
The key factor that enables one to analyse a security are the sources of information with
respect to the company and industry. For the company, as per rules and regulations of
Companies Act every listed company has to periodically publish the result (quarterly) along
with an Annual Report detailing the whole business, operational and financial performance of
the company for the full year. At times, in order to understand the company better, an
interview of the management or a private inquiry may be also be done. A shareholder is
entitled to ask questions to the management and also expect a satisfactory reply. While for the
Industry information, one can refer to many industry journals published at regular intervals.

Obstacles to Intrinsic Value

While doing the analysis, an investor may have to come across certain obstacles before
arriving at the intrinsic value.

1. Irrational behaviour of the market - Marketability of an investment is as important

factors as its intrinsic value given that security markets are increasingly non-
predictable. Ability to realize money at satisfactory price is what constitutes
marketability.
2. Uncertainties of the future - Facts may change due to new events or developments as
a result of which the expectation about future may need to be changed. However it
should be noted that past record is a just rough guide to future.
3. Inadequate or Incorrect data – Though outright falsification of data has reduced with
the presence of Accounting standards, regulations and company laws, incorrect and
inadequate data nevertheless poses severe challenges to arrive at intrinsic value.
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Margin of Safety
The concept of Margin of Safety was introduced by Benjamin Graham more than six decades
ago and ever since then it has remain at the center of investment decision by all money
managers and investors alike and more so after the financial crises. For the best value
investors, this had been at the core of how they about investing. The concept has its origin in
the simplest form where person making any financial decision, practices some kind of
safeguard for his investments against unforeseen future situations. As per Graham “Margin of
safety is the cushion available for any investment against potential future risks”. He writes
that margin of safety comes from “a favorable difference between price on one hand and
indicated or appraised value on the other” and “it is available for absorbing the effect of
miscalculations or worse-than-average-luck”. The margin of safety is an all pervasive concept
universally applicable to all types of asset classes whether bonds, stocks, real estate etc.

To understand the basics of margin of safety let us take a simple Bond example wherein the
underlying Bond should have earned at least five times its fixed costs, before tax, in a period
of years, to be qualified for investment grade issue. This past ability to earn in excess of the
interest requirement is the margin of safety that is expected to protect investors against loss,
if the future income declines.

Another way to look at margin of safety for bonds is by calculating ratio between value of
debt and value of enterprise (lower the better). Value of enterprise is the sum total of market
value of stocks and the market value of debt. Market value of the stocks are dependent on the
earning power of the company. Suppose, an enterprise value of a company is Rs.300 crore
out of which Rs.100 crore is debt in form of bonds and remaining Rs.200 crore is the market
capitalization. So, if for reason market capitalization starts to contract, there is still 2x
sufficient room before bond investors start to worry.

Yet another way to look at margin of safety is that suppose there are two Company A and B.
Company A has an interest coverage of 1.1x while Company B has an interest coverage of 5x
then as a bond investor which of these two companies will one be comfortable to invest in?
Off course, it is Company B because there is a higher margin of safety in the form of earnings
being sufficiently higher than the required pay out to bond holders.

Thus, we saw two methods to calculate margin of safety for fixed income security, one being
earning coverage and another margin of enterprise value over debt.
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Margin of Safety for Common Stocks

In the book “The Art of Value Investing”, an excerpt of Howard Marks of Oaktree Capital,
captures the essence of Margin of Safety in a most classical and descriptive way as follows:

“Investors shouldn’t plan on getting added return without bearing incremental risk. And for
doing so, they should demand risk premiums. But at some point in the swing of pendulum,
people usually forget that truth and embrace risk-taking to excess. In short, in bull markets-
usually when things have been going well for a while – people tend to say, “Risk is my
friend. The more risk I take, the greater my return will be. I’d like more risk, please.” There
are few things as risky as the widespread belief that there’s no risk, because its only when
investors are suitably risk-averse the prospective returns will incorporate appropriate risk
premiums”.

There can be instances where a common stock may be considered sound because it enjoys a
margin of safety as that of a good bond. Normally in times of depression we can find prices
of common shares trading at a very low value as compared to the amount of bonds that could
be issued based on its tangibles and earning power.

Let us look at 2 different types of example

1. First is Infosys which faces severe market declines during 2000 – 2003 period. It’s a
company that less tangible assets but has extremely strong growth rate.
2. Second is more industrial company NTPC. It has very high asset base and a more
gradual earnings growth which faces severe price declines during 2007-08.

An Example of Infosys

The table shows the actual Profit before Tax earned by Infosys during the period 1998 to
2004

5 year
Year end Mar 1999 Mar 2000 Mar 2001 Mar 2002 Mar 2003 Mar 2004 Average

PBT 158.2 333.2 701.5 943.4 1,155.8 1,471.2 921.0

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The chart below shows movement in market capitalization of Infosys during 2000 to 2003

The Average 5 year PBT of

Infosys - from 2000 to 2003
70,000.0 Infosys was ~Rs.921 crore
Market Cap (Rs. Crore)

60,000.0
50,000.0 while the lowest point of
Fall of ~70%
40,000.0 Market Capitalization in
30,000.0
20,000.0 May 2003 was Rs.17,700
10,000.0
crore. Hence the earning
-
200001

200010
200004
200007

200101
200104
200107
200110
200201
200204
200207
200210
200301
200304
200307
yield on pre-tax basis (5-
year average PBT/ Market
cap) was 5.2%. The earnings yield based on 2003 earnings was 6.5% (2003 PBT/ Market
cap). The 10-year Govt. of India bond (called G-sec) was giving pre-tax yield of 5% in 2003.

Hence Infosys whose earnings were growing at 50% CAGR was giving a yield equivalent to
a bond even on the basis of last 5 years average profits. This was the time when Information
technology stocks had crashed to their lowest point after the 2000 bubble. The price of
Infosys stock had fallen 70% from its peak and hence, a significant depressed state of stock
market.

An Example of NTPC

The table shows the actual Profit before Tax earned by NTPC during the period 2004 to 2008

5 year
Year end Mar 2003 Mar 2004 Mar 2005 Mar 2006 Mar 2007 Mar 2008 Average

PBT 3,754.0 5,889.7 6,107.5 6,640.7 8,961.4 10,351.0 7,590.1

The chart below shows movement in market capitalization of NTPC during 2000 to 2003
 105

The Average 5 year PBT

NTPC - 2007 - 2008
2,60,000.0
was ~Rs.7600 crore while
2,40,000.0
Market Cap (Rs. Crore)

2,20,000.0 the lowest point of Market

2,00,000.0 Fall of 60% Capitalization in October
1,80,000.0
1,60,000.0 2008 was near
1,40,000.0
Rs.1,00,000 crore, giving
1,20,000.0
1,00,000.0 an earning yield on pre-tax

May-…
Mar-…

Sep-08
Sep-07

Feb-08

Apr-08
Aug-07

Aug-08
Jun-08
Jul-08
Nov-07

Jan-08
Dec-07

Nov-08
Dec-08
Oct-07

Oct-08
basis (5-year average
PBT/ Market cap) was 7.6%. The earnings yield based on 2007 earnings was 10%+. The 10-
year G-sec was giving pre-tax yield of 7.6% in October 2008. This is despite steady 20%
growth in profits.

The important thing to note in these examples is there are situations which arise in market
viz. depressed stock market situation which provides an opportunity to common stock
investor to gain similar margin of safety as provided to bond investor, notwithstanding the
inherent potential in growth of profitability of common stocks unlike a bond. Under normal
conditions, margin of safety for stocks is its earning power above the rate on bonds. Earning
power, as Graham defines, is the company’s sustainable profit that it will continue to earn
under normal conditions. Today, the earning power is synonymous with earning yield.

Suppose, a company’s bond rate is 7% and earning power is 12%. In other words bond’s
yield 7% on the price and earnings yield 12% on the market price. There is a 5% additional
annual margin which will accrue to the investor. A part of this 12% earning will be paid out
in form of dividend and another will be retained for reinvestment into the business. Over a 10
year period, these retained profit will significantly increase the stocks earnings power and
result in increase of shareholder’s value. If we have a diversified basket of stocks bought at
average level of market (not at the peak of market) with such margins of safety then the
probability of favorable result becomes large.

Currently, such large spreads may not be available to stock investors and even a diversified
portfolio may have these real risk. These risks are covered via profit possibilities of the stocks
in the portfolio. The real risk in stock investment is the purchase of low-quality stocks under
favorable business conditions. Investors wrongly believe that the earning reported in
favorable business condition is its earning power meaning it is going to be sustained in future.
These stocks are low quality because they do not offer adequate margin of safety be it in
terms of interest coverage or preferred dividend coverage (specially tested during best
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business conditions). In order to test margin of safety these coverage should be checked over
a considerable period of time and the period should preferably cover different business or
economic environments. Also, the profits to be considered as an indicator of earning power
needs to be tested across the time series.

Margin of Safety in case of Growth Stocks

One thing to note above is that historical records were used to gauge margin of safety.
Investment in growth stocks, companies whose expected earnings are expected to be higher
than average past earnings, may seem to contravene this margin of safety principle as its
safety accrues based on investment hypothesis on future expected earnings. But, investment
theory, more so in today’s world, supports this use of expected earnings and suggests there is
nothing wrong with use of future expected earning provided calculation of the future is
based on thorough analysis and conservative assumptions. It is basic rule of prudent
investment that all estimates, when they differ from past performance, must err at least
slightly on the side of underestimate. Margin of safety is indirectly proportional to the price
and if the average market levels for the growth stocks are too high then they may not
adequately suffice investors required margin of safety criterion and thus a special judgement
and foresight on the part of investor is required in individual selection.

Example

If we continue with the example of Infosys, an investor who invests into Infosys in Oct 2003
at a market capitalization of Rs.31500 crore (i.e.80% above May 2003 value) was still able to
achieve a similar 5.5% earning yields because Infosys pre-tax profits grew from Rs.921 crore
to Rs.1719 crore in next 2 years. The high growth in profits provided that margin of safety
despite buying at higher price.

These examples are based on past numbers to explain the point. However, in reality investors
will need to make profit assumptions for future which is a challenging task. The key point to
remember is that future earnings should be arrived on conservative basis.

Margin of Safety for Undervalued Stocks

Margin of safety for undervalued stocks is the difference between their price and value. In
such cases emphasis is placed on the ability of the stock (or business) to withstand adverse
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developments. The margin of safety comes from this ability of the business to weather
adversities rather than a strong growth in profits as seen earlier. In practical cases investors
will come across such cases more often where the business is resilient enough but does not
have positive growth outlook. This does not mean that outlook is negative. The key is
identifying companies which can protect themselves if the outlook substantially becomes
negative. If these stocks are bought on bargain prices, even a moderate decline in earning
power need not prevent the investment from showing satisfactory results.

Diversification and Margin of Safety

Margin of safety is a criteria that helps investors weed out risky and overvalued stocks but it
does not assure good returns as future is still unreliable. This is where diversification
becomes very important. When you increase the number of bets with higher margin of safety
a positive return becomes more probable as compared to probable losses. One example that
always fits diversification argument is the game of roulette. There are 38 numbers to bet on
and if you bet 1 rupee on correct one then you get 35 rupee in return but the probability to
win is 1/38. Even if you bet 1 rupee on 37 numbers you still lose 2 rupees. This is negative
margin of safety and diversification is foolish here. Had the winning amount been 39 rupees
he would be making small but certain profit due to positive margin of safety by betting on
every numbers. Hence diversification is the simplest and cheapest way to widen your margin
of safety.

Many investors believe margin of safety comes from quality of businesses.

 Companies which have balance sheets that can withstand credit-crises or businesses that
will be around for years to come.
 Valuations that are cheap enough to make the wait for recovery worthwhile.
 Companies that generate or are about to generate excess free cash flow.
 Some investors go further and believe that the depth of own knowledge combined with
the quality of business is the primary margin of safety.
 Margin of safety can also come from undervalued hard assets or other assets on the
balance sheet or from low valuation relative to book value or cash flow multiples.
 Margin of Safety can also come from good businesses where market isn’t recognizing
how good the business is or the level of cash it generates.
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 The key is avoiding businesses that get snuffed out at the bottom.

Investment vs speculation

Speculators do not have a valid thesis to base their judgement on and it rests solely on
unconvincing beliefs and claims. Investor’s margin of safety criteria is based on logical
reasoning, quantitative support and are convincing as they develop from practical
experiences.

Hence to have a true investment there must be true margin of safety. And a true margin of
safety is one that can be arrived at based on figures, by persuasive reasoning and by reference
to actual experiences.

Conventional vs Unconventional Investments

Conventional investment have defined mandate and they invest in government bonds and
dividend paying stocks. These are high quality stocks and bonds (incl. select tax free bonds).
Unconventional investments are for enterprising investors who cover a wide range of stocks
which are undervalued to low grade bonds also provided they are bought at considerable
discount to their value. There is a case for margin of safety in securities bought at depressed
prices. Sometimes during depression we see some securities dropping 90% of their price.
Though these offers investors a chance to earn large speculative profit, they also had qualities
of investment as upon thorough analysis one can demonstrate that their true value is far above
the market price. Analysis of these securities will yield that investor has much to gain and
little to lose due to high safety margin. However this is for unconventional enterprising
investor (defined more in depth in later chapters).

Hence even a best company becomes a “sell” opportunity when its price goes too high, while
the worst company becomes a “buy” opportunity if its price falls low enough.

There are even special situation (e.g. Merger, demergers, take overs etc.) which calls for
unconventional investment strategies, which are based on thorough ongoing analysis that
promises a higher realization than price paid.

Summary
 109

“Benjamin Graham in Intelligent Investor sums up the chapter of Margin of Safety by

describing four business principle which is must for every investor to follow. He argues that
when a person who enters into the field of investment to make profits from security purchases
and sales, he is embarking on a business venture of his own and hence he needs to follow the
basic business principles. The four business principles

i. Know what you are doing – In this case your business.

ii. Do not let anyone else run your business, unless you can supervise him or you can
rely on his integrity and ability.
iii. Do not enter into an operation unless a reliable calculation shows that it has a fair
chance to yield a reasonable profit. – This is of utmost important from investment
perspective. One should keep away from ventures where there is little to gain and
much to lose. Also an investment choice should be based on logical and arithmetic
support rather than on optimism or market behaviour.
iv. Have the courage of your knowledge and experience. If one has arrived at a decision
making based on following sound process one should act on it even if the crowd
disagrees.

Finally, margin of safety should be engrained into the very basic aspect of how one
approaches the security market and hence the person should confine himself within the safe
and narrow path of standard and defensive investment if he is unable to bring on table all the
qualities required. Finally, always remember satisfactory returns are easier than most people
realize, superior returns are harder than it looks.”
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Chapter

Economic And Industry Analysis –Equity Research Perspective

What Is Fundamental Analysis

The purpose of investing in stocks is to ultimately sell them off at a profit. During the
holding period dividend would be received. Fundamental Analysis involves the determination
of the dividend that is likely to be earned and the price which will be received at a future date.
Since the price in future depends on the earnings of the Company, the task is to determine the
earnings of the Company. Further, the earnings of the Company will depend upon the
performance of the Economy as well as that of the Industry to which the Company belongs.
Fundamental Analysis, therefore, involves an analysis of the Economy, the Industry and the
Company. Fundamental Analysis refers to this E-I-C framework.

Economic Analysis
Economic Analysis involves an assessment of the general economic environment
nationally as well as globally. For this purpose various indicators are analysed. Such
indicators may be lead, lag and coincident indicators.

Significance Of Economic Analysis

Economic activity affects corporate profits and the attitude and expectation of
investors. These in turn affect stock prices. Forming an opinion about the outlook of
economic activity is, therefore, important. This opinion will assist the analyst or investor to
decide the proportion of his portfolio which should be invested in common stocks, preferred
stocks, bonds, gold real estate and other assets. (Fischer, 1994).

A forecast of the GNP will provide a picture of the overall economy. In order to
understand the likely effects of moves in the economy, it will be necessary for the analyst to
understand the impending moves in different components of the GNP. For example, if the
analyst is studying the defence industry, he will have to look into the defence expenditure
planned by the Government. Likewise, an analyst interested in the consumer goods industry
will have to study the forecast relating to disposable incomes, the growth in population and
the per capita income (Fischer, 1994).

Economic forecasting is a difficult and arduous job, which the analyst cannot be
expected to perform. He should, however, be aware of the techniques employed by
specialists, so that he can meaningfully interpret the forecasts provided (Fischer, 1994).

Economic Forecasting Techniques

(Fischer, 1994)

1) Anticipatory Surveys
2) Asking prominent people in government and industry about their plans in respect of
capital expenditure can prove valuable information for preparing economic forecasts.
3) Barometric or Indicator Approach
 111

a. There are several indicators which can indicate the direction in which
economic activity is headed.
b. Those indicators which reach their peaks or troughs in advance of total
economic activity are referred to as leading indicators.
c. Examples of Leading Indicators
i. Fixed Capital Investment
ii. Power Consumption
iii. Freight Movement of Railways
iv. Tax Collections
v. New House Construction
vi. Order books of manufacturers
vii. Changes in commodity prices
viii. Money supply

d. Those indicators which reach their peaks or troughs at the same time as
economic activity are referred to as coincident indicators.
e. Examples of Coincident Indicators
i. Index of Industrial Production
ii. Agricultural Production

f. Those indicators which reach their peaks or troughs after the troughs or peaks
of overall economic activity are referred to as lagging indicators.
g. Examples of Lagging Indicators
i. Unemployment Position
ii. Accumulated Inventories
iii. Labour Cost per Unit of Manufacturing Output
iv. Balance of Payments
v. Foreign Exchange Reserves

h. Limitations of Indicators
i. There may be a time lag before an indicator is confirmed and this
defeats the purpose
ii. Different indicators may give differing signals

4) Diffusion Indexes
a. In order to overcome the limitations of the Indicator Approach, it is possible to
calculate an index of several indicators together. Such indexes are referred to
as Diffusion Indexes.
b. Such indexes are complex in a statistical sense.
c. Judgment is, therefore, of utmost importance.
5) Econometric Model Building
a. Econometric models involve the use of mathematical and statistical techniques
for the purpose of forecasting.
 112

b. Econometrics requires the interrelationship of variables to be clearly

identified.
c. It indicates not only the direction but also the magnitude.
d. The result will depend upon the quality of the data and the validity of the
assumptions made.
6) Opportunistic Model Building
a. This is an eclectic approach which draws on any or all the other approaches
mentioned above.
b. Assumptions are made in respect of:
i. Environmental issues such as war
ii. Political scenario
iii. Imminent tax changes
iv. Rate of inflation
v. Level of interest rates
c. Build a forecast of GNP by estimating the levels of the various components:
i. Consumption expenditures
ii. Gross private investment
iii. Government purchases of goods and services
iv. Net exports
d. The approach requires a great deal of judgment and ingenuity.

Summary Of Indicators
INDICATOR FAVOURABLE IMPACT UNFAVOURABLE
IMPACT

Gross National Product High growth rate Low growth rate

Agricultural Production High Low

Industrial Production High Low

Inflation Low High

Foreign Exchange Reserves High Low

Balance of Trade Positive Negative

Balance of Payments Positive Negative

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Public Debt and Foreign Debt Low High

Domestic Savings Rate High Low

General Employment Nearly full Under-employment

Labour Conditions Peaceful Disturbed

Infrastructure Well developed Poor

Demographic Pattern Larger younger population Larger ageing

population

Government Policies Pro-business Restrictive

Environment Well preserved Un-protected

Political Situation Stable Unstable

International Developments Peaceful War or War-like

Economic Cycle/ Business Cycle Study

(Navarro, 2004)

Economic activity moves in a cycle. Periods of expansion are followed by periods of

contraction. A peak is followed by a trough and again by a peak. The stock market also
moves in cycles: bull markets are followed by bear markets and by bull markets again. The
stock market cycle and the business cycle move in tandem, with the stock market cycle
moving ahead of the business cycle. Thus, the stock market is a barometer of economic
activity. Movements in the stock market depend primarily upon corporate earnings. When
economic activity expands, corporate earnings are expected to increase and this pushes up
stock prices. The reverse happens when economic activity contracts. Since the stock market
moves ahead of the general level of economic activity it is considered to be a ‘lead’ indicator.

