Equity Investments - Zell Education 2024

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Required Disclaimer
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Table of Contents
Market Organization and Structure .............................................................................................................. 4
Security Market Indexes ............................................................................................................................. 51
Market Efficiency ........................................................................................................................................ 74
Overview of Equity Securities ..................................................................................................................... 89
Company Analysis: Past and Present ......................................................................................................... 105
Industry and Competitive Analysis ........................................................................................................... 115
Company Analysis: Forecasting................................................................................................................. 126
Equity Valuation: Concepts and Basic Tools ............................................................................................. 131
Formulae ................................................................................................................................................... 184
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Foreword
Zell's CFA notes have been curated with a clear purpose – To fill the gap for individuals who don't feel very
comfortable studying from extensive study notes that demand special attention. At Zell Education, we are
focused on upskilling a student professionally and personally – To ensure that a student not only clears a
level but clears it with flying colours. With this in mind, we also ensure a student is upskilled and is in line
with the professional demands of the industry.
At Zell, we don't fret about a student's background, prior knowledge, or preferences. The aim is pretty
simple; we focus on ensuring that every student is on the same page as another and with the relevant
knowledge after clearing a level – A student can genuinely be called a professional.
With a state-of-the-art learning management system, we've imbibed the highest quality standards of
teaching coupled with an excellent placement team to ensure a student goes from training to the
application of the skills he's learned. We look at experiential learning at the forefront of our training to
have a 360 based approach for every applicant to be ready to perform at the highest level!
With the aforementioned in context, we bring to you these notes, created by us, for you, to truly help
make the difference and turn your journey with us into a memorable one.
Authored by: Mohit Madhiwalla, Prabhjyot Taluja, Esha Vora

Illustrated by: Ravi Gupta
Market Organization and Structure 4
Market Organization and Structure

There might be a lot of unfamiliar terminology in this reading. You may think of this reading as a precursor
to other readings that explain these terms in detail.
Make sure that you have thoroughly understood the following key areas from this reading:
➢ The use of leverage and interpretation of margins
➢ The different types of orders and instructions
➢ The different types of secondary markets and how market regulation increases informational,
allocational and operational market efficiency
LOS 45a: Explain the main functions of the financial system.
The three main functions of the financial system are to:

1. Provide a market for entities to save, borrow, raise capital, manage risks, and trade assets.
2. Determine equilibrium returns (interest rates) based on the demand for borrowings and supply of
investments. The equilibrium rate is the point at which demand meets supply.
3. Allow efficient capital allocation.

Participants in the financial system can transfer assets and risk not only today but also across a span
of time. For example, those who do not need funds today can save money, and financial institutions
like banks may use these same funds to lend to others who do need money today. The financial system
is composed of individuals, firms, governments, charities, and others.
We will now go through each of the points above in detail.
1. Achievement of Purposes in the Financial System
The financial system facilitates saving, borrowing, raising capital, managing risks and trading assets. These
roles of the financial system are most likely to be fulfilled when:
➢ Markets are liquid.
➢ There are low transaction costs.
➢ There is availability of information.
➢ Regulations ensure the execution of financial transactions and contracts.

Savings
Suppose you plan to save some money in a mutual fund for a 3-year period. You will require some return
on your investment for the risk and time value of money. The return on these savings may enable you to
achieve certain goals like having enough money to afford higher education or even for retirement if the
investment horizon is long enough. Companies also need to save money to fund future expenses and
investments.
The financial system enables these savings via various routes like stocks, bonds, certificates of deposit,
real estate assets, mutual funds, etc.
Borrowing
You may also need to borrow money to fund high-value transactions like purchasing a house, funding
higher education or even for buying an automobile. Personal loans, home loans and business loans
facilitate individuals and businesses to fund such expenditures.
Companies may borrow money from banks or from capital markets to fulfil their working capital
requirements or for larger capital expenditures. Governments may issue debt (and thereby borrow from
the public and the financial markets) to fund their projects.
Lenders may also ask the borrowers to post collateral. For example, the collateral on a home loan could
be the house itself. If the borrower consistently does not service the loan payments, then the lender may
repossess the house (i.e. the collateral). Lenders will typically assess the credit risk of the borrower. This
may be done by calculating the credit scores and creditworthiness of the borrower.
Issuing Equity
Companies can also issue equity as an alternative to taking on debt. Suppose a company issues common
equity in exchange for cash, they do not have an interest obligation to common equity holders, but these
equity holders will have voting rights and a proportionate share of profits.
The equity issuance process involves analysts who value the equity, investment banks who help with the
fundraising, other professional services, regulators and accountants who help to spread information
about the equity issue from the company to other stakeholders.
Risk Management
Market conditions frequently change, so entities holding financial assets can be exposed to interest rate
risk, exchange rate risk, volatility in commodity prices, and credit risk from potential defaults on debt.
For instance, suppose an Indian company is expected to pay an American company in USD 3 months from
today. Suppose the U.S. dollar appreciates in value against the Indian rupee. In that case, this payment
becomes more expensive as the Indian company would have to spend more rupees to buy the same
amount of dollars. A forward contract on the U.S. dollar can fix a certain INR/USD rate, which is lower
than the expected INR/USD rate 3 months from now. The Indian company can hedge their currency risk
exposure.
Hedging a transaction usually reduces the expected risk that the trader, investor, or company will take.
Hedging instruments (like the forward contract described above) are available on exchanges, investment
banks, insurance firms and other institutions.
Exchanging Assets
This is probably the most basic function of any market since a market facilitates the exchange of goods
(or assets) by bringing together buyers and sellers. This could be as simple as exchanging stock for cash.
But it can also be slightly more complex. Currency exchanges, for example, are required for global
transactions. Suppose Indian pharmaceutical manufacturers import some raw material or ingredients
from Germany. They will need to exchange the Indian rupee for the Euro to buy these goods from the
German company. In this case, the two currencies are the assets that are being exchanged.
Utilizing Information
Investors can use the additional information that they have over other investors to make an excess
return. They can usually apply their additional knowledge to pick undervalued or overvalued assets and
then buy or sell them, respectively.
Note that while additional information has its benefits, it may also cost money to obtain this information.
So, there is a tradeoff between the costs and benefits. Also, an investor has to be correct about the
information they have, and the rest of the market must also react accordingly when they get to know this
information. Only then will trade be profitable.
2. Return Determination
Low borrowing rates encourage more borrowing and less saving, while higher rates encourage less
borrowing and more saving. The equilibrium rate is when market participants like individuals, businesses,
and governments are willing and able to borrow meets the rate at which other participants are willing
and able to lend.
These rates differ for different types of borrowing, depending on the differences in risk, liquidity, and time
to maturity of the security. The following rules can be applied in normal market conditions:
➢ The higher the risk, the higher the rate.
➢ The lower the liquidity, the higher the rate.
➢ The higher the time to maturity, the higher the rate.

3. Capital Allocation
Capital is finite, and market participants must find the most efficient use of capital. Imagine you are living
on a fixed budget and have only a small amount of savings every month. You would search for the
securities that match your risk appetite, return expectations, time horizon and other factors. Investors
assess these risks and returns of different assets to find their preferred investments.
Capital is most likely to be allocated most efficiently when all inventors are knowledgeable and have
adequate information about each asset's risk and return profile.
1. Which of the following is least likely a barrier to well-functioning financial markets?
A. Low liquidity
B. Adequate regulation
C. High transaction costs
2. Which of the following is most likely to discourage investors?
A. Variety of savings options

B. Instruments for risk management
C. High information costs
3. Low-interest rates most likely
A. Encourage savings
B. Encourage investments
C. Leave investors indifferent about savings and lending
Answers
1. B is correct. Adequate regulations protect each party in a transaction and various stakeholders
who are directly affected by the financial markets. A and C are both barriers to well-functioning
markets. Low liquidity is a barrier to efficient markets, and high transaction costs discourage
people from trading.
2. C is correct. If it is more costly to obtain information, then the net profit from a trade reduces.
This will potentially discourage investors from researching and taking positions in securities. A is
incorrect because the more options to save and invest (fixed deposits, mutual funds, stocks,
bonds, etc.), the more likely investors are to save. B is incorrect because if investors can manage
their downside risk, then they will be encouraged to take bets with a high risk-reward ratio.
3. B is correct. Companies are more likely to borrow from banks and financial institutions when
borrowing rates are low. Central banks worldwide have reduced interest rates since the middle
of 2020 to encourage more liquidity and investment. A is incorrect because savings are
discouraged when interest rates are low.
LOS 45b: Describe classifications of assets and markets.
The following list of different types of assets and markets gives a broad overview of each asset or market.
Financial Assets
These include securities (like stocks and bonds), derivative contracts, and currencies.
Real Assets
These include tangible assets like real estate, equipment, commodities, and other physical assets.
Debt and Equity
An entity that issues debt promises to repay the borrowed money via interest and principal payments.
An equity security represents ownership of the entity. The company is not obligated to pay dividends to
equity holders.
Private and Public

Publicly traded securities are traded on exchanges or through securities dealers and are regulated.
Example: Reliance Industries Ltd, ICICI bank Ltd and Tata Motors LTD are few of the largest publicly traded
securities in India.
Private securities do not trade on public exchanges. They are often illiquid and not heavily regulated.
Derivatives
The value of a derivative is “derived” from an underlying asset. For example, a call option on the NIFTY
50 index derives its value from the level of the NIFTY 50 index. The index is the underlying asset. The
underlying asset can be based on equities, equity indexes, debt, debt indexes, or other financial contracts.
Index derivatives are cash-settled contracts. The underlying assets of a physical derivative are assets like
gold, oil, wheat, sugar, etc.
Markets for immediate delivery are referred to as spot markets. For example, if you want to buy a
currency right now, you will buy it in the spot market for currencies. Forwards, futures, and options
contracts provide for the future delivery of physical and financial assets.
If you buy an option, then you have the right, but not the obligation, to buy or sell an asset at a
predetermined price at a future date. If you sell an option, you have the obligation but not the right to
deliver the asset when the buyer exercises the option.
In India, derivatives instruments are available for stocks, currency, bonds, and commodities. The NSE,
the Bombay Stock Exchange, the Multi Commodity Exchange are the main exchanges which facilitate
derivatives trading. While MCX purely deals with commodities, NSE and BSE deal exclusively in stocks.
Primary Markets and Secondary Markets

The primary market is the market for newly issued securities. When a company comes with an IPO, this is
first traded in the Primary Market and the subsequent sales of securities take place in the secondary
market.
Money Markets and Capital Markets
Money market basically refers to a section of the financial market where financial instruments with high
liquidity and short-term maturities are traded. Debt securities with less than one year of maturity trade-
in money markets.
Capital markets are where savings and investments are channeled between suppliers—people or
institutions with capital to lend or invest—and those in need. Longer-term debt securities and equity
securities with no specific maturity date trade in capital markets.
Money market - Certificates of Deposit (CD), Treasury Bills, Commercial Paper
Capital Market - Stock shares and Bonds

Traditional Investments and Alternative Investments
Traditional Investments, it means investing your money into assets that are well-known. There are three
types of traditional investment cash, shares, fixed deposits, and bonds. Most of them give a fixed return.
Investment in real estate, commodities, hedge funds, etc is termed as alternative investments. These
types of investments require huge investments and a good understanding of the market and its impact
on investments.
Traditional investments include debt and equity.
Alternative investments include hedge funds, private equity funds, commodities, real estate, collectables,
gemstones, leases, and equipment. It is more difficult to value such assets, and they may trade at
discounts. They do not necessarily trade frequently, and so they are less liquid.
They are subject to less disclosure (in the case of hedge funds or private equity funds), so they require
more due diligence.
1. Real estate is least likely a
A. Alternative investment asset

B. Real asset
C. Derivative instrument
2. A trader buys the shares of Cyient Ltd., an IT company, on the Bombay Stock Exchange. This is
most likely a
A. Primary market transaction

B. Secondary market transaction
C. Private market transaction
3. A money market mutual fund scheme most likely invests in
A. Securities with very short maturities

B. Securities with medium-term maturities
C. Securities with long-term maturities
Answers
1. C is correct. Real estate is a real (tangible) asset, and it falls under the alternative investment
category (it is not a traditional investment like stocks or bonds). Remember that alternative
investment assets are much less liquid than traditional assets. A derivative instrument is
something that derives its value from an underlying asset.
2. B is correct. The secondary market is where shares that have already been issued trade on
exchanges. A is incorrect because a primary market transaction includes companies that have
been newly issued. When they list on stock exchanges, then they are part of the secondary
market. C is incorrect because this is a public market transaction - the shares are publicly listed
on the stock market.
3. A is correct. The “money market” refers to securities that mature in less than one year. These are
short-term securities that are relatively safe, have relatively lower rates of return and are
relatively more liquid. B and C are incorrect because a money market fund would predominantly
invest in short-term securities.
LOS 45c: Describe the major types of securities, currencies, contracts, commodities, and
real assets that trade in organized markets, including their distinguishing characteristics
and major subtypes.
Securities
Securities can be classified as fixed-income or equity securities, and these individual securities can be
combined in pooled investment vehicles. Corporations and governments are the most common issuers of
individual securities. Fixed-Income Securities
These generally refer to debt instruments, and they are promises or obligations by the issuer to repay
the lender. Debt is serviced by paying interest and principal payments to the lender over a period of time.
Fixed-income securities can be classified by their time to maturity:
➢ Short-term: Maturity of less than one or two years
➢ Long-term: Maturity of longer than five to ten years
➢ Intermediate-term: In the middle of the range of maturities for a security
Bonds are usually regarded as long-term fixed-income securities, while notes are usually regarded as
intermediate-term fixed-income securities.
They can also be classified by issuer:
➢ Companies: Usually issue commercial paper. These are short-term debt instruments.
➢ Governments: May issue bills (short-term) or bonds (long-term).
➢ Banks: Usually issue certificates of deposit (CDs).

A repurchase agreement (repo) is an agreement between two parties where the borrower sells a high-
quality asset (collateral security) and has the right and the obligation to repurchase it (at a higher price)
in the future depending on the interest rate of the repo agreement. This is usually done to get some
immediate liquidity. These agreements can range from overnight borrowing to short-term borrowing.
If an investor can exchange debt security for a specified number of equity shares of the issuing company,
it is called convertible debt. The debtholder has the right but not the obligation to “convert” their debt
to equity if the market conditions are favorable.
Equity Securities
These represent ownership of the issuing entity in proportionate to the amount invested. They include:
➢ Common stock: This is a “residual claim” on a company’s assets. Interest on debt and dividends
on preferred stock are paid before dividends to common stockholders (if any dividends are paid
at all). Common stockholders also have the last claim to a company’s assets if the company
liquidates (i.e., debtholders and preferred stocks have a higher priority of claims). However,
common stockholders have voting rights.
➢ Preferred stock: These securities pay scheduled dividends, and this schedule does not usually
change. Preferred stockholders are paid dividends before common stockholders but after interest
payments on debt.
➢ Warrants: These are similar to options. They give the holder the right to buy a company’s equity
shares (usually common stock) at a fixed price before the warrant expires.
Pooled Investment Vehicles

Several investors invest in one fund. A separate investment manager manages this fund on behalf of the
investors. Investors will receive their share of the profits from the fund after managers have been paid.
➢ Mutual funds: Several investors may invest in the same mutual fund scheme and thereby provide
money for fund managers. These fund managers will then invest the money according to the
investment policy of the mutual fund scheme. Investors receive units, and the value of the
underlying investments determines the net asset value (NAV) of these units. Investors can buy
these units from the fund (open-end funds) or in the secondary market (closed-end funds).
➢ Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are mutual fund schemes that
trade like closed-end funds. There are certain provisions to ensure that the value of an ETF or ETN
will not deviate too much from the value of the underlying securities even though they are traded
on the open market. These funds are sometimes referred to as depositories, with their shares
referred to as depository receipts.
➢ Asset-backed securities: Financial assets like mortgages, credit card loans, car loans, etc., can be
pooled into securitized assets. Therefore, asset-backed securities (ABS) represent a claim to a
portion of the cash flows from a pool of financial assets. The return from such financial assets is
passed through to investors. Investors may invest in different tranches or slices of the same ABS
depending on their risk tolerance.
➢ Hedge funds: Investors in a hedge fund are called the limited partners (LP), and the hedge fund
itself is incorporated as a limited partnership. The fund manager is the general partner (GP), and
they carry out investment decisions. Hedge funds can use various strategies, and they can even
short sell assets (short sales are restricted for mutual funds or long-only funds). Hedge funds have
high minimum investment amounts, so only investors with significant wealth and investment
knowledge can directly gain exposure to hedge funds. Hedge funds usually use leverage, and their
risk-return profile is amplified due to leverage. The general partners are compensated based on
the total assets under management and performance-related fees.
Currencies
Central banks like the RBI or the Federal Reserve issue currency of the domestic economy. Some
currencies have a reserve currency status. These are held by governments and central banks all around
the world. Reserve currencies change over a long period of time, and their status highly depends on how
powerful or dominant that currency’s economy is in the context of the global economy. The U.S. dollar is
the largest reserve currency, followed by the euro, the British pound, the Japanese yen, and the Swiss
franc.
Currencies trade in the spot market for immediate delivery and in forward markets for future delivery.
Contracts
A contract is an agreement between two parties that will fulfil their respective obligations at a future date.
Financial contracts may be based on securities, currencies, commodities, or security indexes (portfolios).
They include futures, forwards, options, swaps, and insurance contracts.
Forwards
This is an agreement to buy or sell an asset at a predetermined price in the future. For example, a forward
contract to buy the U.S. dollar at the rate of Rs. 75.50 per dollar 1 month from now is an example of a
currency forward. The party that is long the forward contract will buy the U.S. dollar, and the short party
will sell the dollar.
Forward contracts are not traded on exchanges or in dealer markets. They are usually customized
contracts that are traded over the counter.
Futures
These contracts are similar to forward contracts, but they are standardized and regulated. The expiry of
the contract, amount and characteristics of the underlying will all be regulated by an exchange. They are
exchange-traded contracts and are more liquid than forwards contracts.
Swaps
One asset is swapped for another. For example, an interest rate swap is when one party that is paying a
fixed rate of interest exchanges the fixed interest payments with the other party paying a floating rate of
interest on various settlement dates.
A currency swap involves taking a loan in one currency in exchange for loaning out another currency for
a specified period of time.
An equity swap involves exchanging the rate of the return on an equity index or portfolio for a fixed
interest payment.
Options
The owner of an options contract has the right but not the obligation to buy or sell an asset at a specific
exercise price at a specified time in the future.
➢ A call option gives the option buyer the right (but not the obligation) to buy an asset.
➢ A put option gives the option buyer the right (but not the obligation) to sell an asset.
Sellers, or writers of options receive a premium when they sell the option. This is the price of the option.
But writers have the obligation but not the right to sell (in the case of calls) or buy the asset (in the case
of puts) if the buyer of the option exercises the option.
Options on currencies, stocks, stock indexes, futures, swaps, and precious metals trade on exchanges.
Dealers in the over-the-counter market also sell customized options contracts.
Insurance Contracts
These pay out a cash amount to the insurance holder if an unfavourable event occurs in the future. For
example, an automobile insurance policy can protect against certain damages to the vehicle if the
insurance policy covers it.
Some insurance contracts can be traded, and they often have tax-advantaged payouts.
Credit default swaps (CDS) are a form of insurance for fixed-income securities. They make a payment to
the CDS holder if a debt issuer defaults on their bonds. Bond investors can therefore use them to hedge
default risk.
They can also be used by speculators who do not actually hold the underlying bonds. The CDS holder’s
trade turns profitable when the issuer goes through more financial troubles than expected.
Commodities
Commodities trade in spot, forward, and futures markets.
They include:
➢ Precious metals: Gold, silver.
➢ Industrial metals: Steel, copper, aluminium.
➢ Agricultural products: Wheat, sugar.
➢ Energy products: Oil, natural gas.
➢ Credits for carbon reduction.

Futures and forward markets for commodities allow for both hedging positions and speculative trades.
For example, an oil company may sell a specified amount of oil for a future price and hedge their downside
risk, while a trader may simply speculate on the oil price (by using futures and options) without taking
physical delivery of the oil.
Real Assets
These include real estate, equipment, and machinery.
While such assets are useful for industrial uses, they are increasingly used for institutional investing
through direct and indirect routes.
The tax advantages of real assets provide incentives for high-net-worth investors or institutional investors.
However, there is a trade-off because of the high management and maintenance costs.
Additional due diligence is required because not all real assets are the same. For example, the housing
aspect of real estate can vary from individual homes to apartment buildings. Each type is subject to
different dynamics.
Because of the investment's high value and specialized nature, a particular real asset may attract a limited
number of investors. This makes these assets illiquid and difficult to value.
Also, instead of directly buying real estate, an investor can buy shares of a real estate investment trust
(REIT) or master limited partnership (MLP). These are much cheaper options that require less capital. The
investor does not actually own the real estate property; they will own an interest in entities with a direct
claim to the assets. Ownership via REITs or MLPs is much more liquid, and large sums of money are not
required to gain exposure to such investments. Another way to have indirect ownership is to buy the stock
of firms that have large ownership of real assets.
1. A hedge fund is most likely an example of
A. A repurchase agreement
B. A pooled investment vehicle
C. An equity security
2. A futures contract is a(n)
A. Unregulated contract to trade an asset at some price in the future

B. Regulated contract to trade an underlying asset at some price in the future
C. Regulated contract to trade an underlying asset at some price today
3. Oil futures may be least likely used as a hedging tool for
A. A company that sells oil as its main source of revenue

B. A speculator who makes their living from trading oil futures
C. A company that buys oil as an input in its raw materials
4. Suppose you have Rs. 1,000, you want direct exposure to high-value commercial real estate worth
crores of rupees, and you cannot take a loan. Your least likely course of action is
A. Invest in stocks of companies that own real estate

B. Invest in a small office space
C. Invest in a REIT
Answers
1. B is correct. Limited partners invest in a hedge fund that the general partners manage. Limited
partners claim the profits after managers have been paid a management fee and performance fee
(if applicable). A is incorrect because a repurchase agreement is an agreement between two
parties where one sells an asset to the other and buys it back later. C is incorrect because equity
securities are stocks or warrants. Although a hedge fund can invest in equity securities, they
themselves are not an equity security
2. B is correct. A futures and a forwards contract allows one party to buy or sell an underlying asset
at some point in the future. Futures are regulated, and forwards are not.
3. B is correct. Commodity futures can be used as hedging tools for companies that directly buy or
sell the underlying asset. A company that sells oil can sell oil futures to lock in a specific price at a
future point in time. A company that uses oil as a raw material input can buy a futures contract to
hedge an increase in input prices. These companies either take physical delivery or physically sell
the underlying asset. Traders and speculators do not take physical delivery of oil, and so they are
simply traders of the contract. They make their money from predicting oil prices correctly rather
than extracting and selling oil. They may use futures as a tool to speculate the price of oil. While
traders may have to hedge their futures positions, they do not need a hedge on the underlying
asset specifically.
4. B is correct. The whole point of REITs, MLPs and companies that invest in real estate is to allow
smaller investors to participate in the real estate sector. Rs. 1,000 is not enough to invest in a
high-value property, and so the best course of action is to invest in companies that make money
via commercial real estate.
LOS 45d: Describe the types of financial intermediaries and services that they provide.
A Financial intermediary is an entity that helps buyers and sellers to exchange securities, capital, and risk.
They provide services that ensure that financial markets and the economy functions smoothly. We will
look at the most important intermediaries and their roles in detail.
Brokers
Suppose you have Rs. 10,000 in cash, and you want to invest it in shares of Bharat Dynamics. You will
require a broker like Zerodha, Upstox, Angel Broking, etc., to help you to open a Demat account and then
facilitate the trade.
Even investment management firms will use a broker to help them find a good price on shares. These
firms make block trades (i.e., they buy many shares), and block brokers help facilitate such transactions.
Such block trades can move the share price because the institution takes a lot of supply for that share out
of the market. Block brokers help clients to hide their clients’ intentions so that they get a fair price on
the shares.
Investment banks are like the middle party between a company and investors. They offer services so that
companies can raise capital by issuing stock or debt. They also provide advisory services regarding mergers
and acquisitions and raising capital.
Dealers
Unlike brokers, dealers hold an inventory of the securities that they will then sell to other parties. They
differ from brokers because they provide liquidity to the market (i.e., they can influence the demand and
supply of securities because they effectively trade them).
They profit from the dealer’s spread. This is the difference between the price at which they are willing to
buy a security and the difference at which they are willing to sell the security. It is also called the bid-ask
spread, and we will see this later in the reading.
Broker-dealers are essentially dealers that also offer brokerage services. But there is a conflict of interest
in this case. Brokers aim to find the best price for their clients but dealers’ profit when they can use an
informational advantage to charge clients a slightly higher price and profit through the bid-ask spread as
discussed above. So, traders usually limit their dealings with broker-dealers.
Primary dealers are those who trade with central banks. They buy and sell government securities, and
this affects the money supply in the economy. For example, suppose the RBI issues new bonds and a
dealer buys some amount of these bonds. The dealer will then sell these to the clients. Now, look at it
from the client’s perspective. They have bought security and have let go of cash. This letting go of cash
reduces the money supply in the economy when several clients have bought the bonds. Conversely, a
government can buy back some bonds, thereby increasing the money supply.
Exchanges
Exchanges like the BSE, NSE, NYSE, LSE, etc., provide the primary function of a market - it is a place where
buyers and sellers meet. Exchanges may also fill the role of a broker by providing electronic order
matching but the core role to provide a venue to meet remains unchanged.
Exchanges also regulate their members. The SEBI (Securities and Exchange Board of India) is the regulator
in Indian markets, the SEC (Securities and Exchange Commission) is the regulator in U.S. markets, and the
FCA (Financial Conduct Authority) is the regulator in U.K. markets. For example, regulatory bodies require
that the companies provide accurate, relevant, and timely financial information so that markets remain
integral and efficient. Their purpose is to serve shareholders and all other stakeholders who are directly
related to the company. Exchanges obtain regulatory power through member agreements or from their
governments.
Alternative trading systems (ATS) also fulfil the trading function of exchanges, but they do not fulfil the
regulatory function. They are most effective for matching large orders (bulk orders). They are also called
electronic communication networks (ECNs) or multilateral trading facilities (MTFs). They do not reveal the
intent of their clients (just like bulk brokers), so they are referred to as dark pools.
Securitizers
A securitizer will take many securities or other assets like home loans, auto loans, credit card loans, etc.
and package them into one product. They will then sell chunks of this pool to different investors, and each
investor’s interest is the proportionate amount of their ownership of the product.
So let us assume that there is a security with thousands of credit card loans packaged into one product.
The cash flow to the product is “backed” by the cash flows that the credit card loans will receive
(remember that loans are an asset to such companies because they bring in cash flows). The returns from
these cash flows - net of securitization fees - are passed through to investors. The credit card loans
themselves are more liquid now as there is demand for them to be securitized and traded. Securitization
also reduces the funding costs of the assets in the pool.
Companies securitizing assets are called special purpose vehicles (SPV) or special purpose entities (SPE).
Recall the credit card receivable example. This credit card receivable was at some point on a bank’s
balance sheet. An SPE will essentially buy the credit card receivable from the bank. It is now an off-balance
sheet item for the bank. But the bank will still be responsible for ensuring that the customers service the
loan and performing regular checks to ensure timely payments.
This is advantageous for the bank because they get immediate liquidity. It is also advantageous when you
think about the entire pool of assets - the SPE will carry out this process from several other banks hence
reducing the risk of an individual bank going into financial distress.
The securitized assets are also sliced into different tranches (the French word for “slice”). Each tranche
will have a different risk-return profile so that investors can choose the tranche based on their risk
appetite.
Note that securitization is covered in detail in Fixed Income readings. For now, make sure that you have
at least understood the logic behind securitization.
Depository Institutions
Banks, credit unions and savings and loans (S&L) companies are regarded as depository institutions.
Customers can deposit money with such institutions and earn interest on these deposits. Such institutions
also provide transactional services and checking accounts.
Suppose you invest Rs. 1,000 with a bank. The bank is liable to pay interest to you. They will then loan Rs.
1,000 to another party so that they themselves can earn interest. The difference between the interest
earned from loans given and interest paid to customers from deposits taken is essentially how banks make
money. A bank can create a diverse portfolio of loans this way, and this is their asset base.
Such intermediaries carry out detailed credit analysis to measure the creditworthiness (credit quality) of
the individuals or entities to whom they give loans. For example, you may have to meet certain criteria to
be eligible for a home loan. If your credit score is not high enough, then you may not be eligible for the
loan.
Payday lenders lend money to companies to satisfy the wage bill, and factoring companies essentially
“buy” a company’s accounts receivables (this is covered in the Corporate Finance readings).
Intermediaries can also issue their own commercial paper or debt securities to raise liquidity. This is then
used to pay interest on deposits.
Investors can also trade securities on margin. This is when securities brokers lend their clients some
money that is a percentage of the total trade value. Prime brokers are those who lend to hedge funds or
other such institutions.
Those who invest in a banking or financial company’s stock absorb losses on loans before depositors and
other providers of capital. The more equity capital that a financial intermediary has, the safer their
depositors’ funds are. This is because additional capital allows banks and other financial institutions to
absorb losses with ease. Therefore regulations like the Basel 3 accords have been put in place.
Intermediaries who are relatively less capitalized have less incentive to diversify their portfolios of loans
because they have less risk capital at stake.
Insurance Companies
Suppose you want to protect your office building from a steep loss if there is a fire. You can purchase fire
insurance from an insurance company. You will pay an insurance premium while the insurance company
guarantees risk reduction if the fire does happen.
This is an example of property and casualty insurance. Insurance companies will make many such policies
for different hazards, and so they can diversify their pool of policies. Other companies provide life
insurance, travel insurance, etc.
A diverse pool of policies allows the insurance company to predict the estimated cash outflows and losses
in case an adverse event does take place. This is easier compared to providing only a single type of
insurance contract. Similarly, a bank diversifies its risk of default by offering various loans to various
entities (typically uncorrelated).
But there are a few inherent risks and conflicts associated with insurance companies:
➢ Moral hazard: The insured entity may take more risks since they know that they are protected to
some extent in an adverse scenario. They are more prone to making bets that are riskier than
their organization would usually take. This may be considered morally wrong because the
organization is not completely responsible for all the risk - the insurance company would have to
make a payout in an adverse scenario.
➢ Adverse selection: This issue also happens because the insurance company has more information
than the entity that is taking the policy. This is a case of insurance companies benefitting from
asymmetric information (i.e., one party has more information than the other). So, the insurance
company may selectively choose their clients who know less than them.
➢ Fraud: The insured entity may purposely damage their own property or claim fictitious losses to
collect the claim on insurance.
Starbucks pays more for employee health insurance than they do for coffee.
Arbitrageurs
Pure arbitrage refers to buying an asset in one market at a lower price and selling the same asset in
another market at a higher price. Arbitrageurs act as intermediaries since they provide liquidity and
ensure that markets remain informationally efficient. A detailed example is provided in the Derivatives
readings.
Arbitrageurs essentially seek opportunities for riskless profits. They exploit small price differences as
discussed above (price dominance) or by seeking opportunities where the sum of two parts is greater
than the whole (value additivity).
Risk arbitrageurs may use complex financial models for risk control.
Arbitrageurs may also replicate the payoff on security by combining two securities. Similar types of risk
may be traded and valued at different capacities in different markets. This provides an arbitrage
opportunity, and so even risk is distributed more efficiently.
Clearinghouses and Custodians
A clearinghouse acts as the middle entity between two parties. They provide:
➢ Escrow services: Transferring cash or assets to or from the parties involved.
➢ Guarantee of contracts: The completion of futures contracts, for example, is guaranteed by

clearinghouses, reducing the counterparty risk of a trade. Counterparty risk is the risk that a
party will not satisfy their obligations in a contract.
➢ Assurance: Clearinghouses ensure that each party in a margin trade has a minimum margin that
is maintained.
➢ Limits on trades: They limit the aggregate net order quantity (quantity of buy orders minus
quantity of sell orders) of the members in an exchange.
Sometimes clearinghouses only ensure the trades of the brokers and dealers in the market. The brokers
and dealers then ensure the trades of their retail customers.
Custodians (like the Bank of China, Credit Suisse, Deutsche Bank, etc.) ensure market integrity by holding
their client’s securities. They also help to prevent losses due to fraud or other such instances that affect
the broker or the investment manager.
1. An insurance company sells a more expensive policy to an entity that does not require that policy's
features. This is least likely an example of
A. Adverse selection
B. Moral hazard
C. Asymmetric information
2. Which of the following entities least likely holds assets and then trades them with different
clients?
A. Dealers
B. Brokers
C. Primary dealers
3. A company buys the assets of several banks and packages them into one product. They then sell
these securities to investors. This is most likely done by
A. Exchanges
B. Depository institutions
C. Securitizes
4. A clearinghouse least likely
A. Provide trading limits

B. Mitigates counterparty risk
C. Seeks to identify opportunities for riskless profit
Answers
1. B is correct. This is a case of asymmetric information because the insurance company knows more
than the client. They can select their clients accordingly, knowing that they will take a policy they
do not require. A moral hazard is when an entity takes risks that they are not entirely responsible
for - that is, the insurance policy provides a cushion for losses, which might encourage excessive
risk-taking.
2. B is correct. Brokers essentially facilitate trading by providing trading-related services; they do not
actually buy and sell securities. Dealers and broker-dealers hold inventories of securities that are
traded on dealer markets. Primary dealers deal in government securities. They, too, hold
inventory of these securities.
3. C is correct. The question described the process of securitization, and SPEs or SPVs carry this out.
They package assets like loans and sell them as one securitized product. A is incorrect because
exchanges simply allow buyers and sellers to meet. They regulate their members and provide
order matching services. B is incorrect because depository institutions (like banks) are the ones
who sell the assets; they do not make the securitized product.
4. C is correct. This is the function of arbitrageurs. Clearinghouses provide escrow services (transfer
of assets), guarantee of contract delivery (this mitigates counterparty risk), assurance that each
party in a margin transaction always has enough margin in the account, and limit the net order
quantity.
LOS 45e: Compare positions an investor can take in an asset.