Impact Of FIIs, DIIs & FDI

FIIs, DIIs and FDI have influenced the stock market in a big way because of the huge
liquidity introduced. A large chunk of FII money may be ‘hot money’ which is not an
unmitigated boon for the market. Domestic Institutions have helped to spread the equity
culture amongst a larger population and this has helped to divert domestic savings away from
traditional avenues, such as gold, into the capital market. This has been a salutary effect. FDI
funds are here to stay for a long time horizon and, therefore, contribute to enhancing the
strength of the financial markets.
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Exogenous Shocks
(Navarro, 2004)

1) Commodity Prices (Price Spikes)

2) Currency Movements (Devaluation)
3) War
4) Terrorism
5) Financial Scandals

Current Turmoil In Global Financial Markets

Integration of Market Segments
It is observed that globalization, deregulation of pricing of financial assets, increased
use of IT and monetary policy changes have led to greater integration of the market segments.
The positive effect of this is that changes, say in, monetary policy, are transmitted to other
segments effectively. Greater efficiency in financial markets benefits the investors. There is
also the risk of higher volatility in case of surprising capital flows. Short-term cash flows may
have a destabilizing effect and may lead to instability in exchange rates.

Linkages of Financial Instruments

The price movements of different currencies and financial instruments are correlated,
some positively and some negatively. The determination of this correlation helps in
appropriate diversification of the portfolio.

Appropriate Strategies
The investor can follow appropriate asset rebalancing strategies based upon a study of
likely effects of policy changes. Such studies will be more meaningful as the integration of
different segments progresses.

Bubbles and Crises

(The China Factor)
Credit Bubble (Debt-to-GDP Ratio is too high, indicating heavy leverage)
Real Estate Bubble (Real estate prices are unaffordable and rental yields are down to 2%)
Investment Bubble (Excessively high share prices due to huge investment funds making their
way into the stock market)

Headwinds
Slowing global growth
Demographic challenges
Slow-down in China and the bubbles building there
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Prospects of rate hike by the US Fed

Political opposition in India
Indian bureaucracy

Tailwinds in India
Improvement in India’s macro-economic indicators:
Inflation has fallen to mid-single digits
Forex Reserves are up to $ 350 billion
Current Account Deficit has reduced
Credible reform story
Monetary Independence
Lower crude oil prices
Reasonably good monsoon

Industry Analysis
Industry Analysis involves assessment of the structure of an industry, that is to say, the
market environment prevailing within an industry and how various players in that industry
are conducting themselves in that environment. It also involves determination of the life-
cycle of the industry and the stage at which it is currently placed within that life-cycle. The
effect of Government policies on the industry have also to be evaluated. The total sales, the
growth in sales and the market share of various players in the industry will be the key factors
to be examined.

Industry Classification By Product

The CNX Equity Index is composed of 72 industrial sectors. The Index is maintained
by IISL (India Index Services & Products Ltd.). The constituents of this index provide a list
of industries classified by product. This classification highlights the difficulty of classifying
industries according to products, particularly when companies have a diversified product line.
For example, a fast-food restaurant is also different from a restaurant serving a regular menu.

NIC Classification
The National Industrial Classification Code has been developed by The Ministry of
Statistics & Programme Implementation. The purpose is to collect timely and reliable data in
a standardized manner for decision making. The classification is intended to be compatible
with the United Nations Standard Industrial Classification. The standardization seeks to make
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the data on different aspects of the economy comparable and, therefore, more useful for
economic analysis.

Industry Classification According To Business Cycle

Based on the Business Cycle, industries may be classified as under (Fischer, 1994):

1) Growth Industries
Industries which display high rates of growth, frequently independent of the
upswings and downswings in the economy are described as growth industries.
The following are some examples of such industries:
i. Cellular Phones
ii. Tablets
iii. Genetic Engineering
iv. Environmental/Waste Management
2) Cyclical Industries
These are industries which see ups and downs along with the movement of
business activity in the economy. Such industries prosper during an upswing
and suffer during a downswing. Consumer and Manufacturer Durables are
examples of such industries

3) Defensive Industries
These are industries which are not adversely affected during downswings as
they cater to essential items which have to be bought irrespective of the
general conditions in the economy. Consumer Nondurables and Services are
examples of such industries.
4) Cyclical-growth Industries
These are industries which possess the characteristics of both growth and
cyclical industries. Such industries grow at a high rate for some time, then
stagnate and even decline and then grow again. The growth may often re-
commence because of development of a new technology which would restore
competitive advantages.

Industry Life-Cycle Theory

It is observed that Industries generally have a life-cycle. The life-cycle would
be indicated by the trend in sales. The same is depicted in the following diagram:
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Sales

Pioneering Expansion Stabilization Decaying

Stage Stage Stage Stage

The characteristic features of each stage are as under:

1) PIONEERING STAGE
Demand grows at an increasing rate
2) EXPANSION STAGE
Demand grows at a moderate rate, but the firms are more efficient,
stronger and stable
3) STAGNATION STAGE
a. Increase in Sales is slower than in other industries
b. Latent Obsolescence
4) DECAY STAGE

Identifying the type of industry and the stage at which it is placed in the life-
cycle would help the analyst to know when it would be a good time to buy a stock in a
particular industry and when to exit. A venture capitalist would enter during the
pioneering stage. Other investors would do well to enter during the expansion stage
and exit as the stabilization stage comes to an end.
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Structure-Conduct-Performance Paradigm
The Structure-Conduct-Performance Paradigm is used for carrying out
Industry Analysis. Industry Analysis is carried out by studying the interrelationship
between structure, conduct and performance This paradigm was originally
propounded by the Harvard economist Edward Mason in the 1930s. It was further
developed by his doctoral student Joseph Bain in the 1950s. The original model was a
static model which propounded that the structure of the market (industry) would
determine the conduct of the market participants and their performance would be
determined by this conduct.

The structure is primarily indicated by the number of firms in the industry, the
homogeneity of the product and the barriers to entry and exit. Industries differ from
each other considerably in terms of industry concentration level. The level of
concentration in an industry can be measured by using the four-firm concentration
ratio and Herfindahl-Hirschman Index.

The four-firm concentration ratio involves computing the market share (as a
percentage) of the four largest firms in the industry.

Herfindahl-Hirschman Index is calculated using the following formula (Investopedia):

𝐻𝐻𝐼 = 𝑆12 + 𝑆22 + 𝑆32 + ⋯ + 𝑆𝑛2

where Sn is the market share of the ith firm.

The higher the value of HHI, the higher is the concentration in the market and
lower the value of HHI, the lower is the concentration. If there is only one firm, the
value of Sn would be 100 and HHI would be 10,000.

Conduct refers to the strategies which different firms pursue in order to gain a
competitive advantage. Performance is to be viewed from the point of view of the
firms as well as society. A firm’s performance may be evaluated considering the
degree of competitive advantage it succeeds in achieving. Society will gain if there is
optimum allocation of resources, general level of employment increases and the
economy progresses. This is represented diagrammatically hereunder:
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Later, in the 1980s, McKinsey introduced a dynamic element and suggested

that the performance would affect the conduct of the market participants and this in
turn would affect the structure. This dynamic model is used to simulate the effect of
different strategies on the performance of an individual firm as well as that of the
entire industry.

The dynamic model is depicted in the diagram below:

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Structure Of An Industry
The Structure of an Industry may be summarized in the form of the following
diagram:
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Market Structure
of an Industry

Absolute Imperfect Perfect

Monopoly Competition Competition

Monopolistic
Oligopoly
Competition

Thus, the structure of the market refers to the degree of competition. The
degree of competition will determine the behavior of the participants.

In a monopolistic scenario, the firm may be able to dictate its price because it
is the only firm in the industry. However, it is not usual to come across such a
situation in real life. Further, there would be other factors to be considered, such as,
entry barriers, the availability of substitutes, etc.

On the other hand, a perfectly competitive scenario is one in which there are a
large number of firms producing a homogeneous product and there are low-cost entry
and exit barriers. Homogeneity of products implies homogeneity in terms of product
attributes and cost. If there is perfect competition, the firms will be merely price-
takers.

Generally, industries are characterized by imperfect competition. In an

Oligopoly, there is a small number of firms dominating the market and their products
may be homogeneous or heterogeneous. Further, entry and exit is costly. In such
situations, the firms may behave in various ways and may even collude tacitly and
dictate their price.
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In monopolistic competition, there are a large number of firms which have

carved out niche markets for themselves by way of product differentiation. Thus, in
their respective niche markets, they behave like quasi-monopolists. There would be
low-cost entry and exit barriers. Nevertheless, they can conduct themselves in various
ways in order to gain competitive advantages.

Industry Structure, Competitive Advantage and Value Chain

(Porter, 1985)

Michael Porter explains that a competitive advantage enables a company to earn a rate
of return on investment in excess of its cost of capital. This excess is referred to as the
economic value added (EVA). He states that “the rules of competition are embodied in five
competitive forces: the entry of new competitors, the threat of substitutes, the bargaining
power of buyers, the bargaining power of suppliers, and the rivalry among the existing
competitors”. He further states that “the five forces determine industry profitability because
they influence the prices, costs, and required investment of firms in an industry – the
elements of return on investment”.

The attractiveness of an industry depends upon factors which may generally not be
under the control of a firm. However, a firm’s strategies can make an industry more or less
attractive. In every industry the structural factors will be different and, therefore, the
importance of the five forces will be different. The management has to use its innovativeness
with a view to enhancing its profitability. However, attempting to change the structure of an
industry can be a double-edged weapon. The leader in the industry may not always benefit by
enhancing its own competitive position. Sometimes it is better for the leader to maintain the
balance and protect the industry structure.

A firm can earn an above-average rate of return in the industry by coping with the five
forces better than its rivals. If a firm has a sustainable competitive advantage, it will be able
to earn an above-average return in the long run. The three generic strategies which help to
achieve above-average profits are: cost leadership, differentiation and focus. A firm has to
consciously make a choice between these three strategies if it is desirous of gaining a
competitive advantage. Without a competitive advantage the firm will only earn mediocre
profits.

Cost advantage implies that the firm is able to produce the product at a lower cost as
compared with its competitors. Differentiation implies that the firm offers a product which is
unique. For such uniqueness the firm is able to command a premium price. Such a premium
price should be greater than the cost of differentiation. The focus strategy requires the firm to
focus on a target segment or segments within the industry. This strategy implies that the
target segments are not well served by the broadly-targeted competitors. Such a strategy will
be profitable only if the segments structurally attractive. Further, such a strategy will be
sustainable in the long run only if imitation of the strategy is difficult.
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In order to achieve competitive advantage, a firm has to plan all its activities in each
functional area keeping its chosen strategy in view. Each activity contributes to the overall
competitive advantage. For this purpose, it is useful to analyze the value chain. Such an
analysis helps to determine each activity which the firm undertakes. Each activity is a cost
driver, that is, it is a source of cost. In order to gain a competitive advantage, each activity
must be performed at a lower cost or better than the competitors.

Porter places great emphasis on an analysis of the value chain. In order to determine
whether a firm has a competitive advantage, it is necessary to determine how each activity is
performed and what is the cost of each such activity. How each activity is performed will also
help to determine how the product is differentiated from that of competitors. He states that
“comparing the value chains of competitors exposes differences that determine competitive
advantage”.

For identifying the activities, it is necessary to isolate activities which are

technologically and strategically distinct. The categories in which Michael Porter has
segregated activities are presented in the diagram below:

(Porter)
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It is pertinent to note that the activities in the value chain are inter-linked as a system
of interdependent activities. Also, there is a close connection between the industry structure
and the value chain.

Porter’s Five Forces Model

(Porter, 1985)

Michael Porter used the premises derived from the S-C-P Paradigm as an
analytical tool to understand how firms behave (Porter, 1985). The five competitive
forces that determine industry profitability, as described by him, are depicted in the
following diagram:

Potential
Entrants
Threat of New Entrants

Industry Bargaining Power of

Buyers
Competitors

Suppliers Buyers

Rivalry Among
Bargaining Power of Suppliers Existing Firms

Substitutes Threat of Substitute Products or

Services
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An industry exists because it creates value for the buyers of the product. If value is
not created for the buyers, there will be no value to be shared among the firms in the industry.
How this value will be shared between the different players in the industry will depend on
their relative bargaining power.

Porter explained the factors governing the five competitive forces as under:

Threat of New Entrants

The extent of threat of new entrants would depend on the barriers to entry. Such barriers
could be in the form of:
1) Economies of Scale
This could be overcome by new entrants by:
a) Introducing integrated production facilities
b) Introducing a wider product line and thereby spreading joint costs
2) Proprietary Product Differences
a) Products made by the consumer goods industry are generally differentiated.
b) Where a product is sold as a commodity, such differentiation is not possible.
3) Brand Identity
4) Switching Costs
These are the costs which would have to be incurred for shifting to the new
products which new entrants are attempting to introduce. For example, the cost which
would have to be incurred for switching over from IBM PCs to Mac PCs.
5) Capital Requirements
a) Core Sector requires huge capital investment
b) Longer credit has to be given in order to capture higher market share
c) Heavy advertisement expenditure has to be incurred to introduce a new product in
the market
d) The customers, such as public sector enterprises, are known for making delayed
payments
6) Access to Distribution
A new entrant may have to develop an expensive distribution channel as the
existing players in the industry may have established long term arrangements with
their distribution channels
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7) Absolute Cost Advantages

a) Proprietary Learning Curve (an existing firm may have acquired a good deal of
experience in performing intricate and complex tasks)
b) Access to Necessary Inputs
c) Proprietary Low-cost Product Design
8) Government Policy
a) Licensing requirements for setting up a new plant
b) Environment protection clearances
c) Safety regulations
9) Expected Retaliation
Existing players may adopt various methods to create obstacles in the path of a
new entrant

Determinants of Substitution Threat

The determinants of substitution threat are:
1) Relative price performance of substitutes
2) Switching costs
3) Buyer propensity to substitute

Bargaining Power of Suppliers

The bargaining power of suppliers would depend upon:
1) Differentiation of inputs
2) Switching costs of suppliers and firms in the industry
3) Presence of substitute inputs
4) Supplier concentration
5) Importance of volume to supplier
6) Cost relative to total purchases in the industry
7) Impact of inputs on cost or differentiation
8) Threat of forward integration relative to threat of backward integration by firms in the
industry

Bargaining Power of Buyers

The bargaining power of buyers would depend upon:
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1) Bargaining Leverage
a) Buyer concentration versus firm concentration
b) Buyer volume
c) Buyer switching costs relative to firm switching cost
d) Buyer information
e) Ability to backward integrate
f) Substitute products
g) Pull-through
2) Price Sensitivity
a) Price/total purchases
b) Product differences
c) Brand identity
d) Impact on quality/ performance
e) Buyer profits
f) Decision makers’ incentives

Rivalry amongst Existing Firms

The rivalry amongst the existing firms would be governed by the following factors:
1) Industry growth
2) Fixed (or storage) costs/ value added
3) Intermittent overcapacity
4) Product differences
5) Brand identity
6) Switching costs
7) Concentration and balance
8) Informational complexity
9) Diversity of competitors
10) Corporate stakes
11) Exit barriers

Three Generic Strategies

Within an industry there are three generic strategies which firms would adopt in order to
achieve a competitive advantage:
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1) Cost leadership
2) Differentiation
3) Focus:
a) Cost focus
b) Differentiation focus

Cost Leadership
The activities being carried out as part of the Value Chain as described by
Michael Porter should be compared with those of the competitors. This will highlight
the strengths and weaknesses in terms of the costing structure. It is pertinent to note
that each activity is a cost driver (source of cost). If the Company follows Activity
Based Costing, it would attempt to continuously eliminate unproductive activities and
thereby improve its cost advantage.

Differentiation Advantage
Instead of seeking a cost advantage a firm may choose to pursue a differentiation
advantage. Such an advantage may be attained anywhere in the value chain.
1) Differentiation can take different forms:
a) Brand Image
b) Innovative Features
i. Does a better job than other products
ii. Does more jobs than other products
iii. Does a unique job which other products cannot do
c) Customer Service
d) Convenience and Reliability
2) Differentiation arises out of uniqueness, the drivers of which are:
a) Policies and decisions
b) Linkages among activities
c) Timing
d) Location
e) Interrelationships
f) Learning
g) Integration
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h) Scale
i) Institutional factors
3) It is not restricted to the product or marketing practices
4) If a firm pursues forms of uniqueness which are not valued by buyers, it will be
different, but not differentiated. Differentiation must “delight” the customers. It,
therefore, requires a deeper understanding of customer needs.
5) Sufficient attention must be paid to the cost of differentiation
6) Sustainable advantage depends on the creation of barriers to imitation
a) Barriers to imitation are firm-specific
b) They are created through developing unique capabilities
7) Differentiation and Competitive Advantage
a) Differentiation creates customer loyalty
b) Leads to earning a higher margin
c) Buyers will find it difficult to find a substitute
d) Suppliers’ power is reduced because they find it prestigious to be associated
with a highly differentiated product

The job of the analyst is to delve into the value activities of the firm he is
analyzing and to understand whether the firm has sustainable cost advantages or
whether the firm has succeeded in differentiating its product at a cost which is lower
than the premium price it has been able to charge its buyers. A firm which has
succeeded in either of these will have a competitive advantage and would be a
preferable investment.

Focus
 Focus involves focus on Cost or Differentiation within a limited market segment

Global and National Events – PESTEL

Analysis of a company involves an evaluation of global and national events and
PESTEL factors affecting the company:

1) Political Factors
2) Economic Factors (Navarro, 2004)
a) Macroeconomic Performance
b) Employment
c) Inflation
d) Recession
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e) Productivity
f) Balance of Trade
g) Monetary Policy
h) Fiscal Policy
i) Interest Rate Cycle
j) Yield Curve
k) Tax Rates
l) Domestic Savings and Capital-Output Ratio
m) FII Flows
3) Social Factors
a) Demographic Pattern
b) Education
4) Technological Factors (Navarro, 2004)
a) Disruptive Technologies
b) Substitutes/Obsolescence
5) Environmental Changes
a) Rainfall
b) Pollution
c) Climatic Patterns
6) Legal Changes
Ease of Doing Business
i. Land Acquisition Laws
ii. Industrial Regulations
iii. Labour Laws

Limitations:

The PESTEL analysis is a useful checklist for general environmental factors although
they are all interlinked in the real world industry segments and various sectors. Any single
external development in the environment can have implications for all six PESTEL segments.
In particular political, social and economic affairs tend to be closely interlinked. One should
not try to impose unnecessary divisions on environment analysis and focus on the substance.

Boston Matrix
The Boston matrix is used for industry, business and company analysis. The
Boston Consulting Group has developed a useful matrix that assesses various
businesses in terms of potential cash generation and cash requirements. Strategic
business units are categorized in terms of market growth rate and relative market
share. The matrix can be paralleled with the product life cycle as products develop,
grow, earn good profits, then enter maturity and finally enter decline as there are
innovations in industry and competition in industry gears up.
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A company’s portfolio should be appropriately balanced with profitable cash

cows providing finance for new products.
One of the limitations of the matrix is that it is built around cash flows, but
innovative capacity in industry is a critical resource, particularly with lots of
innovative trends in industries like pharmaceuticals, auto, IT, ecommerce and
financial services.
Market Share
High Low
Market High Stars Question Marks
Growth Low Cash Cows Dogs

The matrix developed by the Boston Consulting Group helps to evaluate the
different products of an organization on the basis of the relative market share and the
growth prospects. This matrix can be used by an analyst for gaining a deeper
understanding about the performance of different products. The matrix involves
classification of the products into Stars, Cash Cows, Question Marks and Dogs on the
basis of 2 dimensions, that is, relative market share and market.