Long Position
An investor or trader who owns an asset is said to have taken a long position. Even if they have the right
to own it at a future date, they are said to take a long position.
For example, if you buy a stock, you own it, so you are long the stock. Similarly, if you buy an option, then
you are long the option. Note that a trader can also be long a put option. Even though a put option gives
the holder of the option the right but not the obligation to sell the underlying asset, they are still long the
option itself.
The same applies to futures and forwards. If a trader buys a futures contract on oil, then they have an
obligation to buy the underlying asset (oil) at the expiration date.
Short Position
An investor or trader who has an obligation to deliver (sell) an asset has taken a short position. This may
also result from borrowing an asset and then “giving” it back to the owner. The point of short selling is to
benefit from a fall in the price of an asset.
Let us consider short selling a company’s shares. Say you borrow one share from a broker (who is also the
lender in this case) at a price of Rs. 100 (with the expectation that the share price will fall). You must return
this share to the broker in one month.
You can then immediately sell it in the spot market to a third party for Rs. 100. This will give you instant
cash. This cash can be deposited as collateral to guarantee that the stock can be bought back when it is
time to return the stock to the broker. You may also have to pay some interest to the lender because you
have borrowed the stock.
You are liable to pay all dividends and interest from the underlying asset to the lender during the
borrowing period. Since you have only borrowed the stock and you don’t own it, the lender is entitled to
such inflows from the asset. These are called payments-in-lieu (payments in light) of dividends and
interest. A short sale may also require the short seller to deposit additional margin in the form of cash or
short-term riskless securities.
Suppose that in one month, your price expectation is correct, and the stock price falls to Rs. 95. You can
buy back the stock at the market price (Rs. 95) and give it back to the initial lender. Look at the cash flows
from this trade. The initial cash inflow from borrowing from the broker and selling in the spot market is
Rs. 100, the cash outflow in one month’s time is Rs. 95, for a gross profit of Rs. 5 per share. The net profit
may be calculated after deducting interest and transaction charges, but you have essentially benefited
from a fall in the share price.
Short Rebate Rate
Recall that you had deposited some funds with the broker. They earn interest on these funds and may
also give you (short seller) a part of this interest. The rate at which interest is given to the short seller is
called the short rebate rate. Note that this rate is generally only given to institutional investors and is
usually 0.10% below the overnight interest rate.
Therefore, the lender’s (broker’s) return is the interest they earn from the short seller minus any rebate
they must pay back to the short seller.
Similarly, if you sell an option, then you are short of the option. You will collect a premium, but you have
an obligation to deliver the underlying (in case of a call option) if the long party exercises the option. Note
that it is important to hold the underlying asset when the long party asks for delivery.
Note that a trader can also short a put option. Even though a put option has an obligation to buy the
underlying asset, they are still short the option itself.
The same applies to futures and forwards. If a trader sells a futures contract on oil, then they have an
obligation to sell the underlying asset (oil) at the expiration date.
When do these respective positions benefit the trader?

One would take a long position when they expect an increase in the price of an asset and a short position
when they expect a decrease in the asset price.
Taking a short position also acts as a hedging tool. Suppose you observe two extremely positively
correlated assets, Asset X and Asset Y - when the price of Asset X decreases, the price of the Asset Y also
decreases. You currently hold a long position in Asset X, and you want to hedge some downside risk. You
can short sell Asset Y so that any decrease in the price of Asset X is cushioned by an increase in the value
of the short position in Asset Y.
This is common for commodities. If an oil refinery wants to hedge against a fall in oil price, then it can sell
a futures contract. Suppose the price of oil today is $71.50 per blue barrel. The company will sell 1,000
such barrels in two months’ time, and they expect that the spot price of oil two months from now will be
$70.50. So, they can sell a futures contract for $72.00 (for example) with a 2-month expiration. This means
that they will have to sell the barrels for $72.00 regardless of the spot price. Their position benefits if the
spot price in 2 months is below $72.00 because they get a better price than the market price in 2 months.
Swaps and Currencies
The long leg of an interest rate swap, for example, is when the party pays a fixed rate and receives a
floating rate. They are long the floating rate because their position benefits when floating rates increase.
But this designation is sometimes arbitrary because technically, the other party is long the fixed-rate and
short the floating rate. So, it can be said that each party is long one rate and short another.
Currencies are also similar. Suppose you hold U.S. dollars in your wallet and have paid for these in Indian
rupees. Then you are automatically long the USD and short the INR (your position benefits when the USD
appreciates and when the INR depreciates against the USD). The same logic applies to currency swaps and
futures contracts.
Leveraged Positions
Whenever an investor or trader borrows funds to buy an asset, it is said to be a leveraged position.
Investors who use leverage buy on margin. Suppose Marico is trading at Rs. 532.45 per share. If the broker
allows you to buy each share at a margin of Rs. 85.19, then you are taking a leveraged position. The
leverage ratio, in this case, is 532.45 ÷ 85.19 = 6.25 times, and we will see how this changes the risk-return
profile of the investment in the next LOS.
The borrowed funds are called the margin loan, and the interest is paid at the call money rate (this is
usually higher than the rate on government bills). This rate is lower for larger investors and if the quality
of the collateral is higher. The broker will lend more funds if the risk of the portfolio is lower.
Investors cannot borrow the entire amount that they are willing to purchase. They are required to provide
a minimum amount of equity called the initial margin requirement. This is set by either the government,
exchange, clearinghouse or broker.
The risk of using borrowed funds is called financial leverage risk. Leverage magnifies both the gains and
the losses on investment depending on the change in the underlying asset price.
1. A put option is the right to sell an underlying asset. You purchase a put option, so you are least
likely
A. Short the underlying asset

B. Short the put option
C. Long the put option
2. Suppose you are the only wheat farmer in the village. You have 0 inventory today, but you will
have it in one month. You are worried that prices will fall in one month and so the most likely
option is to
A. Sell wheat today

B. Buy a futures contract on wheat
C. Sell a futures contract on wheat
3. The short rebate rate is
A. Interest received by the client from the broker

B. Interest earned by investing excess funds from short-selling
C. Interest paid to the broker
4. The margin loan in a leveraged transaction is most likely
A. The additional funds required to maintain a leveraged position

B. Money required to enter a leveraged transaction
C. Money loaned out by the broker to enter a leveraged position
5. Leverage most likely
A. Amplifies the losses but limits the gains

B. Amplifies the gains and the losses
C. Amplifies the gains but limits losses
Answers
1. B is correct. Let us look at option C first. You have purchased a derivative contract. This means
that you are the owner of the contract and that you are long the contract (hence you are long the
option). You are effectively short the underlying asset because your position benefits when the
asset’s price decreases, and so A is valid.
2. C is correct. By selling a futures contract, you are making a promise to sell wheat (deliver the
underlying commodity) at some point in the future at a specified price. You can essentially lock in
a selling price. This hedges the risk that the price might fall below a certain limit. A is incorrect
because you do not own any wheat.
3. A is correct. The broker will have some funds to invest because the short seller has deposited a
margin. The broker may sometimes pay some part of this interest to the client, and this is the
short rebate rate. C is incorrect because this is simply a transaction cost for the client.
4. C is correct. The margin loan is borrowed by the investor from the broker to enter a leveraged
transaction. This reduces the initial equity required to take a position in the security.
5. B is correct. Leveraged positions have much higher financial risk if the investment turns sour.
Investors have previously owed a lot more than they initially invested (losses can exceed the initial
capital invested).
LOS 45f: Calculate and interpret the leverage ratio, the rate of return on a margin
transaction, and the security price at which the investor would receive a margin call.
Leverage Ratio
Leverage ratio is any one of several financial measurements that assesses the ability of a company to meet
its financial obligations.
Recall the Marico example. If the broker allows you to buy each share at a margin of Rs. 85.19 when the
shares are trading at Rs. 532.45, then the leverage ratio is 532.45 ÷ 85.19 = 6.25 times.
The initial margin requirement is Rs. 85.19 per Rs. 532.45. So, the initial margin requirement as a
percentage is 85.19 ÷ 532.45 = 16.00%. This means that your equity requirement (margin) is 16.00% of
the entire investment amount per share, and the broker will provide the remaining 84.00%.
Notice the relationship between the initial margin requirement and the leverage ratio.
Leverage Ratio = 1 ÷ Initial Margin Requirement
This data was taken from Zerodha’s trading platform for intra-day trade. Intra-day trades are trades that
are settled on the same day of the trade. This means that if you took a long position in Marico and the
share price increased by 1.00% by the end of the day, then the gross return on your investment would be
5.3245 ÷ 85.19 = 6.25%. Notice that this is the same as saying that if the share price increases by 1.00%,
then the gross leveraged return is 6.25 × 1.00% = 6.25% (i.e., the leverage ratio times the change in share
price).
Conversely, if the share price decreased by 1.00%, then the gross return would be -1.00% × 6.25 = -6.25%.
The net return would be even lower, considering trading costs like brokerage, commission, and other
charges.
This demonstrates that leverage amplifies the gains and the losses.
Now let us take a hypothetical example with a long-term trade. You want to take a long position in stock
for one year on leverage. The commission is 2-way (i.e., the same rate applies for purchase and for sale).
Suppose the following information has been provided.
Details Amount
Price per Share Rs. 45.00
Initial Margin Requirement 35%
Number of Shares Purchased 750.00
Annual Dividend per Share Rs.1.00
Call Money Rate 3.00%
Commission per Share Rs. 0.10
If the stock trades at Rs. 50 in one year, then calculate the rate of return of this investment and the effect
of leverage.
Trade Value 33,750.00
(Share price x No. of shares) (₹45 x 750)
As calculated, the total value of the investment is ₹33,750, but we do not need all this money as our
initial investment margin because we are taking leverage.
Initial Margin 11,812.50
(Initial Margin Requirement x Trade Value) (35% x 33,750)
This means that we will use only ₹11,812.50 of our own funds and borrow the remaining from our
broker.
Borrowed 21,937.50
(Trade Value – Initial Margin) (₹33,750 – 11,812.50)
But we have also paid a commission to buy these shares.

Commission = Rs. 0.10 × 750 = Rs. 75.00, and this must be added to the initial purchase.
So, the total amount of money (total equity) required to enter the trade is:
11,812.50 + 75.00 = Rs. 11,887.50.
One year later
Price 50.00
Ending Trade Value 37,500.00
(Price x No. of Shares) ( ₹50 X 750)
Total Equity 33,825.00
(Trade Value at start + commission) (₹33,750+₹75)
Gross Gain 3,675.00
(Total Value at End – (Total Value at start + (₹37500 – (₹33,750 + ₹75)

Commission)
But we must consider all the transaction benefits and costs for the net gain (i.e., dividends, interest and
commission on sale).
Dividends = 1.00 × 750 = Rs. 750 (this is a cash inflow because we receive the dividends)
Interest = 3.00% × 21,937.50 = Rs. 658.13.
Commission on Sale = 0.10 × 750 = Rs. 75.00.
Net Return = Gross Gain + Dividends – Interest – Commission on sale
Net Return = 3,675.00 + 750.00 - 658.13 - 75.00 = Rs. 3,691.88.
Net Return (%): Net return (₹) / Initial Investment of owned funds.
In percentage terms (based on the total initial equity) the net return is:
3,691.88 ÷ 11,887.50 = 31.06%.
Let us write this information as follows:
Gross Gain 3,675.00
add: Dividend 750.00
less: Interest 658.13

less: Commission on Sale 75.00
Net Return 3,691.88
Net Return % 31.06%
Now let us think about the returns without leverage. Let us assume that there are no transaction
benefits and costs at all. We can enter the trade by buying the shares with Rs. 33,750 (750 × Rs. 45), and
we can sell the shares later and earn Rs. 37,500 (750 × Rs. 50).
The return purely from a change in price without leverage and no transaction costs is (37,500 ÷ 33,750) -
1 = 11.11%.
Now let us calculate the return by using leverage (remember that there are no transaction costs, so we
must add the commission on purchase to the gross return).
The equity required is Rs. 11,812.50 and the gross return from leverage is Rs. 3,675 + Rs. 75 (commission
added back) = Rs. 3,750.00.
We have earned Rs. 3,750.00 from an equity investment of Rs. 11,812.50. The gross return from leverage
is (3,750.00 ÷ 11,812.50) = 31.75%.
Notice that this is 2.86 times the gross return without leverage.
Let us write this information in the following way:
Gross Return 3,750.00
Initial Margin 11,812.50
Gross Levered Return 31.75%
Return without Leverage 11.11%
Multiple 2.86
Let us now calculate leverage ratio by using the formula that we saw earlier:
Leverage Ratio = 1 ÷ Initial Margin Requirement = 1 ÷ 0.35 = 2.86.
The leverage ratio, therefore, tells us that there is a multiplier effect on equity. It tells us the multiple by
which the gross return on the initial equity investment is amplified.
The easiest way to think about this is that you can generate the same amount of gross return (Rs. 3,750
in this case) with a much lower amount of initial investment. When the denominator is lower, the return
is higher.
We can also think of this entire sum as a series of cash flows. To simplify the explanation, we can use the
following table:
Notation Inflow/Outflow Interpretation Amount
CF0 Cash Outflow Purchased shares with initial -11,887.50

margin and paid commission on
the purchase.
CF1 Cash Inflow Received cash from the sale of 15,579.38

investment. This is the total value
of the initial investment plus net
return on the investment (gross
return plus benefits minus costs).
After entering these cash flows in the cash flow worksheet, press IRR→ CPT, and the result is 31.06%.
This is a helpful tool if the investment horizon is more than one year because it gives an annualized return
on the equity investment.
Maintenance Margin and Margin Call
The investor must maintain a minimum equity percentage in the account to make sure that the asset’s
value covers the loan. This is the maintenance margin.
The minimum margin varies from one broker to another. Also, the more volatile the stock, the higher the
required maintenance margin.
If the balance in the account falls below the maintenance margin, the investor will receive a margin call
so that the margin can be brought back up to the minimum amount. The investor will then have to deposit
funds into the account. If they fail to do so, the broker will have to square off the position.
The margin call is triggered if the stock price falls to a certain level. The stock price determines the
position's value, so the margin call is triggered if the value falls below the threshold. The price at which
the investor receives a margin call is:
𝟏−𝒊𝒏𝒊𝒕𝒊𝒂𝒍 𝒎𝒂𝒓𝒈𝒊𝒏
Margin call price = 𝑷𝟎 ( )
𝟏−𝒎𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆 𝒎𝒂𝒓𝒈𝒊𝒏
Where,
𝑃0 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒

The initial margin for a short sale depends on the value of the shares that were borrowed from the broker.
It is usually a percentage of this borrowed value. This is done to protect the broker if the share price
increases. Since the value of a short position decreases when the stock price increases, the margin call
may occur when the stock price increases.
Let's say you buy shares where the initial margin requirement is 60% and the maintenance margin
requirement is 40%. The initial price of the security, denoted as P₀, is $1,000.
To determine when a margin call would be triggered, we use the formula:
Margin Call Trigger Price = P₀ * ((1 - Initial Margin) / (1 - Maintenance Margin))
Therefore, a margin call would be triggered when the price drops below:
Margin Call Trigger Price = $1,000 * ((1 - 0.60) / (1 - 0.40))
= $1,000 * (0.40 / 0.60)
= $1,000 * 0.6667
= $666.67
So, if the price of the security falls to or below $666.67, a margin call would be triggered. At this point, the
borrower (seller) would be required to provide additional collateral or funds to meet the maintenance
margin requirement, or the lender (buyer) may sell the security to recover their investment.
Use the following information for questions 1 and 2.
An investor wants to make a trade by using leverage. They buy 1,000 shares at a price of Rs. 79, and the
initial margin requirement is 45%. The company pays Rs. 1.00 dividend per share each year, and the
investor will receive this during their investment horizon of 1 year. The broker charges a commission only
on sale of Rs. 0.1 per share, and the call money rate is 2.50%. The price in one year appreciates by 10.00%.
1. Calculate the net profit on the investment.
A. 21.36%
B. 21.70%
C. 18.21%
2. Calculate the leverage ratio.
A. 2.22
B. 1.82
C. 0.45
Use the following information for questions 3 and 4.
An investor wants to make a trade by using leverage. They buy 2,000 shares at a price of Rs. 40, and the
leverage ratio is 5.00. The company pays no dividend. The broker charges a commission of 0.20 per share
on purchase and sale, and the call money rate is 4.50% for the two-year holding period. The price in two
years appreciates by 3.00%.
3. Calculate the absolute net profit on the investment.
A. -7.80%
B. -8.00%
C. 1.37%
4. Calculate the IRR on the investment.
A. -3.98%
B. -3.90%
C. Not computable
5. The leverage ratio on an investment worth Rs. 10,000 is 4.50 times. The price of the share is Rs.
51.25. The maintenance margin is the initial margin minus 10.00%. Calculate the price at which the
investor receives a margin call if they take a long position in the stock.
A. 57.84
B. 45.41
C. 46.13
Answers
1. B is correct. A is incorrect because it takes the commission on sale and on purchase. This increases
the initial equity required and reduces the return. C is incorrect because it takes the initial margin
requirement 55% of the traded value. Remember that 55% is borrowed, not owned by the investor.
Details Amount
Price per Share 79.00
Number of Shares Purchased 1,000
Annual Dividend per Share 1.00
Sales Commission per Share 0.10
Trade Value 79,000.00 1,000 × 79.00
Initial Margin 35,550.00 45% × 79,000.00

Borrowed 43,450.00 55% × 79,000.00
Commission on Purchase 0
Total Equity Required 35,550.00 0 + 35,550.00
One year later
Price 86.90 1.10 × 79.00
Ending Trade Value 86,900.00 10,000 × 86.90
Gross Gain 7,900.00 86,900 – 79,000
Gross Gain 7,900.00
add: Dividend 1,000.00
less: Interest 1,086.25
Net Return 7,713.75
Net Return % 21.70% 7,713.75 ÷ 35.550.00

2. A is correct.
Leverage Ratio = 1 ÷ Initial Margin Requirement = 1 ÷ 0.45 = 2.22.

B is incorrect because it takes 1 ÷ 0.55. C is incorrect because this is the initial margin requirement.
3. A is correct. The initial margin requirement is calculated as 1 ÷ Leverage Ratio.
1 ÷ 5.00 = 20.%.
B is incorrect because the net return calculation does not add 400.00 to the initial equity
calculation. So, it takes -1,280 ÷ 16,000 = -8.00%. C is incorrect because it takes the initial margin
as 80% rather than 20%. Note that this question illustrates that the gross gain can be positive, but
the net return can be negative due to transaction costs.
Details Amount
Price per Share 40.00
Number of Shares Purchased 2000.00
Annual Dividend per Share 0.00
Two-way Commission per Share 0.20
Trade Value 80,000.00 2,000 × 40.00
Initial Margin 16,000.00 20% × 80,000.00
Borrowed 64,000.00 80% × 80,000.00
Commission on Purchase 400.00
Total Equity Required 16,400.00 400.00 + 16,000.00

Two years later
Price 41.20 40.00 × 1.03
Ending Trade Value 82,400.00 2,000 × 41.20
Gross Gain 2,000.00 82,400.00 – 80,400.00
Gross Gain 2,000.00
add: Dividend -
less: Interest 2,880.00
Net Return -1,280.00
Net Return % -7.80% -1,280.00 ÷ 16,400.00
4. A is correct. B is incorrect because it simply takes the net return and divides it by 2. C is incorrect
because it considers only the net return in CF2. Remember that the total sale value is the initial
investment value plus net profit.
Notation Inflow/Outflow Interpretation Amount
CF0 Cash Outflow Purchased shares with initial margin -16,400.00

and paid commission on the
purchase.
CF1 No Cash Flow There is no cash flow in the first year. 0.00
CF2 Cash Inflow Received cash from the sale of 15,120.00

investment. This is the total value of
the initial investment plus net return
on the investment (gross return plus
benefits minus costs).
5. B is correct.
51.25 × (1 - 22.22%) ÷ (1 - 12.22%) = 45.41.
A is incorrect because it swaps the numerator and denominator. C is incorrect because this is
simply 90% (1 - 10%) of the share price.
LOS 45g: Compare execution, validity, and clearing instructions.

Bid and Ask Prices
Dealers and brokers give prices at which they will buy and sell a security. The bid price is the price at which
a dealer will buy the security, and the ask (or offer) price is the price at which they will sell the security.
Consider the following quote from a broker: 45.50 - 46.00. The bid price is Rs. 45.50, and the ask price is
Rs. 46.00. Suppose you want to buy the security. At what price can you buy it?
If the seller is selling at Rs. 46.00 then you can buy it at Rs. 46.00.
The difference between the bid price and the ask price is called the bid-ask spread. This is how dealers
make money.
Now consider bid-ask prices that are quoted on stock exchanges for shares. The share “market” is where
all buyers and sellers come together. So, there will be many positions willing to buy at Rs. 45.50 and many
positions willing to sell at Rs. 46.00. So, we can say that there will be a certain quantity of orders for each
price. This is the bid quantity or ask quantity for each price.
Now let us consider three different sellers who each have the same number of shares to sell. Suppose all
of them have 100 shares of the same company but are willing to sell at different prices. One of them
quotes Rs. 47.00, the other quotes Rs. 46.00 and the other quotes Rs. 45.00. The best ask (or the best
offer) is Rs. 45.00 because this is the lowest asking price to sell the shares. This is the quotation for the
ask price.
Similarly, there will be many buyers willing to buy the 100 shares at different prices. Some will quote Rs.
44.50 while others will quote Rs. 45.00 (suppose this is the highest price from all the buyers). The best bid
is the highest price that one will pay to buy the shares. This is the quotation for the bid price.
A market is made when the best bid meets the best ask, and the trade may be made. Think of it as a very
high-frequency auction system. The one who offers the lowest price to sell an asset and the one who
offers the highest price to buy it are the most likely to execute their trade. The trade is made when these
prices match.
Bid-Ask Spreads
The bid-ask spread (as a percentage of the share price) is lower for those securities that are liquid (trade
more often and have many buyers and sellers). They are also lower for less volatile securities.
This reduces the transaction costs for investors.
Market Makers and Market Takers
Traders who post bids and offers (like we saw above) are said to make a market. They are essentially
telling the market that they are willing to make a trade at a certain quantity and at a certain price.
Traders who trade at these prices are said to take the market.
Market Instructions
Investors and traders must enter the specific size (quantity) and price of the securities and if they want
to buy or sell. They can also give instructions regarding how they want to trade, validity instructions for
the criteria of filling an order and clearing instructions that specify how the trade must be settled.
LOS 45h: Compare market orders with limit orders.
Execution Instructions
Market Order
A market order as an instruction to trade immediately. It takes the best bid or best ask for a given quantity
of the sale or purchase, respectively.
A market order is most appropriate for quick execution. It is most useful when the trader believes that
they have information that is not currently priced into the security and wants to buy or sell it as soon as
possible.
However, market orders may execute at unfavourable prices if the security has a lower quantity of bids
or offers at that specific price. Suppose a trader wants to sell 1,000 shares and the top two bids are for
Rs. 100 for a quantity of 300 and Rs. 98 for a quantity of 700. So, 700 of the traders’ shares will be executed
at a much lower price. The same thing can happen for a buy order.
This price difference is called a price concession that a trader must take if they want immediate liquidity.
Such concessions are unpredictable depending on the market conditions.
Limit Order
A limit order is a minimum execution price on sell orders and a maximum execution price on buy orders.
Suppose the shares of a company are trading at Rs. 121.00. A trader places a limit buy order at Rs. 120.50.
This means that the order will not execute at any price above Rs. 120.50 (i.e., the order will not be filled
at the current market price, it will only be filled if the share price reaches Rs. 120.50 or lower).
Suppose a trader places a limit sell order at Rs. 122.50. This means that the order will not execute at any
price below Rs. 122.50 (i.e., the order will not be filled at the current market price, it will only be filled if
the share price reaches Rs. 122.50 or higher).
This is done to avoid the possibility of price concessions. However, there is a risk that the order might not
execute at all. Suppose the price on the limit sell order just does not reach Rs. 122.50. Then the order will
not be executed.
Now let us consider the following quote for particular security: 130.15 - 130.50.
Recall that the format of a quote is “bid”-“ask”. So, the best price at which a trader can sell the security is
Rs. 130.15, and the best price at which a trader can buy the security is Rs. 130.50.
Suppose a trader posts a limit buy order for Rs. 130.70. This is above the best ask of Rs. 130.50, and this
is said to be a marketable or aggressively priced order. This is because some part of the order is going to
be filled anyway at Rs. 130.50 (some part of the limit order acts like a market order).
Similarly, suppose a trader posts a limit sell order for Rs. 130.00. This is below the best bid of Rs. 130.15,
and this is also said to be a marketable or aggressively priced order. This is because some part of the
order is going to be filled anyway at Rs. 130.15 (some part of the limit order acts like a market order).
So, we can make a general rule:
It is said to be an aggressively priced order if:
A limit buy order is placed above the best ask, and
A limit sell order is placed below the best bid
Suppose a limit buy order is placed at Rs. 130.40. This is between the best bid and best ask and will be
executed only if the best ask price falls to Rs. 130.40. The same can be said for a limit sell order, and the
order will be executed only if the best bid increases to Rs. 130.40. These are called inside the market
orders or orders that make a new market.
So, we can make a general rule:
It is said to be an inside the market order if:
A limit buy order is placed between the best bid and the best ask, and
A limit sell order is placed between the best bid and the best ask
Limit orders that are waiting to execute are referred to as standing limit orders.
A limit sell order that meets the best bid or a limit buy order that meets the best ask is said to make the
market. But there is still a chance that the order might not be filled.
It is said to be a behind the market order if:
A limit buy order is placed below the best bid, and
A limit sell order is placed above the best ask
Behind the market, orders are also only executed if the ask price decreases or the bid price increases.
It is said to be a far from the market order if:
A limit buy order is placed significantly below the best bid, and
A limit sell order is placed significantly above the best ask
All-or-Nothing Orders
These orders are concerned with the volume of the trade rather than the price. They execute only if the
whole order can be filled at once.
Minimum Trade Sizes
The minimum size of a trade can be specified too. This helps to keep trading costs low when the trade
depends on the number of trades executed rather than the size of a trade (when commissions are at a
flat rate per trade rather than variable depending on the trade value).
Visibility of Offers
If only the broker or exchange knows the size of the trade, it is called a hidden order. This is useful for
investors with large trading volumes and those who do not want other market participants to know their
intentions.
Traders can also choose to display a specific size of the entire trade. This is the part of the total volume
that is visible to the market. It is called an iceberg trade because the rest of the volume is hidden from
the market’s view. This allows the trader to reveal some of the trade position while the rest of the trade
may be executed once the visible part has been executed.
Traders may trade a part of the total position just to assess the liquidity (or the buyers’ interest) of the
security.
Validity Instructions
These specify when an order should be executed.
Day Orders
Most orders are day orders. That is, they expire if they are not fulfilled during the day that the order is
placed.
“Good Till Canceled” Orders
These orders remain open until they are filled.
Immediate-or-Cancel Orders
These orders are cancelled unless they are filled immediately. They are also known as fill-or-kill orders.
Good-on-Close
These orders are only filled at the end of the trading day. They are called market-on-close orders if they
are market orders.
Mutual funds often place these orders because the net asset value of their portfolio is calculated by using
closing prices.
There are also good-on-open orders which are filled at the start of the trading day.
Stop Orders
These orders do not execute unless the stop price is met. A stop-loss order is a popular tool for risk
management. These orders limit the downside from a trade.
Suppose you purchase a stock for Rs. 100 and you put a stop-sell order at Rs. 95. This means that if the
stock price falls by 5.00%, the stock is sold, and your loss is limited to 5.00%. The loss is “stopped” at 5.00%
because any price below Rs. 95 will trigger a market sell order. Note that if prices are falling rapidly, then
there is no guarantee that the order will be executed at Rs. 95. It can be executed at a lower price too.
If you hold a short position on a stock, then your investment loses value if the share price increases. In
this case, you can place a stop-buy order. This is entered at a price that is above the market price. So, if
the share price increases, then the losses from a short position can be limited to the stop-buy price.
A stop-buy order can also be placed to buy a security at a price that is higher than the current market
price. Suppose you identify undervalued security. Suppose the security is trading at Rs. 85 and you expect
it to go to Rs. 110, but you would like some sort of confirmation that the market also agrees with you.
Remember that you will benefit from a position only when the entire market sees what you see. So, you
can put a stop-buy order at Rs. 100 so that you can buy it at Rs. 100. If you are correct in your assessment
and the share price does increase to Rs. 110 eventually, then you will still have a 10% profit.
Stop orders reinforce market momentum. Imagine every single trader in the market has a stop-loss order
at a certain price. That means every single stop-loss order will start getting filled, and the prices will crash
(in case of a stop sell order). A trader may then receive an unfavourable price on the downside because
of the sheer momentum of the crash.
Stop-sell orders are filled when market prices are falling, and stop-buy orders are filled when market prices
are increasing.
Clearing Instructions
These instructions tell the broker how to clear and settle a trade. They are not usually attached to order;
rather, they are standing instructions. They inform the broker whether the order is a long sale or a short
sale. A long sale order must ensure that the security can be delivered, while a short sale order must ensure
that the security can be borrowed.
Trades made by retail participants are cleared and settled by the broker, but trades made by institutional
participants may be settled by a custodian or another broker (like the prime broker of a firm). It is
beneficial to use two brokers - one can be used as the prime broker for margin and custodial services,
while the other may be used for specialized execution.
1. A dealer quotes a bid price of Rs. 4,500 and an ask price of Rs. 4,700. What is the price at which a
trader can buy the security?
A. Rs. 4,500
B. Rs. 4,600
C. Rs. 4,700
2. Suppose you have purchased Rs. 2,000 worth of securities at a price of Rs. 20 each. You would
like to limit your downside at 10% of the trade value. You would put a
A. Stop sell order at Rs. 22

B. Stop buy order at Rs. 22
C. Stop sell order at Rs. 18
3. The bid-ask is quoted as 90.00-90.50. A trader places a limit sell order at Rs. 94.00. This is least
likely a
A. Aggressively priced order

B. Far-from-the-market order
C. Behind-the-market order
4. A fill-or-kill order refers to
A. An all-or-nothing order
B. An immediate-or-cancel order
C. An iceberg order
5. Which of the following orders least likely reinforces market momentum?
A. Good till cancelled orders