The endeavour of every Company should be to convert Question Marks into Stars.
However, after the initial high growth, the Stars would grow at a lower rate and become Cash
Cows providing funds for the Stars and Question Marks. The Dogs must be closed down and
the funds released diverted to Stars and Question Marks.

Important Factors for Select Sectors:

The factors outlined below are dynamic and change with developments in industry
and, therefore, need regular monitoring, e. g., few recent important factors for select sectors
could be:

Factors affecting Auto Sector

1) Rising income and young population
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2) Interest rates and financing options - As majority of vehicle purchases are financed
through financial institutions, lower interest rates and ease of finance facility drives
auto sales

3) Research & Development (R & D) focus, Government of India has setup technology
modernization fund and strong policy support

4) Reduced overall product lifecycle and quick product launches

5) Wide distribution channel and excellent after-sales services

6) Increasing investment by global car manufacturers by setting up export oriented

production hubs

Factors affecting Finance Sector

1) Regulatory Issues – Policy actions by the regulator the Reserve Bank of India –
Statutory Liquidity Ratio, Cash Reserve Ratio, Bank Rate, repo, reverse repo affect
liquidity.

2) Focus on financial inclusion

3) Reserve Bank of India has given out new banking licenses and is in the process of
giving more private banking licenses

4) Technological Innovation – increasing use of Automated Teller Machines (ATMs),

internet and mobile banking

5) Favourable demographics and rising income levels – propel demand for housing loans

6) Rising default on loans eat into the banks’ capital as deposits that go into funding
credit have to be serviced and repaid

Factors affecting FMCG Sector

1) Brand value and brand recall ability

2) High advertisement cost to maintain brand recall ability among customers

3) Rise in disposable income and growing middle class

4) Increasing share of organized retail in urban areas and penetration in rural areas

5) Consumer Preferences – Availability of new and innovative products, festive discount

schemes

6) Dealers distribution network, incentives and dealers discount

7) Working capital management

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Factors affecting Energy Sector

Power
1) Government policies related to traffic control, subsidies, rural electrification program.

2) Availability of raw materials like coal, oil & gas.

3) Growing population and increasing penetration and per-capita usage

4) Availability of core equipment like boilers, turbines and generators

5) Favorable benefits for renewable sources

6) Power generation – plant load factor (PLF) etc.

7) Power distribution and transmission losses

Oil & Gas

1) Quality and price of crude oil

2) Refining margins based upon complexity of refineries to process various types of

crude oil in the market

3) Movement of INR against USD

4) Government policies related to oil subsidy

5) Geographical diversification

Factors affecting IT Sector

1) Business model – Time & material pricing, engagement model, pay us for result, sale
of product

2) Shift to Tier II & III cities – cost advantage

3) Geographical coverage, as revenue is dependent on location of client

4) Number of clients, relationship with clients and inorganic growth through mergers
and acquisitions

5) Availability of talent pool and favorable labor arbitrage

6) Currency fluctuations directly affect revenue

7) Social, Mobility, Analytics and Cloud (SMAC) - paradigm shift

8) Start-up India

Factors affecting Pharma Sector

1) Research and Development – Development of new drugs, faster drug discovery
process, new therapies for untreated and under treated diseases / medical conditions
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2) Emergence of Medical Tourism, Expansion of healthcare facilities & diagnostic

centers to rural areas

3) Financing Products – Health & life insurance policy, cashless mediclaim

4) Government Policies – Policy initiatives, tax break , insurance cover to fund research

5) Outsourcing activities – on account of cost efficient research, highly skilled & cheap
labour

Factors affecting Metals Sector

1) Demand Drivers include growth in infrastructure development, rise in automotive
production, power availability and its pricing

2) Mining industry – reserves, production, license

3) Commodity prices are often determined internationally and individual players have no
control

4) Cyclical movements in commodity prices

5) Increasing private company participation

6) Coal – availability from Coal India, reserves to allotted to private companies and
availability through international tie-ups

7) Aluminium – availability of bauxite reserves, availability of power

Factors affecting Media Sector

1) Digitisation – Game changers for Broadcasters, Internet - Digital Media

a. Film making, serials and gaming for broadcasting channels (Paradigm shift –
Corporatization)

b. Hollywood - outsourcing opportunities, 3D

c. Bollywood - low budget and big budget movies

2) Improved quality of picture and sound through digitization, leading to improved

advertisement revenue

3) International presence, regional entertainment channels and niche broadcasting

4) Viewership management system

5) Average revenue per user (ARPU)

6) Brand value of channels

7) Expansion of FM radio, print and digital media

8) Digital India
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Factors affecting Construction, Cement and Realty Sector

1) Infrastructure Development & Government Policies – Industrial corridors, Express
ways, Metro, Monorail, airports, ports & shipping facilities

2) Order Book – Infrastructure, roads, capital goods, etc.

3) Demand for residential properties higher - increased urbanisation and rising

household incomes

4) Easy availability of finance and repatriation of NRIs and HNIs

5) Growing IT & ITES industry, growing preference towards organized retail drives
demand for commercial property and Special Economic Zones (SEZs)

6) Interest rate directly influences buyer’s ability to purchase property

7) Real Estate Investment Trusts (REITs), Tax credits, deductions and subsidies directly
impact real estate

Factors affecting Telecom Sector

1) Pricing of Spectrum

2) Availability of Spectrum in required frequency

3) Adoption and viability of various technologies – CDMA, GSM, 2G, 3G, 4G and 5G,
their costs, technologies for towers etc. and innovations

4) Penetration of mobiles and landlines

5) Data download speeds and servicing various domain areas in education, health,
agriculture, entertainment, news, sports

6) Network issues in voice and data and call drops

7) Net neutrality

8) Digital India

9) Telecom Regulatory Authority of India (TRAI) Regulations

10) Penalty issues

Factors affecting Manufacturing Sector

1) Make in India

2) Innovation in technologies, use of robots, robotics

3) Competition from different countries

4) Dumping and anti-dumping duties

5) Tariff barriers
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6) Cascading taxes

7) Reforms like GST

8) Fiscal incentives, subsidies

Top Down and Bottom Up Approach

A “top-down” approach implies that the investor first analyses the economy in order
to form a view about the “big picture”. If he finds that the economy is likely to do well, he
then proceeds to analyze the various industries to find out which of these are likely to do
better than others. This exercise is very useful because different sectors of the economy tend
to do better at different stages of the business cycle. He then studies the prospects of different
companies in the industries he has identified as being more promising. This approach would
be more effective if the investor possesses the skills required to forecast economic growth,
industry trends, commodity prices and geopolitical risk.

Economic Analysis
Industry
Analysis
Company
Analysis

The “bottom-up” investor, on the other hand, is not concerned about the industry or the
business cycle. He simply identifies the companies which, in his opinion, have good future
prospects and invests in them. If he is looking at growth stocks, his focus would be on return
on assets, return on equity, growth in earnings per share and growth in revenues. If he is
analyzing income stocks, his focus would be on earnings per share, dividend per share and
dividend yield. The idea in this case is that a great company can perform well irrespective of
the market conditions. This approach is more appropriate for an investor who does not
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possess the skills required for carrying out an analysis of the macro factors. Nevertheless, the
macro factors cannot be totally ignored because no company functions in isolation and is,
therefore, bound to be impacted by developments in the economy as a whole and in the
particular sector to which it belongs.

Economic
Analysis

Industry Analysis

Company Analysis

In actual practice, a combination of both approaches is likely to yield a better

portfolio taking the risk-reward trade-off into consideration.

Regulatory Framework
 Some of the Regulators, in India are:

Company related Matters Registrar of Companies

Capital Market related Matters Securities and Exchange Board of India

Financial System and Monetary Policy Reserve Bank of India

Telecommunication Industry Telecom Regulatory Authority of India

Insurance Industry Insurance Regulatory and Development

Authority
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Power sector Central ElectricityRegulatory Commission

Warehouses Warehousing Development and Regulatory

Authority

Some of the Authorities and Associations are (IBEF):

 The Association of Mutual Funds in India (AMFI)
 Society of Indian Automobile Manufacturers (SIAM)
 Automotive Component Manufacturers Association of India (ACMA)
 All India Biotech Association (AIBA)
 All India Industrial Gases Manufacturers' Association (AIIGMA)
 Confederation of Indian Industry
 Cellular Operators Association of India (COAI)
 Cement Manufacturers' Association (CMA)
 Engineering Export Promotional Council (EEPC)
 Electronic Industries Association of India (ELCINA)
 Electronic and Computer Software Export Promotion Council (ECSEPC)
 Electric Lamp and Component Manufacturers' Association of India
(ELCOMA)
 Express Industry Council of India (EICI)
 Federation of Indian Export Organisations (FIEO)
 The Federation of Hotel & Restaurant Associations of India (FHRAI)
 Hologram Manufacturers Association of India (HOMAI)
 Hotel Association of India (HAI)
 Electrical & Electronics Manufacturers Association (IEEMA)
 Indian Machine Tools India Manufacturers Association ( IMTMA)
 Indian Exporters' Guide
 Indian Chemical Council ( ICC )
 Sugar Mill Association (ASMA)
 Indian Drug Manufacturers' Association
 National Shipowners' Association (INSA)
 Indian Printing, Packaging and Allied Machinery Manufacturers' Association
(IPAMA)
 Indian Refractory Makers Association (IRMA)
 The Indian Stainless Steel Development Association (ISSDA)
 Indian Tea Association
 Industrial Diamond Association of India
 Manufacturers Association of Information Technology (MAIT)
 National Association of Software and Services Companies (NASSCOM)
 Organisation of Pharmaceutical Producers of India
 Organization of Plastics Processors of India (OPPI)
 Project Exports Promotion Council of India (PEPC)
 Indian Polyurethane Association
 All India Airconditioning & Refrigeration Association (AIACRA)
 Software Technology Parks of India (STPI)
 Soybean Processors Association of India (SOPA)
 139

 Telecom Regulatory Authority of India (TRAI)

 Telecom Equipment Manufacturers Association of India (TEMA)
 Textile Machinery Manufacturers' Association (India)
 Compound Feed Manufacturers Association (CLFMA)
 The Fertiliser Association of India
 The Institute of Indian Foundrymen
 The Solvent Extractors' Association of India

Points To Be Considered In Industry Analysis

The key points which an analyst will have to examine for the purpose of analyzing an
industry may be summarized as follows:
1) Life cycle of the industry and the stage at which the industry is currently placed.
2) Permanence (in view of rapid technological advances)
3) Key Industry Drivers
The following techniques may be used for evaluating relevant industry factors:
a) Product-demand analysis and regression analysis (Fischer, 1994)

i. Linear Regression and Correlation Analysis can help to estimate the

demand for the product by determining the relationship between demand
and factors such as:

o GNP
o Disposable Income
o Per Capita Income
o Per Capita Consumption
o Price Elasticity of Demand
ii. The period selected for such analysis should be one during which the basic
conditions have remained more or less unchanged.
iii. The variables should be related not only statistically but also in an
economic sense.
iv. Simple linear regression will be useful if there is one variable significantly
affecting the dependent variable.
v. In case there are two or more variables affecting the dependent variables, it
will be more appropriate to use multiple regression analysis.

b) Input-output analysis (Fischer, 1994)

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i. Helps to perform an incisive analysis of an economy’s industrial structure.

ii. Involves the preparation of a matrix in a columnar form, indicating the

value of inputs provided by one industry to another.

iii. Due to technical difficulties, the technique is more useful for intermediate
and long-term forecasting.

4) The major players in the industry and their Past Sales and Earnings Performance
5) Study of the Industry using Porter’s Five Forces Model
6) Competitive Conditions
i. Product Differentiation
ii. Absolute-cost Advantages
iii. Focus
7) Labour Conditions
8) Government Policy
i. Financial or other support
ii. Quotas and Tariffs
iii. Consumer Protection
iv. Favourable Tax Legislation
9) Industry Share Prices Relative to Industry Earnings
10) SWOT Analysis

Sources of Information
Primary Sources
Interviews with
CEO
CFO

Executives of:
1) Production
2) R & D
3) Market Research
4) Sales
5) Purchasing
 141

6) Human Resources
7) Administration
Union Leaders
Suppliers
Customers
Distributors
Competitors
Organisations such as Trade Associations and Regulators to whom Reports/Data are
submitted, such as ROC, SEBI, Chambers of Commerce
Banks, Advertising Agencies connected with the players in the industry.

Secondary Sources
Ministry of Statistics and Programme Implementation
Economic Survey and Union Budget published by the Government of India
Reserve Bank of India
PHD Chamber of Commerce and Industry
India Brand Equity Foundation
Centre for Monitoring the Indian Economy
Stock Exchange Databases
Company Annual Reports
Databases of Financial Newspapers and Magazines
Reports and Newsletters of Investment Advisors

Composition of Indices
Sensex: 30 of the largest and most actively traded stocks on the BSE.

Nifty: Well diversified 50 stock index across 13 sectors of the economy

Nifty Junior: The 50 belonging to the next rung after the Nifty 50, in terms of liquidity

Nifty Midcap 50: Includes liquid midcap stocks from diversified sectors

Nifty Smallcap: 100 tradable exchange listed companies of the small capitalized segment

Sectoral Indices: NSE – Auto, Bank, Energy, Finance, FMCG, Infra, IT, Media, Metal,
Pharma, Realty

BSE – Consumer Durables, Capital Goods

Other Indices: Thematic, such as, Commodities, Consumption, Infrastructure, Service Sector
 142

Strategic, such as, Alpha Index, High Beta Index, Dividend Opportunities,
Low Volatility, Quality 30

VIX: This index measures the expected volatility over the next 30 calendar days based upon
the order book pertaining to the Nifty Index Options

Appendices
Appendix 1: Nifty 50 – Methodology and Fact Sheet

Appendix 2: Nifty Midcap 50

Appendix 3: Nifty Smallcap 100

Appendix 4: Nifty Bank

Appendix 5: Nifty Financial services

Appendix 6: Nifty IT

Appendix 7: Nifty Consumer Goods

Appendix 8: Nifty Auto

Appendix 9: Nifty Pharma

Appendix 10: BSE Sensex

Appendix 11: BSE 100

Appendix 12: BSE 200

Appendix 13: BSE Dollex 30

Appendix 14: MSCI India Index

Questions
1) Comment on the different approaches to economic forecasting.
2) The Government has plans to give a big boost to the defence industry in India.
Which sectors of the economy will be affected by this and what will be the effect
on the economic factors?
3) It is believed that equity stocks are a good “hedge against inflation”. Explain, with
reasons, whether you agree or disagree with this sentiment.
4) What are the reasons for the current turmoil in global financial markets?
5) How would you classify industries within a business cycle framework?
6) The Government plans huge investment in the infrastructure sector. Which sectors
of the economy will be affected by this? What will be the effect on the different
components of GNP?
 143

7) Critically review Porter’s Five Forces Model.

8) Explain the three “generic strategies” identified by Porter to enhance competitive
advantage.
9) What is the significance of “Key Industry Drivers”?
10) Enumerate recent examples of political, social, or economic events that have
caused the stock market as a whole or stocks in a specific industry or the stock of
a particular company to surge ahead or plummet sharply
11) What is a cyclical industry?
12) How does information about the past sales and earnings performance of an
industry help in forecasting the future prospects of an industry?
13) Explain when you would consider industry share prices to be overpriced in
relation to industry earnings.
14) What is the utility of the industry-life-cycle approach in industry analysis?
15) From an investor’s point-of-view, which would be the most profitable stage of the
industry life cycle?
16) If two companies in an industry have identical rates of growth, what factors may
lead an analyst to consider the record of one of the companies to be superior to
that of the other?
17) Write short notes on:
a) Top Down and Bottom Up Approaches
b) Economic Cycles
c) Competitive Advantage

18) State the different sources from where secondary information may be obtained.

Assignments

1) Determine the exogenous shocks which have occurred globally since the middle
of the last Century and graphically present the effect of such events on global and
Indian stock markets
2) Study the effect of different economic factors on the following industries:
a) Banking
b) Financial Services
c) Insurance
d) IT
e) Education
f) Pharmaceuticals
g) FMCG
h) Auto
i) Oil and Gas
j) Telecom
k) Media and Entertainment
l) Power
m) Petrochemicals
 144

n) Agrochemicals
o) Fertilisers and Chemicals
p) Textiles
q) Paint
r) Metals
s) Engineering
t) Infrastructure and Construction
u) Defence
v) Hospitality, Hotels and Tourism
w) Tobacco
x) Tea and Plantations
y) Retail
z) Ecommerce and Startups

3) Identify ‘Key Drivers’ relating to the following industries:

a) Banking
b) Financial Services
c) Insurance
d) IT
e) Education
f) Pharmaceuticals
g) FMCG
h) Auto
i) Oil and Gas
j) Telecom
k) Media and Entertainment
l) Power
m) Petrochemicals
n) Agrochemicals
o) Fertilisers and Chemicals
p) Textiles
q) Paint
r) Metals
s) Engineering
t) Infrastructure and Construction
u) Defence
v) Hospitality, Hotels and Tourism
w) Tobacco
x) Tea and Plantations
y) Retail
z) eCommerce and Startups
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4) Analyse the Industry selected by you in accordance with the framework discussed.
5) On the basis of your Industry Analysis, select a Company for analysis. Give
reasons for your selection.
6) Analyse the following aspects relating to the Company selected by you:
i. Brief History of the Company
ii. Background of the
a. Promoters and Collaborators
b.CEO
c. Key Officers of the Company
iii. Global and macro economic factors which have a significant impact on the
Company’s performance
iv. Impact of business cycles, commodity prices and exchange rate fluctuations
on the Company’s performance
v. Stage in the life cycle and structure of the industry to which the Company
belongs
vi. Relative market shares of the industry rivals
vii. Key Business Drivers
viii. Past performance of the Company in the last 10 years with respect to:
a. Sales
b.EPS
c. Debt-Equity Ratio
d.Dividend
e. Bonus and Rights Issues
ix. Compare the price chart of the Company’s shares with the movements in the
Nifty/Sensex for the last 10 years
x. Credit rating of the Company’s Debt Instruments
xi. Relevant extracts from Prospectuses, if any, relating to any FPOs, Rights
Issues in the past 10 years
xii. Particulars of GDRs issued, if any

Notes:

i. It is essential for participants to read the annual ‘Economic Survey’.

ii. References have been given in brackets.