B. Good on open orders
C. Stop orders
Answers
1. C is correct. If the dealer is willing to sell it at Rs. 4,700, then a trader can buy it at Rs. 4,700.
2. C is correct. The stop sell order will trigger a market sell order when the price is Rs. 18. This is a
stop-loss order. The order is most likely to execute at this price if markets are not in a quick
downfall; otherwise, you will receive a price that is worse than Rs. 18. B is incorrect because this
is a stop-loss order for a short position. A is incorrect because this is a stop-profit order and limits
the upside, not the downside.
3. A is correct. An aggressively placed order is a limit sell order placed below the best bid. B and C
are both plausible because the order lags the market (behind the market) in the sense that it will
take time for the security to reach that price, if at all, and it is far from the best ask price.
4. B is correct. Such orders “fill” immediately or are “killed” completely. A is incorrect because all-
or-nothing orders execute only when the entire order can be filled, but fill-or-kill orders execute
only if they can be filled immediately. All-or-nothing orders remain active until executed and are
not “killed”. C is incorrect because an iceberg order is when the trader reveals only part of the
entire order to conceal their intentions.
5. B is correct. A stop order becomes a market order once a specific price is reached. This either
continues to drive prices upwards (in case of stop buys) or downwards (in case of stop sells). A
good till cancel order can also be a type of stop order. Think about a stop-loss order. This is
nothing but a pre-specified order until it is cancelled. If many stop-losses get triggered at once,
this will reinforce market momentum. A good on open order does not reinforce market
momentum because this is simply an instruction to trade at market open and has nothing to do
with momentum.
LOS 45i: Define primary and secondary markets and explain how secondary markets
support primary markets.
Newly issued securities are issued in primary capital markets. These issues include:
➢ New shares of companies that are already listed on the marketplace. Such issues are called
seasoned offerings or secondary issues. A follow-on public offer (FPO) is also a secondary offer
of shares in addition to an initial public offering.
➢ Companies that issue share for the first time. These issues compose of companies that are not
yet listed on the exchange. They are called initial public offerings (IPOs).
After these issues are listed, they trade in secondary financial markets. For example, if you apply for an
IPO, then that is a primary market transaction, but when these shares are listed on the exchange, and you
can sell them to other market participants, then they are secondary market transactions. Such secondary
market transactions happen on exchanges like the BSE and NSE.
Governments and corporations also issue short-term and long-term debt either by auction (most likely for
government bonds) or via investment banks.
Primary Market: Public Offerings
Investment banking firms help to issue stocks and bonds. Typically, a syndicate (group) of investment
banks will look for investors who agree to buy part of the issue. These are not orders placed by the market.
Rather, they show the interest that the issue is attracting (indications of interest).
If an issue is in high demand and if there is more interest than the total number of shares offered, the
price may be adjusted upwards. Conversely, if the issue warrants less demand than the total issue size,
then the price may be adjusted downwards.
This is the book-building process - the process of assessing the market interest in the issue. The book
builder is also called the book-runner in the U.K. It is said to be an accelerated bookbuild if the securities
must be issued quickly.
The investment bank will release information about the company and its operating and financial prospects
to generate interest in the new issue. The company must make relevant financial and operating
disclosures. The issuer should also explain the use of funds from the issue.
This information is available in the draft red herring prospectus (DRHP) after a company filed for
an IPO and wanted to disclose information publicly.
Investment banks usually take up underwritten offerings. The investment banks involved with the issue
will themselves buy all the shares or bonds of the company to then sell to the public. The price is
negotiated with the issuer. However, the investment bank bears all the risk because if the issue is
undersubscribed, the investment bank must buy the unsold portion, which is a cost to the bank.
The investment banks can also agree to make a market for a stock after an IPO. This provides a support
price.
Investment banks may also take up the best effort offering. The investment bank does not buy all the
shares from the issuer. Rather, they earn a commission from distributing the shares of the company to
various investors. In this case, the investment bank is not liable to purchase the unsold shares, so they
bear less risk.
A greenshoe option allows the underwriter to sell more shares than the company initially wanted to if the
subscription is in extremely high demand. It is an “over-allotment” option.
Conflict of Interest
Investment banks (as issuing companies agents) should act in the best interests of the issuer and should
set the highest price possible so that they can raise enough funds.
But investment banks (as underwriters) may also like the price to be lower so that the entire issue sells.
This may allow the investment banks to allocate some part of an undervalued IPO to their clients. IPOs
may be underpriced for this reason, and they may see sharp gains on the day that the company lists on
exchanges.
Issuers would want to avoid a lower price because of the negative publicity surrounding an
undersubscribed IPO. An oversubscribed IPO has more chances of trading above its IPO price and is called
a hot issue.
Primary Market: Private Placements

Private Placement
Securities are sold directly to qualified investors with the help of investment banks. Qualified investors
are those who have substantial wealth and investment knowledge. Such placements require less
disclosure than public offerings, and they have lower issuance costs too.
Shelf Registration
A company makes all the disclosures regarding an offering but may choose to issue securities as and when
required rather than issuing all the securities at once.
Dividend Reinvestment Plan (DRP or DRIP)

This allows existing investors to use their dividend receipts to buy more shares at a discounted price.
Rights Offering
Existing shareholders have the right to buy new shares at a discount to the current market price. However,
this dilutes the ownership of shareholders who do not participate in the offering.
Note that in some cases, these rights can be traded as separate instruments independent of the shares.
Secondary Market
This is the market wherein the trading of securities is done. Secondary market consists of both equity as
well as debt markets. Securities issued by a company for the first time are offered to the public in the
primary market. Once the IPO is done and the stock is listed, they are traded in the secondary market.
Importance of the Secondary Market
Shares trade in the secondary market, and so the demand and supply dynamics give better price
information. The price information of a security is more accurate when there is more liquidity. Securities
can be sold quickly and without steep discounts in liquid markets.
Also, a well-functioning secondary market also makes it easier for listed companies to raise additional
capital in the primary market. This leads to lower costs of capital for companies that have adequate
liquidity.
1. A secondary issue is most likely issued in
A. Primary markets
B. Secondary markets
C. Both, primary and secondary markets
2. An investment bank does not buy all the shares of a company when they are going to be listed.
They earn a commission for distributing the shares to investors. This is most likely
A. Greenshoe offering
B. Best efforts offering
C. Underwritten offering
3. Which of the following markets is most likely responsible for providing liquidity to shares once they
are issued?
A. Both, primary and secondary markets

B. Primary markets
C. Secondary markets
Answers
1. A is correct. A secondary issue is a security issue for companies that have already been listed. These
are also called seasoned offerings. They are issued only on the primary market and then traded on
the secondary market.
2. B is correct. An investment bank does not buy the shares in a best effort offering, and so they do
not bear the risk of unsold inventory. They earn a commission on distribution. A is incorrect
because a greenshoe is not an offering; it is a provision (or an option). It allows the investment
bank to sell more shares to investors if the offering is oversubscribed. C is incorrect because the
investment bank does buy the shares from the company in an underwritten offering. The bank
bears the risk of unsold inventory.
3. C is correct. Secondary markets allow shares to be traded. Demand and supply dynamics give a
better indication of the company’s market value and liquidity.
LOS 45j: Describe how securities, contracts, and currencies are traded in quote-driven,
order-driven, and brokered markets.
Securities trading in the secondary market has encouraged market structures to develop and to facilitate
trading. We can examine trading in terms of how and when securities are traded.
Call Markets and Continuous Markets
A call auction, or call market, is where market participants place orders to buy or sell at certain bid or
offered (ask) prices, which are then batched together and matched at predetermined time intervals.
In a continuous trading market, traders can trade at any time when the market is open.
Trading takes place only at specific times in a call market. They are very liquid when they are in session
because all traders come together for a specific period. All trades, bids and asks are declared, and
eventually, one negotiated price is set, which clears the trades.
Smaller markets follow this method, but even larger ones follow it after trading is stopped for the day.
The call market system is then used to determine opening prices before the market officially opens. For
example, traders can place their bids and offers from 9 A.M. to 9:08 A.M. on the BSE and NSE in the equity
segment. No new orders can be placed between 9:08 A.M. to 9:15 A.M. All the orders get filled once the
market opens for the regular trading session from 9:15 A.M. to 3:30 P.M.
Trades occur at any time the market is open in continuous markets. The price is set by the auction process
or by bid-ask quotes.
There are three main categories of securities markets:
➢ Quote-Driven markets.
➢ Order-Driven markets.
➢ Brokered markets.
Quote-Driven Markets
A quote-driven market, also known as a price-driven market or dealer's market, is more limited in scope.
It only displays the bid and asks offers for a security from designated market makers, dealers, or
specialists.
Dealers hold an inventory of securities and are the market makers - they post bid and ask prices. Traders
then transact with dealers.
This system is often called a dealer market, price-driven market, or over-the-counter market. Most
securities except stocks trade in such markets, and trades are usually placed electronically.
Order-Driven Markets
An order-driven market is one in which all of the orders of both buyers and sellers are displayed, detailing
the price at which they are willing to buy or sell a security, and the amount of the security that they are
willing to buy or sell at that price.
Orders are executed by using trading rules. Traders are usually anonymous, and so this system is driven
by electronic trading rules - for example, exchanges and other automated trading (algorithmic trading)
systems.
These types of markets use order matching rules and trade pricing rules.
Order Matching Rules
These rules are based on hierarchy criteria and prioritise either the best price or the orders that are not
hidden. So, the highest bid and lowest ask are given the highest priority, and if two traders quote the same
price, then the one with the order that is not hidden gets the priority.
This encourages traders to:
➢ Post aggressive quotes.
➢ Display their full order (rather than a hidden order or an iceberg order).
➢ Trade earlier.
These criteria help to improve liquidity.

Trade Pricing Rules
These come in after the hierarchy of orders is decided.
There are two pricing rules:
➢ Uniform pricing rule: All orders will have a uniform price (i.e., they will trade at the same price).
This results in the highest possible volume of trade.
➢ Discriminatory pricing rule: The limit price of the order that first arrived at the trade price is given
preference.
Institutions are typically the traders in electronic crossing networks. Orders are taken in batches and
crossed (or matched) at specific points in time during the day. These orders are taken at the average of
the bid and ask quotes from the exchanges on which the stock largely trades.
This type of pricing rule is called the derivative pricing rule. It derives the price from the main market on
which the security trades. Note that orders in the crossing network do not determine the price.
Brokered Markets
A brokered market is a marketplace in which an intermediary search for and brings together buyers and
sellers. Brokers find the counterparty (another side of the trade) to execute a trade. This is especially
useful for securities that are unique or illiquid. For example, an investor who wants to place a large block
trade will find this system beneficial. Real estate and artwork are two other examples where brokered
markets are beneficial.
Dealers do not usually hold an inventory of these securities. Also, such trades would not work in an order-
driven market because the volume is too little.
Market Information
It is a pre-trade transparent market if investors can get information regarding quotes and orders before
the trade. A market is said to be post-trade transparent if investors can obtain information after the trade.
This would be information regarding the quantities and prices at which the trades were filled.
Buy-side traders (like mutual funds or investment management companies) would prefer more
transparency. This allows them to understand the security value and trading costs. However, dealers
would prefer less transparency (opaque markets) to have an informational advantage over traders who
trade less frequently. They also benefit from higher bid-ask spreads in opaque markets. It gives the dealers
more pricing power.
1. Dealer markets are least likely
A. Quote-driven
B. Order-driven
C. Over-the-counter
2. A hierarchy criteria in order-driven markets most likely encourage
A. Aggressive quotes
B. Uniform pricing
C. Hidden orders
3. A mutual fund would most likely prefer
A. Pre-trade transparency
B. Post-trade transparency
C. Lower bid-ask spreads
Answers
1. B is correct. Dealer markets are mostly over-the-counter markets, and dealers are not likely to
deal on exchanges (hence over-the-counter). They are quote-driven markets as dealers post their
quotes on the bid and ask prices.
2. A is correct. The hierarchy criterion takes the best bid, and best ask for security. Hence the most
aggressively priced quote wins. It encourages traders to trade earlier and to display the full size
of their orders. B is incorrect because uniform pricing is a trade pricing rule that accepts all orders
at the same price, resulting in the most volume traded.
3. A is correct. Buy-side companies (investment management firms) prefer pre-trade transparency

because they want to know that they get a fair price for their bulk orders. C is incorrect because
lower bid-ask spreads reduce the transaction costs. Dealers would prefer higher bid-ask spreads
and less transparency because that is how they make profits.
LOS 45k: Describe characteristics of a well-functioning financial system.

We saw earlier that many entities participate in financial markets. If they can all fulfil their purpose, then
a market can be said to be well-functioning.
Complete markets fulfil the following criteria:
➢ Investors get fair rates of return for future savings.
➢ Creditworthy borrowers can raise funds or borrow funds easily.
➢ Hedgers can manage their risks.
➢ Traders can obtain the currencies, commodities, and any other asset that they need.
High trading costs are an impediment to trading and can discourage traders. However, lower trading costs
may make markets more operationally efficient. A market is informationally efficient if security prices
reflect all available information quickly and completely. A combination of these two types of efficiency
ensures that markets remain complete.
Think about it from the perspective of an arbitrageur. Arbitrage profits are slim, to begin with as financial
markets become more efficient. But arbitrage is necessary for financial markets to ensure that assets with
similar cash flows are valued similarly. If the gross profit from an arbitrage trade is 1.50%, but the trading
costs are 2.00%, entering the trade may not make sense.
Moreover, a complete market should have financial intermediaries that:
➢ Organize trading venues, like exchanges, brokerages, or alternative trading systems.
➢ Supply liquidity so that positions can be filled.
➢ Securitize assets so that borrowers can raise funds easily.
➢ Manage banks that use depositor capital to fund borrowers.
➢ Manage insurance firms that pool unrelated risks.
➢ Manage investment advisory services that assist investors with asset management inexpensively.
➢ Provide clearinghouses that settle trades.
➢ Manage depositories that provide for asset safety.
Some of the benefits of well-functioning financial systems include:

➢ Entrepreneurs who need capital to raise money can look at banks or alternative investment
funds. These sources are funded by people in the economy who save.
➢ Risk can be distributed so that there is a market for risky companies to raise funds.
➢ There is a multiplier effect in the economy from the above benefits as capital is allocated more
efficiently and risk is distributed.
➢ If markets are truly informationally efficient, then the capital is allocated to its optimal use.
These factors ensure that markets are allocationally efficient.

Traders ensure that prices are informationally efficient because they can bid prices up and down as they
receive new information. If markets are operationally efficient and if trading costs are low, then other
traders will be encouraged to take the market. This will have a network effect, and the fundamentals of
securities will be priced in more efficiently. Capital will be redistributed from investors given the new
security information, so allocational efficiency is another by-product.
The more the companies use the same accounting and financial reporting standards, the lower the cost
of obtaining information.
1. Allocational efficiency most likely refers to
A. Speed of information diffusion

B. Redistribution of risk
C. Trading costs
2. Operational efficiency most likely refers to
A. Trading costs
B. Redistribution of capital
C. Speed of information diffusion
Answers
1. B is correct. Allocational efficiency is all about how capital and risk is allocated in a market or an
economy. Risk capital must be put to optimal use to ensure that companies make most of their
finite capital investments.
2. A is correct. If a market, in general, has low trading costs and transaction costs, it is said to be
operationally efficient. Traders, investors, and arbitrageurs are encouraged to take positions, and
the net profit of trade may not be impacted much by transaction costs. B is incorrect because this
has to do with allocational efficiency. C is incorrect because this has more to do with
informationally efficiency.
LOS 45l: Describe objectives of market regulation.

The following problems could plague financial markets if adequate regulations are not enforced:
➢ Fraud and theft: Larger investment managers may take advantage of smaller, unsophisticated, or
uninformed investors. If these investment managers provide inconsistent returns to investors,
then it becomes difficult to assess if the agents (investment managers and brokers) are
performing in the investors’ best interest.
➢ Insider trading: Many traders that trade on insider information can discourage small investors
from participating in the markets. This reduces liquidity.
➢ Costly information: The more difficult and costly it is to obtain information, the less
informationally efficient a market will be.
➢ Defaults: Default risk can occur if one side of the trade does not meet its obligation to the other.
➢ Market regulation should ensure that these issues are mitigated. Regulation should:
➢ Protect unsophisticated investors: So that investors trust the markets and to protect the integrity
of financial markets.
➢ Maintain minimum standards of competency: This makes it possible to assess the performance
of investment managers as they are held to a minimum standard. The CFA Program and the Global
Investment Performance Standards aim to ensure that investment managers are competent.
➢ Prevent insiders from exploiting other investors.
➢ Require common financial reporting requirements: This makes it easier to compare the
performance of companies. This reduces the information costs. The International Accounting
Standards Board is a benchmark for common reporting standards.
➢ Require minimum levels of capital: Financial institutions (especially insurance companies and
pension funds) should be subject to minimum capital requirements. This ensures that they can
withstand any negative shocks and that the money of pensioners or ordinary taxpayers is not at
risk.
Governments and industry groups can provide regulatory standards. Most exchanges, clearinghouses, and
dealer trade organizations are self-regulating organizations (SROs). They regulate their own members.
For example, SEBI regulates the members of the stock exchange.
Financial markets do not function well when the regulatory organizations do not have an impact on their
members or cannot enforce rules adequately. This poses a liquidity risk; companies are discouraged from
taking on risky (but profitable) projects, innovation is limited, and economic growth may generally slow
down.
1. Why is it least likely important to have adequate long-term capital levels in the financial system?
A. To provide a cushion during bad economic times

B. To repay daily expenses
C. To safeguard clients of banking and financial service companies
2. A potential threat to the objectives of a financial market is most likely
A. Standards on competency for fund managers

B. The widespread adoption of international financial reporting standards (IFRS)
C. Deregulation of insider trading laws
Answers
1. B is correct. Daily expenses must not be paid by long-term equity or debt capital. That is a sign
that the company is in trouble. A and C are both accurate statements because these are valid
reasons for banks to have long-term capital and reserves requirements.
2. C is correct. If insider trading is not strictly regulated, then it threatens the integrity of financial
markets. Smaller investors with less information are disadvantaged. A is beneficial for financial
markets because this allows for benchmarks to assess fund manager’s performance. B is also a
benefit because this reduces the information costs. It allows investors to compare companies’
financial performance with ease.
Security Market Indexes 51
Security Market Indexes

Security market indexes like the NIFTY 50, S&P 500, FTSE 100, etc., are primarily used as benchmarks to
assess the performance of markets and investment managers.
By the end of this reading, make sure that you have understood how to calculate the different types of
indexes, their uses, and their drawbacks.
LOS 46a: Describe a security market index.
An index represents the performance of a(n):

➢ Asset class: Stocks, bonds, commodities, etc.
➢ Security market: Indian equities, U.S. bonds, etc.
➢ Segment of the market: Large-cap stocks, small-cap stocks, top 50 stocks, top 500 stocks, etc.
They are made from individual securities, the constituent securities. For example, the constituent
securities of the NIFTY 50 index are the top 50 Indian companies by market capitalization, adjusted by a
float factor.
In the news, you may have read about the NIFTY or the Sensex scaling new all-time highs, or if there is a
deep correction or a market crash. The index values that you see are calculated in various ways, and we
will discover these methods later in this reading.
The return on an index is simply the percentage change of this numerical value over time.
Example - Some famous international indexes include the DAX (Germany), Hang Seng (Hong
Kong), FTSE (U.K.), Nikkei (Japan), and TSX (Canada). Morgan Stanley Capital International (MSCI)
constructs many of the leading international indexes.
LOS 46b: Calculate and interpret the value, price return, and total return of an index.
We will use a simplified example to explain the price return and total return. Suppose an index has a
beginning value of 100. We have tracked its performance over 3 years and found the following
information:
Year Price Return Total Return
1 10.05% 11.05%
2 5.40% 5.90%
3 -5.50% -5.30%
The price return considers only the index value without dividends, while the total return considers the
index value with dividends (index value plus dividends).
Note that these returns are geometrically linked rather than arithmetically linked. So, we can calculate
the ending index value in the following way:
Price Return = 100 × (1 + 10.05%) × (1 + 5.40%) × (1 - 5.50%) = 109.61.
Total Return = 100 × (1 + 11.05%) × (1 + 5.90%) × (1 - 5.30%) = 111.37.
Conversely, we can also calculate the geometric return if we know the two ending values. That is:
The index value in Year 3 for the price return index is 109.61, and the starting index value is 100. Therefore,
(109.61 ÷ 100)1/3 - 1 = 3.11%.
The index value in Year 3 for the total return index is 111.37, and the starting index value is 100. Therefore,
(111.37 ÷ 100)1/3 - 1 = 3.65%.
What if the following information had been provided and the starting index value is 1,540.00:
Year Price Return
1 0.02%
2 -0.04%
3 0.20%
4 -0.09%
1. Calculate the index value at the end Year 4.
A. 1,541.38
B. 1,541.39
C. 1,540.00
2. Calculate the geometric return in 4 years.
A. 0.09%
B. 0.03%
C. 0.02%
3. Which of the following statements is least likely true about total index returns (TRI)
A. The TRI does not account for changes in price

B. The TRI is the same as the price index return when no dividends are paid
C. The TRI considers dividend payments and is generally higher than the price return index
Answers
1. A is correct.
1,540 × (1 + 0.02%) × (1 – 0.04%) × (1 + 0.20%) × (1 – 0.09%) = 1,541.38
B is incorrect because it simply adds all the returns. These values are very close when the returns
are small, but it is conceptually incorrect to add all the returns.
2. C is correct.
(1,541.38 ÷ 1,540)1/4 – 1 = 0.02%
A is incorrect because it simply adds all the returns.
3. A is correct. A total return index adds dividend values to the price return index. It does consider
price changes. It is generally higher than a price return index. It considers the fact that investors
have also received a dividend during the holding period. This is an additional gain to investor
wealth. B is an accurate statement because if no dividends are paid at all then both, the price
index and total index values are the same.
LOS 46c: Describe the choices and issues in index construction and management.
The following factors must be considered when index providers make an index:
➢ Target market: Which type of security is being measured by the index? For example, should the
universe be all stocks in India or only midcap and large-cap stocks? Or should the target market
be segregated by geographies or economic sectors (like an I.T. index or an automobile index)?
➢ Appropriate securities: Which securities from this total target market should be included in the
index? For example, should the index include a representative sample (most relevant 50 stocks,
most relevant 500 stocks, etc.) or all stocks from the target market? There may be an objective
rule to determine the appropriate securities, or a committee can make subjective decisions.
➢ Rebalancing: How often should the index be rebalanced? (We will discover rebalancing and its
implications later in this reading).
➢ Frequency of evaluation: When and how often should the selection of securities and their weights
be re-evaluated? The index must be a fair representation of the value of the constituent securities.
➢ The target market might be very large (for example, stocks in the United States) or very specific
(for example, small cap value stocks in the United States). It can also be characterised
geographically or by economic sector (for example, cyclical stocks). The index's constituent
stocks could include all of the stocks in that market or just a representative sample. A
committee may determine the selecting procedure objectively or subjectively.
LOS 46d: Compare the different weighting methods used in index construction.
Calculate and analyze the value and return of an index given its weighting method.
Let us assume that we must create an index by using 5 of the largest stocks (by market capitalization) that
trade on the National Stock Exchange of India (NSE). As of 16th July 2021, the top 5 are:
➢ Reliance Industries Ltd.
➢ Tata Consultancy Services Ltd. (TCS)
➢ HDFC Bank Ltd.
➢ Infosys Ltd.
➢ Hindustan Unilever Ltd. (HUL)
Price-Weighted Index
The simple method to calculate a price-weighted index is by using the arithmetic mean of all prices. The
numerator is the sum of all prices, and the denominator is the number of members in the index.
The denominator (i.e., the divisor) is adjusted for stock splits, repurchases or other such events. It is also
adjusted for changes in the composition of the index (additions or removals of securities). This ensures
that the index value is representative of the price value of its members.
The Dow Jones Industrial Average (DJIA) is a price-weighted index based on 30 U.S. stocks. The Nikkei Dow
Jones Stock Average is a price-weighted index based on 225 stocks that trade on the first section of the
Tokyo Stock Exchange.
The advantage is that these are easy to calculate, but there is one major drawback. Given that this index
is based purely on prices, the securities with the highest share price will dominate the value of the index
if all other companies’ prices are much lower. This is because the higher-priced securities will have more
weightage in the index.
Note that if you construct a portfolio where you have invested an equal number of shares in each stock,
then you are replicating the return on a price-weighted index. Think about it this way: the numerator
accounts for the price while the denominator accounts for the number of companies in the index. If the
number of shares per company is common, then the denominator is common, and so the only real
determinant of returns is the price (ignoring dividends).
Let us see how this works. (Note that the prices are as on 16th July 2021).
Company Price
Reliance 2,111.80
TCS 3,194.65
HDFC 1,521.70
Infosys 1,555.00
HUL 2,414.60
The sum of all prices is 10,797.75. Since there are 5 members in this index, the average is 10,797.75 ÷ 5 =
2,159.55.
Let us assume that the prices in one year are as follows (and no dividends have been paid):
Company Price in One Year
Reliance 2,407.45
TCS 3,418.28
HDFC 1,476.049
Infosys 1,570.55
HUL 1,979.97
The index value is 2,170.46 and the return is (2,170.46 ÷ 2,159.55) - 1 = 0.51%.
Now let us assume TCS implements a 3-for-1 stock split at the end of the trading day on 16th July 2021.
Note that the value of the index must remain unaffected, and the divisor must be adjusted. So, we are
holding the value constant for now and only adjusting TCS’s share price and the denominator.
TCS will now have 3 times the number of shares it has already issued in circulation. But the value of their
company remains unchanged. So, to balance out the increase in the number of shares (by 3x), the share
price must reduce by 3x.
TCS’s share price on the next day will be 3,194.65 ÷ 3 = 1,064.88. Now let us hold the value of the index
constant and solve for the denominator:
The index denominator will be adjusted so that the index value would remain at 2,159.55 if there were
no changes in the stock prices other that to adjust for the split. The new denominator X should justify
(2,111.80 + 1,064.88 + 1,521.70 + 1,555.00 + 2,414.60) ÷ x = 2,159.55
2,159.55 = (2,111.80 + 1,064.88 + 1,521.70 + 1,555.00 + 2,414.60) ÷ x

2,159.55 = 8,667.98 ÷ x
x = 4.01
Notice that the numerator reduced, and so the denominator also reduced.
This is not the exact method because the index value should represent the price of the index constituents
appropriately. Nevertheless, the intuition is that the denominator is adjusted when any such event
significantly affects a company's share price in the index.
Market Capitalization-Weighted Index (or Value-Weighted Index)

Weights are based on the market capitalization (market cap) of each stock.
Total Market Capitalization of a Company = Price per Share × Total Number of Shares Outstanding
Weight per Share = Total Market Capitalization of Share ÷ Total Market Capitalization of all Shares in
the Index
One can replicate a market-cap-weighted index by matching the weight of each stock in the portfolio with
its weight in an index. This is essentially an index replication method. So, if Reliance has a weight of 10%
in the NIFTY 50 index, HDFC Bank has a weight of 9.90%, and so on (based on total market cap), then even
the portfolio should replicate these weights based on the investment amount per share.
Note that these calculations will give us the current market cap and current weightages. To compute the
index value, we must use the following formula:
Current Index Value = Base Year Index Value × (Current Total Market Cap ÷ Base Year Total Market
Cap)
Remember that this is an index, and an index (like this one or the consumer price index) is always adjusted
for the base year. The base year index value is 100.
These indexes do not need to be adjusted for stock splits, bonuses, etc. This is because the price per share
is already adjusted by the changes in the total number of outstanding shares.
The NIFTY 50 index uses a free-float adjustment. The market float is the number of shares that investors
and traders can trade. Think about it this way: Mukesh Ambani will not trade his shares on the stock
exchange, so it is unreasonable to include his shares in the market cap calculation. That is why a float
factor is used for each stock to show us the total number of tradable shares (available to investors and
traders). This is also called the float-adjusted market-capitalization method.
Let us now add the shares outstanding and free float data to calculate the index for the 5 stocks that we
have chosen. (Data has been obtained from Yahoo Finance).
A B C D E=B×C F=B×D
Company Price Total Shares Free Float Total Market Float-Adjusted

Outstanding (million) Capitalization (Rs. Market
(million) million) Capitalization (Rs.
million)
Reliance 2,111.80 6,760.00 2,990.00 14,275,768.00 6,314,282.00
TCS 3,194.65 3,700.00 1,010.00 11,820,205.00 3,226,596.50
HDFC 1,521.70 5,530.00 4,610.00 8,415,001.00 7,015,037.00

Infosys 1,555.00 4,260.00 3,670.00 6,624,300.00 5,706,850.00
HUL 2,414.60 2,350.00 858.23 5,674,310.00 2,072,282.16
Total 46,809,584.00 24,335,047.66
The weightage per stock is simply the market cap per stock divided by the total market cap of the index:
Company Weightage Based on Total Market Cap Weightage Based on Free Float
Market Cap
Reliance 30.50% 25.95%
TCS 25.25% 13.26%
HDFC 17.98% 28.83%
Infosys 14.15% 23.45%
HUL 12.12% 8.52%
Let us assume that the base year total market cap for these stocks is 292,560.00. The actual index value
is, therefore:
Current Index Value = Base Year Index Value × (Current Total Market Cap ÷ Base Year Total Market
Cap)
100 × 46,809,584 ÷ 292,560.00 = c. 16,000
Let us compare the effect of price changes on the price-weighted index and the market-cap-weighted
index.
We will use the following information:
Company Price Total Shares Outstanding Total Market Capitalization

(million) (Rs. million)
Reliance 2,111.80 6,760.00 1,42,75,768.00
TCS 3,194.65 3,700.00 1,18,20,205.00

HDFC 1,521.70 5,530.00 84,15,001.00
Infosys 1,555.00 4,260.00 66,24,300.00
HUL 2,414.60 2,350.00 56,74,310.00
Recall that the price-weighted index equals 2,159.55.

Let us increase the share price of HUL by 2x. It now has the highest share price in the index.
Price-weighted index = (2,111.80 + 3,194.65 + 1,521.70 + 1,555.00 + 4,829.20) = 2,642.47. This is an
increase of 22.36% from the previous index value.
We can now see the market cap in the following table:
Company Price Total Shares Outstanding Total Market Capitalization

(million) (Rs. million)
Reliance 2,111.80 6,760.00 1,42,75,768.00
TCS 3,194.65 3,700.00 1,18,20,205.00
HDFC 1,521.70 5,530.00 84,15,001.00
Infosys 1,555.00 4,260.00 66,24,300.00
HUL 4,829.20 2,350.00 1,13,48,620.00
The total market cap is Rs. 52,483,894.00.