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Suggested Websites
Corporate Governance

 National Foundation of Corporate Governance

 Whistleblower.org.in
 Global Corporate Governance Forum
 Asian Corporate Governance Association
 Institutional Investor Advisory Services
 Ingovern
International Financial Institution

 IOSCO
 International Capital Market Association
 International Finance Corporation
 World Bank
 Asian Development Bank
 Banks for International Settlements
Investor Education

 Corporate Filing & Dissemination System

 Centre for Advanced Financial Research & Learning
 Centre for Investment Education & Learning
 SEBI - Investor Guidance and Redressal
 NSE - Investor Guidance and Redressal
 ICAI Handbook for Investing & Investor Protection
 National Institute of Securities Markets
 Investor Awareness
 Invest India
 Securities Investor Protection Corporation
 International Forum for Investor Education
 Roubini Global Economics
Investor Help Guide

 Investor Education & Protection Fund

 Watchout Investor
 Investor HelpLine
 Invest India
 Money Life
 Investor Guide to Capital Markets - NSE
 Jago Investor
 Milk or Water
 Research Bytes
Regulatory Bodies

 Securities and Exchange Board of India

 Forward Market Commission
 Reserve Bank of India
 Insurance Regulatory and Development Authority
 Banking Codes and Standards Board of India
 Pension Fund Regulatory and Development Authority
 147

 Corporate Education & Research Centre

 US Securities and Exchange Commission
 Commodity Futures Trading Commission
 Financial Conduct Authority (UK)
 Hong Kong Securities and Futures Commission
 Swiss Financial Market Supervisory Authority
 Monetary Authority of Singapore
Industry Bodies & Rating Agencies

 Confederation of Indian Industries

 Federation of Indian Chambers of Commerce and Industry of India
 The Associated Chambers of Commerce and Industry of India
 AMFI
 AMBI
 CRISIL
 Standard and Poors
 ICRA
 Moodys
 CARE Ratings
 India Rating & Research (FITCH Group)
 Fitch Ratings
Stock Exchanges

 National Stock Exchange

 Bombay Stock Exchange
 National Commodity and Derivative Exchange
 Multi Commodity Exchange
 InterConnected Stock Exchange
 World Federation of Exchanges
 New York Stock Exchange
 NASDAQ
 Singapore Stock Exchange
 London Stock Exchange
News & Periodicals

 Firstpost
 Money Control
 Business Week
 Economic Times
 Economonitor
 The Economist
 The Wall Street Journal
 Financial Times
 Bloomberg
 CNN
Professional Bodies

 The Institute of Chartered Accountant of England and Wales

 The Institute of Chartered Accountant of India
 The Institute of Company Secretaries of India
 The Institute of Cost Accountant of India
 148

 Financial Reporting Council

 Financial Planning Standards Board India
 International Financial Reporting Standards
 Chartered Financial Analyst
Government Bodies

 Ministry of Finance
 FIMMDA
 Foreign Exchange Dealer's Association of India
 Securities Appellate Tribunal
 Income Tax Department
 Central Board of Excise and Customs
 Ministry of Corporate Affairs
Others

 MarketWatch
 Money Control
 HDFC Securities
 ICICI Direct
 Wall Street Survivor
 Virtual Trader (UK)
 www.euromonitor.com/
 149

Chapter

Company Analysis: Stock Selection and Fundamental Concepts of

Valuation for Equity Research
Preliminary Screening as a Basis for Stock Selection
Once the choice of an industry has been made for the purpose of investment, the next
step would be to analyse the various companies for the purpose of stock selection. This
Company Analysis will involve analysis of the financial as well as non-financial aspects of
the company. For the purpose of stock selection a preliminary screening of a Company can be
carried out by examining the top-line growth, the growth in EPS and the Debt-Equity Ratio
over a period of 10 years. If the screening reveals attractive results, the analyst may proceed
with a detailed analysis, otherwise he may look for another Company, unless he has authentic
information about expected positive changes envisaged in the immediate future.

Non-Financial Analysis
Non-financial analysis involves assessment of the quality of the management, quality
of the product, production facilities, marketing strategies, productivity and other aspects of
the company’s operations.

Vision, Mission and Goals

An understanding of the Vision and Mission enables the analyst to make a judgment
about the culture of the Management. It indicates how the top management views the future
and the direction in which it proposes to take the Company. The goals lay down the specific
steps which are proposed to be taken for attaining the Vision and Mission. The practicality of
those goals and the success achieved in the past will provide valuable insights into the
performance of the Management. In this context, it would be useful to examine whether the
Company has developed core competencies and also focused on them. The analyst will also
know whether the Company intends to expand through organic growth or inorganic growth.

Management Quality
The foregoing analysis would make it possible for the analyst to form an opinion
about the quality of the Management. The analyst has to form an opinion whether the
Management is capable of achieving the goals of the Company. The assessment made by
the analyst will influence his decision about the P/E multiple which he will assign to the
Company for the purpose of valuation. The following further factors would facilitate
carrying out of a critical evaluation:
 150

1) Transparency
2) Credentials of Top Management
3) Integrity
4) Independent Directors
5) Corporate Governance

Graham suggests the following tests of Management quality:

1) The management say what they will do, then do what they said
2) Are they acting in the interests of the owners (what kind of pay packets are they
drawing?)
3) Keep away from a Company which re-prices, reissues or exchanges stock options
for its insiders
4) Buying and selling of the Company’s shares by senior executives
5) Are they managers or promoters (promoting the Company to the investing public)
6) Accounting practices followed by the Company (Extraordinary and non-recurring
items)

Organisation Structure
The analyst’s report must contain comments on the following aspects of the
Organisation Structure:

1) The Strategic Business Units in the organization

2) The Internal Control mechanisms
3) The contribution of the Independent Directors
4) The skill development programmes implemented
5) The succession plans laid down

Production, Technology and R & D

The analyst must gather information about:

1) Technology used, extent of automation and efficacy of processes

2) Technical Collaborations
3) Flow of Production
4) Installed Capacity of the Plant and the Economies of Scale achieved
5) Location of the Plant vis-à-vis the location of raw materials and the market
6) Data of capacity utilization
7) Power requirements, in-house generation and reliability of external sources
 151

8) Maintenance and insurance policies adopted

9) Quality Control procedures followed
10) Incidence of Wastages
11) Impact on the Environment
12) Importance given to R & D activities

Purchasing
The suppliers are an important part of the industry structure. Purchases must be
appropriately integrated to achieve the objectives of quality, speed, dependability,
flexibility and cost control. The following aspects need to be looked into by the
analyst:

1) Use of techniques of:

a. Just-in-time Inventory
b. Total Quality Management
c. Enterprise Resource Planning
2) Alliances with suppliers in order to provide improved service, technological
innovation and product design
3) Improvement of processes through business process re-engineering
4) Reduction in Inventories with a view to increasing the ROI

Marketing
In today’s competitive times, the marketing function is more important than ever
before. The following aspects need to be examined in this context:

1) The structure of the Marketing Department and the qualifications and experience of the
marketing team
2) The products of the Company in the context of their respective life cycles
3) The product mix of the Company should be evaluated using the BCG matrix
4) The brand values of the products should be appropriately valued. The brands may be
reviewed keeping in mind the geographies in which they are sold, the demographic
patterns of different markets and other relevant socio-economic factors.
5) Using Michael porter’s model, the analyst can identify the markets in which the Company
has adopted the (i) Differentiation Strategy, (ii) Cost Leadership Strategy and (iii) Focus
Strategy
6) The performance of the new products launched in recent years
 152

7) Evaluate the product mix in terms of the 5Ps:

a. Product: What is its perceived value?
b. Price: Market-skimming, market-penetration; price elasticity of the products
c. Promotion: Advertising, Personal selling, Sales Promotion, Special Offers and
Public Relations
d. Place: How the product will be provided to the customer, distribution channels
e. Pace: Speed with which the product is being placed with the customer
8) Public Relations handling by the Company
9) Strategies for wholesale, retail and export marketing activities
10) After-sales services provided to customers
11) Rating of products and services by the customers

Human Resource Management

A study of the HR function should cover the following aspects:

1) The overall industrial relations position

2) The recruitment policies at different levels
3) The compensation methods adopted
4) Incentives provided and productivity bonuses given
5) The training programmes for skill upgradation
6) Employee participation in decision-making
7) Sales achieved per employee

Wealth Creation and Other Aspects

The track record of wealth creation, Economic Value Added, Quantitative
Data, Corporate Actions, Insiders’ Transactions and Corporate Announcements will add
value to the analyst’s report. In this context, Graham suggests a review of the following
aspects:
1) Two overriding questions to be answered when looking through Annual Reports:
a. What makes this Company grow?
b. Where do (and where will) its profits come from?
2) Problem areas to watch for:
a. Is the Company a serial acquirer?
b. The Company is an OPM addict
c. The Company relies on one customer
d. The Company has a wide “moat” (that is, competitive advantage)
 153

i. Brand Identity
ii. Monopoly
iii. Economies of Scale
iv. Unique Intangible Asset
a. A Resistance to Substitution
b. The Company is a marathoner, not a sprinter
3) Stock Policy
a. Avoid Companies which split their shares frequently
b. Companies should be buying back their shares when the share prices are low and
not when high (Should not be wasting the Company’s cash)

CSR Activities
The nature and extent of CSR activities will reflect upon the core values of
the organisation. If a Company carries out genuine activities to take care of the
environment and of the community in which it functions, it will indicate that the
management is more enlightened and its business more sustainable in the long run.

SWOT Analysis and the 7-S Framework

This involves an evaluation of the external and internal environment. Changes may
take place in the external political, technological, social, cultural or economic
environment which may affect the future prospects of the Company. If the changes are
positive, opportunities would become available to the Company to enhance its sales as
well as its profits. On the other hand, negative changes would be threats which may
reduce its sales and/or profits. A study of the internal environment will highlight the
strengths and weaknesses in respect of production, finance, marketing and organizational
competencies. The analyst must diligently carry out a SWOT analysis of the Company
and see how the Company is capitalising on its strengths, overcoming its weaknesses,
exploiting the opportunities that come its way and countering the threats that arise from
time to time.
McKinsey have suggested a 7S Framework for studying the policies of an
organisation. These 7Ss focus attention on important aspects which affect a Company’s
long-term prospects.
 154

The following diagram indicates the 7S Framework. All 7 are interlinked and must be
borne in mind when implementing any action. Strategy, Structure and Systems are the
rational and hard Ss and Skills, Staff, Style and Shared Values are the emotional and soft
Ss.

Financial Analysis
Financial analysis will involve looking into the profitability, short-term and long-term
stability, business and financial risk, turnover of assets, growth in sales and earnings, past
cash flows and those expected in the future. Financial Statements are analysed using Ratio
Analysis, Common-size Analysis, Trend Analysis and Comparative Statement Analysis. Such
an analysis will facilitate the process of ‘valuation’.

Annual Report
Company Analysis involves a detailed analysis of the contents of the Annual Report
of the Company. The Annual Report contains the following:

1) The Chairman’s Statement

2) The Directors’ Report
3) Corporate Social Responsibility Report
4) Corporate Governance Report
5) Auditors’ Certificate on Corporate Governance
 155

6) Business Responsibility Report

7) Management Discussion and Analysis Report
8) Secretarial Audit Report
9) The Auditor’s Report
10) The Financial Statements
a. The Balance Sheet
b. The Profit & Loss Account
c. The Cash Flow Statement
d. Notes to Accounts

The Annual Report generally contains a review of the general economic and industrial
scenario and indicates how that scenario has affected the performance of the Company. It
may also indicate the implications of the same for the future performance of the Company.
The Financial Statements provide detailed information of the historical performance of a
Company. The Financial Statements are prepared on the basis of GAAP, which the analyst
must be fully aware of.
A Company raises its funds from two broad sources, that is, borrowed funds and
owned funds. The funds so raised are invested in Fixed Assets, Capital Work-in-progress and
Working Capital. The Fixed Assets and Working Capital generate cash flows today. Capital
Work-in-progress will result in cash flows in future and, in that sense, it represents ‘growth
assets’. Damodaran suggests that an ‘Accounting Balance Sheet’ can be converted to the
following ‘Financial Balance Sheet’ for the purposes of analysis:

A FINANCIAL BALANCE SHEET

LIABILITIES ASSETS

Fixed Interest DEBT ASSETS IN PLACE Existing Investments

Fixed Maturity Generate Cash Flows

today
No role in
Management Include Fixed Assets
and Working Capital
Tax Benefit
 156

Residual Claim on EQUITY GROWTH ASSETS Expected Value that

Cash Flows and will be created in
Assets future

Control on
Management

Perpetual

It takes years of practical learning for an Analyst to understand business dynamics

and do business and financial analysis of a selected company based on the available Annual
Report and Accounts, subsidiary company financials and other relevant financial information.

The following are some of the important factors which facilitate an understanding
of Business and Financial Models of selected companies:

1. Management and JV Partners

2. What are the external pressures?
3. Competitive Advantages
4. Sustainability
5. Profitability vs Peer Group and Industry Profitability
6. Is it cyclical?
7. Business cycles
8. Life cycles
9. Any tests? Litmus and Stress Testing?
10. Innovations and Disruption

Key factors in analysis of Annual Accounts and Financial Reporting are

analytical or substantive.

The analyst then seeks to understand the following from various sources of financial
and other information from the Annual Reports, quarterly disclosures and analyst
presentations and releases provided by select companies to exchanges and select analysts:

A. Basic Information
 157

1. Sources of numbers and reconciliation

2. Significant accounting policies and procedures
3. Quality of management information
4. Auditors’ reputation and track record of assignments handled
5. Assessment about customers and vendors

B. Earnings
1. Quality of Earnings
2. Earnings Summary
3. Adjusted EBIDTA
4. EBIDTA Bridge
5. Key value drivers - customers, products etc.
6. Accounting - consistency and compliance issues
7. Non- recurring items / One-offs
8. Non- operational items
9. Discontinued businesses
10. Proforma items

C. Quality of Cash Flow Analysis

1. Consolidated
2. Net working capital
3. Fixed Assets capex - maintenance vs expansionary
4. Normalised Working capital
5. Seasonality of working capital

D. Quality of Net Assets and Balance Sheet considerations

1. What are the assets in place?

2. How valuable are those assets?

3. How risky are those assets?

4. Stock obsolescence

5. Receivables recoverability and ageing

6. Fixed assets impairment

 158

7. Cash deployment and surplus

8. Accruals and provisions - whether enough

E. Growth Assets
1. What are the growth assets?

2. How valuable are those assets?

F. Equity
1. What is the amount of equity funds?

2. How risky is the equity?

G. Contingent liabilities
1. Whether contingent liabilities are fully disclosed
2. Whether any adjustments should be considered

H. Net Debt considerations

1. What is the amount of debt funds?
2. What is the cost of debt?
3. Which currency and whether hedged?
4. Type of debt, whether institutional, secued or unsecured, long term or short term and
whether use for the purpose for which intended?
5. Fresh borrowing during the period.
6. Repayments during the period.
7. How risky is the debt?

I. Others
1. Any future cash outflows
2. Employee liabilities
3. Non- current provisions
4. Bonuses / ESOPS
5. Deferred capex/ capex committed
 159

Adjusted Financial Statements

Information about the earnings of a Company is required for finding answers to some
of the above stated questions. However, the earnings reported in the financial statements
need to be adjusted in order to overcome the limitations of accounting rules. Before
carrying out such analysis, the Analyst must go through the Report carefully to decide
whether it is necessary to adjust the figures in respect of unusual or exceptional items, so
that he can arrive at ‘normalized’ figures. He may also have to make adjustments in
respect of qualifications which may have been made by the Auditors. Certain explanatory
notes may also lead to adjustments. While making such adjustments, the Analyst must
take into consideration the explanations provided by the Directors in respect of the
matters under consideration. The Analyst has to carry out his analysis after making all
appropriate adjustments. It is pertinent to note that though financial statements appear to
be factual, actually they are based on estimates and judgments. Also, due to the rapid
changes taking place, the analyst must obtain as updated data as possible. Quarterly
reports are a source of such updated information. However, information which is not
available in quarterly reports will have to be estimated. Damodaran suggests the
following adjustments:
1) Adjusting for Capital Expenses

Capital expenses such as R & D are generally treated as revenue expense in the
financial statements due to the uncertainty of the results of research. Such expenses, however,
yield benefits over a period of years. Further, the commercial benefits would start flowing in
after the elapse of time. This period is referred to as the amortizable life of such assets. The
amortizable life will vary from firm to firm.

Damodaran suggests that “in the case of the research asset with a five-year life, you
cumulate 1/5 of the R&D expenses from four years ago, 2/5 of the R & D expenses from
three years ago, 3/5 of the R&D expenses from two years ago, 4/5 of the R&D expenses from
last year and this year’s entire R&D expense to arrive at the value of the research asset. This
augments the value of the assets of the firm, and by extension, the book value of equity.
Adjusted Book Value of Equity = Book Value of Equity + Value of the Research
Asset”
Having determined the value of the research asset, it will also be necessary to make
appropriate adjustments to the figure of earnings. The research expenses will be added back
and appropriate depreciation (amortization) will be deducted.
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It is to be noted that where the expense on R& D is substantial, the return on equity as
well as the return on capital employed will be significantly reduced due to the adjustment
process.

In the case of consumer goods companies such as Dabur a similar adjustment in

respect of advertising expenses may be considered to be appropriate as high expenses on
advertising are likely to enhance the brand value. In case of consulting Companies such as
Accenture the costs of recruitment and training would be treated in like manner. Etailers like
Amazon.com may treat a part of their expenses on selling and administration as capital
expenses. Such a treatment will, however, be justified only if there is convincing evidence
that the benefit of such an expense will be derived over a long period of time.

2) Adjusting for financing expenses

Adjustments will require to be made in respect of expenses on operating leases. The

present value of the future operating lease payments will first have to be determined. The pre-
tax interest rate of the Company’s debt will be used as the discount rate. The present value so
arrived at will be added to the conventional debt of the Company. The operation lease rent
will then be added back to the income and depreciation on the leased asset will be reduced to
arrive at the adjusted operating income.

Adjusted Debt = Debt + Present Value of Future Lease Commitments

Adjusted Operating Income = Operating Income + Operating Lease Expenses –

Depreciation on Leased Asset

This approach can also be followed in respect of other commitments made by the
Company, where the payment is not connected with performance, since such a
commitment would be the equivalent of debt. Such would be the case in respect of sports
teams signing contracts with star players.

3) Accounting Earnings and True Earnings

Some Companies adopt dubious accounting practices from time to time or even
regularly quarter after quarter. One of the indications of this is the gap between the
earnings reported for equity investors and that disclosed to the Income Tax authorities.
One of the reasons for doing this is the payment of profit-linked bonuses to the
management, which leads the management to report higher earnings. Companies may, of
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course, also do this to influence the market price of their shares. This practice of reporting
“managed earnings” poses a serious challenge to analysts. Adjustments will be required
to determine the true earnings.
Some of the techniques employed for "managing earnings" are as follows:
a) Recognizing revenues early
b) Postponing recognition of earnings
c) Capitalizing revenue expenses
d) Using reserves to smooth out earnings
e) Income from Investments
Since it is known that some Companies "manage earnings", the current year's earnings
cannot be used for making future projections, without critically evaluating the financial
statements and undoing the effect of such creative practices. The areas which will have to be
so looked at are:

a) Extraordinary, Unusual and Non-recurring Items

i. One-time items of incomes and expenses should be excluded
ii. Incomes and expenses which occur periodically, say, once in three or
four years, should be averaged out
iii. Incomes and expenses which are positive in some years and negative
in some years, such as difference in foreign exchange, should be left
out as they would tend to cancel out
iv. Incomes and expenses which appear every year, but are volatile,
should be averaged out
b) Acquisitions
In the case of acquisitions, the accounting for goodwill poses a
challenge. Usually goodwill is amortized over a number of years. This
has the effect of reducing the reported earnings. However, there would
actually be no effect on operating income. The analyst should,
therefore, look at earnings prior to amortization of goodwill.
c) Divestitures
If a firm divests infrequently, the same can be ignored as a one-time
item. If, however, a firm divests regularly, the capital expenditures
should be considered net of the cash inflows resulting from the
divestitures.
 162

d) Income from Investments

Income by way of interest and dividend on investments should be
ignored and the market value of the securities should be added to the
operating assets at the end of the process.
e) Investments in Subsidiaries
i. A Company may have a minority passive interest in a subsidiary. In
such a case only the dividend received will be recorded. For
determining the value of the holding company, the value of the
subsidiary should be determined separately and this value should be
added on to the value of the holding company. The income received
from the subsidiary will be ignored for calculating the value of the
holding company.
ii. If the interest in the subsidiary is an active minority interest, a portion
of the income or loss of the subsidiary would be recorded in the
income statement and would get included in the net income, though not
in the operating income. In such a case also the value of the subsidiary
should be determined separately and this value should be added on to
the value of the holding company.
iii. The interest in the subsidiary could be a majority, active interest. In
such a case the holding company will show the entire operating income
of the subsidiary as a part of its own operating income. The share of
the minority interest will be shown as an adjustment in order to arrive
at the net income of the holding company. The analyst can value the
combined firm using the consolidated financial statements. The share
of the minority interest would then have to be reduced. This will be
done with the assumption that the cost of capital of both the firms is
same. This assumption can be made if both the firms are in the same
business and have equivalent risk.

Financial Ratio Analysis

Financial Ratio Analysis is a principal tool of financial statement analysis. A ratio is an
arithmetical relationship between two figures. Financial ratio analysis is a study of ratios
 163

between two various items or groups of items in financial statements. The following are the
more important ratios:
 Profitability with respect to Sales
o Gross Profit Margin
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
 𝑥 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

1) This ratio shows the margin left after meeting manufacturing

costs.
2) It measures the efficiency of production as well as pricing.
3) The maintenance of a steady gross profit ratio is necessary in
order to be able to recover the fixed overheads of the business.
4) The efficiency of the management can be judged by studying
the trend of the ratio over a period of time or by comparing it
with the ratios of other firms.
5) Usually, there is a standard gross profit ratio for each industry
and such a ratio helps the individual firm to judge its own ratio.
o Operating Profit Margin
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
 𝑥 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

1) This ratio measures the operational efficiency.

2) The higher the ratio, the greater is the profitability.
3) A comparison with the past as well as with other firms in the
same industry will be useful.
o Pre-Tax Profit Margin
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥
 𝑥 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

1) This ratio indicates the final trading results.

2) It indicates the portion of net sales left for the proprietors and
the Government - Income - tax.
3) Trend analysis of this ratio is very useful.
4) It can be compared with other companies.
o Post-Tax Profit Margin
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
 𝑥 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

1) This ratio shows the earnings left for the shareholders as a

percentage of net sales.
 164

2) It measures the overall efficiency of production, administration,

selling, financing, pricing and tax management.
3) The Gross and Net Profit Ratios together provide a valuable
understanding of the cost and profit structure and enable an
analysis of the sources of business efficiency or inefficiency.
 Return on Investment Ratios
o Return on Equity
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥−𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
 𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′𝐹𝑢𝑛𝑑𝑠

1) This ratio shows the percentage of earnings on the amount

contributed by the equity shareholders.
2) It enables the earning capacity of the enterprise to be compared
with the earning capacity of other companies and investments.
3) It reflects on the effectiveness of the management, the probable
demand for the company’s products and the industrial
conditions.
4) It is an indication of the dividend prospects. The dividend
prospects are higher when this ratio is higher.
o Return on Capital Employed
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
 𝑥 100
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠+𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

1) This ratio measures the efficiency with which the capital is

employed
2) The ROCE should be higher than the cost of capital. Otherwise
there will be no value creation from the point of view of the
shareholders.
3) It is very useful for comparing profitability across companies,
more so companies which are in capital intensive sectors.
4) An investor would prefer a company which has a stable ROCE,
with a rising trend from year to year.
o Return on Total Assets
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
 𝑥 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

5) This ratio measures the overall efficiency.

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6) It is a measure of the business performance which is not

affected by interest charges and tax payments.
 Activity Ratios
o Debtors’ Turnover Ratio
 Average Collection Period =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡𝑜𝑟𝑠+𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑖𝑙𝑙𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑜𝑟 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

1) This ratio indicates whether or not the book debts are being
collected promptly and the extent to which the credit policy is
being adhered to.
2) The average collection period is compared with the firm’s
credit terms to judge the efficiency of receivables management.
3) As a rule of thumb, the average collection period should not
1
exceed 1 2 times the credit period.

o Inventory Turnover Ratio

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑐𝑘

1) This ratio reflects the efficiency of inventory management/

2) Higher the ratio, the better it is as it indicates :-
(a) Efficient utilisation of working capital.
(b) Stocks are fresh.
3) Lower ratio will indicate over-stocking.
4) Very high ratio may indicate inadequate inventory which may
result in frequent stock - outs and loss of sales.
5) With the same net profit ratio, the amount of profit will be
more with a higher stock turnover.
o Creditors’ Turnover Ratio
 Average Credit Period Enjoyed =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑜𝑟 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

It indicates whether the credit allowed by suppliers is being

properly taken advantage of.

o Total Assets Turnover ratio

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 166

1) This ratio measures the efficiency with which the assets are
employed.
2) A high ratio indicates a high degree of efficiency in asset
utilisation and a low ratio reflects inefficient use of assets.
 Financial Stability
o Immediate Solvency
𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
 Quick Ratio =
𝑄𝑢𝑖𝑐𝑘 𝐿𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

1) The quick ratio measures the ability of a firm to meet its

immediate liabilities.
2) The higher the ratio, the greater is the immediate solvency.
3) The desired norm is 1 : 1.
4) This ratio is a stringent measure of liquidity and must be
considered together with the current ratio to test the short term
financial strength and solvency of the company.

o Short Term Solvency

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
 Current Ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

1) The current ratio measures the ability of a firm to meet its

current liabilities.
2) The higher the current ratio, the greater the short term solvency.
3) In interpreting the current ratio the composition of current
assets must be analyzed. A firm with a higher proportion of
current assets in the form of cash and debtors is more liquid
than one with a higher proportion of stocks, even though the
firms have the same current ratio.
4) The desired norm is 2 : 1.
5) A high ratio indicates inefficient use of capital which may be
due to poor inventory control.
6) A low ratio indicates lack of liquidity and suggests a shortage
of working capital.

o Long Term Solvency

 167

𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

 Debt - Equity Ratio = 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 𝑎𝑛𝑑 𝑆𝑢𝑟𝑝𝑙𝑢𝑠

1) This ratio helps to measure the financial leverage of a

company.
2) A high ratio implies higher risk and greater volatility in
profits due to higher interest burden.
3) If a company earns a higher return on its capital employed
than the interest rate it pays on the debt, the shareholders
benefit from such leverage. However, if the interest rate
ends up being higher than the return on capital employed,
the shareholders will end up losing. A very high interest
burden due to high debt may even lead to bankruptcy.
4) The debt – equity ratio varies from industry to industry.
Generally, it is will be higher in the case of capital intensive
industries.
5) Lenders would prefer a lower ratio as it would imply lower
risk from their point of view.
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟𝑠 ′𝐹𝑢𝑛𝑑𝑠
 Proprietory Ratio or Net Worth Ratio = 𝑥 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

6) This ratio is also known as the ratio of Net Worth to Total

Assets.
7) It measures the relationship between the funds invested by the
proprietors themselves and the total funds invested in the
business.
8) This ratio is a test of the capitalisation or the capital structure of
the business. It measures the long term solvency or the
ultimate solvency of a company.
9) The higher the ratio, the less is the dependence of the company
on borrowed funds. However, a very high ratio is a sign of
over - capitalisation.
10) This ratio must be considered along with the current ratio and
the liquid ratio.
 Capital Gearing Ratio =
𝐹𝑢𝑛𝑑𝑠 𝐸𝑛𝑡𝑖𝑡𝑙𝑒𝑑 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐹𝑢𝑛𝑑𝑠 𝑁𝑂𝑇 𝐸𝑛𝑡𝑖𝑡𝑙𝑒𝑑 𝑡𝑜 𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑟 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
 168

1) This ratio measures the capital gearing of a company.

2) The technique of raising finances for the company by resorting
to fixed interest or dividend carrying securities is called
“gearing” the capital.
3) If the ratio> 1, the company is highly geared.
4) If the ratio< 1, the gearing is low.
5) If the ratio = 1, the company is evenly geared.
6) A high gearing may result in some benefit to equity
shareholders. This benefit will accrue if the rate of interest /
dividend on fixed interest /dividend securities is lower than the
rate of return on investment in the business. A company with
‘geared’ capital is said to be ‘trading on equity’.

𝐸𝐵𝐼𝑇
 Interest Coverage Ratio = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

1) This ratio is very important from the point of view of lenders.

2) It indicates whether the business is able to earn sufficient
profits to pay the interest charges.
3) The higher the number, greater is the margin of safety for the
lender.
4) If this ratio dips below 1.5, the risk of default would be very
high and the company could end up in bankruptcy, if the ratio
drops below 1. A drop below 2.5 is considered to be a warning
signal.
5) An investor would gain a good understanding by studying the
trend of this ratio on a quarterly basis for the last 5 years.
6) For inter-company comparison, one would have to consider the
nature of the industry, the business models employed and the
turnovers.

DuPont System
The Return on Equity can be analysed further by using what is known as the DuPont
System. Analyzing ROE using the DuPont System will provide insights into the financial
 169

performance of a company. Return on Equity depends upon the after-tax profit margin,
the asset turnover and the leverage. This may be expressed as follows:
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
ROE = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑥
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑥
𝐸𝑞𝑢𝑖𝑡𝑦

The relationships could be presented in the form of the following chart:

 170

Return on Equity

Return on Assets Assets/Equity

Profit Margin Assets Turnover

Net Profit/ Net Sales Sales/ Total Assets

Total Revenue
Total Cost Fixed Assets Current Assets
minus

Operating Costs

Inventories
Accounts
Interest Receivable
Depreciation Cash and
Marketable
Securities
Other Current
assets

Non-operating
Incomes/Expenses

Taxes

Preferred Dividend
 171

Considerations about Financial Strength, Capital Structure and Dividends

(Graham, The Intelligent Investor, 2003)

1) Financial Strength and Capital Structure

a. Company generates more cash than it uses
b. Owner earnings = Net Income plus Depreciation and Amortization minus
Normal Capital Expenditures minus Unusual, nonrecurring, extraordinary
incomes minus Cost of granting stock options to insiders
c. In the case of industrial Companies Long-term Debt should not exceed the Net
Current Assets (or Working Capital)
d. Fixed Charges Coverage Ratio
2) Dividend Record
Payout Ratio (Low ratio should be justified by better performance as
compared with competitors)
(The defensive investor could restrict his investments to companies
which have paid dividends continuously for the last 20 years)
3) Current Dividend Rate (Payout Ratio)
4) Graham suggests the following simple formula for valuing growth stocks (instead of
refined mathematical calculations):
Value = Current (Normal) Earnings × (8.5 plus twice the expected annual
growth rate)
(The growth should be that expected over the next 7 to 10 years; 8.5 is
the P/E Ratio for a Company with Zero % EPS growth)

Analysis of Expenses with respect to Sales

This analysis will enable the analyst to understand the operating results in-
depth.

Trend Analysis
Trend Analysis involves a study of trends in the various items of expenses and
incomes. These will not only help in analyzing past performance, but will also
facilitate in preparing a model for projecting future performance.

Comparative Statement Analysis

Comparative Statement Analysis involves a comparison of a Company’s
performance relative to other companies as well as relative to the Company’s own
performance in earlier years. (In order to make the statements comparable it may be
 172

necessary to adjust the statements in respect of different accounting treatments that

may have been given by different companies or even by the same company in
different years).

Common-size Analysis
Common-size statements help the analyst to compare companies of different
sizes as all figures are expressed as a percentage of a base figure. In the case of the
Income Statement, the figure of total revenue is used as a base figure. In the case of
the Balance Sheet the figure of total assets is used as a base figure.

Analysis of Cash Flow Statement

The Cash Flow Statement provides valuable information about the Sources
and Application of Cash. The analyst needs to examine whether long term fund
requirements have been met out of long term sources and short term fund
requirements out of short term sources. Also, the analyst will get valuable insights
about the company by ascertaining whether the long term funds have been generated
internally or externally. Further, externally raised funds may be in the form of debt or
equity and would have different effects on the finances of the company.

Interrelationships between Certain Parameters

The relationships among stock prices, ROE, Book Value, the payout ratio,
growth and the discount rate need to be studied over a period of time.

Other Important Financial Parameters

On the basis of information given in the Annual Report it may/ would be
possible to make estimations and to comment on the following:
1) Productivity of Retained Earnings
2) Impact of Other Incomes
3) Credit-rating of the Company’s financial instruments
4) Brand values
5) Tax Planning
6) Weighted Average Cost of Capital (which can be compared with that of
competitors)
 173

Cost Advantage
(10 Major Cost Drivers)

Porter suggests that for controlling costs and achieving cost advantage, a firm needs to
focus on identification of activities in the value chain and the controlling of costs of each
activity. He identifies 10 major cost drivers or sources of cost:
1) Economies or Diseconomies of Scale
a) As the volume increases, it becomes possible to perform activities more
efficiently. This will reduce the costs.
b) R & D and other costs, which are to be amortized will be lowered if spread
over a larger volume.
c) Beyond a point supplies of inputs may become inelastic and, therefore,
costlier, resulting in diseconomies.
d) Unionization may occur if expectations of workers increase due to size.
2) Learning and Spillovers
a) Over a period of time, as learning takes place, costs may decrease due
to various factors, such as, “layout changes, improved scheduling,
labor efficiency improvement, product design modifications that
facilitate manufacturing, yield improvements, procedures that increase
the utilization of assets, and better tailoring of raw materials to the
process” (Porter, 1985).
b) Learning may spillover to other firms in the industry through former
employees, suppliers, consultants and so on. Such spillovers will then
reduce the cost for the entire industry and not just one firm. However,
a firm may still enjoy a first-mover advantage (Porter, 1985).
3) Pattern of Capacity Utilization
a) The pattern of capacity utilization will depend upon seasonal and cyclical
fluctuations in demand. This pattern does not depend upon competitive
position.
b) If a firm varies its capacity utilization from time to time, it will incur costs of
expanding or contracting. Another firm may decide not to make such changes
and may, therefore, have lower costs even though both have the same average
level of utilization.
c) The pattern of utilization is, therefore, a more appropriate cost driver than the
average level of utilization (Porter, 1985).
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4) Linkages at Various Levels

a) Linkages among activities exist within a value chain as well as with value
chains of suppliers and channels.
b) If activities are coordinated and optimized better, then changing the way one
of them is performed can reduce the cost of both.
c) Managing linkages with suppliers and linkages with channels can also lower
total cost through coordination or joint optimization. (Porter, 1985)
5) Interrelationships with Other Business Units
a) Sharing of know-how between different business units of the firm can help to
reduce costs. This is basically a form of sharing the benefits of learning
(Porter, 1985).
b) It may also be possible for different business units to share a value activity
itself (Porter, 1985).
6) Integration of Systems
Vertical integration can help to reduce costs. Sometimes, de-integration may
lead to reduction in costs. Accordingly, the firm has to take an appropriate
decision taking into consideration the potential benefits (Porter, 1985).
7) Timing and Speed
A firm may enjoy the advantage of lower cost by virtue of being a first-mover.
Sometimes, a firm may enjoy a cost advantage by virtue of being a late-mover.
The analyst will have to understand whether the firm enjoys a first-mover cost
advantage or a late-mover cost advantage or not (Porter, 1985).
8) Discretionary Policies Independent of Other Drivers
A firm may make policy choices which may affect the cost of value activities.
Such policy decisions would indicate whether the firm has chosen to opt for
gaining a cost advantage or has preferred differentiation. Differentiation
generally will lead to a higher cost. The firm must, therefore, compare this
increased cost with the price premium that results from differentiation (Porter,
1985).
9) Location of Activity
The location at which a value activity is carried out can significantly impact
the cost. The location relative to the location of suppliers will impact the cost
of inbound logistical costs. The location relative to the location of buyers will
impact the cost of outbound logistical costs. The location relative to the
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location at which other activities are carried out within the organization will
affect the costs of transportation, inventory and coordination (Porter, 1985).
10) Institutional Factors
These are the factors which are largely beyond the control of the firm, such as,
taxes, labour unions, tax holidays and other financial incentives (Porter, 1985).

Leverage

Concept of Leverage
Leverage refers to influence. In financial analysis leverage could be either or
operating leverage or financial leverage. Total leverage refers to the combination of operating
and financial leverage. The Research Analyst needs to understand the leverage of the
company he is analysing. This will give him an idea about the forecasting risk involved in his
analysis.

Operating leverage helps to measure the effect of changes in Output on Earnings

Before Interest and Taxes (EBIT). Financial leverage helps to measure the effect of changes
in EBIT on Earnings per Share (EPS).

To understand the measures of leverage, it is necessary to understand the functional

relationships between items in an Income Statement. The Income Statement can be presented
in the following format:

Format of Income Statement

Total Revenue

Less: Variable Costs

Less: Fixed Costs

Earnings Before Interest and Tax

Less: Interest

Profit Before Tax

Less: Tax

Profit After Tax

Less: Preferred Dividend

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Earnings for Equity Shareholders

The relationships embodied in the above Income Statement can also be presented in
algebraic terms. We can use the following notations for doing so:

TR = Total Revenue

Q = Quantity produced and sold

P = Selling price per unit

V = Variable cost per unit

F = Fixed cost

EBIT = Earnings Before Interest and Tax

I= Interest

T = Income Tax Rate for Corporates

Dp = Dividend on Preference Shares

E = Earnings for Equity Shareholders

N = Number of Equity Shares outstanding

EPS = Earnings per Share

On the basis of the Income Statement, the following relationships can be stated, using
the above notations:

Total Revenue (TR) = (Q X P)

Variable Cost = (Q X V)

EBIT = (Q X P) – (Q X V) – F

= Q (P – V) – F (EQ 1)

Equation ‘EQ 1’ is useful for understanding the dependence of EBIT on Q.

(𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(1−𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)−𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑛 𝑃𝑟𝑒𝑓 𝑆ℎ𝑎𝑟𝑒𝑠
EPS = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
 177

(𝐸𝐵𝐼𝑇−𝐼)( 1−𝑇)−𝐷𝑝
= 𝑁
(EQ 2)

Equation ‘EQ 2’ is useful for understanding the relationship between EPS and EBIT.

Substituting for EBIT, we get

[𝑄(𝑃−𝑉)−𝐹−𝐼](1−𝑇)− 𝐷𝑝
EPS = 𝑁
(EQ 3)

Equation ‘EQ 3’ is useful for understanding the relationship between EPS and Q.

Operating Leverage
Operating leverage depends upon the combination of fixed and variable costs. Higher
the proportion of fixed costs, higher is the operating leverage.

The Degree of Operating Leverage (DOL), which helps to understand the sensitivity
of EBIT to changes in Q is defined as follows:

∆𝐸𝐵𝐼𝑇 ⁄𝐸𝐵𝐼𝑇
Degree of Operating Leverage = ∆𝑄⁄𝑄
(EQ 4)

𝑄(𝑃−𝑉)
= 𝑄(𝑃−𝑉)−𝐹 (EQ 5)

Thus, the Degree of Operating Leverage helps to measure the percentage change in
EBIT as a result of a 1% change in the level of output. Further, it is possible to determine the
operating break-even quantity, that is, the level of output at which the EBIT will be zero. The
break-even quantity can be determined from the following equation:

𝐹
Q = 𝑃−𝑉 ( EQ 6)

The degree of operating leverage helps us to measure one of the factors of business
risk. The other factor is the variability of output. Together, the two factors help us to analyse
the variability of EBIT. Using the degree of operating leverage, we can measure the extent to
which EBIT may vary from its forecast value, if there is an error in the forecast value of Q.
The higher the degree of operating leverage, greater will be the forecasting risk as a small
error in forecasting sales will lead to a large error in cash flow projections.