Current Index Value = 100 × 52,483,894 ÷ 292,560 = 17,939.53
The increase in the index value is 12.12% from the previous index value of c. 16,000.
This illustrates that price-weighted indexes are more sensitive to price changes than market-cap-weighted
indexes. This is because market-cap-weighted indexes also consider the number of shares outstanding.
HUL has the least number of shares outstanding, and so mathematically speaking, even if the share price
doubles, it will be third in the market cap table (all else held constant).
Equal-Weight Index
Equal-weight indexes are calculated as the arithmetic mean return of all the stocks in the index. One can
replicate such a return by buying equal weights invested in each stock.
The DSP Equal NIFTY 50 Fund is a mutual fund scheme that uses the equal weighting principle.
Since there are 50 stocks in the NIFTY 50 index, the scheme has invested c. 2.00% in each stock to
create an equal-weighted portfolio of stocks in the NIFTY 50.
These are easy to construct but must be rebalanced to ensure that the investment value remains equal
as the securities prices change. This may lead to high transaction costs, and these costs reduce the net
return on the portfolio.
Also, suppose that HDFC Bank's weight in the NIFTY 50 index is 10.05% based on a market capitalization
weighting method. HDFC Bank’s weight in the NIFTY 50 equal-weight index will always be 2.00% (1 ÷ 50).
Similarly, suppose JSW Steel’s weight in the NIFTY 50 index is 1.00%. JSW Steel’s weight in the NIFTY 50
equal-weight index will always be 2.00%. This proves two things:
1. The weight of extremely large stocks in the index is expected to be lower in an equal-weighted index
relative to a market-cap-weighted index
2. The weight of extremely small stocks in the index is expected to be higher in an equal-weighted index
relative to a market-cap-weighted index
You can think of the same effect if you want to construct an S&P 500 equal weight index. Each stock in
the index should have a weightage of 0.20% (1 ÷ 500) but, companies like Apple and Microsoft have a
weightage of c. 6.00%. This is a significant difference.
The Value Line Composite Average and the Financial Times Ordinary Share Index are two examples of
equal-weighted indexes.
Let us create an equal-weighted index for the 5 stocks that we had picked earlier and see how a change
in prices changes the value of the index.
Let us solve this intuitively. Suppose you have Rs. 50,000 to invest in total, and you want to create an
equal-weighted portfolio. You would invest close to Rs. 10,000 in each of the 5 stocks (remember that
stock quantities cannot be bought in fractions, and so each stock will not have exactly Rs. 10,000 invested
in each of them). We can compare the weights to the market-cap-weighted portfolio that we saw earlier.
Company Price Quantity Investment Equal-Weighted Market Cap-

Value Portfolio Weighted
Portfolio
Reliance 2,111.80 5.00 10,559.00 21.21% 30.50%
TCS 3,194.65 3.00 9,583.95 19.25% 25.25%
HDFC 1,521.70 7.00 10,651.90 21.40% 17.98%
Infosys 1,555.00 6.00 9,330.00 18.74% 14.15%

HUL 2,414.60 4.00 9,658.40 19.40% 12.12%
Total 49,783.25 100.00% 100.00%
Now let us change the share price of each stock at random and see which adjustments are made.
Company Price Quantity Investment Equal-Weighted Market Cap-

Value Portfolio Weighted
Portfolio
Reliance 2,639.75 4.00 10,559.00 19.11% 35.48%
TCS 2,715.45 4.00 10,861.81 19.66% 19.98%
HDFC 1,369.53 8.00 10,956.24 19.83% 15.06%
Infosys 1,881.55 6.00 11,289.30 20.43% 15.94%
HUL 2,897.52 4.00 11,590.08 20.98% 13.54%
Total 55,256.43 100.00% 100.00%
Let us look at Reliance and at TCS. Since Reliance’s share price increased, one of their shares had to be
sold to maintain an equal weight. Similarly, since TCS’s share price decreased, one of their shares had to
be bought to maintain an equal weight. This rebalancing incurs transaction costs.
However, the weights in the market-cap-weighted portfolio changed depending on the price changes.
There was no rebalancing required.
Now let us assume that the index value of the equal-weighted index was initially the same as the
investment value 49,783.25. It is now worth 55,256.43. The gain is (55,256.43 ÷ 49,783.25) - 1 = 10.99%.
If we calculate the index value based on the market cap-weighted index, then it is 100 × 50,289,950.90 ÷
292,560 = 17,189.62 and the increase is (17,189.62 ÷ 16,000) -1 = 7.44%.
When we analyze the difference, we can see that the market-cap-weighted portfolio puts more weightage
on the stocks that have increased in value and less on the ones that have decreased in value. Conversely,
the equal-weighted index sells the stocks that have increased in value and buys the ones that have
decreased. There is automatically a bias to pick lower-priced stocks in the equal-weighted index.
Market Capitalization- Equal-Weighted

Price-Weighted Index Weighted Index Index
- Provides equal
- Simple calculation - Reflects the relative size of exposure to all
Advantages methodology companies stocks
- High-priced stocks - Prone to overweighting - Higher turnover
Disadvantages dominate the index overvalued stocks and transaction costs
- Buy shares of each
component in - Buy shares in proportion to - Buy equal shares of
Replication Method proportion to its price their market capitalization each component
Fundamental Weighted Index

These use company fundamentals - like earnings, dividends, or cash flows - to decide the weights of each
company.
Although the share price is related to these fundamentals in the long term, changes in share price do not
directly affect the weights of such an index. The weights can be determined by one fundamental factor or
a combination of fundamental factors.
The advantage of this type of index is that it is not biased towards overvalued companies, and it gives less
weightage to companies with poor fundamentals. Therefore, such indexes are said to have a value tilt -
the index or the portfolio is “tilted” towards value stocks.
Factors like high book-to-market ratios, high earnings yields, or low P/E ratios are favorable. Such stocks
will have more weightage in the index relative to the market-cap-weighted index.
1. An index provider wants to create an index based on the number of shares that investors can
trade. They are least likely to use a
A. Free float method

B. Price weightage method
C. Market capitalization method
2. Which of the following portfolios most likely has the highest transaction costs?
A. Float adjusted market-capitalization index

B. Market capitalization-weighted index
C. equal-weighted index
3. Which of the following is most likely correct about a price-weighted index?
A. Only the numerator must be adjusted when there is a stock split

B. The numerator and denominator are both adjusted when there is a stock split
C. No adjustments are needed for stock splits
Use the following information for questions 4 to 7:
Company Price Total Shares Outstanding Free Float (million)

(million)
Stock A 12.50 9,045.00 7,688.25
Stock B 45.00 9,103.00 6,827.25
Stock C 32.00 9,800.00 8,820.00
The base year market capitalization for these three stocks is Rs. 3,413.46, and the float-adjusted market
capitalization is Rs. 3,462.47.
4. Calculate the float-adjusted index value for an index that comprises these three stocks.
A. 3,462.47
B. 19,800.01
C. 24,500.00
5. Calculate the value of the price-weighted index.
A. 29.83
B. 26.21
C. 32.00
6. Calculate the proportion per stock in an equal-weighted index.
A. 33.33%
B. 25.00%
C. 16.67%
7. Which of the following indexes least likely gives most weightage to stocks with high prices?
A. Fundamental-weighted index
B. price-weighted index
C. Market capitalization-weighted index
Answers
1. C is correct. The market capitalization method takes the total number of shares outstanding in
the calculation. This includes all the shares that are held by owners or majority investors who
would not generally trade their shares. A is likely because the free float method considers only
those shares that are available for trading. B is also likely because this method considers only the
price of the shares and does not consider the number of shares outstanding at all.
2. C is correct. An equal-weighted index is most likely to be rebalanced every time there is a

significant change in the price of a constituent member. This is done to ensure that the value of
each constituent member is held equal. A and B are incorrect because these indexes do not
require rebalancing, but they may require reconstitution. Reconstitution is much less frequent
than rebalancing and will have lower transaction costs.
3. B is correct. The numerator is adjusted to reflect the fall in the price of a security after a stock
split. The denominator is adjusted too because the value of the index must be held constant.
4. B is correct.
Current Index Value = Total Float-Adjusted Market Capitalization of All Stocks
= (12.50 × 7,688.25) + (45 × 6,827.25) + (32 × 8,820.00) = Rs. 685,569.38
Current Index Value = Base Year Index Value × (Current Float-Adjusted Market Capitalization ÷
Base Year Float-Adjusted Market Capitalization)
Current Index Value = 100 × (685,569.38 ÷ 3,462.47) = 19,800.01
A is incorrect because this is the base year’s float-adjusted market capitalization. C is incorrect
because this is the index value of the total market capitalization rather than the index value of the
float-adjusted market capitalization.
5. A is correct. The price-weighted index is the arithmetic mean of all the prices in the index.
PWI = (12.50 + 45.00 + 32.00) ÷ 3 = 29.83
B is incorrect because this is the geometric mean. C is incorrect because this is the median.
6. A is correct. Each stock will have an equal proportion in the index. That is, since there are 3 stocks,
we can say that each stock will have 1/3rd weight.
B is incorrect because this is 1/4th
C is incorrect because this is 1/6th
7. A is correct. Fundamentals-based indexes consider company fundamentals like earnings, cash

flows, etc. They will most likely give more weightage to those companies with solid fundamentals
rather than price momentum. B and C both are likely to overweight stocks with high prices, and
this is always the case with price-weighted indexes. However, since market capitalization-based
indexes also consider the total number of shares outstanding, the price is not the only factor.
(Think about it this way: one share has a price of Rs. 100 and 10 shares outstanding. Its market
capitalization is Rs. 1,000. Another share has a price of Rs. 1 and 1,000 shares outstanding. Its
market capitalization is also Rs. 1,000). Price momentum is still a factor in such indexes, so the
most appropriate answer is still A.
LOS 46f: Describe rebalancing and reconstitution of an index.

Rebalancing
We saw this in the example with the equal-weighted index. The weight of each stock had to be adjusted
after the prices changed - the weights were “rebalanced” to reflect a target weight.
An investment manager may also want to rebalance a portfolio if they feel that one sector will outperform
another. So, they will overweight stocks in the sector that is expected to outperform and underweight
the stocks in the sector that is expected to underperform.
Indexes are usually rebalanced to target weights periodically - usually quarterly. Equal-weighted indexes
need to be rebalanced the most because the weight must be adjusted for price changes.
Reconstitution
An index is said to be reconstituted when securities are added or removed from an index. The stocks in
an index must meet certain criteria to be in that index. For example, there must be a minimum free-float
market capitalization to enter the NIFTY 50 index. If the bottom stocks do not meet that criterion, then
they must be removed and replaced by other stocks.
This usually happens if a company is under severe financial distress and its share price plummets or if a
company is delisted (cannot trade at all). These may be judgement calls that a committee makes.
Note that when a security is added to an index, it automatically attracts fund managers who have made a
portfolio that matches the weights of the index. Suppose you have created an equal-weighted portfolio
that replicates the NIFTY 50. Now let’s say that Mahindra and Mahindra are removed from the index, and
Coal India is added. You will have to sell Mahindra and Mahindra and buy Coal India to ensure that your
portfolio still replicates the index.
As a result of the above, the price of companies that are added increases and the price of companies that
are deleted decrease further.
1. A highly valued mid-cap stock replaces a low valued large-cap stock in an index. This is most likely
A. Reconstitution
B. Rebalancing
C. Both, reconstitution and rebalancing
2. A highly valued mid-cap stock replaces a low valued large-cap stock in an index. This affects the
weight of each stock in an index, and each stock’s weight is adjusted accordingly. This is most
likely
A. Reconstitution
B. Rebalancing
C. Both, reconstitution, and rebalancing
3. A highly valued mid-cap stock falls in price drastically. This affects the weight of each stock in an
index, and each stock’s weight is adjusted accordingly. This is most likely
A. Reconstitution
B. Rebalancing
C. Both, reconstitution, and rebalancing
Answers
1. A is correct. An index is reconstituted when the “constituent” members change completely. A
large-cap stock is removed, and a mid-cap stock has replaced it, which is a reconstitution. B and C
are incorrect - there is no information regarding a change in weights, and so we cannot say that
there is a rebalancing.
2. C is correct. A stock was removed, and another was added. This is reconstitution. The weights were
changed as well, and so the index has been rebalanced.
3. B is correct. An index is said to be rebalanced when each stock is given a different weight based on
changes in price or other factors. A and C are incorrect because there was no addition or removal
of stocks, so we cannot say that there is a reconstitution.
LOS 46g: Describe uses of security market indexes.
Gauge for Market Sentiment

Indexes reflect the market sentiment of the securities concerned. For example, the NIFTY 500 Total Return
Index is a suitable index to assess how confident investors are in the top 500 stocks of the Indian stock
market. The Sensex index comprises 30 stocks which are relatively less than the NIFTY 500 index or the
NIFTY 50 index, and so it may not be the best indicator for broad-based market sentiment.
Benchmarks
Index returns serve as a minimum rate of return on a portfolio. The point of active management is to earn
an excess risk-adjusted return over a benchmark index. So, if the NIFTY 50 index earns 15% over one year,
then a fund manager must earn a risk-adjusted return that is above 15% to beat the market.
But an appropriate benchmark must be chosen depending on the purpose of the fund or the investment
style. For example, it makes much more sense to compare the returns on an I.T. sector fund against the
NIFTY IT index than it does to compare the fund against the NIFTY 500 index. So, the benchmark should
be closely related to the fund’s investment style so that the fund manager’s performance can be evaluated
by comparing it to an appropriate benchmark.
Measure of Market Risk and Return
Whenever one must find the expected return or the standard deviation of “the market”, they will use a
broad-based benchmark like NIFTY 50 for large caps or NIFTY 500 (if the portfolio has stocks with varying
market capitalizations) as a proxy for the market.
Beta and Risk-Adjusted Returns
The capital asset pricing model (CAPM) is used to determine a stock’s required rate of return. This is
covered in Portfolio Management. Market returns are used to calculate the beta and the equity risk
premium in the CAPM formula. Beta is a measure of a company’s systematic risk (undiversifiable risk). The
required rate of return can then be compared to the actual stock returns to calculate the excess return or
alpha. Active fund managers will always strive for a positive alpha - this indicates that the average
portfolio stocks have had an excess risk-adjusted return.
Model Portfolio
If beating the benchmark is not an objective (i.e., a fund manager wants to create a passive portfolio),
then indexes like the NIFTY 50, Sensex, NIFTY Midcap 100, etc., can be used as a model portfolio. The fund
manager will replicate their portfolio to match the returns of an index as closely as possible.
There are index mutual funds and index exchange-traded funds, as well as private portfolios.
1. Which purpose is an index most likely fulfilling if a fund manager uses that index to replicate their
entire portfolio?
A. Indexes are a measure of market risk

B. Indexes are used to calculate the alpha of a fund manager’s portfolio
C. Indexes are model portfolios
2. Which purpose is an index least likely fulfilling if a fund manager says that the markets have been
volatile lately due to an increase in standard deviation?
A. Indexes are a measure of market risk

B. Indexes are a gauge for market sentiment
C. Indexes are model portfolios
Answers
1. C is correct. In this case, the fund manager is making a passive portfolio. This means that they
want to earn a return that is as close to the index’s return as possible. So, they will base their
portfolio on a model portfolio, i.e., the index. B is incorrect because the alpha is needed only for
active management strategies (that is, fund managers want to create a portfolio to beat the
benchmark index). In this case, the fund manager is trying to earn a risk-adjusted return that is
superior to the index and so will not necessarily use the index as a model portfolio.
2. C is correct. A and B are both valid because the manager is talking about market sentiment
(volatility) and is referring to a risk measure (standard deviation).
LOS 46h: Describe types of equity indexes.

Broad Market Index
An index that contains more than 90% of the total market value is most likely to reflect the market's
overall performance.
For example, the Wilshire 5000 Index contains more than 6,000 equity securities. This is a good
representation of the performance of U.S. equities.
Multi-Market Index
These are usually constructed from a bunch of indexes of markets all around the world. They usually
measure the returns from a geographic region (like Southeast Asian indexes), from a group of countries
in a similar stage of economic development (like emerging market indexes) or from the entire world (like
the MSCI World Index).
A multi-market index can also use fundamental weighting. These indexes take the market capitalization-
weighting for individual country indexes, but a fundamental economic factor like GDP determines the
weights of each country. This avoids the upward bias in countries with previously high market returns and
ensures that they are not overweighted in a multi-market index.
Sector Index
These indexes measure the returns of an industry or sector. We saw from a previous example that a fund
manager could compare their returns to the NIFTY IT index. The NIFTY IT index is an example of a sector
index.
These indexes can be used to assess how cyclical a sector’s returns are. For example, the NIFTY Metal
index will do well during economic upturns but badly in downturns. So, a fund manager may choose stocks
from the NIFTY Metal according to their economy expectations.
Sector indexes can be global indexes or for a specific country. They are also used to construct portfolios
that replicate an index.
They may also be compared to broad-based indexes to assess the performance of a single sector relative
to the overall market. For example, one can use the NIFTY Auto index’s returns and compare them to the
NIFTY 500 index’s returns to assess if the auto industry has underperformed or outperformed the broad
equity index.
Style Index
Such indexes measure the returns of market capitalization and value or growth strategies. For example,
a mid-cap growth fund would use a growth style index for mid-cap stocks as a benchmark.
But the boundaries between small-cap, mid-cap and large-cap are not clearly defined, and each index can
use a different calculation. For example, the top 500 companies in a market could be defined as large-cap
stocks, or there could be a cutoff of market capitalization where a large-cap is classified as a small-cap.
It is also possible that a small-cap company grows and becomes large enough to be classified as a mid-cap
or even a large-cap. Therefore, such indexes must be reconstituted depending on the changes in
classifications. Factors like the price-to-earnings ratio (P/E ratio) or dividend yields are used to identify
value and growth stocks. Growth stocks typically have high P/E ratios.
1. An analyst combines indexes from India, Brazil, and Mexico. These indexes include all the shares
from each of these markets. The analyst has most likely created a
A. Sector index
B. Multi-market index
C. Broad-based index
2. You want to assess the performance of stocks in the real estate market in India. You are most
likely to use the
A. NIFTY 200 Momentum 30 Index

B. NIFTY 500 Index
C. NIFTY Realty Index
Answers
1. B is correct. A multi-market index combines indexes from multiple markets. The weightage may
depend on factors like GDP. C is incorrect because the analyst has used broad-based indexes to
make a multi-market index. A broad-based index reflects the overall market sentiment. A is
incorrect because a sector index is like an automobile industry index - it uses the stocks from a
specific sector or industry.
2. C is correct. You would want to use a sector index that represents the returns on real estate stocks
in India. The NIFTY Realty index is the most appropriate in this case. A is incorrect because this is
a style index - it tracks the performance of 30 high momentum stocks across large and mid-cap
stocks in the NIFTY 200 index. B is incorrect because this is most likely a broad-based index. It will
have so many stocks besides real estate that it is not possible to assess the performance of just
one sector by using this index.
LOS 46i: Compare types of security market indexes.
Following is a list of indexes and their characteristics.

LOS 46j: Describe types of fixed-income indexes.

Fixed-income securities (like bonds) vary depending on factors like:
➢ Coupon rates.
➢ Ratings.
➢ Maturities.
➢ Issuer.
➢ Collateral.
➢ Embedded options.
➢ Default risk.
➢ Inflation protection or other index-linked bonds.
These are covered in the Fixed Income readings.

The indexes are, therefore, variable depending on such factors. They may be constructed for different
sectors, geographies or based on the economic development of countries. An index can be broad-based,
sectoral, based on style or some other specialized index.
However, since the fixed-income universe is larger than the stock universe, this results in large differences
between the securities in the index itself. Each bond may have very different characteristics. Remember
that bonds are issued not only by corporations but also by governments and quasi-government agencies.
Each of these financial bodies may issue several types of fixed-income securities too.
Stocks do not mature, but bonds do. Bonds that mature must be replaced in the index. This increases the
turnover and transaction costs.
Also, note that fixed-income securities trade-in dealer markets. They do not trade on exchanges, are less
liquid and are less frequently traded. The index provider must turn to dealer prices to calculate the value
of the index. But if there is a lack of trades and dealers quote vastly different prices, the index provider
may need to estimate the price.
So, it becomes very difficult and expensive for fixed-income portfolio managers to replicate a fixed-income
index due to a lack of complete or accurate information. Illiquidity, transaction costs and turnover also
make it costly to construct a portfolio that replicates a fixed-income index.
LOS 46k: Describe indexes representing alternative investments.

Alternative investments provide diversification benefits. Investors may diversify their portfolios by
investing in commodities, real estate, or hedge funds.
Commodity Indexes
These use futures contracts of the underlying commodity to determine the value. Commodities include
grains, livestock, metals, and energy.
Some popular commodity indexes are:
➢ Thomson Reuters/Core Commodity CRB Index (previously the Commodity Research Bureau
Index).
➢ S&P GSCI (previously the Goldman Sachs Commodity Index).
But these index providers do not have a standard weighting system, so it becomes difficult to assess the
risk-return profile of a commodity portfolio relative to an index. The weighting methods include
weightings based on:
➢ Equal weighting.
➢ Global production values.
➢ The index provider determines fixed weights.
For instance, one index may give more weightage to energy commodities (like oil and natural gas) while
another may give more weightage to agricultural products (like wheat or sugar).
Note that these prices are based on futures contracts rather than the spot price (current trading price).
The index value accounts for the risk-free rate of return, futures prices, and roll yield. Also, note that
futures contracts have expiration dates. So, the contracts must be replaced once they mature.
This explains differences in the actual commodity returns and the index values for long positions.
Real Estate
These can be made by using:
➢ Appraisals of properties.
➢ Repeat property sales.
➢ Performance of Real Estate Investment Trusts (REITs).
REITs are essentially closed-end mutual funds, and they invest in real estate or mortgages. They then issue
ownership interests in the pool of assets (owned by the REIT) to investors. REIT shares trade on stock
exchanges, but the actual properties are illiquid. Therefore, REITs are like a liquid and low-budget
investment alternative to directly investing in real estate.
FTSE International publishes REIT indexes.
Hedge Funds
Hedge funds are also pooled investment vehicles. They raise funds from high-net-worth investors and
invest this money on their behalf into traditional and alternative assets.
Most hedge fund indexes are equally weighted. However, since hedge funds are largely unregulated, not
all hedge funds must provide information to index providers. This creates a survivorship bias because only
the best hedge funds are most likely to report their performance. This creates an upward bias in the
returns, and the returns may not represent the return of the aggregate hedge fund industry.
They may also choose to report to one index provider but not another. Additional due diligence may be
required to see how the index has been created and which hedge funds are part of the index. It is therefore
difficult to assess the performance of different hedge fund indexes.
1. Which of the following indexes is most likely to be reconstituted the most often?
A. An equity index like the NIFTY Midcap 100

B. A fixed-income index like the Barclays California 1-Year Municipal Bond Index
C. A real estate index like the ARES Japan Property Index
2. Illiquidity is least likely an issue for
A. Real estate indexes

B. Fixed-income indexes
C. Equity indexes
3. Which of the following most likely require additional due diligence?
A. Equity indexes
B. Hedge fund indexes
C. Real estate indexes
4. One of the drawbacks of a commodity index is most likely that

A. They do not reflect the futures prices appropriately
B. Index providers may give different weights for each commodity in different indexes
C. They do not account for the roll yield of commodity futures
Answers
1. B is correct. A fixed-income index with bonds with 1-year maturities is much more likely to be
reconstituted than any other options. The bonds must be replaced every year (security will be
removed and added every year).
2. C is correct. Equities trade on exchanges and are very liquid. There is a much higher volume of
trades that occur for equities than there are for the other two options. Fixed-income securities
are traded on dealer markets, and it may not be easy to accurately create a fixed-income index.
Real estate is also an illiquid asset - property appraisals or repeat sales indexes are based on
infrequent data.
3. B is correct. It is likely that only the hedge funds that perform well will report their performance
to index providers. Hedge funds may not even report their performance to index providers. This
creates survivorship bias (performance is overestimated). Real estate indexes also require due
diligence because of the various types of real estate investments possible but not as much as
hedge fund indexes. Equity indexes require the least due diligence.
4. B is correct. One index may give more weightage to energy commodities (like oil and natural gas)
while another may give more weightage to agricultural products (like wheat or sugar). A is
incorrect because these do reflect futures prices appropriately, but they do not necessarily reflect
the spot prices appropriately. C is incorrect because the futures contracts in the index do account
for the roll yield.
Market Efficiency 74
Market Efficiency
The degree of market efficiency is important to understand from the context of portfolio management.
Portfolio management aims to beat a benchmark index like the NIFTY 50 or a sectoral index like the NIFTY
IT Index if the portfolio is based on IT stocks.
It becomes difficult to beat the benchmark as markets become more efficient and so it is important to
understand the different types of market efficiency and their implications for stock picking and portfolio
management.
Make sure that you are familiar with the three forms of market efficiency and their implications for
portfolio management (specifically the role of technical analysis and fundamental analysis). Also, make
sure that you have understood the different market anomalies and the behavioural finance section of this
reading.
LOS 47a: Describe market efficiency and related concepts, including their importance to
investment practitioners.
A perfectly efficient market (or an efficient security price) reflects all available information related to that
market or security. Theoretically, it is a statistical concept that says that all available information should
be priced rationally, quickly, and completely.
If this theory always holds, then the efficient market hypothesis states that it is not possible to beat the
market because all possible information is already priced in, and all parties have the same rational
expectations. So, any returns to a portfolio will only match the benchmark index returns, and it does not
make sense to actively try to research stocks or portfolios that will beat the market.
This leads to the passive management versus active management debate.
Suppose you are trying to construct a portfolio with 60-70 stocks. You choose the NIFTY 50 as the
benchmark index, and you aim to earn a higher return than the NIFTY 50.
Suppose the NIFTY 50 returns 25% over a period of one year. If markets are truly and perfectly efficient,
then it means that a fund manager cannot beat the benchmark index. So, your portfolio of 60-70 stocks
may have some outperformers and some underperformers, but the net effect will be that you have earned
close to 25% on that portfolio after transaction costs and management costs.
In this case, you would be better off by just investing in a NIFTY 50 index fund or a NIFTY 50 ETF (exchange-
traded fund), which tracks the returns of the NIFTY 50 index. This is a form of passive investing. Then
there is no need to try to actively manage the portfolio because there is no point in trying to pick an entire
portfolio of winners that will beat the index.
A portfolio manager will incur trading fees and transaction costs for making an actively managed portfolio.
This reduces the net returns of the portfolio, and so active investment strategies will underperform the
market even more.
It isn't easy to assess just how efficient a market is.
One way to measure market efficiency is to see how long it takes for traders to price in the information
that companies have released. For example, developed currency markets can price in new information in
a matter of minutes, but it may take a few days in emerging equity markets for things like earnings to be
priced in.
If there is an information delay, traders are at an advantage because they can place their bets knowing
that the security price has not adjusted properly yet. Note that only new information will really move a
security price. For example, suppose it is expected that a speciality chemicals company’s earnings will be
higher than the previous quarter by20%. In that case, likely, this has already been priced into the market.
The new information, in this case, would be if the company has beaten the market expectations and the
earnings have increased by 40%. So, investors and traders are rewarded for placing bets that beat the
market and identifying stocks that will surpass expectations.
LOS 47b: Contrast market value and intrinsic value.
The market value of a security is simply the current price of that security. It is observable and is dictated
by demand and supply factors.
The intrinsic value is more subjective and is not always observable. It is the value that a rational investor
with perfect information (about maturity, default risk, liquidity, and other characteristics) would be
willing to pay for the security. This may be easier to calculate for securities like fixed-coupon bonds. The
cash flows and their timing are known; only the yield must be adjusted based on expectations.
It is more complex to find the intrinsic value of a security like a stock because there are many more
variables that must be accounted for. Nonetheless, the market value equals the intrinsic value in a
perfectly efficient market.
This is not always the case, so fund managers who follow active investing will buy securities that they
think are undervalued and will sell those that they think are overvalued. Remember that the market value
is observable, and the intrinsic value is subject to analyst assumptions and expectations. If an analyst has
calculated the intrinsic value based on their expectations, the simple rule is:
If Market Price < Intrinsic Value, then BUY

If Market Price > Intrinsic Value, then SELL
Suppose you perform a detailed analysis of Reliance, and you find that the intrinsic value is Rs. 2,000. You
observe that the current market price is Rs. 2,200. So based on your analysis and expectations, it does not
make sense to enter this trade right now because if you are right, then the share price should be Rs. 2,000
and not Rs. 2,200. You would not buy the stock at the market price. If there were no restrictions on short
selling, then you would short sell the stock with the expectation that the price will fall to Rs. 2,000.
1. If markets are perfectly efficient, which of the following strategies is an investor most likely to
adopt?
A. Passive strategy
B. Active strategy
C. Mix of both passive and active
2. Suppose the consensus analyst expectation of a widely followed large-cap company's earnings
per share (EPS) is Rs. 90.00 per share. This is much higher than the previous year’s EPS of Rs. 60.50
per share. Which of the following is most likely the case when the earnings are released if the
company posts an EPS of Rs. 90.00 per share?
A. The stock price decreases

B. The stock price increases
C. The stock price does not change much
3. You calculate the intrinsic value of a stock as Rs. 56 per share. The current market price is Rs. 50
and there is a big, positive announcement related to the expected stock in the next few days. You
have priced in the impact of this announcement in your financial model. Which of the following is
the most likely action that you should take?
A. Do nothing
B. Buy the stock
C. Sell the stock
4. Which of the following statements about intrinsic value and market value is most likely true?
Statement 1: Intrinsic value is directly observable and is subjective.
Statement 2: Market value is directly observable and is not subjective.
A. One of these statements is true
B. Neither statement is true
C. Both statements are true
Answers
1. A is correct. If markets are perfectly efficient, then one cannot beat the benchmark index returns.
It does not make sense to try to pick securities that will beat the market actively.
2. C is correct. It is unlikely that the stock price would change significantly if the company posted a
result that analysts already expected. This information is already priced in; it is not new.
3. B is correct. Suppose you are confident in your analysis and have accurately priced in the impact
of the announcement in your analysis. In that case, the most likely route is to buy the stock and
wait until the rest of the market has priced in this information. If you are correct about your
expectations, then the market price should reflect Rs. 56, up from Rs. 50.
The market price and the intrinsic value will keep changing as new information is updated in the
market or into the financial model that was used to calculate the security’s price.
4. A is correct. Statement 2 is true. Statement 1 is false because although the intrinsic value is
subjective, it is not directly observable. It is subject to an analyst’s expectations and evaluation of
a company’s current operations and prospects.
LOS 47c: Explain factors that affect a market’s efficiency.
It is unlikely for a market to be perfectly efficient or perfectly inefficient. There will always be a degree of
efficiency that will vary depending on, but not limited to, a few factors.
Number of Market Participants and Availability of Information
The more the participants, the greater the efficiency. Suppose there are 50 analysts that are following a
large-cap stock like HDFC Bank. They will all have different sources of information, different opinions, and
different expectations. But all of these will balance out, and all of these will be reflected in the current
market price. This does not leave a lot of room for unexpected information to shock the stock price.
On the other hand, suppose there are only 4 analysts who are following Redington. There will be limited
information that is priced into this stock, and people who have an informational advantage can make
profitable trades because they will be the first to make the trade, and then the rest of the market will
follow.
So, the more the investors, traders, and analysts can price in more and more information into a stock, the
more efficient each security will be and the more efficient the overall market will be.
Therefore, there have been such strict regulations around insider information. Suppose you are the CFO
of a company. You will know the earnings of a company before any member of the public. Suppose this
information is not conveyed via applicable regulatory requirements to analysts and investors. Then in a
world without insider regulations, you could have placed a trade on the company's stock and waited until
the market reflected this new price.
Two Infosys employees, among other parties, were fined for violating SEBI’s insider trading rule regarding
unpublished price sensitive information (UPSI). The employees allegedly supplied information regarding
Infosys’ earnings to Capital One and Tesora, who generated a total of Rs. 3 Crore via futures and options
trading.
Impediments to Trading (Arbitrage and Transaction Costs)

Efficient trading is necessary for market participants to price in new information into securities and
security markets. Suppose two securities with the same expected payoff are trading at different prices in
two different markets.
Traders can make arbitrage trades to cancel out this difference. They can buy the same security in one
market where the asset is trading at a lower price and at the same time sell it in the market where it is
trading at a higher price. Eventually, the prices will converge to an arbitrage-free price.
For example, suppose ITC’s shares are trading at Rs. 200.00 on the BSE but at Rs. 201.50 on the NSE. In a
world with zero transaction costs and taxes, a trader can buy these shares for Rs. 200.00 on the BSE and
sell them for Rs. 201.50 on the NSE. Although the gain in percentage terms is marginal, the sheer volume
of traded shares can deliver profits.
But this is only possible if the following basic conditions are met:
➢ Low transaction costs: Arbitrage profits are relatively small, and so transaction costs should be
low enough to ensure a net profit
➢ Perfect information: Traders in one market should have perfect information about prices in other
markets
➢ No restrictions to short selling: If the higher-priced security cannot be short sold, then arbitrage
trades cannot happen
Transaction and information costs are the key factors. If costs like commissions, brokerage or delivery
charges are so high that traders are discouraged from taking arbitrage trades, this impedes efficient prices.
Even the cost to acquire information about security can be high. Software like the Bloomberg Terminal or
VCCEdge require installation costs, and it also costs money to buy high-quality industry research reports.
So, markets will remain inefficient, and there will be some potential risk-adjusted returns from making
trades on securities that do not accurately reflect their intrinsic value. If markets are truly efficient, then
there will be no risk-adjusted returns possible, and the return is likely to be that of the benchmark index.
1. Which of the following are least likely impediments to market efficiency?
A. Restrictions on short-selling
B. High commissions
C. Perfect information
2. A stock that has significantly more analyst coverage will most likely be which of the following
compared to a stock with less analyst coverage?
A. Less efficiently priced

B. More efficiently priced
C. Equally efficiently priced
3. High market efficiency is most likely characterized by
A. Availability and accessibility of information

B. Market prices that differ greatly from the intrinsic value of a security
C. Widespread potential for abnormal risk-adjusted profits
Answers
1. C is correct. A and B both will discourage arbitrageurs from making arbitrage trades, so
inefficiencies are not likely to be priced out of the market.
2. B is correct. The more the participants that are tracking a stock (and the more the information
that is priced into the stock by these participants), the greater the efficiency of the stock price.
3. A is correct. B is incorrect because if markets are efficient, then it is likely that market prices closely
match the intrinsic price of the security. C is incorrect because there is less potential for
widespread abnormal profits if prices reflect available information.
LOS 47d: Contrast weak-form, semi-strong-form, and strong-form market efficiency.
In general, there are three types of market efficiency. The main difference between the three forms is the
degree of information that is priced into securities. Note that there is no absolute form of market
efficiency. Markets can have varying degrees of efficiency from time to time.
Weak-Form Market Efficiency
This form states that current market prices fully reflect all past market data. So, any trader who uses
historical information will not be able to make a positive abnormal return because this has already been
priced in.
This means that no returns can be made from technical analysis. This is the analysis of previous price
movements and patterns. There is no analysis of a company’s fundamentals or news; it solely predicts
how the price will change given previous price patterns.
Therefore, abnormal returns can be made via fundamental analysis and insider trading.
Semi-Strong-Form Market Efficiency
This form states that security prices reflect all publicly known and available information. Prices will adjust
quickly to any new information without any bias.
This means that an investor or trader cannot make abnormal returns by fundamental analysis. This is the
study of a security’s financials and any news or economic conditions that might affect the security price.
Investors or traders cannot make positive risk-adjusted returns since this information is already priced
into the security price.
In this case, abnormal returns can be made only by insider trading.
Strong-Form Market Efficiency
This form states that security prices fully reflect private and public information. It includes everything
from past price data to publicly available information to inside information.
This means that no one has priority access to company information. Even an employee or a CFO cannot
make an abnormal return based on inside information. Such efficiency is unreasonable because all this
information would be readily and fully priced only if insiders could make trades based on the information
they know. So, it is still likely that company insiders will know the true intrinsic value of a company.
However, since they cannot act on this information (considering regulations on insider trading), the
market will take time to reflect this information.
The following Venn diagram summarizes the different forms of market efficiency.
1. A trader uses only technical analysis and generates negative returns over a period of three
months. Which of the following statements is most likely correct?
A. The weak form of EMH was violated

B. The weak form of EMH was not violated
C. The weak form of EMH is not relevant with the given information
2. An investor cannot generate positive abnormal returns by using company fundamentals and
economic data. Which of the following is least likely correct?
A. The weak form of market efficiency is not violated

B. The semi-strong form of market efficiency is not violated
C. The strong form of market efficiency is not violated
3. A trader generates an abnormal return based on insider information that they received form a
company’s management regarding the announcement of a merger. Which of the following is most
likely correct regarding market efficiency?
A. Insider information is a part of fundamental analysis, and so the semi-strong form was
violated
B. Insider information is part of private information, and so the strong form was violated
C. Insider information is a part of fundamental analysis, and so the strong form was violated
Answers
1. B is correct. The weak form of the EMH would only be violated if the trader generated consistent
positive abnormal returns. This is because they would generate a positive return only based on
previous price data.
2. C is correct. There is not enough information to know if the strong form has been violated. The
weak and semi-strong forms have not been violated because the investor could not generate
abnormal returns using fundamental analysis.
3. B is correct. The strong form of market efficiency states that all public and private information has
been priced into security so that no one can benefit from an informational advantage. This was
violated because the trader had an informational advantage and made an abnormal return from
this information.
LOS 47e: Describe market anomalies.