Financial Leverage
Financial leverage is indicated by the debt-equity ratio. Higher the proportion of debt,
higher is the debt-equity ratio. A firm with a high debt-equity ratio is considered to be highly
leveraged. The financial leverage can also be judged by calculating the capital gearing ratio.
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A firm with a capital gearing ratio of more than ‘one’ is considered to have a highly geared
capital structure.

The Degree of Financial Leverage (DFL), which helps to understand the sensitivity of
EPS to changes in EBIT, is defined as follows:

∆𝐸𝑃𝑆 ⁄𝐸𝑃𝑆
DFL = ∆𝐸𝐵𝐼𝑇 ⁄𝐸𝐵𝐼𝑇 (EQ 7)

Substituting, the following equation can be derived:

𝐸𝐵𝐼𝑇
DFL = 𝐷𝑝 (EQ 8)
𝐸𝐵𝐼𝑇−𝐼−
1−𝑇

Thus, the Degree of Financial Leverage helps to measure the percentage change in
EPS as a result of a 1% change in EBIT. Further, it is possible to determine the financial
break-even point, that is, the value of EBIT at which EPS will be zero. The financial break-
even point can be determined from the following equation:

𝑝𝐷
EBIT = I + 1−𝑇 (EQ 9)

The degree of financial leverage helps us to measure the financial risk. The financial
risk arises due to raising of debt capital. The DFL ascertains the effect of interest and thereby
gives a view about the financial risk. Higher the DFL, higher are likely to be the interest
payments. A high DFL makes the EPS more volatile.

Total Leverage
A combination of Operating Leverage and Financial Leverage gives us the Total
Leverage. The Degree of Total Leverage (DTL), which helps to understand the sensitivity of
EPS to Q, is defined as follows:

∆𝐸𝑃𝑆 ⁄𝐸𝑃𝑆
DTL = ∆𝑄⁄𝑄
(EQ 10)

DTL may be calculated as the product of DOL and DFL, thus

DTL = DOL X DFL

𝑄( 𝑃−𝑉) 𝑄(𝑃−𝑉)−𝐹
= 𝑄(𝑃−𝑉)−𝐹 X 𝐷𝑝
𝑄(𝑃−𝑉)−𝐹−𝐼−
1−𝑇

𝑄(𝑃−𝑉)
= 𝐷𝑝 (EQ 11)
𝑄(𝑃−𝑉)−𝐹−𝐼−
1−𝑇
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The degree of total leverage helps us to measure the percentage change in EPS as a
result of a 1% change in Q. Further, it is possible to determine the overall break-even point,
that is, the value of Q at which EPS will be zero. The overall break-even point can be
determined from the following equation:

𝐷𝑝
𝐹+ 𝐼+
1−𝑇
Q= 𝑃−𝑉
(EQ 12)

The degree of total leverage helps us to measure one of the factors of total risk. The
other factor is the variability of output. Together, the two factors help us to analyse the
variability of EPS. Using the degree of total leverage, we can measure the extent to which
EPS may vary from its forecast value, if there is an error in the forecast value of Q. In order
to manage risk, a firm cannot impose a high financial leverage on a high operating leverage.

Earnings Estimates
Standard approach to estimating future earnings
(Graham, The Intelligent Investor, 2003)

The steps involved in the standard approach to estimating future earnings are as follows:

4) Evaluate the general economic conditions and make forecasts about the gross national
product as well as the impact thereof on the industry under study and the company for
which the earnings estimates are to be made.The prospects for the economy and the
industry will have a bearing on the future prospects of the Company.
5) A meaningful study of an industry will require:
a) field visits
b) interview of researchers
c) intensive inquiry into technological advances
6) From the past data obtain the average of the following:
a) physical volume
b) prices received
c) operating margin
7) Calculate estimated future sales, making appropriate assumptions about expected
changes in the volume and prices. The comments made by the Chairman and the
Directors will provide valuable guidance for making such assumptions.
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8) Applying the operating margin ratio, the estimated earnings before interest and tax
can be calculated
9) Interest and tax burdens can be incorporated on the basis of the expected rates
10) The estimated earnings after interest and tax are then multiplied by a “capitalization
factor”, based on the under-mentioned factors, in order to arrive at the projected
market value
a) General long-term prospects
b) Management
c) Financial Strength and Capital Structure
d) Dividend Record
e) Current Dividend Rate (Payout Ratio)
11) Since the foregoing procedure is not dependable, diversification is a must

Graham’s suggested approach to estimating future earnings

(Graham, The Intelligent Investor, 2003)

12) Determine the “past-performance value”

a) For this, solely the data relating to the past would be used
b) It would be assumed that the conditions prevailing in the last seven years would
continue to prevail in the next seven years
c) The process would be carried out mechanically applying a formula that would
give appropriate “weights to past figures for profitability, stability and growth and
also for current financial condition”.
13) Adjust the “past-performance value” taking into consideration the changes expected
to take place in the future

Other Approaches
As stated by Fisher & Jordan, the following are the different approaches which may
be used for estimating the earnings:
1) The Return-on-Investment Approach
2) The Market Share/Profit-Margin Approach
3) Independent Forecasts of Revenue and Expenses
a) Forecasting each and every revenue item separately
b) Broader-brush Approach
4) Regression Analysis, Correlation Analysis, Trend Analysis, Decision-tree Analysis and
Simulation
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Valuation

Philosophy of valuation
1) There is a need to understand what the value is
2) It is also necessary to understand the source of that value
3) There is uncertainty in the exercise because of:
a) The nature of the asset itself
b) The method employed to determine the value
4) The value of a financial asset depends upon the future cash flows expected from the
asset and the growth in those expected cash flows
5) An investor should not pay more for an asset than it is worth

Concept of fair value

(Francis, 1986)

Fair Value is the true value of a stock based on appropriate criteria. Fundamental
Analysis aims at determining this fair value or intrinsic value of a Company’s shares using
the past, present and projected future information relating to earnings. The past provides
factual data relating to the actual performance of the Company. The present helps to focus on
the earnings yield currently offered by the Company. In a dynamic world, however, it is
necessary to make a reasonable and rational forecast of the future earnings. The present value
of the future cash flows represents the fair value or intrinsic value. Even though complex
mathematical formulae are used for such an exercise, due to the uncertainties of the future,
one can never arrive at an estimate which will prove to be precisely correct. However, in the
words of Warren Buffet "It is better to be approximately right than precisely wrong."

Damodaran writes: “ For lack of a better definition, consider it the value that would be
attached to the firm by an unbiased analyst, who not only estimates the expected cash flows
for the firm correctly, given the information available at the time, but also attaches the right
discount rate to value these cash flows.”

Graham & Dodd suggest that:

1) Intrinsic Value should be determined on the basis of certain analytical standards

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a) Value based on facts relating to ‘assets, earnings, dividends, definite

prospects’
b) This value is neither definite nor as easily determinable as the market price
c) One view is that the Intrinsic Value depends upon the ‘Earnings Power’, but
the ‘Earnings Power’ itself cannot be determined with accuracy
d) However, the security analyst does not intend to determine the exact intrinsic
value
e) The analyst primarily attempts to determine approximately whether the value
is adequate to purchase the share or that the value is much higher or lower
than the market price
f) The concept of Intrinsic Value is flexible and the analyst could provide a
“range of approximate value”
g) The reliability of the value depends upon factors such as stability of the
business and the general level of certainty
2) The time to buy should be associated with an attractive price in relation to such an
intrinsic value
3) The time to sell would also be when the price has gone unreasonably higher than such
a value
4) The buy and sell decisions should not be taken on the basis of market signals

Core principles
(Graham, The Intelligent Investor, 2003)

1) Underlying Value does not depend on the price of a stock

2) The Market swings like a pendulum between Unsustainable Optimism and Unjustified
Pessimism
3) The Intelligent Investor is a realist who sells to optimists and buys from pessimists
4) The future value is a function of the price you pay
5) No investor can ever eliminate the risk of being wrong; this risk can be minimised by
maintaining a “margin of safety”
6) “The secret to your financial success is inside yourself . . . how your investments
behave is much less important than how you behave”
7) The risk is not in the stocks you own, but in you. It is important to make a realistic
assessment of the probability that your decision will be right and how you will react if
your decision turns out to be wrong:
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a. Is your confidence well-calibrated?

i. How much experience do you have?
ii. What is the typical track record of others who have attempted
the same thing in the past?
iii. If you are buying, someone else is selling. How likely is it that
this other person does not know what you know?
iv. If you are selling, some other person is buying. How likely is it
that this other person does not know what you know?
v. Have you calculated the break-even level of the stocks you
own, after taking into consideration the trading costs and taxes?
b. Have you fully understood the consequences if your analysis proves to
be wrong?
i. If you are wrong, how much could you lose?
ii. Do you have other investments to tide you over, if a particular
investment proves to be wrong?
iii. How did you behave when you last lost money?
iv. Have you controlled your own behaviour by diversifying and
through rupee-cost averaging or are you hoping to control your
behaviour only with the help of will power?
8) Even if there are obvious prospects of a business growing in terms of volume, there is
no guarantee that it will lead to profits for investors
9) The experts do not have dependable ways of identifying the most promising industries
and the most promising companies within those industries and, therefore, they
diversify widely
10) Do not lose, as the cost of losing is very high
11) The effort should, therefore, be to:
a. Minimize the odds of suffering irreversible losses
b. Maximise the chances of earning sustainable returns
c. Control self-defeating behaviour
12) Intelligent means:
a. Patient, disciplined and eager to learn
b. Harnessing of emotions and refusing to stoop to the market’s level of
irrationality
c. Think for yourself
 184

d. More a matter of “character” than “brain”

Myths about valuation

(Damodaran, 2012)

Myths relating to Valuation

a. “Myth 1: Since valuation models are quantitative, valuation is objective”
Valuation is a subjective exercise
b. “Myth 2: A well-researched and well-done valuation is timeless”
i. Firm-specific circumstances may change
ii. The factors affecting a sector may change
iii. Expectations at the level of the economy may change
c. “Myth 3: A good valuation provides a precise estimate of value”
i. Valuation is done on the basis of assumptions
ii. Cash flows and discount rates are estimated
iii. The degree of precision will also depend upon where the firm is placed
in the life cycle
d. “Myth 4: The more quantitative a model, the better the valuation’
i. The larger the number of inputs, the greater the risk of error
ii. It is the analyst who is the valuer, not the model
iii. The information that does not matter should be kept aside
e. “Myth 5: To make money on valuation, you have to assume that markets are
inefficient (but that they will become efficient)”
i. Markets do make mistakes
ii. To find these mistakes one requires a combination of skill and luck
f. “Myth 6: The product of valuation (i.e., the value) is what matters; the process
of valuation is not important”
The process of valuation helps us to understand what are the
determinants of value and provides answers to important issues such as
the following:
o Appropriate price for high growth
o Worth of brand names
o Importance of improving returns on projects
o Effect of profit margins on value
 185

The role of valuation

Valuation in Portfolio Management
1) Minimal role for a passive investor
2) Larger role for an active investor
a) Market timers would use valuation to a lesser extent
b) Long term stock pickers would give greater importance to valuation
i. Fundamental analysts would give it greater importance
ii. Technical analysts would give it peripheral importance

Valuation and fundamental analysts

Underlying Assumptions
1) It is possible to measure the relationship between value and the underlying
financial factors
2) The relationship is stable
3) Methods used:
a) Discounted cash flow models
b) Multiples such as P/E and P/BV

Valuation and chartists

1) Not much role for valuation
2) Can use values for determining support and resistance levels

Valuation and information traders

The information trader attempts to focus on the relationship between information and
changes in value, rather than value per se.

Valuation and market timers

1) Market timers attempt to predict turns in the overall market rather than in individual
stocks
2) Such market timers could value the overall market and compare it to the current level
3) They could also use the discounted cash flow technique to value individual stocks
and if they find that the number of overvalued stocks is significantly larger than the
number of undervalued stocks, then there would be reason to believe that the market
is overvalued

Valuation and efficient marketers

1) Efficient marketers believe that the price represents the true value
 186

2) Such efficient marketers can then attempt to understand what assumptions about
growth and risk are implied in a given market price
3) Such assumptions can then be critically evaluated

Valuation models
1) Discounted Cash Flow Valuation
a. Total Cash Flow Models
i. Equity Valuation
ii. Firm Valuation
b. Excess Cash Flow Models
(These models help to focus on the point that earnings in excess of
the required return create value and not the earnings per se)
c. Suitable for use where
i. Cash flows are positive
ii. Cash flows can be estimated with reasonable reliability
iii. Discount rates can be estimated by evaluating the risk
d. Since firm-specific assumptions have to be specified under this approach, the
valuation will be less affected by market factors which could affect the
valuation
e. Flexibility will be required in the following cases:
i. Firms in trouble
ii. Cyclical Firms
iii. Firms with unutilised assets
iv. Firms with unutilised patents
v. Firms in the process of restructuring
vi. Firms involved in acquisitions
vii. Private Firms
2) Relative Valuation
a. P/E, P/BV, P/Sales, P/Cash Flows
b. Industry-average ratios may be used
c. This approach places reliance on the market
d. Multiples may be compared across Companies
e. Multiples may also be compared for the same Company over a period of time
f. Approach is simple and easy to use
g. Risk and growth factors should be carefully evaluated before making
comparisons
 187

h. Errors of under-valuation or over-valuation in the market will get built into the
valuation
3) Contingent Claim Valuation
a. Option Pricing Models may be used for valuing assets which have the
characteristics of an Option
b. Patents or undeveloped reserves (of say, oil) are two such assets
c. These are assets that result in a payoff depending upon the occurrence of an
event

Determining cash flows

1) The value of an asset depends upon its capacity to generate cash flows.
2) The process of determining cash flows involves three steps:
a) Estimating earnings on the basis of existing assets and investments
b) Estimating the tax liability considering:
i. Depreciation (Difference in Accounting Depreciation and Tax
Depreciation)
ii. Deferred Tax Benefit/Liability
iii. Incentives, Subsidies and Rebates
iv. Brought forward losses
v. R & D Expenses
c) Projecting the reinvestments for future growth in:
i. Fixed Assets
 Estimate the average capital expenditures in the past 3 or 4
years
 In the case of a new firm, obtain the estimate on the basis of
industry averages (using an appropriate subset of the industry;
as a percentage of sales or total assets)
ii. Working Capital
 Exclude Cash and Marketable Securities from Current Assets,
unless a large cash balance is needed for the day-to-day
operations
 Changes in Working Capital can be negative for 3, 4 or even 5
years, due to increased efficiency in Working Capital
Management
 188

 Negative Working Capital would imply that the firm is using

supplier credit to meet its capital requirements. This could
increase the default risk of the firm and would not be viewed
favourably by rating agencies
iii. R & D
 Include the expenditure in capital expenditure
 Include the amount of amortization in the depreciation &
amortization
iv. Acquisitions
 Should be normalized in the same way as internal capital
expenditures
 Another approach could be to ignore acquisitions. However, in
that case growth arising in the past on account of acquisitions
will have to be ignored. Otherwise, the exercise will result in
over-valuation.

Estimating growth
The three ways for estimating growth rate are:

1) Historical growth rate

a) The analyst may look at the growth in revenues or the growth in
earnings
Difficulties may arise in respect of the following
matters: how the average is to be estimated (arithmetic mean or
geometric mean or linear regression), whether allowance is to
be made in respect of compounding, how negative earnings in
certain periods are to be dealt with, predicting earnings using
time series models
b) The historical growth rate may not be reliable for estimating the
growth rate for the future
c) Higgledy Piggledy Growth
d) More reliable for forecasting revenue growth than earnings growth
e) Future growth will also be affected by the size of the firm and the
systems it has put in place for handling growth
f) It may be useful to look at growth each year rather than the average
growth rate over a period of time
g) Project only in the near future, considering the rapid changes taking
place in technology
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h) Consider historical growth rates in the entire market and in the other
firms serving it and use this for projecting the growth of the firm
2) Trusting the growth rates estimated by equity research analysts
a) Damodaran suggests that analysts’ forecasts should provide better
estimates of the future growth rate than those based purely on
historical data because they are in a position to obtain information
additionally from certain sources such as the following:
i. “Firm-specific information that has been made public since the
last earnings report
ii. Macro-economic information that may impact future growth
iii. Information revealed by competitors on future prospects
iv. Private information about the firm
v. Public information other than earnings”
b) However, in actual practice, the quality of such estimates has been
found to be better only for short term forecasts for a period of one to
four quarters, but quite poor over longer periods (3 to 5 years)
c) When it comes to valuation, the forecast for a longer period is more
relevant
d) Damodaran recommends that the weight that is assigned to analysts’
forecasts should consider the following:
i. “Amount of recent firm-specific information
ii. Number of analysts following the stock
iii. Extent of disagreement between analysts
iv. Quality of analysts following the stock”
3) Estimating the growth rate from the firm’s fundamentals
a) Making such an estimate can be a challenging task
b) It is very useful to examine the inconsistencies between analysts’
estimates and the fundamentals of a firm
c) The most important factors for determining the growth rate are: how
much of the profits are retained for reinvestment (retention ratio) and
the quality of such reinvestment (which can be judged from the return
on equity)
d) In this context it is useful to determine the growth in earnings per share
and growth in net income and to breakdown the return on equity into
its components
e) Measuring the marginal return on equity will provide an understanding
of the return on more recent projects
f) If due to higher efficiency the return on equity increases, there will be
a spurt in the growth rate. Such additional growth will be generated if
there is an increase in the return on equity on old investments.
g) For estimating growth in net income, the retention ratio will be
replaced with the equity reinvestment rate.
h) For estimating growth in operating income, return on capital and the
reinvestment rate will be used.
 190

Estimating terminal value

The terminal value may be determined in one of the following three ways:

1) Liquidation Value
a) This is the value which the firm would get if all the assets were to be sold on
the cessation of its business at a future date.
b) This value will depend upon the accounting book value, adjusted for inflation.
c) Thus, this value will not reflect the earning power of the assets.
d) An alternative approach would be to determine the cash flow from the asset
after the terminal year and then discount those cash flows to the present.
e) To complete the process, it will be necessary to deduct the outstanding amount
of debt in order to arrive at the liquidation proceeds for the equity
shareholders.
2) Multiple of earnings, revenues or book value in the terminal year
a) Since the multiple will be obtained by looking at comparable firms, the
valuation so arrived at will be a relative valuation.
b) On the other hand, if the multiple is determined on the basis of fundamentals,
it will converge towards the stable growth model and can be determined with
the help of the following model:

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑡𝑜 𝐹𝑖𝑟𝑚𝑛+1

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑛+1 − 𝑔𝑛

3) Perpetual growth model

a) Estimating how long a firm will be able to maintain a high growth rate is
subjective and will depend on the following factors:
i. Size of the firm
ii. Existing growth rate and excess returns
iii. Magnitude and Sustainability of Competitive Advantages
b) After the high growth phase, firm’s go into a stable growth period.
c) It is pertinent to note that the stable growth rate cannot be greater than the
overall growth rate of the economy
d) In this context, the following observations made by Damodaran are pertinent:

“Nominal riskless rate = Real riskless rate + Expected inflation rate

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In the long term, the real riskless rate will converge on the real growth
rate of the economy and the nominal riskless rate will approach the
nominal growth rate of the economy. In fact, a simple rule of thumb on
the stable growth rate is that it should not exceed the riskless rate used
in the valuation.”
Dividend discount models

The General Model

When an investor buys shares of a company, the main cash inflow arises in the form
of dividends. The second source of cash inflow is the expected price of the shares at the end
of the holding period. This price itself depends upon the dividends expected to be received in
future. The value of the equity shares, therefore, is the present value of the dividends through
infinity, that is,
𝐸(𝐷𝑃𝑆𝑡 )
Value per share = ∑𝑛=∞
𝑛=1 (1+𝑘 𝑡
𝑒)

Where DPS = Expected dividend per share and k e = Cost of equity

The dividend will depend upon future growth rates and payout ratios. The cost of
equity will depend upon the degree of riskiness, which is determined by calculating the beta
using the CAPM.

Versions of the Model

1) The Gordon Growth Model

This is a simple model which is useful in the case of companies which:

a) are expected to have a stable growth rate

b) have a growth rate which equals or is less than the nominal growth rate of the
economy
c) have well established payout policies
d) payout a substantial part of their profits

2) Two-stage Dividend Discount Model

This model assumes that the growth can be classified in two categories, that is,
an initial phase of extraordinary growth followed by a phase of stable growth. The
model is suitable for companies which:

a) can clearly delineate the two phases of growth. For example, companies
which have patent rights which will expire after a specified time period
b) are in an industry where there are significant barriers to entry
c) have a moderate growth rate in the initial phase
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d) payout most of their cash flows remaining after repaying their debts and after
meeting their needs for reinvestment

3) The H Model for Valuing Growth

This model is a variation of the two-stage model. It assumes that the
high growth declines linearly during the phase of extraordinary growth. It is
also assumed that the dividend payout and the cost of equity are constant
throughout. Since the model requires the growth and the payout to be high, it
has limited applicability.

4) The Three-stage Dividend Discount Model

This model assumes that there would be a phase of high growth,
followed by a phase of linearly declining growth and then ultimately there
would be a third phase of stable growth. The payout ratio would be low during
the phase of high growth, it would increase during the phase of decline in the
growth rate and thereafter it would be stable. The model would require inputs
relating to year-specific payout ratios, growth rates and betas. Thus, though
the model is more flexible than the other models, the chances of errors are
much higher if there is noise in the inputs from year-to-year.

Observations about the Dividend Discount Model

It is observed that the model finds fewer and fewer undervalued stocks as the
prices of shares increase relative to their fundamentals. A similar result can be
achieved by investing in stocks which have low P/E ratios and high dividend yields.

Free cash flow to equity discount models

Free Cash Flow to Equity

The Dividend Discount Model assumes that the only cash flow to equity shareholders
is from dividends. Free cash flow to equity is defined more expansively. To determine the
free cash flow to equity the analyst must consider not what has actually been distributed to
equity shareholders, but rather the amount available for distribution to them.

Free Cash Flow to Equity (FCFE) is calculated as under:

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FCFE = Net Income – (Capital Expenditures – Depreciation) – ( Change in

Non- cash Working Capital) + (New Debt Issued – Debt Repayments) –
Preferred Dividends

Like the dividend payout ratio, it is possible to calculate the proportion of total cash
returned to equity shareholders to FCFE. This would indicate how much of the FCFE is being
paid out and how much is being retained. If the ratio is greater than 1, it would imply that the
firm is paying out more than it can afford.

Dividend
Dividend Payout Ratio = Earnings

Dividend+Equity Buybacks
Cash to Shareholders’ FCFE Ratio = FCFE

In valuation if the ratio of cash to FCFE to the shareholders is less than 1, it means
that cash is being retained and appropriate allowance should be made for this, failing which
the value will be understated.

FCFE Valuation Models

The FCFE Models are modified versions of the Dividend Discount Models. The free
cash flows replace the dividend in the models. Likewise, an appropriately modified formula
is used to compute the expected growth rate. It is found that the FCFE Models are more
appropriate for determining the value of a firm in case of takeovers or where there is a chance
of a change in the corporate control.

Free cash flow to the firm

Free Cash Flow to the Firm is the cash flow to all the stakeholders, that is, equity
shareholders, preference shareholders and lenders. This cash flow may be arrived at by
starting with the profit before interest and deducting the taxes and cash flows required for
reinvestment needs. Thus, the FCFF can be derived by using the following formula:

FCFF = EBIT(1 - Tax Rate) + Depreciation – Capital Expenditure -

∆ Working Capital

The tax benefits arising due to the payment of debt are not considered in the above
calculation. The effect of leverage is given by considering the after-tax cost of capital for
discounting purposes. The value of the firm is computed by discounting the FCFF at the
weighted average cost of capital.
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The model used for determining the value will depend upon the assumptions made
about future growth, in the same manner as the dividend discount model.

Estimating equity value per share

Once the firm value has been determined, the following further adjustments have to
be made:

1) The value of cash, marketable securities and non-operating assets has to be

added. Non-operating assets could include holdings in other companies and
assets such as undeveloped land. The principle is to determine the fair value of
such assets and include that fair value.
2) The value of non-equity claims, that is, debt and preferred shares, has to be
deducted.

The value arrived at through the above exercise has to then be divided by the number
of equity shares outstanding in order to calculate the value per share. It will, however, be
necessary to adjust for management and employee stock options. Most of those options will
have exercise prices well below the market price of the shares. This will have the effect of
reducing the value of equity. The most appropriate method for valuing options is to use an
Options Pricing Model and then applying the following formula:

Value Equity−Value of Options Outstanding

Value per Equity Share = Number of Shares Outstanding

The Value per Equity Share may require to be adjusted to incorporate differential
voting rights. It will be necessary to ascertain the premium for the shares with more voting
rights than others.

Valuation Matrices
1) Earnings Based

a) Dividend Yield - Dividend to Price Ratio

b) Earnings Yield – Earnings to Price Ratio

c) Growth Adjusted Price to Earnings Ratio (PEG Ratio)

d) Enterprise Value to EBIDTA Ratio

e) Enterprise Value (EV) to Sales Ratio

2) Assets Based
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a) Return on Equity

b) Price to Book Value Ratio

c) Return on Capital Employed (ROCE) based valuation – Enterprise Value (EV)

to Capital Employed Ratio

d) Net Assets Value Approach

3) Sum-of-the-parts Valuation

Relative valuation: fundamental principles

In the case of relative valuation, the endeavor is to value assets depending upon how
similar assets are currently priced in the market. Relative valuation involves two exercises:

1) Standardization of prices by converting them to a multiple of earnings, book

values or sales
2) Finding similar firms, which is a difficult task because no two firms are the
same considering their risk characteristics, growth potential and cash flows

Relative valuation is popularly employed due to the following reasons:

1) It requires fewer assumptions

2) It can be carried out relatively quickly than a discounted cash flow valuation
3) It is simpler to understand
4) It is much more likely to reflect the mood of the market

The drawbacks of relative valuation are:

1) It ignores risk, growth and cash flow considerations

2) The mood of the market influences the value determined
3) There is lack of transparency regarding the assumptions made, which offers
scope for biased valuations by analysts

The different multiples which are used are:

1) Earnings Multiples
a) Use of current earnings will yield a current P/E Ratio
b) Use of earnings of the last 4 quarters will result in a trailing P/E Ratio
c) Use of expected earnings per share in the next year will provide a
forward P/E Ratio
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2) Book Value Multiples

a) Use of the book value will provide the P/BV Ratio
b) Instead of the book value one may use the replacement cost, since
book values do not represent the true value of assets
3) Revenue Multiples
a) Use of sales will yield the Price/Sales Ratio
b) This facilitates comparison of firms in different markets and
employing different accounting systems
4) Sector-specific Multiples
a) For example, e-tailers may be judged by the number of hits on their
websites
b) Such multiples can result in persistent over or under-valuation relative
to the rest of the market as investors may have no sense of what is a
high, low or average multiple
c) It may be difficult to relate such a multiple to fundamentals

Steps to Using Multiples Wisely

1) Definitional tests
a) Numerator and denominator should be consistently defined
b) The multiple should be uniformly defined across all firms in the group
c) Adjustments may be required for differences in Accounting Standards
employed
2) Descriptional Tests
a) It is useful if one has a sense of what is a high value, low value and a
typical value of a multiple
b) One also needs to have awareness about high, low and typical values
across sectors in order to know when a particular sector is under or
over-valued.
c) Percentile values can be useful in this exercise.
d) It would also be appropriate to ignore outliers while calculating
averages or it may be better to use the median value.
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e) If firms which are losing money get excluded from the exercise, it
would be better to determine the multiple using aggregate values of all
the firms put together in order to avoid biases in calculation.
3) Analytical Tests
a) Though the assumptions made in a relative valuation are not stated, the
fact remains that implicit assumptions are made. It is important to be
aware of the following:
i. The fundamentals that influence the multiple (risk, growth and
cash flow generating potential)
ii. Effect of changes in the fundamentals on the multiple
b) It is possible to use simple discounted cash flow models for deriving
the multiples
c) Such discounted cash flow models can also be used to analyse the
relationship between each fundamental variable and the multiple by
asking what-if questions.
d) Usually, it is possible to identify one variable which dominates the
relationship and explains changes in the multiple to a great extent.
Such a variable is called the ‘companion variable’. The ‘companion
variable’ can be identified by examining multiples across different
firms and across the entire market.
4) Application Tests
a) A comparable firm is one which has a similar risk, growth and cash
generating profile.
b) Firms in the same industry are preferred for comparison purposes, but
if valuation fundamentals (beta, expected growth rate in EPS and
ROE) match one can find comparable firms across the market.
c) The analyst will have to control for differences in fundamentals using
statistical techniques such as multiple regressions.

Questions

1) What are the different aspects which an analyst will have to look into while
examining the organization structure and the following functional areas of a company:
a) Production, Technology and R & D
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b) Purchasing
c) Marketing
d) Human Resource Management

2) Which are the factors which an analyst should consider for critically evaluating the
Management of a company?
3) What inferences can be drawn from the CSR activities of a company?
4) How will a SWOT analysis and the 7S framework suggested by McKinsey help the
analyst?
5) What information can an analyst gather from the following:
a) The Chairman’s Statement
b) The Directors’ Report
c) Corporate Social Responsibility Report
d) Corporate Governance Report
e) Auditors’ Certificate on Corporate Governance
f) Business Responsibility Report
g) Management Discussion and Analysis Report
h) Secretarial Audit Report
7) What adjustments may be required to be made by an analyst to the earnings as
disclosed by financial statements?
8) Explain the utility of common-size statements in a time series fashion.
9) Explain how trend statements can be used to make cross-sectional comparisons.
10) What are the advantages of using financial ratios as opposed to the absolute values in
financial statements?
11) Elucidate the components of return on equity with the help of the DuPont System.
12) Is the use of industry averages as benchmarks in ratio analysis justified?
13) Explain the 10 major cost drivers identified by Porter.
14) Explain the concept of ‘Leverage’.
15) How does the break-even point affect the business risk of a company?
16) Which are the different approaches that can be employed for making earnings’
estimates?
17) Explain the process which has to be followed for determining cash flows from the
earnings.
18) Elucidate the three ways in which growth may be estimated.
19) What are the three ways for estimating the terminal value?
20) Explain the Dividend Discount Models and the Free Cash Flow to Equity Valuation
Models.
21) How is the Free Cash Flow to the Firm determined?
22) How would you estimate the Cost per Equity share?
23) Explain the fundamental principles relating to Relative Valuation.
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Chapter

Company Analysis: Financial Modelling, Risk and Return

What Financial Modelling Is
Financial Modelling includes the preparation of a simple spreadsheet to add up
expenses as also the preparation of a sophisticated model for determining the risk of a project.
It involves analysis of data with a view to finding solutions to business problems. It requires
bringing together financial skills, modelling and design methodology.
A model helps to achieve the following objectives:
1) It facilitates the processing of data and converting it into information suitable for
management decision making.
2) It helps to learn more about the behavior of different variables.
3) It provides a clearer understanding of the processes and the relationships between
different variables.
4) It leads to a discovery of the key variables and their sensitivity.
5) It helps to understand the possible effects of different scenarios.

Tools for Financial Modelling

The Microsoft Excel Software is the most commonly used tool for financial modeling.
The main advantages of this software are its simplicity and its versatility in handling data. It
includes specialist functions, macros for automating spreadsheets and add-ins such as solver
for targeting and optimization which make it a sophisticated software. Models could also be
built with the help of other spreadsheets or, in specialized situations, using statistical
packages.

EXCEL Functions
Some of the relevant Excel features/functions used for this purpose are:

1) Net Present Value

Given a series of cash flows, using this function it is possible determine the
Net Present Value of the stream of cash flows. The discount rate will have to be
specified. The cash flows must occur at regular intervals.
2) Internal Rate of Return
The IRR is the discount rate at which the NPV of the cash flow stream equals
zero. For using this function, a “guess” has to be provided. The “guess” provides a
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starting point for carrying out the iteration process which is involved in this
calculation. This function can be used for determining a geometric average growth
rate.
3) Sensitivity Analysis
Using a data table it is possible to vary one or two inputs and perform a
sensitivity analysis.
4) The Goal Seek Command
This function enables finding answers to ‘what-if’ questions by working back
from an answer. This function can be used when there are no rules and constraints. If
rules and constraints are to be specified, one needs to use Solver.
5) Scenario Manager
Using the Scenario Manager function, it is possible to create scenarios such as
optimistic, pessimistic and most likely.
6) Excel Solver
The Solver is a more advanced form of Goalseek and can be used in ‘what-if’
scenarios based on adjustable cells, constraint cells, and optionally, cells that must be
maximized or minimized.
7) Relevant Statistical Functions
a) Estimating Straight Line Relationships
b) Modelling Exponential Growth
c) Using Correlations to Summarize Relationships
d) Multiple Regression
e) Modelling Nonlinearities and Interactions
f) Making Probability Statements from Forecasts
8) Black-Scholes Option Pricing Model
9) Pivot Tables

Application of EXCEL Functions

Financial Appraisal of Historical Performance
1) Profit & Loss Account
2) Balance Sheet
3) Cash Flow Statement
4) Ratio Analysis
5) Common size Statements
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6) Trend Analysis
7) Comparative Statement Analysis
8) Leverage

Financial Forecasting
1) Estimating Revenues, Costs and Earnings
2) Estimating Assets, Liabilities and Equity and their constituents
3) Estimating Cash Flows
4) Building Scenarios
5) Sensitivity Table showing a Range of Results

Valuation
1) Dividend Discount Model
2) Free Cash Flow Valuation
3) Relative Valuation
4) Cost of Capital and Terminal Value

Statistical Functions for Risk Management

1) Beta
2) Standard Deviation
3) Correlation
4) Markowitz Diversification

Performance Measurement:
1) Sharpe’s Model
2) Treynor’s Model

Risk and Return

Return
Investors invest in equities because of the returns such investments offer. The return
‘r’ may be defined as under:

r=i+p+b+f+m+o

where:

i = real interest rate (riskless rate)

p = purchasing-power-risk allowance
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b = business-risk allowance

f = financial-risk allowance

m = market-risk allowance

o = allowance for “other risks”

Risk in holding securities

(Francis, 1986)

While investors like return, they dislike risk. Risk arises because of factors which
contribute to variations in return. If such factors are external to the firm, affect a large number
of securities and cannot be controlled, they are referred to as sources of Systematic Risk. On
the other hand, if such factors are internal, affect some specific industries and/or firms and
are controllable, they are referred to as sources of Unsystematic Risk.

Systematic Risk
1) Market Risk

2) Interest-Rate Risk

3) Purchasing-Power Risk

4) Political Risk

Unsystematic Risk
1) Business Risk

2) Financial Risk

3) Management Risk

i. Acts of God

ii. Product Obsolescence

iii. Loss of Important Customers

4) Callability Risk

5) Convertibility Risk

6) Marketability Risk

Since investors dislike risk, they invest in more than just one, two or even three securities.
The effect of such diversification is represented in the following diagram:

Risk
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Total Risk

Unique Risk or Unsystematic Risk

Market Risk or Systematic Risk

No. of Securities

Measuring Return
(Fuller, 1987)

Return may be measured using the following formula:

r t = {(P t – P t-1) + D t}/P t-1

For calculating the average return over a period of time, one may calculate:

1) The Arithmetic Mean, or

2) The Geometric Mean

Measuring Risk
(Fuller, 1987)

Risk, which arises due to the variability of returns, may be measured using the following
formula:

1) Standard Deviation, that is, the average deviation from the mean return

2) Variance

3) As the number of stocks in a portfolio is increased, the unsystematic risk is

diversified away, leaving only the market-related risk
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Valuation and Risk-Return Theory

(Francis, 1986)

Comparing Price with Value

Price is determined by value. However, determining the value is a difficult exercise.
The price frequently goes below or above the value.

The buy and sell rules, which professional investors follow, can be stated as under:

1) Buy when the price < value (as the security is under-priced)
2) Sell when the price > value (as the security is over-priced)
3) Don’t trade when the price = value (as there is nothing to be gained)

The naïve investors, who do not understand this end up buying when the price is
above the value and selling when the price has gone below the value.

Cootner’s Price-Value Interaction Model

Price
Upper Reflecting Barrier

Value

Price

Lower Reflecting Barrier

Time

Cootner suggested that the investors in the market could be classified as naïve
investors and as professional investors. In the above diagram, value represents the consensus
estimate arrived at by the professional investors. When the price equals value, the market is
in equilibrium. The naïve investors tend to buy when the price is higher than the intrinsic
value. When the price goes above the value significantly, the professional investors sell the
security and this pushes the price down. The naïve investors again tend to sell when the price
has fallen below the intrinsic value. The professional investors step in again when the price
has dropped significantly below the intrinsic value. The prices at which professional investors
step in are referred to as the Upper Reflecting Barrier and the Lower Reflecting Barrier.
 205

The Dynamics of Valuation and Investment

Price is determined by the forces of demand and supply prevailing at any
given time. The return depends on the price, as the capital gain to be earned will change with
every change in price.

Value is the present value of the income stream expected in the future. For
determining the present value, the returns expected in future are required to be discounted at
an appropriate rate. The discount rate depends on the risk involved. Thus, for example, the
risk will change whenever there is a change in the financial leverage.

Price and value are, thus, closely inter-twined. This dynamic relationship can be
represented in the form of the following diagram:

Price increases if demand

exceeds supply

Buy if Price < Value

Estimate the present value
Risk and Return,
of future cash flows using
based upon the Don’t trade if Price = Value
an appropriate discount
latest price of the
rate Sell if Price > Value
security
Sell if Price > Value

Prices declines if supply

exceeds demand

As stated by Francis, Jack Clark, the values change continuously… and.., “this is what
makes being a security analyst a fast, exciting and dangerous job.”

Management of Risk by Investors with Different Risk Aversion

(Graham, The Intelligent Investor, 2003)

Graham categorises investors into the following 3 categories:

1) The Casual Lay Investor

2) The Defensive Investor
3) The Enterprising Investor
 206

He makes the following recommendations for the 3 categories of investors for

managing risk:

The Casual Lay Investor

1) Should invest in a broad based index fund

2) Adopt the practice of Rupee-cost Averaging

The Defensive Investor

(Graham, The Intelligent Investor, 2003)

A defensive investor may be defined “as one interested chiefly in safety plus freedom
from bother”.