Anything that is outside the norm of common market rules is considered an anomaly. Anomaly studies
are used to test the efficient market hypothesis (EMH). Therefore, a market anomaly is something that
would lead us the reject the null hypothesis of the market efficiency.
It is possible that a few random variables will be part of a strategy that delivers abnormal returns. Note
that these studies are extremely subjective to the market conditions in the selected time horizon, so these
anomalies will not persist over a period.
This is the catch. Suppose you compile data and create a statistical model with 25-30 variables to find a
statistically significant relationship. This is called data mining or data snooping. You perform a regression
analysis that seeks to explain the relationship between these variables and abnormal returns, and you
find that 6 of these variables are statistically significant in explaining the abnormal returns. How likely is
it that this relationship is consistent over other periods of time, and how likely will this relationship hold
in the future?
Suppose you keep analyzing data just to find a significant relationship. In that case, you are likely to find
a few variables that show a significant relationship by chance, and this is a drawback of data mining. It is
therefore important to note which variables have an economic significance, not just a statistical
significance.
The key point here is that correlation does not mean causation.
Now we will discover a few popular anomalies that have been discovered.
Calendar Anomalies
One of the most popular theories is the “turn-of-the-year” effect or the January effect. The fiscal year for
companies in the U.S. ends in December, and so one explanation is that investors sell losing positions in
December so that they are eligible for a tax loss. This capital loss will set off the capital gains on other
securities and help reduce the tax liability for that year.
So, traders sell in the last week of December and buy back during the first trading week of January with
no real change in fundamentals. This means that the returns during this week are higher than they are for
the remainder of the year. Traders can exploit this anomaly for an abnormal profit. This is most likely true
for smaller, riskier companies.
Another explanation is that fund managers sell their risky stocks at the end of the year to not appear on
the year-end statements. Then they buy these same stocks in the first trading week of January.
Other such anomalies were found, and they include:
➢ Turn-of-the-month effect: Stock returns increase at the end of the month.
➢ Day-of-the-week effect: Returns on Monday are, on average, negative.
➢ Weekend effect: Returns on Friday are positive and are followed by negative returns on Monday.
➢ Holiday effect: Returns before a holiday are higher.
These anomalies have not been persistent, so it is impossible to say that they are true in practice.
Overreaction and Momentum Anomalies

The overreaction theory states that if a portfolio is created using stocks with poor returns over the last 3-
5 years, then this portfolio will perform better in the next periods. This is due to overreaction to both
unexpected goods news and unexpected bad news and that the “losers” have more value than what is
currently priced in.
A momentum effect is when positive short-term returns are followed by more positive short-term returns.
Rakesh Jhunjhunwala is a famous momentum investor who believes in this characteristic of stock prices.
Both violate the weak-form efficiency because a winning portfolio can be created using only past price
data.
Size Effect
This theory states that small-cap stocks outperform large-cap stocks over a given period. While this may
be true for a few years after a recession, the finding does not hold consistently. Small-cap stocks are
generally more sensitive to economic cycles than large-cap stocks. So, this finding heavily depends on the
time horizon and economic conditions.
Value Effect
This theory states that value stocks have outperformed growth stocks. Value stocks are usually defined
by relatively lower price-to-earnings ratios (P/E ratios), lower market-price-to-book-price ratios (M/B
ratios), and higher dividend yields. The argument here is that the price of a stock that is trading at a lower-
than-expected P/E will adjust upwards to reflect the fundamentals of the stock, the industry or the
market.
The semi-strong form is violated because an analyst requires the fundamentals of a stock to understand
if it is a growth stock or a value stock (which is publicly available). But again, this theory does not hold
consistently.
Other Anomalies
Closed-End Investment funds
An open-ended investment fund is like a regular mutual fund. You can buy the units of a mutual fund
scheme at a particular net asset value (NAV), and then this NAV will change depending on the performance
of the underlying shares in that scheme. These units cannot be traded on the open market.
However, the units of a closed-end investment fund can be traded on the open market. So, it is possible
that prices sometimes deviate from the true NAV of the underlying stocks. The closed-end fund puzzle is
that the prices of closed-end funds usually trade at steep discounts to the NAV as long as the scheme is
closed-ended.
This is like saying that you have cut a pizza into 8 different slices and given the whole pizza to your friend.
But your friend finds that the value of the sum of all slices is as good as 7 slices. This describes the
irrationality of closed-end funds.
Arbitrage should ensure that the price of the closed-ended scheme equals the NAV, but this is not the
case. Explanations like management fees, taxes and illiquidity are not adequate to explain this puzzle. The
transaction costs would cancel out any arbitrage profits arising from exploiting the closed-ended fund
discounts' unexplained portion.
Earnings Announcements
We saw before that earnings surprises are likely to move the stock price in the direction of the surprise.
For example, if earnings are better than expected, the stock price will likely increase. But it is the speed
of this increase that is concerning.
Stock prices may not immediately reflect the new information. So, it is possible that instead of an
immediate price increase, there is a gradual price increase.
Traders can take advantage of this post-announcement drift if they think that the effect of the earnings
release has not been priced in completely yet. It is important to note that the profits from these trades
must account for transaction costs too.
Initial Public Offerings
Studies have shown that IPOs are usually underpriced, and so there are gains to be made from subscribing
to IPOs. But the long-term performance of a group of IPOs is subpar. This suggests that there is an initial
hype or irrational optimism around IPOs when they first list, but this hype subsides eventually.
Economic Fundamentals
One would expect stock returns to be related to fundamentals like dividend yields, volatility, and interest
rates, but this is true only for efficient markets. There is usually a divergence between current economic
fundamentals and market prices, and one of the reasons is that stock prices reflect expectations of future
conditions. Also, market data is much more volatile than economic data. Consider that GDP data is
released on a quarterly basis while market prices move every day.
What do these anomalies mean for investors?
Most of the evidence points towards the fact that all of these anomalies are not violations of the EMH,
but they are found due to the statistical methods used. So, they do not provide a lot of informational value
for trading or investing strategies if investors cannot benefit from them consistently.
1. Why is a market anomaly least likely inconsistent over different periods of time in practice?
A. The variables could be correlated by economically significant factors

B. The variables could be correlated by chance
C. The variables have little economic significance
2. Which of the following is a least likely explanation for the January effect?
A. Investors sell their losing stocks in December so that they get the benefit of a capital tax loss
and then buy them back in January
B. Investors buy stocks in December and then sell them in January for tax benefits
C. Fund managers sell risky stocks in December to show that their portfolio is of a low-risk profile
at the end of the year
3. Momentum anomalies are most likely characterized by which form of market inefficiency?
A. Semi-strong-form
B. Strong-form
C. Weak-form
4. Which of the following statements are most likely true regarding the size and value effects?
Statement 1: The size effect states that large-cap stocks typically outperform small-cap stocks
over time because they are safer.
Statement 2: The value effect states that a group of stocks with low P/E and M/B ratios will
outperform another group of stocks with high P/E and M/B ratios over time.
A. Both statements are true
B. Neither statement is true
C. One of these statements is true
5. Which of the following most accurately describes the closed-end fund anomaly?
A. Closed-end funds typically trade at premiums relative to the value of all the underlying
securities
B. Closed-end funds typically trade at discounts relative to the value of all the underlying
securities
C. Closed-end funds typically fluctuate between discounts and premiums relative to the value of
all the underlying securities as and when arbitrage opportunities are capitalized
6. Why are reactions to earnings surprises most likely considered inefficient?
A. Inside information is not priced into the earnings, and so it violates strong-form market
efficiency
B. Although the market reacts to the news, they do not react quick enough, and so there are
potential profits to be made from fundamental analysis
C. A trader can use only past price data to predict the price movement when earnings are
announced, and so profits can be made from technical analysis
Answers
1. A is correct. If economically significant factors truly correlated variables, then it is likely that the
relationships would hold over different time horizons and different samples. The variables in such
anomaly studies are likely to be statistically valid but economically invalid. B and C are incorrect
because these are both valid reasons for anomalies to be inconsistent over different time
horizons. Just because a statistically significant relationship for a particular sample does not mean
that the theory is valid over different periods.
2. B is correct. A and C are both valid explanations for the January effect.
3. C is correct. Momentum analysis largely uses price data to identify predictable patterns of high
momentum periods. The use of past price data to earn abnormal returns violates the weak form
of market efficiency.
4. C is correct. Statement 1 is incorrect. Small-cap stocks are perceived as riskier, and investors are
typically rewarded with higher returns (although these returns are more volatile). Statement 2 is
correct and accurately describes the value effect.
5. B is correct. The closed-end fund puzzle describes the phenomenon where the net asset value
(NAV) of closed-end funds trade at steep discounts relative to the aggregate price of the
underlying securities. Arbitrageurs cannot capitalize on these opportunities, and no explanation
has been found for this phenomenon that holds consistently over different studies.
6. B is correct. If a company releases information regarding its earnings, it is part of fundamental

analysis. But if the market does not process this information quickly and completely, a trader can
profit if they expect prices to move more than they already have after the earnings release. A is
incorrect because earnings releases are only insider information before they are released to the
public. If anything, the stock price becomes more efficient as company management releases
more information regarding the company. C is incorrect because only past price data cannot be
used to measure the impact of an earnings release.
LOS 47f: Describe behavioral finance and its potential relevance to understanding
market anomalies.
Theories are valid only if they hold in practice. Behavioural finance bridges the gap between theoretical
studies and practice because it studies how investors make actual decisions.
Traditional finance theories assume that investors act rationally, but behavioural finance has proven that
humans do not make decisions that always maximize their utility. This means there is always some
unconscious bias in our decisions as investors, and we are irrational to some extent.
Further, investors do not assess risk in the same way that traditional models assume they do. Many types
of investor irrationality have been proposed as explanations for reported pricing anomalies.
But rationality is not a necessary assumption of the EMH. So, just because a few investors behave
irrationally, it does not mean that the entire market is so inefficient that it violates the EMH. There are a
few findings from behavioural finance that are of use to the investment decision-making process:
➢ Loss aversion: Here investors will dislike losing ₹50 more than they will like gaining ₹50. Hence,
investors dislike losses more than they like gains. This can be summed up in a simple quote by
Jimmy Connors, a famous tennis player who once said, “I hate losing more than I love to win.”
➢ Investor overconfidence: Fund managers who have earned an average return think that their
skills are above average. They overestimate their abilities to analyze security information and
identify differences between securities’ market prices and intrinsic value.
➢ Herding: Investors make investment decisions based on the actions of other investors (they copy
or mimic other investors’ trading strategies) and put less weight on their own information and
beliefs.
A likely effect of herding is an information cascade. This is likely to happen when less-informed investors
copy the actions of informed traders or investors. So, assuming that the more informed groups act first
and then the less-informed groups follow, new information can be steadily priced into the markets, and
this will lead to more efficient markets.
Remember that these explanations only tell us about the irrationality of market prices. If rationality were
an assumption for the EMH to hold, then markets would not be efficient. It is possible to have efficient
markets with periods of irrational prices.
Other behavioural biases include:
➢ Representativeness: Investors process new information and the likelihood of future outcomes
based on familiarity. They tend to classify past events and compare them to current market
conditions to predict what might happen next.
➢ Mental accounting: Investors track their gains and losses for different investments as if they were
in different “pockets”. For example, suppose you invest in Stock A, and the unrealized gain is 10%
while the loss on Stock B is 15%. Instead of seeing these in the context of the entire portfolio, an
investor may treat these as two separate accounts altogether.
➢ Conservatism: Investors may react to new information slowly and may continue to hold their prior
opinions even considering new information.
➢ Narrow framing: Investors respond to a certain situation in the context of how they have
“framed” the issue. They may look at certain facts or pieces of evidence as individual pieces rather
than looking at the entire puzzle.
1. An information cascade is most likely a consequence of which of the following findings from
behavioural finance?
A. Loss aversion
B. Overconfidence
C. Herding
2. Which of the following most accurately describes loss aversion?
A. Investors hold on to losing investments because they dislike realized losses but like realized
gains equally
B. Investors hold on to losing investments because they dislike realized losses more than they
liked equal amount of realized gains
C. Investors demand a higher risk premium for more risky assets
3. An investor looks at the current market conditions, and it reminds them of market conditions
based on 10 years ago. They base their investment decisions solely on the fact that what
happened 10 years ago is likely to repeat itself. This is most likely a
A. Conservatism bias
B. Representativeness bias
C. Mental accounting bias
Answers
1. C is correct. Information cascades are likely to happen when less-informed investors copy the
actions of informed traders or investors. Prices steadily move to more rational prices as more
rational information gets priced into them.
2. B is correct. One of the consequences of loss aversion is to hold on to losers for long and to sell
winners quickly. The negative effect of realizing a loss hurts more than the positive effect of
enjoying a gain.
3. B is correct. Representativeness means that certain market factors “re-present” themselves. But
this does not mean that history will completely repeat itself. There may be some correlations, but
an investment decision cannot be based entirely on what has happened previously because there
will always be some differentiating factor between the past and the present. A is incorrect
because conservatism is more about how an investor responds to new information. Investors may
hold on to their previous beliefs even if new information is presented to them. C is incorrect
because the mental accounting bias is about treating two different investment positions as two
separate accounts instead of seeing them as one portfolio or part of a portfolio.
Overview of Equity Securities 89
Overview of Equity Securities

You may read about equities and the stock market regularly, but it is important to understand their risk
and return characteristics. This reading gives a basic understanding of the different types and avenues of
equity investments, how equity financing is important to companies, a brief overview of the required rate
of return and difference between the book value of equity and market value of equity and what this
difference represents
Make sure that you have a solid understanding of the concepts mentioned above.
LOS 48a: Describe characteristics of types of equity securities.
Companies raise funds via debt and equity. Interest and principal payments on debt are obligations and
must be paid. However, dividends on ordinary shares are paid at the discretion of the Management.
Investors in equity securities largely generate returns from capital appreciation (share price appreciation).
A company can issue various types of equity shares.
Common Shares (or Ordinary Shares)
These are the most common, and they represent equity ownership in the company. Common
shareholders have the last claim on a company’s assets (after debt holders and preferred stockholders) if
the company is liquidated. However, they have voting rights and can direct the company by voting on
important matters. If they are unable to vote themselves, they can vote by proxy (having someone else
vote for them as directed)
The voting rights also allow shareholders to vote for the board of directors on merger decisions and on
the selection of auditors during the annual general meeting. Shareholder rights have been covered in
detail in the Corporate Finance readings of the curriculum.
There are two general types of voting systems. A statutory voting system allows one vote per share for
each member of the board of directors. A cumulative voting system allows shareholders to pool all their
votes on one candidate or spread their votes across candidates. Suppose a shareholder has 500 shares
and 4 candidates are to be elected. Under statutory voting, the shareholder has 500 votes for each
director in each election. Under cumulative voting, the shareholder has 2,000 votes (4 candidates times
500 shares), concentrated on one candidate or spread across the 4 candidates. Minority shareholders
benefit from a cumulative voting system as they can pool their votes onto one candidate giving them
more proportional representation on the Board.
Preference Shares (or Preferred Stock)
These have features of debt and equity. Preferred stock dividends are not an obligation, and the shares
are usually perpetual (unlike debt, perpetual preferred shares do not have a fixed maturity date). These
shares do not have voting rights. But they typically pay regular dividends.
Preferred shares may be callable or putable. A call option allows the company to buy the shares back at a
specified price and a put option allows the shareholder to sell the shares back to the company at a
specified price.
Cumulative Preference Shares

The dividend of this type of share is usually paid at a fixed rate on the face value of the shares. So, if a
preference share with a par value of Rs. 100 is issued at a rate of 4.50% per share, then the dividend paid
is Rs. 4.5.
If a dividend is not paid in one year, the cumulative preference share dividend must be paid before the
dividend on ordinary shares. Hence the term is cumulative because the unpaid dividends must be
recovered in subsequent years. The dividend is said to accumulate hence the term “cumulative”.
Dividends of non-cumulative preference shares do not accumulate in this way.
If the company exceeds a certain predetermined profit level, investors of participating preference shares
may receive an extra dividend. They may also get a value that exceeds the par value if the company
liquidates. Participating preference shares are more likely to be issued by smaller and riskier companies
with high default probabilities. The extra dividend entices investors so that they have a claim to the
potential upside.
However, investors of non-participating preference shares will receive a payment that is equal to par
value if the company liquidates.
Let us compare two financial services companies in the U.S. - Wells Fargo and Arlington Asset Investment.
Wells Fargo has issued 7.50% non-cumulative, convertible preference shares. This means that they must
pay a dividend of 7.50% on the face value of the shares, and if they do not pay the full amount in any given
year, they are not obliged to make up the difference in subsequent years. However, Arlington Asset
Investment has issued 8.25% cumulative preference shares, and they are obliged to make up the
difference if they fail to pay a dividend in one of the years.
Convertible Preference Shares
These can be converted to common shares at a pre-specified conversion ratio. There are a few advantages
of holding convertible preference shares:
➢ Their dividend is usually higher than the dividend on common shares but lower than that of non-
convertible preference shares.
➢ The upside is not limited to the preferred dividend rate because the shareholder can convert their
shares to ordinary shares, which have theoretically unlimited upside.
➢ The conversion option value increases as the share price of the common shares increases.
➢ They hold less risk than common shares because the stable dividend payments largely cushion
the downside. These shares also have a higher priority of claims over ordinary shares if the
company liquidates.
Just like in a participating preference share, the conversion option is attractive for venture capital
investors who would like to have upside potential for the additional risk of investing in small and risky
companies.
For example, a private limited company called Carnation Auto India Pvt. Ltd. had issued fully convertible
0.01% preference shares in 2008, and these shares matured in 2018. Holders of this security had the
option to convert each preference share for one ordinary share. The conversion option would give each
shareholder voting rights (1 vote per equity share). Notice how small the dividend rate is, given the
conversion option.
1. Which of the following is the most accurate order of claims to a company’s assets on liquidation?
A. Senior debt, ordinary shares, preference shares

B. Senior debt, preference shares, ordinary shares
C. Ordinary shares, senior debt, preference shares
2. A company does not pay preferred dividends in one year, but it pays the outstanding amount next
year plus the amount due for that year. Which of the following is the most likely type of share that
has been described?
A. Non-cumulative preferred shares

B. Cumulative preferred shares
C. Participating preferred shares
3. An analyst claims that minority shareholders benefit from a statutory voting system and that a
cumulative voting system allows each investor to pool all their votes for one candidate if they
wish to do so. The analyst is most likely correct about which of those statements?
A. The analyst is correct regarding both statements

B. The analyst is incorrect regarding the benefits of minority shareholders but correct about the
cumulative voting system
C. The analyst is incorrect about both statements
4. Convertible preference shares are least likely beneficial because
A. The conversion value increases as the price of ordinary shares increases

B. Their downside is largely protected by the dividend payments
C. Their upside is limited even if the company exceeds operating performance expectations
Answers
1. B is correct. Ordinary shareholders have the last claim to a company’s assets on liquidation.
Creditors and preference shareholders must be paid before them.
2. B is correct. The dividend due on cumulative preferred shares carries forward from one year to
the next. The dividend accumulates. A is incorrect because non-cumulative preferred shares do
not have this feature. C is incorrect because participating preferred shares pay an extra dividend
if a predetermined profit level is exceeded.
3. B is correct. A cumulative voting system allows shareholders to pool all their votes on one
candidate if they choose to do so. Minority shareholders benefit from such a system because they
can pool their votes on a board member candidate who best represents their interests.
4. C is correct. The conversion option allows convertible preference shareholders to convert their
shares to ordinary shares. If the company’s value increases, then the value of its ordinary shares
increases. The conversion option value of preferred shares then increases too because
shareholders can take advantage of the upside.
LOS 48b: Describe differences in voting rights and other ownership characteristics
among different equity classes.
A company can have different classes of shares. For example, Class A shares may have voting rights, but
Class B shares may not. The owners of the company will hold Class A shares so that they hold the majority
of the voting power and control of the company. Both classes of shares can trade on the same stock
exchange. The Class A shares may also have a higher priority on the company’s assets if the company
liquidates. This is also called a dual-class share structure.
Even the treatment of dividends, stock splits, or other shareholders' transactions can differ between
classes. The rights of each class of shares will be given in the regulatory filings provided by the company.
Other potential differences between the two classes of shares include
➢ Conversion rights: Suppose there are a total of 100,000 Class A shares trading on the exchange,
and each share is convertible into one Class B share. There may be a stipulation that says there
must always be a minimum number of Class A shares. So, if the minimum is 80,000 Class A shares,
then only 20,000 can be converted into Class B shares at any given time.
➢ Liquidation Rights: It is not always the case that only one class of shares receives priority claim to
a company’s assets on liquidation. Both Class A and Class B shares may be equally entitled to a
claim on available assets for distributions.
➢ Preemptive Rights: This is the right to have the first option to buy certain securities. For instance,
the holder of any class of shares does not entitle that shareholder to receive shares of any other
class of shares or other convertible securities. Each class of shareholders or each class of security
holders have the first right to their own class and not any other class.
LOS 48c: Compare and contrast public and private equity securities.
The characteristics described so far have been relevant mostly to publicly traded companies. But there is
a massive market of private companies and private equity that you should be familiar with. Private equity
is usually issued to institutional investors via private placements.
How does private equity differ from public equity?
➢ Shares of privately held companies are not listed on stock markets, and so they are much less
liquid.
➢ Since there is no observable market price, the share price is negotiated between Company and
investors.
➢ Private companies are subject to less regulation in terms of the financial information that must
be reported publicly. This reduces their reporting costs.
➢ But less public scrutiny may lead to complacent corporate governance standards, and so investors
might have to do more due diligence before investing in such companies.
➢ There is no public pressure for short-term performance so that the company can focus more on
their long-term goals.
➢ Large exit multiples for investors if the company issues their shares to the public.
2020 was a blockbuster year for IPOs in India, and around 55% of the money raised through IPOs
were for venture capital or private equity exits. SBI Cards and Payment Services was the largest IPO
(Rs. 10,341 crores), and PE firm Carlyle sold 10% of its stake at this valuation.
There are a few avenues by which private equity investments can be made.
Venture Capital
This is usually the preferred route for early-stage investments. Venture capital funds typically invest in
companies to finance growth and development, but the investment can take place at various stages:
➢ Seed or start-up stage: This is the earliest stage of investing when the company could still be in
the development stage
➢ Early-stage: There is a proof of concept, and the company at least has some sales to back their
valuation
➢ Mezzanine financing: A combination of debt and equity is used to fund an expansion or

acquisition
Venture capital investors range from family and friends to private equity funds and all other wealthy
investors in between. Such investments take a lot more time than public equities to become profitable,
especially if the company requires restructuring or change in its business model. Funds are often locked
in for 3-10 years before a venture capital investor exits (or cashes out) their investment.
Leveraged Buyouts (LBOs)
A leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of
consideration. Investors use debt financing to buy all the equity of a company. This is typically done for
mature companies that have stable cash flows because the debt that was used to finance the acquisition
must be repaid.
It is called a management buyout if the company’s current management has bought the entire equity in
the company.
Private Investment in Public Equity (PIPE)
A publicly listed firm can sell a stake to private equity investors if they need quick cash. This is likely if a
company needs liquidity to repay large amounts of debt or are in a financial distress scenario. The
company must have growth prospects for private investors to provide quick cash. The shares are sold at
a discount to entice investors.
1. A company is seeking funding from venture capitalists, but they do not have any sales yet. Which
of the following stages is the company most likely in?
A. Early stage
B. Mezzanine stage
C. Seed stage
2. An analyst claims that the share price of private companies can be observed, and such companies
are subject to more scrutiny for short-term performance. The analyst is most likely correct about
which of those statements?
A. The analyst is incorrect regarding both statements

B. The analyst is correct about both statements
C. The analyst is incorrect regarding the share price but is correct about the short-term
performance
3. Which of the following funds most likely has the longest investment horizon?
A. An equity-linked savings scheme (ELSS)

B. A mutual fund scheme for the IT sector
C. A venture capital fund that invests in 3 different companies
4. The management of a private equity company buys all the company's shares by using leverage
(debt financing). This is most likely a
A. Leveraged buyout
B. Management buyout
C. Venture capital buyout
5. The owners of a certain type of ordinary shares of a company do not have voting rights, but other
shareholders do. Which of the following is the most appropriate term to describe this feature?
A. Private shares
B. Minority shares
C. Dual-class shares
Answers
1. C is correct. The company described is most likely still developing their products since they are
pre-sales. This is the earliest stage and is called the seed stage. A is incorrect because the company
has proved itself in this stage and has some sales to back its valuation. B is incorrect because this
is the latest of all three stages when a company most likely wants to fund expansion.
2. A is correct. Owners and investors negotiate the share price of private companies. It cannot be
observed. Publicly traded companies are more subject to scrutiny for short-term performance
due to investor pressures. Private companies do not have such pressure because they are not so
much in the public eye.
3. C is correct. Venture capital funds and such alternative investment funds typically have a lock-in
of 3-10 or 5-10 years. A is incorrect because an ELSS has a lock-in of 3 years. B is incorrect because
this scheme is unlikely to have a lock-in period at all.
4. B is correct. The management of the company itself can execute a leveraged buyout, giving them
full control of the company.
5. C is correct. Dual-class shares may allow only one class to have voting rights. This structure can
also ensure that owners of the superior class have a priority claim on the company’s assets on
liquidation.
LOS48d: Describe methods for investing in non-domestic equity securities.

Globalization and digitization have led to financial market integration. Capital has been allowed to flow
freely between jurisdictions, which has opened avenues for funds to invest in global markets. Some
countries restrict foreign ownership of domestic stocks primarily to restrict foreign companies from
controlling their companies and to decrease the variability of capital inflows and outflows.
BlackRock opened an emerging markets portfolio in 1989, and it now manages close to $4 billion
in this fund. Investors in this fund have exposure to stocks from China, India, Korea, and Taiwan,
among others.
It is also possible for companies to list in stock exchanges of other countries. This is beneficial for the
issuing company because it increases their shares' liquidity and transparency because of stricter
regulatory and disclosure requirements.
What are the avenues that investors can use to invest in foreign equities?
Direct Investing
If the investor’s jurisdiction allows direct holding of foreign shares, the investor can buy the foreign
company's shares in the foreign company’s currency. But there are a few drawbacks to this method:
➢ The investment is subject to foreign currency risk because the investment is denominated in the
foreign currency.
➢ The foreign market or the market for that stock may be illiquid.
➢ The foreign company may be subject to more lenient reporting requirements, and so the investor
may not have complete information about the company.
➢ The investor must do some additional due diligence regarding the regulations of the foreign market.
Depository Receipts (DRs)

A depositary receipt (DR) is a type of negotiable financial security that allows investors to hold shares in a
foreign public company. A bank will deposit the shares of a foreign company and then issue a receipt. This
receipt represents ownership of that company. An investor can buy and sell this receipt in the local market
using the local currency. The depository bank is the custodian and is responsible for crediting the
shareholder with dividends, stock splits, bonus shares, etc.The value of the receipt is still subject to foreign
currency risk because the underlying shares are of a foreign country. The value of the receipt is also subject
to the company’s fundamentals, economic events and other factors affecting the value of the underlying
stock.
Let us take Infosys as an example. They have a wide global presence, and a U.S. investor might be
interested in buying Infosys shares. Instead of directly purchasing them from the NSE or BSE in India, they
can buy an ADS (American Depository Share) of Infosys, which trades in the U.S. markets.
This is also called an American Depository Receipt (ADR). A depository bank will buy the shares and issue
a receipt which allows investors to participate in the ADS in terms of U.S. dollars.
Note that since the underlying shares of the ADS trade in India (and the company is Indian), the value of
the ADS itself will be determined by Infosys’s fundamentals, USD/INR fluctuations and any other factor
which can affect the stock price.
Most ADRs require U.S. Securities and Exchange Commission (SEC) registration, but some are privately
placed (Rule 144A or Regulation S receipts).
The four types of ADRs, with different levels of trading availability and firm requirements, are summarized
below:
Level I Level II Level III Rule 144A
Trading Location Over the counter NYSE, NASDAQ NYSE, NASDAQ Private
(OTC) and AMEX and AMEX
SEC Registration Yes Yes Yes No
required
Ability to raise No No No Yes
capital in the US
Firm listing Low High High Low
expenses
When a depository bank buys the shares and issues a receipt, it is called an unsponsored DR. The bank
maintains the voting rights since they technically own the shares.
When the company themselves are directly involved with issuing the receipt, it is called a sponsored DR.
In this case, the investor maintains the voting rights, just like any other ordinary share.
When a DR is issued outside of the U.S. and the issuer’s domestic country, it is called a global depository
receipt (GDR). These are mostly traded in London and Luxembourg markets or other markets where the
company is familiar to investors. Note that these are still generally issued in U.S. dollars even though they
are not traded in the U.S. This makes it attractive for institutional investors. GDRs are also attractive for
foreign investors because they are not subject to restrictions on capital flows.
Other Avenues
Global registered shares (GRS): These are traded on different stock exchanges worldwide in different
currencies.
Basket of listed depository receipts (BLDR): These are exchange-traded funds (ETFs) that are a basket (or
a collection) of different DRs. Think of an ETF as a mutual fund scheme that trades on the stock exchanges.
They trade like shares but have certain price limits. They derive their value from the underlying portfolio
of assets.
1. A company sells its shares to a foreign bank, and this bank issues receipts which can be traded in
the foreign country. The value of these receipts is derived from the share price of the company
that sold the shares. This instrument is most likely a
A. Global registered share

B. Unsponsored depository receipt
C. Sponsored depository receipt
2. The bank holds the voting rights for
A. Sponsored depository receipts

B. Unsponsored depository receipts
C. Both, sponsored and unsponsored depository receipts
3. Which of the following statements is most likely correct?