Strategy:

1) Invest in highly rated bonds and leading stocks

2) Portfolio should be well diversified
a. Graham recommends investing an equal amount in each Company included in
an Index
b. Alternatively, the investor could apply the following 7 criteria for stock
selection:
i. Adequate size of the enterprise
ii. A Sufficiently Strong Financial Position
iii. Earnings Stability
iv. Uninterrupted Dividend Record for 20 years
v. Earnings Growth (a minimum of 33% in EPS over a period of 10
years, using three year averages at the beginning and at the end)
vi. Moderate P/E Ratio (“Current price should not be more than 15 times
average earnings of the past three years”)
vii. Moderate Ratio of Price to Assets (“Current price should not be more
than 1.5 times the book value last reported. However, a multiplier of
earnings below 15 could justify a corresponding higher multiplier of
assets. As a rule of thumb we suggest that the product of the multiplier
times the ratio of price to book value should not exceed 22.5.”) This
would ensure that the ratio of earnings to price of the portfolio would
be at least as high as the return on high quality bonds.
 207

viii. Based on the above, Graham’s recommended price is calculated using

the following formula:

2
ix. 𝐺𝑟𝑎ℎ𝑎𝑚 𝑁𝑢𝑚𝑏𝑒𝑟 = √22.5 ∗ 𝐸𝑃𝑆 ∗ 𝐵𝑉𝑃𝑆

x. Graham recommends investing in at least 10 such stocks

3) Rebalance: 50-50, 25-75, 75-25 (Debt:Equity)
4) Invest regularly in order to gain advantage of rupee-cost averaging
5) Future can be approached in two ways:
a. The way of prediction – a qualitative approach (anticipating the future, which
is unpredictable)
b. The way of protection – a quantitative approach (margin of safety)
c. Best handled by way of diversification

The Enterprising Investor

(Graham, The Intelligent Investor, 2003)

1) It is very difficult to perform better than the broad average

2) One possible explanation for this is:
a. Price movements are random
b. Market is Efficient
c. The price reflects the past and current performance as well as reasonable
expectations about the future
d. The analyst is trying to "predict the unpredictable" and, hence, the effort is
ineffective
e. This is the result because there is a very large number of analysts doing the
same job and, therefore, the price reflects the consensus opinion.
3) The second possible explanation is:
Most of the analysts follow a flawed approach in that they assume an
unrealistic growth rate which cannot be sustained
4) What then can the Enterprising Investor do:
a. Follow an approach which is totally innovative and superior to what the
majority of analysts are doing
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b. Invest in undervalued stocks of secondary Companies, which are available at

two-thirds or less of the value of such stocks. He could select companies
applying the following criteria:
i. Current Ratio of at least 1.5
ii. Debt not more than 110% of the Net Working Capital
iii. No losses in the last 5 years
iv. Some current dividend
v. Earnings in the last year are greater than the earnings in the preceding
year
vi. Price is less than 120% of the net tangible assets
vii. Small companies may be bought on a group basis
viii. Graham recommends investing in at least 20 such stocks

c. A single most valuable criterion for selecting stocks could be those with a
price below their working capital value
d. Avoid second-quality issues unless they are demonstrable bargains, that is,
i. NCAV Stocks, which have positive earnings at least in the last one
year:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
ii. Net Current Assets Value = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

e. Graham recommends investing in at least 30 such stocks

Margin of Safety

(Graham, The Intelligent Investor, 2003)

The concept of ‘Margin of Safety’ is a central concept propounded by

Graham. He makes a strong case for maintaining an adequate ‘Margin of Safety’. His
observations in this regard are as under:
1) Margin of Safety for Bond holders and Preferred Stock holders
a. A High Fixed Charges Coverage Ratio provides a Margin of Safety for Bond
and Preferred Stock holders
b. Bond holders may also determine their Level of Safety by determining the
excess of "Enterprise Value" over Debt
2) Margin of Safety for Equity Shareholders
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a. Under extremely bearish conditions an investor may be able to get the same
Margin of Safety as a Bond holder if the Company has only Equity Capital
and the shares are selling at a price at which the Company could have issued
Bonds in accordance with its property and earnings power
b. Under normal circumstances, the investor's Margin of Safety lies in the excess
of earnings power of the Company above the interest rate on Bonds (The
Earning Power can be determined by taking the inverse of the P/E Ratio)
c. For Graham earning power is the amount a firm "might be expected to earn
year after year if the business conditions prevailing during the period were to
continue unchanged"
d. There is risk in paying too high a price for good-quality stocks, but there is
higher risk involved in purchasing poor-quality stocks in times when business
conditions are favourable, as the profits of such Companies are not likely to be
sustained
e. The philosophy of investing in growth stocks contravenes the principle of
margin-of-safety, as the projected future earnings are used for decision making
instead of past performance. However, there may be a margin of safety if the
evaluation of the future is done conservatively and with adequate competence.
A high degree of foresight and judgment will be involved in this exercise.
f. There is a close connection between Margin of Safety and the Principle of
Diversification. In fact, diversification is a companion to the margin-of-safety
principle.
g. Where there is no Margin of Safety, the transaction would be in the nature of a
speculative transaction.
h. A true Margin of Safety would have the following features:
i. It can be demonstrated by figures
ii. It is backed by persuasive reasoning
iii. It is supported by actual experience

Questions
1) Explain the different Excel functions used for data analysis.
2) Explain the sources of risk.
3) How are risk and return measured?
4) Explain the difference between ‘price’ and ‘value’
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Assignment(s)
I. Using the Excel functions taught in this Module, analyse the data relating to
the company selected by you.

II. Using the framework discussed, analyse the Companies selected by you
obtaining required information from the Company Annual Reports, RHPs and
other relevant sources of information.

Note: References have been given in brackets.

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Chapter

Financial Markets –Research Perspective -Others

What are Derivatives?
A derivative is an instrument which derives its value from an underlying asset. The
underlying asset may be almost any variable, including the price of live cattle, sugar, copper
or gold. We will be concerned with financial assets, such as an equity share or a stock index.
Further, the derivatives we will be concerned with are ‘futures’ contracts or ‘options’
contracts.

A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future for a certain price. Futures contracts have the following features:

1) Futures contracts are normally traded on an exchange.

2) The exchange specifies certain standardized features so that trading is possible
in the futures contracts.
3) The exchange also provides a mechanism so that both the parties are assured
that the contract will be honoured.

An option may be either a call option or a put option. A call option gives the holder
the right to buy the underlying asset by a certain date for a certain price. A put option gives
the holder the right to sell the underlying asset by a certain date for a certain price. The
following terms are relevant in respect of options contracts:

1) The price stated in the contract is known as the exercise price.

2) The date in the contract is known as the exercise date, maturity date or
expiration date.
3) American options can be exercised at any time up to the expiration date.
4) European options can be exercised only on the expiration date itself.

The following are the differences between futures contracts and option contracts:

1) In the case of a futures contract, the buyer as well as the seller are obligated to
buy/sell the underlying asset at the settlement date. In the case of an options
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contract, the buyer is not obligated to exercise his right. He will exercise the
right only if the price moves in a favourable direction from his point of view.
2) In the case of a futures contract, both the buyer and the seller have a
symmetrical risk profile. In the case of an options contract, the buyer’s risk of
loss is restricted to the premium paid, whereas the seller’s risk of loss is
unlimited.
3) The buyer of options pays the seller (writer) a premium. In the case of futures,
no premium is paid by either party.
4) The price of a futures contract is affected only by the movements in the price
of the underlying asset. The price of options is affected by the following
factors:
a) Price of the underlying asset.
b) Time remaining for the expiry of the contract
c) Volatility of the underlying asset
d) Interest rate
The following terms are relevant in the context of option contracts:
Strike Price/Exercise Price
This refers to the price at which the owner of the option can buy the
underlying stock in the case of a call option. In the case of a put option, it refers to the
price at which the owner of the option can sell the underlying stock.
At-the-Money
An option is said to be at-the-money when the current price is equal to the
strike price.
In-the-Money
A call option is said to be in-the-money if the current price is greater than the
strike price. A put option is said to be in-the-money if the current price is less than the
strike price.
Out-of-the-Money
A call option is said to be out-of-the-money if current price is below the strike
price. A put option is said to be out-of-the-money if the current price is above the
strike price.
Types of Value
Intrinsic Value
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Intrinsic Value is the amount by which an option is in-the-money. An out-of-

the-money option has no intrinsic value. It is calculated as the difference between the
current price of the underlying and the strike price of an option. Thus, if the current
price of a share is Rs. 105 and the strike price of a call option is Rs. 100, the intrinsic
value will be Rs. 5. In the case of a put option with a strike price of Rs. 50, if the
current market price is Rs. 47, the intrinsic value will be Rs. 3.
Time Value
Time value refers to the portion of the premium caused strictly by the passage
of time. The time value premium evaporates as the expiration nears. Option sellers
gain because of this decline in time value. For option buyers, time value is the biggest
enemy, particularly, closer to expiration. What is generally referred to as time value
premium includes extrinsic value premium.
Extrinsic Value
The extrinsic value reflects the volatility in the underlying stock. Thus, if a
stock has a wider trading range, the extrinsic value of the option will be higher.
Higher the extrinsic value, greater will be the tendency of the option to overreact to
changes in the price of the underlying.
Assignment
Assignment occurs when the buyer of a call or put exercises his right to ‘call
away’ the underlying stock or ‘put’ a stock to the seller (writer) of the option. It refers
to the process followed by the exchange of ‘assigning’ a specific call or put to a
trader.
Open Interest
Open interest is the total number of contracts outstanding. It is the sum of all
long positions, or equivalently, it is the sum of all short positions.
Volume of Trading
Volume is the total number of contracts traded on the day. If on a given day,
the volume of trading is greater than the open interest at the end of the day, it
indicates that there were a large number of day trades on that day.
Put-Call Ratio
This is the ratio of trading volume in put options to the trading volume in call
options. This ratio is an indicator of the market sentiment. It provides a quantitative
measure of the bullishness or bearishness of investors.
Option Greeks
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Delta
Delta measures the sensitivity of the option’s theoretical value in relation to a
change in the price of the underlying asset. The delta of a stock option is the ratio of
the change in the price of a stock option to the change in the price of the underlying
stock. The delta of a call option is positive, whereas the delta of a put option is
negative. Deltas vary between +1 and -1. The more in-the-money an option is, the
higher is its delta. The less in-the-money an option is, the lower is its delta, assuming
other factors remain constant.
If a short position is taken in options, then the delta is the number of units of
the stock the investor would have to hold in order to create a riskless hedge. For
example, assume that the delta of a call option is 0.65. This means that if the price of
the stock changes by Re. 1, the price of the call option will change by about 65 paise.
Suppose an investor has sold 10 call option contracts, that is, options to buy 1,000
shares. He can hedge his position by buying 10 x 0.65 shares, that is, 650 shares. The
gain (loss) on the options position will be offset by loss (gain) in the stock position.
For example, if the price of the stock increases by Rs. 10, the price of the options will
increase by about Rs. 6.50. From this price movement there will be a profit of Rs.
6,500 (Rs. 10 x 650) in the stock position. At the same time there will be a loss of Rs.
6,500 (Rs. 6.50 x 1,000) in the options written. If the price of the stock declines by
Rs. 10, the price of the options will decline by about Rs. 6.50. This will result in a loss
of Rs. 6,500 in the stock position and a profit of Rs. 6,500 in the options written.
Gamma
Gamma is the rate of change of the value of the option portfolio with respect
to delta, that is, it is an estimate of the change in delta for a one unit change in the
price of the underlying stock.
Vega
Vega is the rate of change of the option portfolio with respect to the asset’s
volatility, that is, if the volatility changes by one per cent, how much will the option
value change.
Theta
Theta is the rate of change of the option portfolio with the passage of time. It
is an estimate of the change in option value given a one unit change in time to
expiration. Theta values are negative because the longer an option is held, the greater
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is the effect of time decay. Hence, as the option expiry approaches, the negative value
of theta increases.
Rho
Rho is the rate of change of the option portfolio with respect to the risk-free
interest rate, that is, it is an estimate of the change in option value given a one percent
change in interest rates. Since interest rates do not change frequently, rho is not
important in the short term.

Cash and Futures Arbitrage

The cash and futures arbitrage strategy is a strategy adopted by risk averse investors
for generating risk free returns. When there are imperfections in the market, it is possible to
buy in one market and sell in the other. The return from such a strategy is risk free and is
better than that on savings account deposits as well as other risk free liquid assets.

The price of the futures of any security is a combination of the price in the cash
market and the cost of carry for the period remaining till the expiry of the futures instrument.
Thus, for example:

The one month futures price of TCS = Cash Price of TCS + Cost of Carry for a period
of one month. Further, it is to be noted that at expiry the futures price closes at the spot price
of the security.

One can benefit from arbitrage whenever the futures price is more than the spot price
+ the interest cost. An arbitrageur is always looking out for such imperfections in the market.

To illustrate, if the Cash Price of TCS is Rs. 2,400 and the Futures are quoted at Rs.
2,435, then one can purchase a share of TCS at Rs. 2,400 and sell the Futures at Rs. 2,435. If
the interest rate is 12% p. a., the share can be purchased by borrowing at 12% p. a., that is to
say, the interest cost for one month will be Rs. 24. The Futures Price being Rs. 2,435, there is
opportunity to earn an arbitrage profit of Rs. 11 {(Rs 2,435 – (2,400 + 24)}.

The following points may be noted with regards to this strategy:

1) This strategy cannot be employed at all times.

2) It works better in bull markets.
3) Choppy sideways markets also offer reasonable arbitrage opportunities.
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4) One needs to act swiftly, as arbitrage opportunities get exhausted rapidly.

5) If the Cost of Carry is very high, say 35%, it indicates that the market is
overbought and one should take profits on long positions.
6) Though the opportunities are more lucrative in individual stocks, one can also
buy Nifty Bees and sell Nifty Futures, if one desires to invest in index
arbitrage. Instead of buying Nifty Bees, large investors could buy the entire
basket of Nifty shares in the cash market.

Call and Put Options: Payoffs

Purchase of Call Option: Payoffs
If a call option with a strike price of Rs. 100 is purchased at a premium of Rs. 10, the
breakeven point will be Rs. 110 (strike price plus option premium paid). If the price of the
stock remains below Rs. 100, the buyer of the call option will incur a loss of Rs. 10, that is,
he will lose the entire premium paid by him. He will earn a profit if the price of the stock
increase above Rs. 110. If the price increases to Rs. 130, the buyer of the call option will earn
a profit of Rs. 20. The payoffs at different prices are shown in the following table as well as
depicted in the diagram below :

25
Strike Price: 100
Premium: 10 20

15
Stock at: Gain/Loss
80 -10 10
90 -10 5
100 -10
110 0 0
80 90 100 110 120 130
120 10 -5
130 20
-10

-15

Purchase of Put Option: Payoffs

If a put option with a strike price of Rs. 100 is purchased at a premium of Rs. 10, the
breakeven point will be Rs. 90 (strike price minus option premium paid). If the price of the
stock remains above Rs. 100, the buyer of the put option will incur a loss of Rs. 10, that is, he
will lose the entire premium paid by him. He will earn a profit if the price of the stock
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decreases below Rs. 90. If the price decreases to Rs. 70, the buyer of the put option will earn
a profit of Rs. 20. The payoffs at different prices are shown in the following table as well as
depicted in the diagram below :

Strike Price: 100

Premium: 10

Stock
at: Gain/Loss
70 20
80 10
90 0
100 -10

Gain/Loss on Purchase of Put Options

15

10

110 -10 5
120 -10
0 Gain/Loss
80 90 100 110 120
-5

-10

-15

Straddle
Straddle is an option strategy involving buying a call option and a put option
of the same strike price and expiration date. This strategy is employed when a large
movement is expected in the price of the underlying, but the direction of the
movement is not known. Such a strategy is useful before an event such as the
presentation of the Budget. It would also be useful when a takeover bid is being made.
The price of the stock would move up sharply if the takeover bid is successful. On the
other hand, the price of the stock would move down sharply if the bid fails. The
payoff from a straddle is depicted in the following chart:
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Call Put Straddle

Strike
Price: 100 100
Premium 10 10 20
Stock at: Gain/(Loss) Gain/(Loss) Gain/(Loss)
70 -10 20 10
80 -10 10 0
90 -10 0 -10
100 -10 -10 -20
110 0 -10 -10
120 10 -10 0
130 20 -10 10
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It is to be noted that a long straddle strategy is a difficult strategy as the

movement required for a gain is very high.

Strangle
Strangle is an option strategy involving buying a call option and a put option
of the same strike price and different strike prices. The call strike price is higher than
the put strike price. A strangle strategy is similar to a straddle strategy. In the case of a
strangle, the price of the share has to move farther than in a straddle in order to make
a profit. The downside risk is, however, lower in the case of a strangle. The profit
pattern will depend on how close the strike prices are to each other.

Hedging with Futures and Options

Hedging Using Futures

If an investor holds a portfolio of stocks and he believes that the overall market is
likely to decline temporarily, he may either sell his portfolio, or he may sell futures of the
stocks held by him. He may also sell index futures equivalent in value to the portfolio held by
him. Such action will protect the value of his portfolio as the loss in the value of the portfolio
will be offset by the value of the gain in the futures. Moreover, this arrangement will result in
considerably lower transaction costs than he would incur if he disposed of his portfolio in the
cash market and reinvested in the stocks later.

Hedging Using Put Options

Instead of selling futures, the same effect can be achieved by an investor by
purchasing put options. By buying put options on individual stocks, the investor will acquire
downside protection. The premium paid on put options will be subject to time decay and will
decline to zero on the expiration date. The premium paid is, thus, the cost of insurance of the
portfolio.
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History of Indian & Global Markets

BSE
Established in 1875
Asia’s first Stock Exchange
Market for trading in equity, debt instruments, derivatives, mutual funds
Platform for trading in equities of small-and-medium enterprises (SME)
5,500 Companies

National Stock Exchange

Nov-1992 Incorporation

Apr-1993 Recognition as a stock exchange

May-1993 Formulation of business plan

Jun-1994 Wholesale Debt Market segment goes live

Nov-1994 Capital Market (Equities) segment goes live

Oct-1995 Became largest stock exchange in the country

Apr-1996 Launch of CNX Nifty

Jun-2001 Commencement of trading in Index Options

Jul-2001 Commencement of trading in Options on Individual Securities

Nov-2001 Commencement of trading in Futures on Individual Securities

Apr-2008 Launch of India VIX

London Stock Exchange

First regulated Stock Exchange in the World came into existence in 1801

The FTSE 100 Index was launched in 1984 for tracking the movement of the 100 leading
companies listed on the Exchange

NYSE
Came into existence in 1817

World’s largest Stock Exchange by market capitalization

DJIA first published in 1896

NYSE Composite Index was started in 1966

NASDAQ
Came into existence in 1971
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World’s second-largest Stock Exchange by market capitalization

NASDAQ Composite Index was started in 1971

NASDAQ-100 Index was introduced in 1985

Other International Exchanges

Australia (ASX), Japan (Nikkei), Hong Kong (Hang Seng), Singapore (Straits Times), China
(SSE Composite), Germany (DAX), France (CAC), Luxembourg (LuxX)

Accounting Framework Affecting Equity Research

(Resource material can be accessed from http://www.icai.org/)

The research analyst needs to possess knowledge of the following so that he can understand
the financial statements and decide the adjustments required to be made to the earnings
disclosed in the accounting statements:

The Companies (Indian Accounting Standards) Rules, 2015

Preface to the Statements of Accounting Standards (revised 2004)

Framework for the Preparation and Presentation of financial Statements

Accounting Standards issued by the ICAI

Accounting Standards notified by the Central Government under the Companies Act

Regulatory Requirements
The regulatory requirements can be accessed from the following websites:

1) Reserve Bank of India

https://www.rbi.org.in/
2) Securities and Exchange Board of India
http://www.sebi.gov.in/sebiweb/
3) Insurance Regulatory and Development Authority
https://www.irda.gov.in/
4) Pension Fund Regulatory and Development Authority
http://www.pfrda.org.in/
5) Ministry of Corporate Affairs
http://www.mca.gov.in/
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Questions
1) What are Derivatives?
2) Explain the use of futures for arbitrage.
3) Describe the pay-offs in the purchase of call and put options.
4) Write short notes on Straddle and Strangle strategies.
5) How would you use futures and options for hedging?
6) Summarize the knowledge which an analyst must possess about the accounting
framework relevant for conducting equity research.
7) Explain the Salient Features of ‘Securities and Exchange Board of India (Research
Analysts) Regulations, 2014’.
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