Statement 1: American depository receipts are subject to foreign exchange risk.
Statement 2: Global depository receipts are not subject to foreign exchange risk.
A. Both statements are correct
B. One of these statements is correct
C. Neither statement is correct
Answers
1. B is correct. It is unsponsored because a bank has issued the receipts. C is incorrect because it is
a sponsored DR only when the company is directly involved in the issue. A is incorrect because
global registered shares are simply shares that trade on global exchanges.
2. B is correct. The bank has bought the shares and then issued a receipt, so technically, they hold
the voting rights. A is incorrect because the holder of the sponsored depository receipts has
voting rights.
3. B is correct. Although depository receipts are bought in the domestic currency of the market in
which the receipts are traded, the underlying shares are of another country. An ADR is
denominated in U.S. dollars, while a GDR could be of any other currency depending on the
country. The underlying shares of the receipt are denominated in another country’s currency.
There is a foreign exchange risk for both ADRs and GDRs.
LOS 48e: Compare the risk and return characteristics of different types of equity
securities.
Sources of Returns
Although capital appreciation is the most likely source of return for equities, dividend payments are
another major source of returns. Note that unrealized gains are not cash-based returns, and so there is
no tax implication until the investor sells the shares. Dividends are taxable immediately. That is why it is
said that capital gains tax can be deferred until the investor chooses to sell the shares.
Equities denominated in foreign currencies are also subject to foreign currency appreciation or
depreciation. For instance, if an Indian investor holds shares of Tesla by directly investing in U.S. equity
markets using the U.S. dollar, then an appreciation of the dollar against the rupee will benefit the investor.
Dividends can be beneficial for investors who hold large amounts of shares in a company. The gain from
reinvesting dividends can prove to be a good source of returns over long time horizons.
Suppose you hold 100,000 shares of a company, and the company pays Rs. 2 per share. You have
essentially received Rs. 200,000 worth of dividends. Suppose the share price is Rs. 4,000 on the date that
the dividend is paid. You can buy 50 shares of the company by using the dividend earned. The value of
these shares will grow over some time.
However, it is important to note that companies do not always pay dividends. It is therefore important to
read about the dividend payout policy from their disclosures.
Risk
The standard deviation of market returns usually measures risk and volatility.
Preferred shares are typically less risky than ordinary shares because a known dividend is paid, which
forms a large portion of the returns. Preference shareholders also have a claim to assets before common
shareholders in liquidation. However, the lower risk is also matched with lower returns on average.
The dividend on cumulative preference shares accumulates and must be paid in subsequent periods if
payment has not been made previously. Non-cumulative preference shareholders do not have this luxury
and so face more risk.
Callable shares are riskier than shares without a call option because they can buy the shares back when it
is beneficial to exercise the call option. Shareholders potentially lose out on the upside in this case. To
compensate the shareholders for this added benefit to the company, the dividend yield on callable shares
is usually higher than that on shares that cannot be called back.
Putable shares are less risky because the shareholder has the option to sell the shares back to the
company if the prices fall too much. To compensate the company for this added benefit to shareholders,
the dividend yield on putable shares is usually lower than that on shares that cannot be sold back to the
company.
1. Reinvestment risk is least characteristic of which source of return?
A. Unrealized gains
B. Realized gains
C. Dividends
2. A putable share most likely benefits
A. Only shareholders when the price falls below a certain level

B. Only share issuers when the price increases over a certain level
C. Both, shareholders and issuers depending on market conditions
3. The standard deviation of ordinary shares is least likely to be
A. The same as that of preference shares

B. Higher than that of bonds
C. Lower than that of commodities
4. A callable share most likely benefits
A. Only shareholders when the price falls below a certain level

B. Only share issuers when the price increases over a certain level
C. Both, shareholders and issuers depending on market conditions
Answers
1. A is correct. B and C both result in the investor receiving cash. This cash must be re-invested to
continue to generate income. If the investor cannot re-invest these cash flows at the same rate
of return (or a higher rate), they may lose out on cash-based compounding effects.
2. A is correct. A putable share allows the shareholder to sell the shares back to the issuer at a
predetermined price. If the share price falls below the put price, the investor can sell the shares
at the put price (the higher of the two).
3. A is correct. Preference shares are less volatile than ordinary shares, and so they are likely to have
a lower standard deviation of returns. B is incorrect because bonds are less volatile than stocks,
and C is incorrect because commodity prices, in general, are more volatile than stocks.
4. B is correct. A callable share allows the issuer to buy back the shares from the shareholders at a
predetermined price. If the share price increases above the call price, the company can buy the
shares back at the call price (the lower of the two).
LOS 48f: Explain the role of equity securities in the financing of a company’s assets.
Equity capital is usually raised in large sums and is used to finance long-term assets. Purchase of
equipment or machinery, investing in R&D or expansion projects are some uses of equity financing.
Note that equity financing is the most expensive source of financing. It dilutes the share of existing
shareholders, and the cost of equity is usually higher than the cost of debt.
A company can also raise equity capital to buy another company. This may be a more suitable option than
raising debt because the debt will have to be repaid.
Equity capital can also be used for employee stock option plans (ESOPs). This is equity given to employees
so that they have an upside for themselves too if the company performs well over a longer period.
Equity financing is especially important to banking and financial services companies. Publicly traded
equity capital is liquid and may be important to meet the minimum ratios required by regulators. The
main ratios are the capital adequacy ratios and liquidity ratios. These are covered in detail in CFA Level
2.
Indian companies raised a record $31 via equity financing in 2020. $13.68 billion of this total (approx.
44%) flowed into the banking and financial services sector to safeguard banks and the economy from
the adverse impact of lockdowns.
LOS 48g: Contrast the market value and book value of equity securities.
The primary goal of the firm’s management is to increase the book value of the firm’s equity ad thereby
increase the market value of its equity. The book vakue of equity is the value of the firm’s assets on the
balance sheet minus its liabilities whichis largely the company’s issued equity capital and its reserves. The
retained earnings of a company are the most important reserves to analyze. So, any increase in net profit
that is not paid out as a dividend (or is attributable to minority shareholders) is added to the retained
earnings of the company.
Growth in the book value is likely to increase the market value of a company. Note that the market value
is subject to several other variables that the company cannot control and is much more volatile than a
company's book value.
The market value or the market capitalization of a company is simply the number of shares outstanding
multiplied by the current market price per share. It reflects the fundamentals and the future expectations
of the company.
The market value is based largely on demand and supply and on expectations of the company’s prospects.
It is a much more complex function, so there can be times when there is a huge divergence between the
growth of the book value of a company and the growth of the company's market value.
Even if the market value and the book value move in the same direction, it is highly unlikely that the two
will be the same.
A measure of the market value of a company to its book value is the price-to-book ratio (P/B ratio).
For example, a P/B ratio of 2.5 indicates that the market price is 2.5 times the book price of a
company. P/B ratios of a stock cannot be seen in isolation and must be compared to the P/B of the
overall market and comparable stocks in the industry.
1. The book value of a company is least likely obtained from
A. Its quarterly reports

B. All forms of market data related to the company
C. Its annual reports
2. The share price of a company falls by 3.00%. All else held constant, which of the following is least
likely a consequence of this?
A. The market capitalization reduces by 3.00%

B. The book value remains the same
C. The book value reduces by 3.00%
Answers
1. B is correct. The book value can be found from a company’s financial statements. These may be
found in quarterly or annual reports. Note that although quarterly reports are not audited, they
still represent the company’s financial position.
2. C is correct. The book value of equity will not fall because of a fall in the share price. The book
value of equity is dictated by the face value per share (not the market value per share) and largely
by retained earnings, among other reserves. A is incorrect because the market capitalization is
heavily dependent on the share price - it is the number of shares outstanding multiplied by the
share price.
LOS 48h: Compare a company’s cost of equity, its (accounting) return on equity, and
investors’ required rates of return.
Required Rate of Return and Cost of Equity

The cost of equity and the required return on equity are two sides of the same coin. The cost of equity is
from the company’s perspective, and the required return on equity is the investor’s expected return of
the shares that are traded in the open market. This can be calculated by using the CAPM or the dividend
discount model. Both methods of calculating the cost of equity are covered in detail in the Cost of Capital
reading of Corporate Finance.
A fall in the share price will increase the stock's expected to return as there is more upside potential if the
company has an adequate growth strategy. An increase in the share price will reduce the expected return,
and this is likely if the stock has had a massive bull run and the upside potential is limited.
The cost of equity is used as a discounting factor to the firm’s free cash flow to equity (FCFE). A company’s
intrinsic value is derived from the present value of the expected future cash flows, and so any increase in
the cost of equity will reduce the present value of FCFE, thereby reducing the equity value of the company.
Any decrease in the cost of equity will discount the same cash flows at a lower rate and increase the
company's equity value.
The expected market return can also be compared to the cost of equity. The cost of equity is typically
interpreted as the minimum return that an investor requires. If the expected return on the stock is greater
than this minimum return, the investor will likely buy that stock. Conversely, if the expected return is too
low and does not attract the investor, then it is unlikely that they will buy the stock.
Estimates of risk and required return can be subjective, and each investor or analyst can have different
expectations. Some analysts may consider a stock riskier than others do, based on different opinions. So,
the cost of equity can be considered the average of all investors’ minimum required return on stock to
compensate them for the risk of the stock.
Accounting Return on Equity (ROE)
The return on equity is a profitability measure based on the financials of a company. It does not require
any sort of market data at all and can be found from a company's financial statements.
Let us look at Asian Paints and calculate their return on equity for FY21. We can get the following
information from their consolidated financial statements:
Details FY20 FY21
Net Income 2,774.19 3,206.75
Total Shareholder's Equity 10,533.69 13,229.15

The ROE is calculated as:

ROE = Net Income ÷ Average Shareholder Equity during the year
The ROE for Asian Paints in FY21 is:
ROE = 3,206.75 ÷ [(10,533.69 + 13,229.15) ÷ 2] = 26.99%
This ROE can then be compared to a peer’s ROE (like Berger Paints) or to Asian Paints’ historical ROE. A
relatively higher ROE is generally viewed as a positive indicator of a company’s profitability.
But it is important to analyze why the ROE is increasing. For instance, if the average shareholder equity
decreases faster than the net income, the ROE will increase. Simply put, the denominator is getting smaller
at a quicker rate than the numerator, so the ROE increases. This is not a good sign.
Moreover, a company may issue debt to repurchase equity. This will reduce average shareholder equity
and artificially increase the ROE (even if net income is held constant). This will also make the firm’s shares
riskier because the company is taking on more financial leverage (debt).
The ROE can also be calculated as per the opening book value of equity instead of the average. But it is
better to use the average because it is more representative of the equity that has been used during the
year to generate the given net income.
Further, average shareholder equity is more appropriate when it is the industry convention or when the
book value is volatile. On the other hand, the opening book value of equity is more appropriate when
evaluating ROE for several years or when the book value is stable. Note that the average shareholder
equity must also be adjusted if new equity has been issued during the year.
As an exercise, let us compare this to the cost of equity of Asian Paints. The CAPM formula is discussed in
detail in the Corporate Finance readings so let us have a simple recap of the formula and then input the
relevant variables.
We will assume that the risk-free rate is 6.18%, the beta has been obtained from Yahoo Finance, and the
equity risk premium (ERP) from Aswath Damodaran’s estimates of India’s ERP.
CAPM Cost of Equity = 6.18% + (0.48 × 6.56%) = 9.33%
We can see that the required return on equity and the accounting return on equity are two extremely
different concepts. The required return on equity is heavily dependent on market factors, while the return
on equity has everything to do with the company's profitability.
1. The return on equity of a company is 15.00%. Which of the following is most likely true?
A. The cost of equity is 15.00%

B. The company’s profitability based on net income and shareholder equity is 15.00%
C. Investors require a 15.00% return on the stock of the company
2. All else held constant, the higher the required rate of return on equity
A. The higher the present value of FCFE

B. The lower the present value of FCFE
C. The lower the value of FCFE
Answers
1. B is correct. The return on equity is a profitability measure and has nothing to do with market-
based factors. A and C are incorrect because the cost of equity and required rate of return are
two sides of the same coin and are dictated by market factors.
2. B is correct. The required return on equity is the discounting rate to calculate the present value
of FCFE. The higher the discounting rate, the lower the present value. C is incorrect because the
required return does not affect the actual value of the cash flows; it only affects the present value.
Company Analysis: Past and Present 105
Company Analysis: Past and Present

LOS 49a: Describe the elements that need to be covered in a thorough industry analysis.
There is never a clear-cut formula for performing a solid industry analysis, and there is some flexibility in
the process. But there are a few key pointers to remember for some key aspects of industry analysis.
Data Gathering
Obtain data on the different macroeconomic variables and industry trends. This can be found from
information given by companies, industry publications, suppliers, customers, etc.
These could include demographic, macroeconomic, governmental, social, and technological influences.
Assess these relationships to understand the overall industry dynamics and competitive environment.
Create estimates of the expected changes in these variables over some time for different scenarios and
using different approaches.
Compare these estimates with other analysts’ forecasts. This will help to confirm whether the variables
are relevant and if anything has been missed out. It may also help to find industries that are not
appropriately valued based on the consensus of other analysts.
Industry Composition and Life Cycle
Divide the companies within the industry by strategic groups (companies that are distinct from the rest
of the industry due to delivery, barriers to entry etc.). These will have a degree of complexity that is slightly
different from others in the industry group. For example, automobile companies that specialize in low
output and high-value cars (like Ferrari or Lamborghini) will have a different strategy and competitive
dynamics compared to automobile companies that specialize in high output and low-value cars (like Ford
or Toyota).
Identify the life-cycle stage of the industry and if there is upside potential shortly. For example, book shops
and related companies are a dying business in the face of e-readers. But there are other emerging themes
in India, like speciality chemicals which may stay for the foreseeable future.
Identify the industry’s position on the experience curve. This is the cost per unit given a level of output. If
an industry is going through technological change or a fundamental shift in inputs, then it is likely that
their cost per unit will reduce. If the industry can capture economies of scale, then this will also reduce
the cost per unit. This is especially important for industries with high fixed costs (like steel manufacturing).
Further, consider the effects of factors like demographics, government policies, social etc. and examine
the forces that determine competition within the industry.
Valuations
Determine the relative valuation of different industries.
Evaluate the valuation over some time to understand the long-term and short-term performance. This
also helps to understand how volatile the industry is compared to the business cycle. This gives an insight
regarding possible industry rotation and if the industry will perform well in the near term, given its past
performance.
1. If an analyst expects an economic downturn in the near term, which of the following industries
would they most likely prefer?
A. Energy
B. Consumer discretionary
C. Consumer staples
2. An example of a defensive stock is most likely
A. A food manufacturing company

B. A steel manufacturer
C. An oil and gas company
3. An analyst compares their own estimates of an industry’s prospects to four other analyst’s
estimates. Why have they least likely done this?
A. To search for potentially missed variables

B. To find a consensus opinion
C. To create different scenarios for changes in variables
4. Why is it least likely important to identify the life-cycle stage of an industry?
A. To understand its position on the experience curve

B. To understand its future prospects and if there is potential for further growth
C. To understand its past performance relative to the economy
Answers
1. C is correct. Consumer staples are least likely to be affected by business cycles out of the three
options, and so it will be most protected from an economic downturn.
2. A is correct. Defensive stocks are not so affected by the stage of the business cycle as aggressive
stocks are. B and C are both cyclical, and so they will perform well during booms but poorly during
recessions.
3. C is correct. An analyst does not necessarily need to look at other analysts’ reports to create
different scenarios. This should be done after data has been gathered. The comparisons must be
made to check if some variables have been omitted (or are irrelevant) so that the analysis can be
refined. The consensus opinion can also be understood by reading other reports and finding
common opinions and forecasts.
4. C is correct. Although this is helpful to understand the relationship between the economy and
the industry from previous cycles, it is most likely important to understand how the industry is
positioned in the context of the future. Profitable investment decisions are released when an
industry does well in the future. A is also most likely correct because this is helpful to understand
the potential impact of technological changes. If these changes help to reduce costs, then it is a
positive factor for future growth.
LOS 49b: Determine a company’s business model
A company's operational framework emphasizes the fundamental factors that ultimately impact its
financial statements. This business model serves as the bedrock for shaping the analyst's expectations.
The business model encompasses the following elements that delineate its operations: (1) offerings of
products and services, (2) target clientele, (3) avenues of sales, (4) pricing structures and payment
conditions, and (5) supplier and critical partner relationships. Analysts should delve into what the
company is selling, who its customers are, its strategies for customer acquisition, its distribution channels
for products or services, its pricing strategies, and its pivotal supplier relationships. It is also important to
assess the bargaining power held by customers (e.g., few or many) and suppliers (e.g., specialized or
general inputs). In instances where a company adheres to a conventional business model, analysts should
highlight any deviations that distinguish this particular company's model from its industry peers.
Analysts rely on four main categories of information to discern a company's business model:
1. Direct data from the company (e.g., annual or quarterly regulatory filings, investor presentations, press
releases, company's investor relations, website)
2. Publicly accessible third-party information (e.g., analyst assessments, government research and
publications, news sources, social media)
3. Proprietary third-party data (e.g., analyst evaluations, Bloomberg)
4. Exclusive primary research, undertaken or commissioned by the analyst (e.g., surveys, market
investigations)
1) Which of the following statements regarding company research reports subsequent

to initiating coverage is most accurate?
A. The report updates the recommendation in light of new information about the
company.
B. The primary audience is those who are not already knowledgeable about the
company or security.
C. The report provides information such as industry overview, competitive
positioning, and ESG considerations.
2) Reports and data from Bloomberg are best considered to be:
A. public third-party sources.

B. proprietary primary research.
C. proprietary third-party sources.
Answers:
1. A is correct as subsequent research reports update the recommendation and rationale from
initial research report. The primary audience for an initial company report is those who are not already
knowledgeable about the issuer or security.
2. C is correct as reports and data from platforms such as Bloomberg and FactSet are classified as
proprietary third-party sources, available for a fee. They are not publicly available for free (e.g., general
news, social media), and the information provided is not primary research.
LOS 49c: Evaluate a company’s revenue and revenue drivers, including pricing power.
Assessing Revenue Drivers

Before proceeding with financial forecasting and eventual company valuation, analysts must examine a
company's historical and current financial statements. A common starting point in financial statement
analysis is the income statement, specifically focusing on revenues. Within this context, analysts
concentrate on revenue drivers, which can be evaluated using either a bottom-up or top-down approach.
In a bottom-up analysis, revenue is deconstructed into specific drivers like price and volume, business
segments, or geographical factors. Conversely, in a top-down analysis, macroeconomic indicators such as
market share or GDP growth act as the drivers of revenue. Often, both methods are employed in tandem
to comprehensively evaluate a company.
Understanding Pricing Power

The foundation of revenues lies in pricing, and pricing is inherently influenced by the concept of pricing
power—a company's ability to set selling prices without adversely affecting sales. As established in
Economics, pricing power is contingent on the industry's market structure and the company's competitive
standing within that market.
Markets characterized by intense competition feature nearly identical products, leading to limited pricing
power. Prices in such instances are determined by the forces of supply and demand. Consequently, all
participants act as price takers, accepting the prevailing market price. Over the long term, markets defined
by price-taking behavior generally yield returns approximating the cost of capital, resulting in negligible
economic profit. An exception to this rule is a low-cost producer. Companies boasting substantially lower
costs than competitors may realize returns exceeding the cost of capital, though maintaining such profits
over time necessitates a perpetual cost advantage.
Markets that are highly competitive share several attributes: absence of product differentiation, multiple
substitutes, minimal barriers to entry, limited brand loyalty, and insignificant switching costs. The term
"commoditization" characterizes industries transitioning toward this competitive state, as more
participants enter the market. In commoditizing industries, innovation tends to decrease while imitation
increases.
Contrastingly, less competitive markets (monopoly, oligopoly, monopolistic competition) exhibit more
pronounced product differentiation, few or no substitutes, formidable entry barriers, strong customer
loyalty, and substantial switching costs. In such markets, companies wield varying degrees of pricing
power, enabling them to raise prices without significant sales declines. Pricing strategies like value-based
pricing and price discrimination require a company to possess pricing power.
Pricing power can be gauged by profit margins. When prices consistently outpace costs, a company
demonstrates its capacity to pass those costs onto customers through higher prices while maintaining
sales. This is particularly evident in markets with high switching costs or for products with limited
substitutes.
Macro Factors
A top-down approach considers external (macro) factors that impact revenue, encompassing aspects such
as market size and the company's market share. Market size denotes the combined revenue of all
companies within the market, while market share represents the proportion of a company's revenue
relative to the market size. Monitoring changes in market share over time provides insights into how
favorably the company is perceived by consumers.
Calculating market size can present challenges. For instance, should it account solely for sales of identical
products, or should it encompass sales of similar or substitute products? Analysts generally include
identical and similar products while excluding substitute products, although such an approach might not
always be appropriate.
LOS 49d: Evaluate a company’s operating profitability and working capital using key
measures.
Operating Costs Analysis

Within a company's financial statements, three primary cost categories are evident: operating costs,
investing costs (such as capital and intangible asset purchases), and financing costs (including interest
expenses). This discussion is dedicated to operating costs, which encompass expenditures incurred by a
company in the process of generating revenue within the current period. It's important to note that an
analyst's interpretation of costs may not always align with the treatment prescribed by IFRS and U.S.
GAAP. For instance, while research and development costs might logically be categorized as investing
costs, accounting standards often classify them as operating costs.
The magnitude of operating costs is influenced by both the company's business model and its scale. We
can classify operating costs through three distinct lenses:
1. By Their Relationship with Output (Fixed or Variable): Operating costs can be delineated based on their
response to changes in output. Some costs remain relatively constant regardless of production levels
(fixed costs), while others fluctuate in tandem with output changes (variable costs).
2. By Nature: This approach categorizes operating costs based on their inherent characteristics,
encompassing expenses like work in progress, utilities, and promotional activities.
3. By Function: Operating costs can also be segmented by their purpose within the company's operations.
This includes functions like selling, advertising, travel, and income tax-related expenses.
Analyzing Costs by Relationship with Output

The concept of operating profit can be expounded upon by dissecting it into fixed and variable cost
components, resulting in the following representation:
Operating profit = [Q * (P -VC)] – FC
Where,
Q = number of units sold
P = price per unit
VC = variable costs per unit, those that change with the level of output
FC = fixed costs in total, which are sticky i.e., do no change within a specific range of output.
The term (P – VC) within this equation is recognized as the per-unit contribution margin (CM). A company
generates profits when the per-unit CM is positive and Q is of sufficient magnitude to yield a total
contribution margin surpassing fixed costs.
Operating leverage originates from the fixed component of a company's operational expenditures. The
extent of fixed costs within a company's cost structure determines the rapidity of operating profit growth
with a given increase in quantity sold (and the speed of decline with a given decrease). This leverage is
quantified through the degree of operating leverage (DOL):
DOL = % change in operating profit / % change in sales.
Analyzing Costs by Nature or Function

When examining costs from an accounting standpoint, a functional categorization is customary, leading
to uniform presentation of income statement items across companies based on functions (e.g., "cost of
sales" and "selling, general, and administrative").
Typical metrics for assessing operating profitability encompass gross profit, earnings before interest,
taxes, depreciation, and amortization (EBITDA), and earnings before interest and taxes (EBIT), where EBIT
often equates to operating profit.
• Gross profit = revenue - cost of sales
• EBITDA = gross profit - operating expenses
• EBIT = EBITDA - depreciation and amortization
These measures can be expressed as ratios of revenue, yielding gross margin, EBITDA margin, and EBIT
margin (or operating margin).
While functional cost classification diverges from fixed and variable cost classification, there exists an
overlap in concepts. For numerous companies, the cost of sales exhibits high variability, resulting in close
alignment between gross margin and contribution margin. Many operating expenses, though recorded as
separate line items, such as rent, promotions, and management salaries, primarily possess fixed
attributes.
Operating costs predominantly hinge on production levels. This is evident for variable costs and holds true
over the long term for fixed costs, as heightened output necessitates cash expenditures like acquiring
more efficient equipment. Industry profitability is largely shaped by competitive dynamics among
companies in a given sector, given comparable revenue types and input costs. A reduction in prices by
one company in a competitive sector typically prompts others to follow suit, potentially leading to
diminished industry profitability. Analysts should assess individual company profitability within the
broader context of industry profitability.
Economies of scale materialize as increased output diminishes unit costs, with fixed costs being spread
across a larger production volume. Even in cases where a company's cost structure is predominantly
variable, economies of scale can emerge if the company attains sufficient size to exert greater influence
over suppliers and progressively reduce variable expenses.
Economies of scope manifest when incorporating divisions or product lines leads to reduced unit costs.
This can occur through shared costs and streamlined operations among multiple divisions or product lines.
For instance, divisions within a larger firm can share a single human resources department, whereas they
would each require their own if operating as stand-alone companies.
Working Capital
Recalling from the section on Corporate Issuers, analysts can assess a company's working capital
management by analyzing its cash conversion cycle. A lengthier cash conversion cycle implies a greater
need for working capital financing. Another pivotal metric is the ratio of net working capital to sales, where
positive net working capital indicates internal financing, while negative net working capital suggests
external sources (e.g., suppliers) are providing the funding.
LOS 49e: Evaluate a company’s capital investments and capital structure.
A company's capital sources encompass operational cash flows, funds obtained from debt and equity
issuances, as well as proceeds from selling assets. Capital utilization involves maintaining liquidity through
cash and marketable securities, acquiring tangible and intangible assets, repaying debt, disbursing
dividends, and conducting share buybacks.
The evaluation of a company's capital investments revolves around determining if the company has
achieved a minimum required rate of return over the long term, thereby generating economic value from
investor capital. The assessment of its capital structure entails gauging whether its opportunities outweigh
the associated risks.
When analyzing the risks inherent in the capital structure, analysts employ metrics such as leverage ratios,
coverage ratios, and the degree of financial leverage (DFL).
DFL = % change in net income / % change in operating income.

DFL increases when a company introduces fixed interest expenses through borrowing.
Unlevered returns are measured by indicators like return on assets (ROA) or return on invested capital
(ROIC). Financial leverage is mirrored in return on equity (ROE). As previously learned in Financial
Statement Analysis, the components influencing ROE, including financial leverage, can be delineated
through DuPont analysis.
1) A cake shop earned $500 million in revenue in the current year. Based on an
estimated market share of 10%, what is the market size for the baking industry?
A. $50.0 million.
B. $4.5 billion.
C. $5.0 billion.
2) Bayco, Inc., sells 10,000 units at a price of $5 per unit. Bayco’s fixed costs are $8,000,
interest expense is $2,000, variable costs are $3 per unit, and EBIT is $12,000. The
degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest
to:
A. 2.50 DOL and 1.00 DFL.
B. 1.67 DOL and 2.00 DFL.
C. 1.67 DOL and 1.20 DFL.
Answers:
1. C Market share = revenue / market size = 0.10 = $500 million / market size. So,
market size = $5 billion.
2. C DOL = [10,000 (5 - 3)] / [10,000(5 - 3) - 8,000] = 1.67
DFL = 12,000 / (12,000 - 2,000) = 1.20
Industry and Competitive Analysis 115
Industry and Competitive Analysis

LOS 50a: Describe the purposes of, and steps involved in, industry and competitive
analysis.
Industry and competitive analysis adopt a macro-level perspective to investigate the driving forces behind
industry dimensions, profits, and market share. This analysis also aids in discerning a company's standing
within its industry.
Distinct industries exhibit varying levels of long-term profitability, contingent upon their opportunities
and exposure to risks. A company's ability to sustain economic profits is heavily reliant on the
characteristics of its industry. Over time, competition tends to align company profitability with the
industry's baseline rate.
Within a specific industry, disparities in profitability among participants arise from variations in business
models, company size, and competitive strategies. Although industry factors set an upper boundary for
company profitability, instances of underperformance are often attributed more to company-specific
factors.
The purpose of industry and competitive analysis is to establish an industry's foundational profitability
rate and identify factors that influence it. This insight enables analysts to predict the industry's future
profitability and gauge companies' positions relative to the industry median or mean.
Industry analysis proves valuable in enhancing financial forecasts by scrutinizing industry drivers and
consolidating industry-wide data. Analysts should avoid underestimating the influence of macro-level
factors and should bear in mind that a company's success is not solely shaped by company-specific
elements.
Furthermore, industry analysis aids in discovering appealing investments that might have been
overlooked without an examination of the broader industry and its participants. From a portfolio
standpoint, investors might prefer industry-specific risk over company-specific risk. Achieving this can
involve making smaller investments in multiple companies operating within a targeted industry.
The process of industry and competitive analysis entails the following steps:
1. Define the industry, which may involve some subjectivity in identifying defining factors (like product
similarity or geographical region) and addressing companies with operations across multiple industries.
Third-party classification systems can provide assistance.
2. Explore the industry's size, growth rate, profitability, and trends in participant market shares.
3. Evaluate the industry structure through frameworks such as Porter's five forces and pinpoint the pivotal
forces influencing industry profitability.
4. Examine external impacts on the industry, encompassing political, economic, social, technological,
legal, and environmental influences (PESTLE analysis).
5. Scrutinize companies' competitive strategies to determine their alignment within the industry and the
competitive advantages each firm possesses.
LOS 50b: Describe industry classification methods and compare methods by which
companies can be grouped
In a top-down approach to investment analysis, it is important to understand the industry dynamics of

the company. This sets a boundary for company analysis, and it makes the analyst aware of the different
variables to consider when valuing a company.
In a broad sense, industry analysis is a starting point to understand:
➢ The business environment.
➢ The competitive landscape.
➢ The industry-specific risks.
➢ The industry and the company’s prospects.
These are also important for a credit analyst to evaluate whether the company will be able to meet its
debt servicing obligations (interest and principal payments) during the next economic downturn. Industry
analysis can be a good indicator of how well the industry, in general, can deal with a recession or how well
it will perform during a boom. For instance, FMCG companies are more likely to survive a recession since
they provide essential products. But infrastructure companies are more likely to do better than FMCG
companies during economic booms.
Industry analysis can also be used to identify when it is the correct time for industry rotation. Active
managers seeking abnormal returns over the benchmark will perform such analysis to overweight stocks
that will benefit from near-term economic conditions and underweight those that have completed their
run from the previous business cycle. FMCG and IT companies performed well at the start of the
pandemic, but steel companies outperformed as demand and commodity prices increased later on. A
skilful fund manager will pick stocks before the next cycle to get the benefit of the full upturn or downturn
in economic conditions.
Industry analysis is also important for portfolio evaluation. Fund managers’ performance may be based
on attribution analysis. This is a detailed analysis of the sources of portfolio returns given a benchmark.
Let us consider the NIFTY 50. Above 30% of the float in the NIFTY 50 index comes from a banking and
financial services. If a fund manager wants to beat this benchmark, they must identify industries that will
perform better than the banking and financial services sector with the given economic conditions. Then
they must give more weight to these stocks than their weight in the NIFTY 50.
So, if the source of NIFTY 50 returns comes largely from banking and financial services stocks, then the
actively managed fund’s returns must come from industries that have outperformed the largest stocks in
the NIFTY 50.
1. Industry rotation is most beneficial when
A. The portfolio manager identifies industrial trends based on the current cycle
B. The portfolio manager identifies industrial trends based only on past cycles
C. The portfolio manager identifies industrial trends based on past cycles and expected future
cycles
2. Abnormal profits over a benchmark can be attributed to
A. Overweighting those stocks that outperform the benchmark

B. Underweighting those stocks that underperform the benchmark
C. Overweighting those stocks that outperform the benchmark and underweighting those stocks
that underperform the benchmark
Answers
1. C is correct. It is important to analyze industry factors based on the previous market and economic
cycles so that fund managers can position their portfolios to capture the next cycle's upside before
it happens. They will then buy stocks which will benefit from the next cycle and sell those which
have run their course.
2. C is correct. A portfolio will earn superior returns as long as more weight is given to outperformers
and less weight to underperformers relative to a benchmark index.
Compare methods by which companies can be grouped.
It is important to group stocks into comparable industry characteristics so that each stock within that
category can be compared fairly.
Sectors usually classify companies. These are groups of similar industries. So, the healthcare sector could
consist of companies in the pharmaceutical industry, hospitals industry and so on. Companies are usually
grouped into an industry based on their main line of business (a primary source of revenue).
The popular classification systems are as follows:
➢ Global Industry Classification Standard (GICS).
➢ Russell Global Sectors (RGS).
➢ Industry Classification Benchmark.
Companies can also be classified based on their relationship with the business cycle. For example, non-
cyclical companies (that are essential and less sensitive to business cycles) could be companies in the
FMCG and healthcare sectors. Cyclical companies benefit more from booms but suffer more in recessions.
They include infrastructure companies, automobile companies, real estate, and related companies, etc.
Some companies may have statistical correlations with each other. Companies that have had highly
correlated return and risk characteristics can be classified together. This is important if a fund manager
wants to diversify the risk-return profile of their portfolio. They can avoid highly correlated companies so
that the portfolio is not affected too much by adverse conditions. But this method has limitations
because:
➢ Correlations are taken on past data, so there is no guarantee that the same correlation (and
degree of correlation) will hold in the future.
➢ Companies may be grouped differently based on time horizons or countries.
➢ The grouping may not make sense. For example, it is possible to have two companies in unrelated
industries to have similar risk-return characteristics based on price data.
➢ Data mining and data snooping is a concern here too. It is possible to find correlations just by
chance that have no real economic significance.
Industry Classification Systems

It is best to categorize companies based on their line of business and industry.
Following are the two types of classifications that you should be familiar with, commercial classifications
and government classifications.
Commercial Classifications
GICS, RGS and the Industry Classification Benchmark are all provided by companies like S&P, MSCI Barra,
Dow Jones and the FTSE.
Following is the industry classification and the types of companies in that industry:
Government Classifications
Government agencies like the U.N. also provide classification systems. The point is to make companies
with similar characteristics comparable over some time and across geographies.
Following are some of the government classifications:
➢ The U.N. introduced the International Standard Industrial Classification of All Economic Activities
(ISIC).
➢ The Statistical Classification of Economic Activities in the European Community is like ISIC but
specifically for European companies.
➢ Australian and New Zealand Standard Industrial Classification were developed by Australia and
New Zealand.
➢ North American Industry Classification System (NAICS) was developed by the United States,
Canada, and Mexico.
Key Differences
Such classifications use different methods than those that providers of commercial classification use. But
it is difficult to know the industry group’s composition because such governmental classifications do not
put individual companies in a group. A commercial classification will show each company that makes up
the group.
Governments also do not account for the company's size, whether it is a for-profit or not-for-profit
organization or whether it is a private or public company. Commercial providers do not include any
privately owned and not-for-profit companies, and they do classify based on size.
Also, government classifications are updated less frequently (the NAICS is updated every 5 years).
It is also unfair to assume that two companies that are seemingly close in the industry classification can
be compared for valuation. It is better to create peer groups.
LOS 50c: Determine an industry’s size, growth characteristics, profitability, and market
share trends.
Industry Size:
Industry size refers to the total annual sales of a particular product, which may not align directly with the
combined annual sales of all companies within that industry. This discrepancy can arise when companies
operate across multiple product lines, making only a portion of their total sales relevant to a specific
industry. Sometimes, industry size includes sales from private companies and unincorporated businesses,
posing challenges in data collection. To address this, alternative data sources like government economic
indicators or independent third-party data are often used to approximate industry size.
Industry Growth Characteristics:

The growth rate of an industry can be calculated annually or as a compound annual growth rate over
several years. Analysts broadly categorize industry groups as growth industries or mature industries.
Growth industries have products with significant growth potential, often tied to new technology. Success
in growth industries is generally independent of the overall economy. Analyzing the persistence of high
growth rates and predicting their decline becomes complex, especially when growth is driven by emerging
technology. In contrast, mature industries possess minimal growth potential in their markets. Growth
rates align with the general economy, or they might decrease if substitute products pose threats. Analysts
should monitor changes in competition intensity and signs of overall industry decline. The sensitivity to
the business cycle should also be taken into account, with cyclical industries experiencing higher return
volatility.
Industry Profitability:
Ideally, industry profitability is assessed through return on invested capital (ROIC), an after-tax metric
independent of capital structure. Companies can be ranked in deciles or percentiles to observe their
relative profitability over time. However, estimating ROIC for private companies without publicly available
financial statements is often impractical. In such cases, analysts can use publicly traded company returns
as proxies for private companies, considering publicly available market prices and production costs data
or information from the government or third-party researchers. The objective is to identify trends in
industry profitability over time.
Market Share:
Market share is calculated by dividing a company's annual revenues by the industry size. Due to challenges
in measuring industry size accurately, market shares are typically estimates rather than precise figures.
The trajectory of a company's market share over time is crucial for assessing customer perception of its
products. Acquiring a competitor naturally increases a company's market share, necessitating closer
examination to distinguish whether a company's net market share is increasing post-acquisition.
Industry Concentration:
Industry concentration is often quantified using the Herfindahl-Hirschman Index (HHI), which sums the
squares of market shares for all participants. HHI values indicate concentration levels: an HHI below 1,500
signifies low concentration, 1,500 to 2,500 suggests moderate concentration, and above 2,500 indicates
high concentration. Generally, lower or decreasing concentration implies higher competitive intensity,
less pricing power, and lower profitability. Conversely, higher or increasing concentration implies lower
competitive intensity, more pricing power, and greater profitability, except in cases of local industries and
highly differentiated products where exceptions may apply.
Market Share
Market share is determined by dividing a company's annual revenues by the overall industry size.
However, accurately measuring industry size can be challenging, leading market shares to be
approximations rather than precise figures. Monitoring the trend in a company's market share over time
is vital for assessing customer perception of its products.
Acquiring a competitor automatically boosts a company's market share, but it's important to delve deeper
to ascertain whether a company's net market share increase accounts for acquisitions.
Industry concentration is often quantified using the Herfindahl-Hirschman Index (HHI). The HHI involves
summing the squares of market shares for all participants. For instance, if a market has five firms with
shares of 35, 25, 20, 10, and 10, the HHI would be calculated as follows:
HHI = 35^2 + 25^2 + 20^2 + 10^2 + 10^2 = 2,450.
Based on the HHI, industries can be categorized as follows:

- HHI less than 1,500: Low concentration
- HHI between 1,500 and 2,500: Moderate concentration
- HHI greater than 2,500: High concentration
In general (with exceptions for local industries and highly differentiated products), the concentration level
has significant implications:
- Low or decreasing concentration suggests heightened competitive intensity, reduced pricing power, and
lower profitability.
- High or increasing concentration implies lower competitive intensity, greater pricing power, and higher
profitability.
1. Industry classification systems from commercial index providers typically classify

firms by:
A. statistical methods.
B. products and services.
C. business cycle sensitivity.
2. Firms and industries are most appropriately classified as cyclical or non-cyclical

based on:
A. their stock price fluctuations relative to the market.
B. the sensitivity of their earnings to the business cycle.
C. the volatility of their earnings relative to their competitors.
Answers:
1. B is correct as Commercial classification systems (e.g., GICS, ICB, and TRBC) classify firms according to
the product or service they produce.
2. B is correct as for industry analysis, cyclical firms and industries are those with earnings that are highly
dependent on the business cycle, while non-cyclical firms and industries are those with earnings that are
relatively less sensitive to the business cycle.
LOS 50d: Analyze an industry’s structure and external influences using Porter’s Five
Forces and PESTLE frameworks.
While Porter's five forces framework is valuable for internally analyzing an industry, an analyst must also
account for external factors that can impact it. In this context, a PESTLE analysis examines political,
economic, social, technological, legal, and environmental factors. Given the gradual evolution of external
factors, a PESTLE analysis does not require as frequent updates as a competitive forces analysis. Not all
influences are equally significant for a specific industry, so the analysis should prioritize key factors.
Political influences exert widespread effects on businesses, including taxation and regulation. Notably,
the energy, health care, and defense sectors face substantial political influences. The energy sector, for
instance, contends with considerations like stable energy prices desired by governments to maintain
public favor and climate regulations that may conflict with nonrenewable energy affordability.
Governments also significantly influence the health care sector due to their role as major purchasers,
potentially altering public health care provision and implementing price controls. The defense sector relies
heavily on government procurement, with defense spending tied to geopolitical threats and fiscal
priorities.
Economic influences encompass cyclic and structural trends, impacting GDP, productivity, labor force size,
and interest rates. Interest rates affect financing costs and institution profitability, while credit availability
influences consumer and business spending. Inflation influences costs, prices, interest rates, and
confidence, primarily affecting cyclical sectors.
Social influences pertain to shifts in lifestyle, spending patterns, and work behavior, particularly relevant
to consumer-oriented industries. For instance, the rise of social media and influencers has bolstered
demand for quality beauty products. Increasingly, businesses face pressure to use sustainable inputs and
ethical production processes to align with social trends.
Technological influences can drastically alter industries through introductions of new or enhanced
products. These innovations can be sustaining, improving existing products incrementally, or disruptive,
creating new markets or value in novel ways. Disruptive innovation, often from new industry entrants,
can reshape markets and challenge established players.
Legal influences encompass changes in laws and regulations, presenting both risks and opportunities. The
tobacco industry has encountered revenue declines due to smoking bans and stringent packaging
disclosures. Conversely, the legalized cannabis industry has emerged in regions permitting its sale and
use.
Environmental influences, such as climate change and sustainability concerns, are increasingly pivotal for
industry growth and profitability, reflecting a growing societal and regulatory focus on environmental
impact.
LOS 50e: Evaluate the competitive strategy and position of a company
Every company, whether by design or unintentionally, operates with a competitive strategy. Intentional
strategies are meticulously planned, executed, and evaluated in iterative cycles to refine their
effectiveness. In contrast, unintentional strategies lack coordination, often following past or industry
norms without a deliberate approach. While unintentional strategies may not yield optimal outcomes in
most cases, exceptions exist, such as within the pharmaceutical industry, where informal and less
structured approaches have led to notable successes in drug development by smaller companies.
Competitive strategies are deemed effective in hindsight when they consistently generate positive
economic profits over the long term. To evaluate competitive strategies proactively, considerations
include their responsiveness to relevant forces, neutrality or benefit from external influences, and the
company's ability to execute the chosen strategy effectively.
Michael Porter has outlined three primary competitive strategies: cost leadership (low-cost), product or
service differentiation, and focus. According to Porter's framework, a company must choose one of these
strategies to compete effectively.
In a cost leadership strategy, a company aims to achieve the lowest production costs within its industry,
enabling it to offer competitive prices and attain sufficient sales volume for superior returns. This strategy
can be employed defensively to safeguard market share or offensively to gain market share. Companies
adopting a cost leadership approach should align managerial incentives to enhance operational efficiency.
A differentiation strategy revolves around creating distinct products or services in terms of type, quality,
or delivery. For success, the cost of differentiation must be lower than the price premium buyers are
willing to pay for these unique features. This premium should also be sustainable over time. Successful
differentiators typically possess robust marketing research teams (supporting premium pricing), skilled
production staff (ensuring superior quality), and innovative advertising personnel (promoting unique
product attributes).
A focus strategy involves targeting a specific niche market. Executing a focus strategy may incorporate
elements of both cost leadership and differentiation, tailored to the unique needs of the chosen niche.
1. Two of the five competitive forces in the Porter framework are:

A. threat of entry and barriers to exit.
B. power of suppliers and threat of substitutes.
C. rivalry among competitors and power of regulators.
2. Which of the following best describes a cost leadership strategy?

A. Volume sold can range from modest to high.
B. Managerial incentives promote operational efficiency.
C. Success depends heavily on investments in customer service and proprietary
distribution channels.
Answers:
1) B is correct as Porter’s five forces are rivalry among existing competitors, threat of entry,
threat of substitutes, bargaining power of buyers, and bargaining power of suppliers.
2. B Firms that use a cost leadership strategy should have managerial incentives to create efficient
operations. In a cost leadership strategy, the firm seeks to generate a high-enough sales volume to make
a superior return. Investments in customer service and proprietary distribution channels are key elements
of a differentiation strategy.
Company Analysis: Forecasting 126
Company Analysis: Forecasting

LOS 51a: Explain principles and approaches to forecasting a company’s financial results
and position
Financial statement forecasts serve both valuation and investment recommendations. External forecasts
tend to highlight key metrics like revenue and EPS, while internal company forecasts can be more
comprehensive, extending over several years.
The four primary forecast objects encompass the following:
1. Financial statement lines guided by clear drivers: For instance, in retail, net sales might be modeled
based on the number of stores and sales per store. Forecasting drivers offers explanatory power and
accuracy, though dealing with multiple intricate drivers can be challenging.
2. Financial statement items lacking clear drivers: These items can be directly forecasted using
management estimates or adjustments from prior years.
3. Summary measures: Metrics like EPS or free cash flow consolidate various financial statement line
items. While speeding up forecasting, such measures might obscure transparency.
4. Ad hoc items: Forecasts might accommodate events not yet reflected in financial statements, like
contingent liabilities or potential gains/losses.
Forecast Approaches
Effective forecasts rely on readily available, recurring information. For multi-product or divisional
companies, detailed financial breakdowns are crucial. Simplification is advised, avoiding unnecessary
complexity that doesn't substantially enhance accuracy. Sometimes, skipping a few steps can streamline
forecasts without sacrificing quality.
There are four primary approaches to forecasting, each of which can be employed individually or
combined:
1. Historical Results: This method initiates the forecasting process by using actual past performance as a
baseline and assumes that these results will persist into the future. It is most suitable for companies and
industries that are noncyclical or have reached a mature stage. However, it may not be applicable to
cyclical industries or companies undergoing significant transformations.
2. Historical Base Rate Convergence: In this approach, the forecast is built on the assumption that a
forecasting metric, such as a company's growth rate, will eventually converge to an industry average or
median growth rate. It is particularly effective for well-established industries with stable conditions, but
may not be appropriate for emerging or rapidly changing sectors.
3. Management Guidance: Many public companies provide forward-looking guidance on their earnings
and revenue targets for upcoming periods. Analysts often incorporate this guidance into their forecasts,
especially when management has a track record of providing accurate estimates. However, this approach
may not be suitable for cyclical industries or companies that experience significant fluctuations.
4. Analyst Discretionary Forecast: This versatile approach encompasses any forecasting method beyond
the previous three. It may involve utilizing surveys, models, or probability distributions. Analysts may
choose this approach when the other methods are insufficient, such as for companies in cyclical
industries, those with limited comparable peers, or those undergoing substantial operational changes.
For instance, projecting the impact of a transition to renewable energy sources for energy companies
requires a customized forecast based on factors like regulatory changes and emission reduction targets.
Forecast Horizon
Determining the appropriate forecast horizon depends on various factors, including the investor's time
horizon, the cyclicality of the industry, and company-specific circumstances. For industries subject to
business cycles, the forecast horizon should ideally span at least one full cycle, capturing the midpoint of
the cycle for more accurate projections. Companies implementing strategic operational enhancements
may necessitate a longer forecast horizon to fully capture and assess the benefits of these changes.
LOS 51b: Explain approaches to forecasting a company’s revenues.

Top-Down Revenue Forecasts
In the top-down analysis, the forecasting process begins by considering macro variables, often focusing
on the anticipated growth rate of nominal GDP or a specific market segment.
When forecasting revenues in relation to nominal GDP growth, an analyst may establish a model that
correlates nominal GDP with company sales. Alternatively, the analyst might use the real GDP growth
rate to predict quantity and an inflation projection to estimate prices. Generally, it is projected that a
company's growth will outpace or lag behind GDP growth. For instance, if nominal GDP is projected to
grow by 5%, and the company's revenue is anticipated to increase at a rate 20% higher, the projected
sales growth would be 5% × (1 + 0.20) = 6%. Expectations of growth or decline often correspond to a
company's life cycle stage and the level of cyclicality.
Bottom-Up Revenue Forecasts
Conversely, bottom-up analysis initiates with an individual company or its distinct reportable segments.
Bottom-up revenue projections may stem from historical revenue growth patterns or the introduction of
new products over the forecast period.
Some illustrative examples of bottom-up drivers are:
1. Average Selling Prices (P) and Volumes (Q): By independently forecasting P and Q and subsequently
multiplying the results, an analyst can generate a revenue projection, assuming the necessary data is
readily available.
2. Product Line or Segment Revenues: Analysts may predict revenues for distinct products, business lines,
geographic regions, or reporting segments, which are then aggregated into an all-encompassing
company-wide revenue forecast. However, this is only feasible if a company provides comprehensive data
of this nature.
3. Capacity-Based Measures: Anticipated revenue growth for a company's existing facilities can be
estimated alongside a separate forecast for newly established locations.
4. Return- or Yield-Based Measures: These entail projecting items on the balance sheet and the resulting
return the company will earn from them. For instance, predicting interest revenue for a bank involves
considering changes in loan balances (assets) and adjustments in customer deposits (liabilities).
Integrating elements of both top-down and bottom-up approaches can help identify any inconsistencies
in assumptions. This approach assists in addressing potential anomalies, such as instances where a
company's sales projections based on expected capacity do not align with what is projected given the
anticipated economic growth. This prompts analysts to revisit the model's assumptions and ascertain the
reasonableness of the forecast.
Recurring and Nonrecurring Items

When conducting a forecast, it is important to differentiate between recurring and nonrecurring items.
Nonrecurring items should not be incorporated into a forecast object, but rather analyzed separately.
These items include those explicitly disclosed by company management, as well as other items that the
analyst deems relevant for the forecast. An analyst must be prepared to quantify both types of items.
Items classified as nonrecurring, as disclosed by management, typically pertain to one-time events that
are unlikely to be sustained or repeated, such as significant special orders or foreign exchange gains.
These exceptional items are often segregated from regular revenues and presented as a distinct line item.
This separation aids analysts in determining the portion of revenue that is more likely to recur, provided
they have confidence in the reliability of management's assessments. If a company frequently cites
"nonrecurring" items, analysts might reasonably anticipate this pattern to persist and incorporate them
into their forecasts.
Nonrecurring items that lack quantification by management demand the judgment and insight of the
analyst. For instance, during the COVID-19 pandemic of 2020-21, some analysts speculated that a
permanent shift toward online retail would occur, resulting in sustained online sales growth. However,
after about 18 months, online sales began retreating toward pre-pandemic levels, suggesting that some
analysts who treated the shift as nonrecurring were ultimately accurate in their assessment.
Forecast Approaches
The selection of a forecast approach requires consideration of various risk factors, including competition,
fluctuations in the business cycle, inflation or deflation, and technological advancements. While not all
these factors may be equally relevant to a given company or industry, analysts must determine their
significance and factor them into their forecasts. Employing scenario analysis can be a valuable method
for forecasting the potential impact of these types of risks on a company's performance.
LOS 51c: Explain approaches to forecasting a company’s operating expenses and

working capital
Cost of Sales and Gross Margins
The cost of sales (also known as cost of goods sold or COGS) is intricately linked to a company's revenue.
Consequently, analysts commonly project future COGS as a proportion of revenue using the following
methods:
1. Historical Relationship Method:

Forecast COGS = (Historical COGS / Historical Revenue) × Estimated Future Revenue
2. Gross Margin Method:

Forecast COGS = (1 − Gross Margin) × Estimated Future Revenue
Changes in a company's gross margin can often be indicative of shifts in its market share. A decline in
market share, driven by the emergence of more appealing and cost-effective substitutes, can exert
downward pressure on a company's gross margins. Conversely, a company that is capturing greater
market share through the introduction of innovative and unmatched products might be in a position to
enhance its gross margins.
It's worth noting that gross margin is the difference between revenue and COGS, expressed as a
percentage of revenue. It provides insight into a company's pricing strategy, cost efficiency, and ability to
maintain a competitive edge. As such, monitoring changes in gross margin can offer valuable information
about a company's competitive position and market dynamics.
Illustration
Imagine a company with an initial 25% COGS-to-sales ratio. In the next period, despite selling the same
quantity as before, input costs double. To counter this, the company raises prices by 25%. As a result, the
COGS-to-sales ratio in the following period increases to 40%, as equal amounts are added to both the
numerator and denominator.
Period 1 Period 2
Sales 100 125
COGS 25 50
Gross Profit 75 75
COGS as a % of sales 25% 40%
Gross Margin % 75% 60%
Thus, although the absolute amount of gross profit will remain constant, the gross margin will decrease
(from 75% to 60%).
Due to its significance within a company's costs, even slight changes in COGS can substantially affect profit
forecasts. Analyzing input volume and prices, particularly in the short term, can enhance COGS forecasts.
For instance, fuel expenses heavily impact an airline's COGS, gross margin, and net margin, given their
volatility.
Companies often hedge future input costs using derivatives like forward contracts. Analysts should
ascertain the extent of such hedging or historical practices and durations. While hedges guard against
rising input prices, they also prevent gross margins from rising when input costs decrease.
Comparing a firm's gross margins to its competitors' can validate gross margin estimates and reveal
variations potentially stemming from differing business models.
SG&A Expenses
Relative to COGS, changes in sales volume have less impact on selling, general, and administrative (SG&A)
operating expenses. This is due to the larger fixed cost portion within SG&A expenses, encompassing
items like research and development, corporate overhead, and management salaries. These costs could
be represented using a fixed growth rate, considering expected inflation. In contrast, costs related to
selling and distribution may correlate more directly with sales volume, reflecting the necessity to hire
additional sales personnel for higher sales levels.
Segment disclosures usually lack detailed breakdowns like COGS and SG&A by segment. Consequently,
analysts creating segment forecasts often rely on summary data such as segment operating margins.
Working Capital
Working capital forecasts involve three key balance sheet components: accounts receivable, inventories,
and accounts payable. To explain the forecasting process for these components, we draw upon concepts
and ratios introduced in the Corporate Issuers and Financial Statement Analysis topics.
Accounts Receivable:
Recall that days sales outstanding (DSO) is calculated as 365 divided by receivables turnover. Receivables
turnover can be forecasted as forecasted annual revenues divided by forecasted average receivables.
Alternatively, accounts receivable can be forecasted as DSO divided by forecasted revenues divided by
365.
Inventory:
Inventory days on hand (DOH) is calculated as 365 divided by inventory turnover. Inventory turnover can
be forecasted as forecasted cost of goods sold (COGS) divided by forecasted average inventory. Another
approach is to forecast inventory as DOH divided by forecasted COGS divided by 365.
Accounts Payable:
Days payable outstanding (DPO) is calculated as 365 divided by payables turnover. Payables turnover can
be forecasted as forecasted annual purchases divided by forecasted annual payables. Accounts payable
can also be forecasted as DPO divided by forecasted COGS divided by 365.
LOS 51d: Explain approaches to forecasting a company’s capital investments and capital
structure.
Predicting capital investments involving tangible and intangible assets necessitates an analyst's use of the
cash flow statement to ascertain acquisitions and dispositions, while the income statement aids in
determining depreciation and amortization expenses. To enhance forecast accuracy, capital expenditures
should be categorized into maintenance and growth.
Typically, historical depreciation serves as the initial reference point for predicting maintenance capital
spending. Accounting for anticipated inflation is essential when estimating maintenance outlays since
replacement costs tend to rise with inflation. Projecting depreciation and amortization can be achieved
by utilizing the net book value of property, plant, and equipment, alongside the projected useful life of
these assets. Forecasting capital expenditures for growth demands a comprehensive understanding of a
company's forthcoming business strategies and revenue expansion plans.
Anticipating a firm's capital structure is often underpinned by examining its leverage ratios (e.g., debt-to-
assets, debt-to-equity). Analysts should be vigilant about any borrowing obligations arising from planned
capital expenditures. Company management might furnish insights into their target capital structure or
any debt covenant ratios they are obligated to uphold.
LOS 51e: Describe the use of scenario analysis in forecasting

When forecasting financial statements, it's insufficient to rely solely on a single point estimate for
variables like net income. Instead, an analyst should engage in scenario analysis by considering various
alternative assumptions. This approach helps assess how sensitive net income is to changes in these
assumptions, which can encompass shifts in economic conditions, competition, technological
advancements, and more. The outcome of this analysis is a comprehensive range of estimates derived
from multiple scenarios.
Equity Valuation: Concepts and Basic Tools 131
Equity Valuation: Concepts and Basic Tools
This reading sets the foundation for valuation models. This is an extremely important reading for equity
valuation as it is applicable to CFA Level 2, CFA Level 3 and practical purposes.
Make sure that you have understood the foundations of each model, which model is appropriate for which
case, and their advantages and disadvantages.
LOS 52a: Evaluate whether a security, given its current market price and a value
estimate, is overvalued, fairly valued, or undervalued by the market.
We saw the differences between intrinsic value and market value in the reading related to market
efficiency.
Analysts use valuation models like a discounted cash flow model to calculate the intrinsic value of a stock.
This is the rational value that the analyst would pay for the stock, given all the available information and
assumptions that have been made while making the valuation model.
This intrinsic value is compared to the market value to understand the following relationships:
➢ If the market price is greater than the intrinsic value, then the stock is overvalued.
➢ If the market price is less than the intrinsic value, then the stock is undervalued.
➢ If the market price is equal to the intrinsic value, then the stock is fairly valued.
Different analysts likely find different intrinsic values because of differences in opinion. Remember that
the intrinsic value is subjective and not directly observable.
So, the true value addition comes from the accuracy of these financial models and which analyst has the
most reasonable estimate of the stock’s intrinsic value. For fund managers who can only buy stocks (and
not short sell stocks), the aim is to find undervalued securities. But it is important that the rest of the
market also sees these securities as undervalued. This way, the rest of the market will demand more of
the stock and increase the stock price. It is only when the stock price increases that the investment will
become profitable.
Following are a few factors to consider when looking at mispriced securities relative to the subjective
intrinsic value.
Margin of Safety
Small differences between market price and the intrinsic value may not attract an investor to buy a stock.
An investor may have a margin of safety.
Suppose an analyst finds that the intrinsic value of Axis Bank is Rs. 750 per share and the investor’s margin
of safety is 10%. One interpretation of this is that the investor expects their valuation to be mispriced by
plus or minus 10%.
So, if the market price of Axis Bank is Rs. 675 per share, then it may not be such an attractive investment
because the analyst already expects a 10% error in their estimates. Similarly, they cannot say that the
stock price is overvalued if the market price is Rs. 825.
Therefore, the larger the percentage difference between market prices and estimated values, the more
likely the investor is to take position based on the estimate of intrinsic value.
Confidence
The analyst is wrong until proven right. It may take time for the intrinsic value to be proven right because
the market must see what the analyst sees to justify the estimate of the intrinsic value. It requires
conviction to stick to one’s beliefs about the assumptions.
So, the more confident the analyst is regarding their assumptions and appropriateness of the financial
model, the more likely they are to make an investment decision.
Model Inputs
It is also important to see how sensitive the output of the financial model is to a change in key inputs. For
example, the output of a discounted cash flow model is very sensitive to the terminal growth rate
assumption. We will see this later in the reading.
Mispriced Stock or Incorrect Model?
If a stock is mispriced according to a financial model, it is important to see why it is currently priced at that
price in the market. This raises the question of how efficient a stock price is and if it is a close
representative of its intrinsic value. It also raises the issue of if the model is wrong or if the market is
wrong.
Let us go back to the Axis Bank example, where the analyst found the intrinsic value as Rs. 750. If the
current market price is Rs. 600, does that mean that the entire market has not seen what the analyst has
seen, or does it mean that some inputs in the model are incorrect? The analyst may have to revisit the
model to ensure the accuracy and conviction of their inputs.
Convergence to Intrinsic Value
The analyst must also believe that the rest of the market will catch on, and the price will converge to the
intrinsic value. Only then any investment decision based on mispricing will be beneficial. Imagine an
analyst identifies an overvalued stock and takes a short position. However, the market just does not see
it the way the analyst does. The share price may never fall enough for the investment to be profitable.
1. An analyst prepares a DCF model on Infosys and finds that the intrinsic value according to their
assumptions is Rs. 1,800. The current market price is Rs. 1,560. The stock is most likely
A. Fairly valued
B. Undervalued
C. Overvalued
2. An analyst prepares a DCF model on Infosys and finds that the intrinsic value according to their
assumptions is Rs. 1,800. The margin of safety is 15%, and the current market price is Rs. 1,560.
The stock is most likely
A. Fairly valued
B. Undervalued
C. Overvalued
3. An analyst makes the following statement

“The intrinsic value must converge to the market price for the analyst to be proven right.”
They are most likely
A. Incorrect because the market value converges to the intrinsic value, not the other way round
B. Correct because the intrinsic value must be adjusted to match the market value
C. Correct because the margin of safety ensures that the intrinsic value converges to the market
price
Answers
1. B is correct. According to the analyst’s assumptions, the rational price that one would pay for a
share of Infosys is Rs. 1,800, but the market is paying Rs. 1,560. The market is undervaluing the
potential of the company.
2. A is correct. The margin of safety provides a range for which the analyst thinks that the stock is
fairly valued. In this case, the range is 15% plus or minus the intrinsic value (Rs. 1,800). Therefore,
the range is Rs. 1,530 to Rs. 2,070. Since the market price of Rs. 1,560 falls within this range; the
stock is fairly valued. Note that a lower margin of safety reduces the range, and so a margin of
safety of 10% would mean that the stock is undervalued.
3. A is correct. The intrinsic value remains relatively constant unless there is a significant change in
the estimates of a company and the model inputs need to be updated. The market price must
converge to the intrinsic value over a while so that the analyst is proven right. C is incorrect
because the margin of safety is simply an approximation of how far off an analyst’s intrinsic
valuation calculation is. It does not actually change the intrinsic value calculation. B is incorrect
because this would defeat the purpose of intrinsic valuation (i.e., to assess how a stock is valued
compared to its current market price).
LOS 52b: Describe major categories of equity valuation models.
We will see the details of each category of valuation models in detail later, throughout the reading. For
now, make sure you have understood the different types and their differences.
Discounted Cash Flow Models
The DCF model is a valuation method that estimates the current value of future cash flows by discounting
them back to their present value. It involves forecasting expected cash flows, applying a discount rate,
and summing them up to determine the fair value of the investment.
A free cash flow to equity (FCFE) model is a variation of the DCF model that is specifically used to
determine the equity value of the company which calculates the available cash flow after a company has
serviced the appropriate debt payments, paid its capital expenditures and met the working capital
requirements. The present value of all these cash flows (including a terminal value) that a company will
make over a period of time is discounted back.
A dividend discount model (DDM) calculates the expected dividend that a company will pay to its
shareholders. The present value of all these dividends (plus a terminal value) that a company will pay over
time is discounted back. These are most appropriate for companies that pay regular and predictable
dividends.
Multiplier Models
These use a multiple that is obtained from market factors and apply them to a fundamental factor of a
stock to calculate its intrinsic value. This is a type of relative valuation because the multiples are obtained
from a peer group.
Analysts can use the stock price of companies and find a ratio of this price relative to a fundamental factor
like earnings, sales, cash flows etc.
For example, the price-to-earnings (P/E) ratio is a multiple of the current market price relative to the
earnings per share of a company (net income divided by weighted average number of shares outstanding).
Suppose a company is trading at Rs. 100 per share, and they have earned earnings of Rs. 5 per share. The
P/E ratio is 20 (100 ÷ 5), and this means that the market is willing to pay 20 times (or 20x) the earnings of
the company to buy its share.
The same logic can be applied to calculate and interpret the price-to-sales ratio, price-to-book value ratio
and the price-to-cash-flow from operations ratio.
Analysts can also use the enterprise value of a company and compare it to a fundamental factor. The
enterprise value is calculated as:
EV = Total Market Value of Equity + Total Market Value of Debt - Cash on hand - Short-Term Investments
This is then compared to fundamental factors like:
➢ Sales, to obtain the EV/Sales ratio.
➢ Earnings before interest, taxes, depreciation, and amortization (EBITDA), to obtain the EV/EBITDA
ratio, Earnings before interest and taxes (EBIT), to obtain the EV/EBIT ratio.
Asset-Based Models
This is simply the fair value of a company’s asset minus the fair value of its total liabilities and preferred
stock. Book values are adjusted to reflect an appropriate fair value while using this type of model.
1. An analyst states that the HDFC Bank’s P/E multiple is 26.40 and that this is lower than the P/E
multiple of the NIFTY 50 index. This is most likely a
A. Discounted cash flow model

B. Asset-based model
C. Multiplier model
2. An analyst states that HDFC Bank’s intrinsic value is Rs. 1,900 and that it is undervalued because
the market price is Rs. 1,520. This is least likely a
A. Discounted cash flow model

B. Asset-based model
C. Multiplier model
3. An analyst states that they have used the present value of expected free cash flows of a company
to find its intrinsic value. They have most likely used a
A. Dividend discount model

B. FCFE model
C. Relative valuation model
4. A company pays irregular dividends, which cannot be predicted. They are consistently cash flow
positive, and these cash flows are relatively stable. It is most appropriate to use which model to
find the intrinsic value?
A. Dividend discount model

B. FCFE model
C. Relative valuation model
Answers
1. C is correct. A multiplier model uses relative valuations like the P/E ratio of a company. These
ratios are compared to other companies' ratios, the ratio of the index or the same company’s
ratio over a period of time. A and B are incorrect because those models do not use the P/E ratio.
2. C is correct. A DCF or an asset-based model is used to find the intrinsic value, while a multiplier
model is used to assess the relative value of a company.
3. B is correct. FCFE stands for free cash flow to equity. This is the cash flow that is available to a
company after debt holders have been paid. A is incorrect because the dividends have not been
predicted; the cash flows have been predicted. Note that the FCFE is not the same as the actual
expected dividend payment. C is incorrect because relative valuation models do not use the
present value of free cash flows.
4. B is correct. The DDM is most useful only when dividends can be predicted accurately in terms of
amount and in terms of time. An FCFE model is especially appropriate if a company has stable
cash flows. C is incorrect because relative valuations are not informative regarding the intrinsic
value.
LOS 52c: Describe regular cash dividends, extra dividends, stock dividends, stock splits,
reverse stock splits, and share repurchases.
Cash Dividends
➢ Shareholders receive a dividend payment in cash.
➢ If a company has a dividend policy that will ensure regular dividend payments, investors can
expect dividend receipts as per the schedule.
➢ A record of stable or growing dividends is a good sign of the company’s financial stability.
➢ There could also be special dividends when favorable circumstances allow the firm to make a one-
time payment to shareholders, in addition to any regular dividends the firm pays. This is likely for
cyclical companies that have had exceptional earnings during a market cycle.
Stock Dividends
➢ Shareholders receive more shares instead of cash. In this case, there will be more shares
outstanding but each will be worth less as result of which the value of the company does not
change.
➢ Suppose a company’s share price is Rs. 10, and there are 10,000 shares outstanding. So, the
market value is Rs. 100,000. If they announce a stock dividend of 15%, then each shareholder will
get 15% more shares than they already hold. So, there will be 15% more shares outstanding, but
the company value remains at Rs. 100,000. There are now 11,500 shares outstanding, and each is
worth approximately Rs. 8.70.
Stock Splits
➢ Each share is divided into multiple shares. There are now more shares outstanding, but the share
price will drop accordingly so that the market value remains unchanged.
➢ If a company announces a 2-for-1 stock split, it means that each shareholder will receive 2 shares
for each share that they hold.
➢ These are more common than stock dividends.

Reverse Stock Splits

➢ This is the exact opposite of a stock split.
➢ The price per share increases after a reverse stock split, but the company's total market value
remains unchanged.
Share Repurchase
➢ A company buys back some of its own outstanding shares, so it is called a “re”-purchase.
➢ A company buys these shares from existing shareholders in exchange for cash, and so those
investors that choose to participate in the repurchase typically receive a favorable price.
➢ This is an alternative to cash dividends, but it also reduces the number of shares outstanding.
➢ So, it is a convenient way to signal that the management believes that the share price is
undervalued, and it must be propped up to a higher level. If too many employees stock options
have been exercised, management may also participate in a share repurchase to offset an
increase in outstanding shares.
➢ Shareholders may prefer share repurchases if the dividend tax is higher than the capital gains tax.
Remember that dividends are taxed immediately while capital gains taxes can be deferred.
1. A stock split most likely results in (a)
A. Lower share price

B. Higher share price
C. No change in share price
2. If the tax rate on dividends is higher than the income tax rate on capital gains, then shareholders
most likely prefer
A. Cash dividends
B. Share repurchases
C. Either cash dividends or share repurchases
3. A stock dividend most likely results in (a)
A. Lower share price

B. Higher share price
C. No change in share price
4. A company currently has 140,000 shares outstanding. If they announce a 1-for-3 reverse stock
split, then after the split, there will be
A. 46,666.67 shares outstanding, and the share price decreases

B. 46,666.67 shares outstanding, and the share price increases
C. 420,000 shares outstanding, and the share price decreases
Answers
1. A is correct. A stock split means that more shares are outstanding. Holding the market
capitalization constant, the price per share should reduce.
2. B is correct. Both A and B result in more cash in hand for the investor, but the dividends are taxed
immediately. If the cash flow received is taxed immediately at a higher rate than a repurchase,
investors are worse off. According to the Finance Act, 2013, individuals are no longer liable to pay
income tax on share buybacks.
3. A is correct. This follows the same logic as a stock split. There are more shares outstanding, but
the market capitalization is held constant. So, shareholder wealth does not change, but each share
is worth less.
4. B is correct. A reverse stock split of 1-for-3 means that every 3 shares will be converted to one
share. There are fewer shares outstanding. Holding the market capitalization constant, the share
price must increase, so that shareholder wealth remains unchanged. C is incorrect because this is
the effect of a stock split, not a reverse stock split.
LOS 52d: Describe dividend payment chronology.
The following timeline illustrates the key dates for a dividend payment.
Declaration Date
The board of directors approve the dividend payment on this date and declare it to the shareholders. They
specify the dividend per share, the record date, and the payment date.
The dividend, in this case, has been declared on April 9th and will be finally paid to shareholders on April
30th.
Ex-Dividend Date
It is the date that the stock goes Ex-dividend, i.e., the value of the dividend will be lost to any new
purchaser. It is usually 1-2 days before record date and anyone who purchases ON OR AFTER ex-dividend
will not receive the Dividend.
Stocks may take two or three days to be credited into shareholders’ accounts. An investor may place an
order to buy the shares, but they may not be credited into the account. So, if an investor does not have
the shares on April 26th, then they are not entitled to the dividend payment.
Holder of Record Date (Record Date)
It is the date when the company extracts the list of current shareholders and who ever are having the
share in their account as of this date will receive dividends.
This is the date on which the company pays the dividend. In this case, it is April 28th.
Payment Date
The date when the company actually pays the dividends. In this case, it is April 30th.
On ex-dividend date, the stock price of the share typically decreases by the amount of dividend payment.
This is because when a company declares a dividend, it is distributing a portion of its earnings to its
shareholders. As a result, the company’s cash reserves decrease, leading to a corresponding decrease in
the overall value of the company.
Suppose a company announces a dividend of $1 per share and has a total of 10,000 outstanding shares.
The current market price of the stock is $25.
Before the ex-dividend date:
Total dividend payout = $1 x 10,000 = $10,000
Assuming the market reacts efficiently, the share price tends to adjust downwards by approximately the
dividend amount. In this example, the share price might drop by around $1 on the ex-dividend date. So,
the new share price after the ex-dividend date could be $24.
The reason behind this adjustment is that investors buying the stock after the ex-dividend date will not
receive the upcoming dividend payment. As a result, the market prices the stock lower to reflect this
change in the company's value.
1. An investor purchases shares on the dividend declaration date, but it takes 2 days to show in the
investor’s account. The ex-dividend date is 2 weeks away. Are they entitled to a dividend payment,
and what is the most likely explanation?
A. No, because they must have the shares on the declaration date
B. Yes, because they must have the shares on the ex-dividend date
C. Yes, because the order was placed on the declaration date
2. An investor purchases shares on the dividend declaration date, but it takes 2 days to show in the
investor’s account. The record date is 3 weeks away, and the shareholder still holds the shares.
Are they entitled to a dividend payment, and what is the most likely explanation?
A. No, because they must have the shares on the declaration date
B. Yes, because they placed their order on the declaration date
C. Yes, because they have held the shares on or before the ex-dividend date
Answers
1. B is correct. Investors must have the shares in their account on or before the ex-dividend date. A
and C are incorrect because the declaration date has nothing to do with whether the investor
receives a dividend.
2. C is correct. Investors are entitled to a dividend if they hold the shares on or before the ex-
dividend date. The record date is always after the ex-dividend date. Given that the shareholder
holds the same shares on the record date, they must also have held it on the ex-dividend date. A
and B are incorrect because dividend entitlement has nothing to do with the declaration date.
LOS 52e: Explain the rationale for using present value models to value equity and
describe the dividend discount and free-cash-flow-to-equity models.
Any present value model that uses the expected cash flows of a company assumes that the intrinsic value
of that company is derived from the cash flows that it generates.
The two models that can be used are the DDM and the FCFE model.
Dividend Discount Model (DDM)
Dividends are cash payments that are paid out to shareholders. The expected dividend can be directly
used to estimate the value of the company.
It considers the dividend payments and the expected price (referred to as Terminal value) at the end of
the period.
The most general form of the model is as follows:
Where,
V0: Current stock value
Dt: Dividend at any time t
Ke: Required rate of return of common equity

One-Year Holding Period

For a holding period of one year, the value of the stock today is the present value of any dividends during
the year (D1) plus the present value of the expected price of the stock at the end of the year (P1).
Suppose you want to buy a stock today, and you expect to sell it one year later. You will also receive a
dividend payment on that day.
Suppose the dividend per share is Rs. 6 and the expected share price one year from now is Rs. 210.
We can draw out a timeline as follows:
The total of Rs. 6 + Rs. 210 is a cash inflow and must be discounted back to today to find V0, i.e., the share's
intrinsic value today.
So, we can say that D1 = 6 and P1 = 210
We must discount these cash flows at the cost of equity. We are only concerned with the equity portion
of the capital structure, and so we must not use the WACC. Suppose the cost of equity is 6.70%.
So,
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝑉𝑎𝑙𝑢𝑒 = +
(1+𝑘𝑒 ) (1+𝑘𝑒 )
V0 = 6 ÷ (1 + 6.70%)1 + 210 ÷ (1 + 6.70%)1 = 202.44

Multi-Stage DDM
The same logic can be applied if the holding period is more than one year (or more than one discounting
period). But there is a slight twist that accounts for the dividend growth rate.
Suppose you want to buy that same stock, but you will hold it for 3 years instead of one year. It is likely
that the dividends will grow over this period. Let us assume that the dividends grow at a rate of 5% every
year. We will also assume that the expected share price three years from now is Rs. 235.
Now we have the following information:
Details Amount
Dividend in one year 6
Price in three years 235
Dividend growth rate 5.00%
Cost of Equity 6.70%
Now we need the dividend that must be discounted 2 years from now and 3 years from now. That is, we
have D1, but we need D2 and D3.
D2 = D1 × (1 + 5.00%) = 6 × 1.05 = 6.30
D3 = D2 × (1 + 5.00%) = 6.30 × 1.05 = 6.62
Now we can draw out the following timeline:
All of these cash flows must be discounted back to find V0.
Time 1 2 3
241.62
Cash Flow 6 6.30 (6.62+ 235)
Discount Rate 6.70% 6.70% 6.70%
Present Value Calculation 6 ÷ (1+6.70%)1 6.30 ÷ (1+6.70%)2 241.62 ÷ (1+6.70%)3
Present Value 5.62 5.53 198.90
The sum of the present values is the intrinsic value that is Rs. 210.05.
Let us also calculate the intrinsic value of a stock with the following information:
The company has paid a dividend of Rs. 4 per share in its latest year. An investor buys the shares after this
dividend has been paid. The dividend growth rate is 4.00% per year and the investor’s holding period is 2
years. They expect to sell the share for Rs. 350 in 2 years. The cost of equity is 5.00%. Calculate the intrinsic
value using the DDM.
Note that since the dividend has already been paid, this is not a future cash flow. We can call it D0. But
we need D1 and D2 to calculate the intrinsic value. We can apply the same logic that we applied before to
find these variables.
D1 = D0 × (1 + 4.00%) = 4 × 1.04 = 4.16
D2 = D1 × (1 + 4.00%) = 4.16 × 1.04 = 4.33
Also note the following relationship. If there is a constant growth rate, then we can also find D2 by using
D0 as follows:
D2 = 4 × (1.04 × 1.04) or,
D2 = 4 × 1.042
D2 = 4.33
We now have the following information:
Time 1 2
Cash Flow 4.16 354.33
Discount Rate 5.00% 5.00%
Present Value Calculation 4.16 ÷ (1 + 5.00%)1 354.33 ÷ (1 + 5.00%)2
Present Value 3.96 321.39
The intrinsic value is, therefore, Rs. 325.35.

Free Cash Flow to Equity (FCFE) Model
You can think about the FCFE as the potential amount of cash that can be paid out to shareholders. This
is the cash flow that is remaining after all debt has been serviced, and capital expenditure has been paid.
In other words, the FCFE is the capacity of a company to pay dividends.
We will see how this works with the following formula:
FCFE = Net Income + Depreciation and Other Non-Cash Items − Increase in Working Capital − Fixed
Capital Investment − Debt Principal Repayments + New Debt Issues
Remember that net income contains non-cash items, and so it must be adjusted to represent a cash flow-
based income. Depreciation, amortization, and other non-cash items reduce the net income, but the
company does not actually pay out cash when these items are charged to the profit and loss statement.
So, they must be added back.
An increase in working capital could be something as simple as increasing inventory. When inventory
increases, the company must pay out cash. Increases in working capital must be reduced because they
are a cash outflow.
The same logic applies to fixed assets (capital investments). If a company has purchased a machine, there
must be some cash outflow that is associated with this purchase. Fixed capital investment can be called
“FCInv”.
Any debt payments are a cash outflow, and any receipts from new debt issues are a cash inflow to equity
shareholders. “Net Borrowing” is simply the net amount of what has been borrowed minus what has been
repaid during the period.
So, a free cash flow balance remains after all these adjustments have been made. This free cash flow is
available to equity holders, but they do not actually receive these cash flows. The company still holds this
free cash flow, so they choose how much of this they want to pay out as dividends. This is why the FCFE
is the capacity to pay dividends rather than the dividend payment itself.
The alternative formula for FCFE is:
FCFE = Cash Flow from Operations − FCInv + Net Borrowing
where:
Cash Flow from Operations = Net Income + Depreciation and Other Non-Cash Items − Increase in Working
Capital
We can apply the same formula that we did for the DDM. It is simply the sum of all FCFE from one period
to the next discounted back to today.
The Required Return on Equity
Recall from previous readings that the cost of equity and the required return on equity are two sides of
the same coin. The most common method to calculate the cost of equity is the capital asset pricing model
(CAPM).
CAPM Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
Other methods to calculate the cost of equity have been covered in detail in the Corporate Finance
readings.
Let us work with the following data as an example:
Details Value
Free Cash Flow in Year 0 Rs. 100,000
FCFE Growth Rate 4.50%
Forecast Horizon 3 years
Terminal Value of FCFE 12,000,000.00
Number of Shares Outstanding 100,000

We aim to find the present value of these cash flows over the forecast horizon of 3 years. Note that the
terminal value is added to the FCFE in Year 3. We can draw out the cash flows in the following way:
Year 1 2 3
FCFE 104,500.00 109,202.50 12,114,116.61
Discount Rate 5.50% 5.50% 5.50%
Present Value 99,052.13 98,113.25 10,316,547.24
Now we can use the following calculation:
Sum of Present Value 10,513,712.62
FCFE per Share 105.14
Therefore, the intrinsic value per share is 105.14 (10,513.712.62 ÷ 100,000).
The terminal value uses a terminal growth rate and a terminal cost of equity. It is calculated as:
FCFEn × (1 + gT) ÷ (ke - gT), where FCFEn is the FCFE in the latest year of the forecast period, and
gT is the terminal growth rate.
1. Suppose the following information is provided regarding a company’s dividends, growth, and cost
of equity
The company recently paid a dividend of Rs. 5 per share. The dividend growth rate is 4.50% per
year, and the cost of equity is 6.50%.
An investor purchases a share today and expects to sell it for Rs. 600 in three years.
Calculate the intrinsic value per share.
A. 510.53
B. 511.16
C. 480.85
2. An investor has identified a company that is expected to pay a dividend of Rs. 9.50 in one year.
They will sell the shares in one year for an expected price of Rs. 870. Calculate the intrinsic value
per share if the cost of equity is 7.00%.
A. 813.08
B. 879.50
C. 821.96
3. A company will pay a dividend of Rs. 9.00 at the end of 3 years. The dividend growth rate is 5.60%
per year. What is the dividend at the end of 5 years?
A. 9.50
B. 10.04
C. 11.82
4. An analyst claims that the FCFE is always paid out to the shareholders as a dividend. They are most
likely
A. Incorrect because FCFE is the dividend-paying capacity, not the actual dividend
B. Correct because FCFE and dividend mean the same thing
C. Correct because FCFE is essentially the dividend payment for non-dividend paying companies
5. Suppose you are provided with the following information:
Details Value
Free Cash Flow in Year 0 Rs. 500,000
FCFE Growth Rate 3.25%
Forecast Horizon 4 years
Terminal Value of FCFE 61,000,000.00
Calculate the intrinsic value per share by using the FCFE model.
A. 210.56
B. 178.12
C. 178.32
Answers
1. B is correct. The cash flows can be drawn out as follows:
Now we must discount each cash flow at the cost of equity.
5.23 5.46 605.71

𝑉0 = + + = 511.16
1.065 1.0652 1.0653
A is incorrect because it takes D0 as D1 (i.e., it does not account for the fact that this dividend has
already been paid). C is incorrect because it discounts the expected price in the fourth year, not
the third year.
2. C is correct.
The cash flows can be drawn out as follows:
9.50+870
𝑉0 = 1.072
B is incorrect because it does not discount the cash flows. C is incorrect because it does not add
the dividend.
3. B is correct. The dividend growth can be calculated as follows:

𝐷3 = 9.00
𝐷4 = 9.00 × 1.56 = 9.5040
𝐷5 = 9.50 × 1.056 = 10.0362
A is incorrect because this is the dividend at the end of the fourth year. C is incorrect because this
is the dividend growth rate assuming that the Rs. 9.00 dividend was paid today. It takes = 9.00 ×
1.0565.
4. A is correct. The FCFE is not the actual dividend that is paid out. It simply indicates the amount of
dividend that can be paid out. C is incorrect because a company can have consistently positive
FCFE but no dividend payment. The dividend payment depends on their dividend policy.
5. C is correct.
Year 1 2 3 4
FCFE 516,250.00 533,028.13 550,351.54 61,568,237.96
Discount Rate 4.30% 4.30% 4.30% 4.30%
Present Value 494,966.44 489,983.56 485,050.84 52,025,886.71
Sum of Present Value 5,34,95,887.55
FCFE per Share 178.32
A is incorrect because it takes the sum of FCFE rather than the sum of present value of FCFE. B is incorrect
because it takes FCFE0 (500,000) as the starting point rather than FCFE1.
LOS 52g: Calculate the intrinsic value of a non-callable, non-convertible preferred stock.
Recall from the Cost of Capital reading that the cost of preferred stock is calculated as follows:
kps = Dps ÷ P0
where:
kps = cost of preferred stock
Dps = preferred stock dividend
Since our objective is to find P0 (which is also V0 if the intrinsic value is equal to the price), then we can
rearrange the formula as follows:
V0 = Dps ÷ kps
The logic here is simple. A preferred stock will pay a constant rate of dividend on face value, so there is
no real growth rate. We can assume that these dividends will be paid in perpetuity. So, to find the present
value of a perpetuity, we simply divide the dividend by the cost of preferred stock.
Suppose a company’s $500 par preferred stock pays a $10 annual dividend and has a required return of
9%. Calculate the value of the preferred stock.
Value of Preferred Stock:
V0 = Dps ÷ kps
V0 = $10 / 0.09 = $111.11
1. The dividend rate on a company’s preferred shares is 5.00%, and their face value is Rs. 100. The
cost of preferred shares is 3.00%. Calculate the value of preferred shares.
A. 100.00
B. 166.67
C. 60.00
2. The cost of preferred shares is 6.00%, and the current price is Rs. 98. The face value is Rs. 100.
Calculate the dividend per share.
A. 5.88
B. 6.00
C. 6.88
3. The price of preferred shares is Rs. 105, and the face value is Rs. 100. The dividend rate is 6.00%.
Calculate the cost of preferred shares.
A. 6.71%
B. 5.71%
C. 6.00%
Answers
1. B is correct. The dividend rate is multiplied to the face value to find the dividend per share.
V0 = Dps ÷ kps = 5 ÷ 3.00% = 166.67
A is incorrect because this is the face value, not the price. C is incorrect because it takes 3 ÷ 5.00%
rather than 5 ÷ 3.00%.
2. A is correct.
V0 = Dps ÷ kps
Dps = V0 × kps = 98 × 6.00%= 5.88
B is incorrect because it takes the face value rather than the price.
3. B is correct.
V0 = Dps ÷ kps
kps = Dps ÷ V0 = 6 ÷ 105 = 5.71%
C is incorrect because it uses the face value, not the price.

LOS 52h: Calculate and interpret the intrinsic value of an equity security based on the
Gordon (constant) growth dividend discount model or a two-stage dividend discount
model, as appropriate.
We saw from the multi-stage DDM that all dividends are discounted back to the present. But what if there
is no specific investment horizon?
We can assume that the dividends will be received in perpetuity, just like we saw in the preferred stock
model. But the difference here is that there is dividend growth. So, we must tweak the preferred stock
pricing model to account for this growth.
We can start with the following expression:
𝐷0 (1+𝑔𝑐 ) 𝐷0 (1+𝑔𝑐 )2 𝐷0 (1+𝑔𝑐 )3 𝐷0 (1+𝑔𝑐 )∞
𝑉0 = + + + 0…+
(1+𝑘𝑒 ) (1+𝑘𝑒 )2 (1+𝑘𝑒 )3 (1+𝑘𝑒 )∞
We have seen this expression before. It is simply all the dividends discounted back to today. But it is
without a target share price because we assume that the dividends are paid in perpetuity and that there
is no specified investment horizon. The cash flows, therefore, pertain only to the dividend payments.
When we reduce this formula to a simple formula (assuming constant dividend growth rate), we get:
𝐷0 (1+𝑔𝑐 ) 𝐷1
𝑉0 = =
(𝑘𝑒 −𝑔𝑐 ) 𝑘𝑒 −𝑔𝑐
This is the Gordon Growth Model, and it accounts for the fact that dividends grow at a constant rate for
an infinite period. It is essentially a perpetuity of dividends that accounts for dividend growth.
Note that if g = 0 (i.e., if there is no dividend growth at all), then it is the same as the model to calculate
the value of preferred stock.
There are a few assumptions of this model:
➢ Dividends are an adequate proxy for intrinsic value and shareholder wealth.
➢ The variables do not change. So, the growth rate and cost of equity are expected to remain
constant over time.
➢ ke > gc
If ke = gc, then the denominator is 0, and the result is invalid.
If ke < gc, then the denominator is negative, hence the share price is negative, and the result is
invalid.
Hence, ke must be greater than gc
If any one of these assumptions is not met, the model is not appropriate.
Relationship Between Cost of Equity and Growth

The Gordon Growth Model is extremely sensitive to the assumptions of cost of equity and growth. As a
simple example, assume that the numerator is constant at 100. Let us see two different scenarios:
Scenario 1: ke = 5.00% and gc = 3.00%
V0 = 100 ÷ (5.00% - 3.00%) = 5,000
Scenario 2: ke = 5.00% and gc = 2.50%
V0 = 100 ÷ (5.00% - 2.50%) = 4,000
In this case, we can see that a 0.50% decrease in gc decreases the value by 20.00%.
So, we can make the following rule:
All else held constant,
A decrease in the growth rate decreases the firm value
An increase in the growth rate increases the firm value
The opposite is true for the cost of equity.
All else held constant,
A decrease in the cost of equity increases the firm value
An increase in the cost of equity decreases the firm value
So, it is important to note that as the denominator of the Gordon Growth Model decreases, the firm value
increases and that as the denominator increases, the firm value decreases.
In other words, as the difference between ke and gc reduces, the value increases, and as the difference
between ke and gc increases, the value decreases.
We can also carry out the following analysis to see how much of the firm’s value is coming from dividend
growth.
Let us assume that we have the following information:
Details Value
Current dividend 5
Cost of equity 7.00%
Growth rate 4.00%
V0 = [5 × (1 + 4.00%)] ÷ (7.00% - 4.00%) = 173.33

Now let us assume that there was no dividend growth at all.
V0 = [5 × (1 + 0.00%)] ÷ (7.00% - 0.00%) or,
V0 = 5 ÷ 7.00% = 71.43
The difference between the two cases is 173.33 - 71.43 = 101.90
So, we can say that the dividend growth accounts for 101.90 out of the total value of 173.33.
The Growth Rate
There are three different ways to obtain the growth rate, gc:
➢ Historical average growth rate of the company’s dividends.
➢ Median of the industry’s rate of dividend growth.
➢ Calculate an estimate for the sustainable growth rate.
The sustainable growth rate assumes that equity, earnings, and dividends grow at a constant, sustainable
rate. It can be calculated as follows:
g = Retention Rate × Return on Equity
The return on equity (ROE) is a profitability measure that shows how much profit the company generates
from the equity capital provided.
The retention rate is the amount that is not paid out as dividend. This is the proportion of earnings that
is reinvested into the company. It can also be expressed as the following:
Retention Rate = 1 - Dividend Payout Rate
Suppose a company pays 30% of its earnings as dividends. This means that they have retained 70% of
their earnings.
Recall the assumption of the sustainable growth rate from the Cost of Capital reading: whatever is not
paid out by the company will be reinvested into the company. This investment will return a rate similar
to the company’s current profitability.
It is possible that a company does not currently pay dividends. It may not have the adequate cash flow
and size to do so yet, but it may be expected to start paying dividends at a future point in time. It could
also be that the company prefers to re-invest their earnings until they have reached a certain size, and
then they would be in a better position to pay dividends.
Note that it is very important to estimate the timing of these dividend payments accurately because we
are dealing with time value of money calculations.
Suppose that a company currently pays no dividends, but it is expected to start paying dividends at the
end of the 5th year of its operations. Their dividend payout ratio will be 25%, and their expected earnings
will be Rs. 20 per share. The analyst expects that the ROE at the end of year 5 will be 15%, and the cost of
equity will remain constant at 20%. What is the value of the share price today?
We now have the following information:
Details Value
EPS (earnings per share) 20

Payout Ratio 25%
ROE at end of year 5 (ROE5) 15%
Cost of Equity 20%
Time 5 years
Note that we want to calculate the company’s value at the end of year 5 and then discount this back to
today.
So, we can write the following formula using the Gordon Growth Model:
V5 = D6 ÷ (ke - gc)
To find the value of D6 we need D5 and the sustainable growth rate because:
D6 = D5 × (1 + gc)
Let us first find the value of D5 as follows.
If the company is going to earn Rs. 20 per share and pay out 25% of this as dividends, then:
D5 = EPS5 × Payout Ratio
D5 = 20 × 25%
D5 = 5
We can then find the value of gc using the sustainable growth rate formula.
g = ROE5 × Retention Rate or,
g = ROE5 × (1 - Payout Ratio)
g = 15% × (1 - 25%)
g = 11.25%
Therefore,
D6 = 5 × (1 + 11.25%) = 5.56
We can now solve for the company value at the start of year 6 as:
V5 = 5.56 ÷ (20.00% - 11.25%) = 63.54
But this is the value 5 years from now. We must discount this back to today using the cost of equity:
V0 = V5 ÷ (1 + ke)5 = 63.54 ÷ (1 + 20.00%)5 = 25.54
As a comparison, let us take the same information but let us assume that the company starts paying
dividends 7 years from now rather than 5 years from now.
V7 = D8 ÷ (ke - gc) = 5.56 ÷ (20.00% - 11.25%) = 63.54
and
V0 = V7 ÷ (1 + ke)7 = 63.54 ÷ (1 + 20.00%)7 = 17.73
We have taken an exaggerated cost of equity, in this case, to show how important it is to get the timing
and the inputs right. Notice how much of the value was taken off just because of the time value of money.
Multi-Stage Growth Models
Companies may grow faster than their cost of equity for a certain period. This is not sustainable. This is
because a company with abnormally high growth will attract competition, and its growth rate will
eventually fall to a more sustainable level.
We can combine a multi-stage DDM (that we saw earlier) with the Gordon Growth Model in this case. Let
us see how this works.
Suppose a company is expected to grow at 8.50% in Year 1, 7.50% in Year 2 and 5.00% in Year 3. After
this, it will experience a perpetual, sustainable growth rate of 3.50%. The company recently paid a
dividend of Rs. 20.10 per share, and its cost of equity is 6.50%.
Let us first calculate the dividend timeline for these payments.
Details Amount (Rs.) Calculation
D0 20.10
D1 21.81 20.1000 × 1.085
D2 23.44 21.8085 × 1.075
D3 24.62 23.4441 × 1.05
Notice that we must also account for the perpetual growth rate. We can do this by using the Gordon
Growth Model. We are simply assuming that the intrinsic value at the end of Year 3 is the price of the
stock.
So,
V3 = D3 × (1 + gT) ÷ (ke - gT) = 24.6163 × (1 + 3.50%) ÷ (6.50% - 3.50%) = 849.26
Now we have the following cash flows:
Details
Amount (Rs.) Calculation
D1 21.81 20.1000 × 1.085
D2 23.44 21.8085 × 1.075

D3 24.62 23.4441 × 1.05

24.6163 × (1 + 3.50%) ÷ (6.50% - 3.50%)
V3 849.26
We can calculate the present value of these cash flows as follows:
Year 1 2 3
Cash Flow 21.81 23.44 873.88
Discount Rate 6.50% 6.50% 6.50%
Present Value Calculation 21.81 ÷ (1 + 6.50%)1 23.44 ÷ (1 + 6.50%)2 873.88 ÷ (1 + 6.50%)3
Present Value 20.48 20.67 723.44
The sum of the present value is Rs. 764.59, which is the shares' intrinsic value.
1. Suppose an analyst gathers the following information for the Gordon Growth Model:
Details Value
Most recent dividend paid 8.70
The sustainable growth rate of 3.55%

dividends
Weighted Average Cost of Capital 7.50%
Calculate the share value today.
A. 144.16
B. 139.20
C. 228.07
2. An analyst uses the company’s latest dividend while calculating the company value using Gordon
Growth Model. They claim that increasing the growth rate will increase the company value while
using the Gordon Growth Model. They are most likely
A. Correct because the numerator increases and the denominator decreases, hence increasing
the value
B. Incorrect because the increase from the denominator offsets the increase from the
numerator
C. Correct because only the denominator decreases
3. An analyst finds the following information for a company’s stock:
Details Value
Expected dividend of next year 10.50
Return on Equity 12.00%
Earning’s retention rate 35%

Calculate the share value by using the Gordon Growth Model.
A. 455.88
B. 318.18
C. 437.50
4. An analyst finds the following information for a company’s stock:
Details Value
Expected dividend at the end of 4 years 21.00
Return on Equity at the end of 4 years 15.50%
Perpetual Cost of Equity 12.00%
Earning’s payout rate at the end of 4 years 65%
Calculate the share value of the company today by using the Gordon Growth Model.
A. 213.99
B. 763.14
C. 336.72
5. Analyst X and Analyst Y have the exact same inputs for valuing a company using the Gordon
Growth Model except for the cost of equity. Analyst X uses a lower cost of equity than Analyst Y.
Which of the following is most likely correct?
A. The share value will be the same for Analyst X and Analyst Y
B. The share value will be lower for Analyst X than it will be for Analyst Y
C. The share value will be higher for Analyst X than it will be for Analyst Y
6. An analyst compiles the following information regarding the dividend growth rate and cost of
equity of a company:
Details Value
Year 1 8.70%
Year 2 7.40%
Sustainable Growth Rate 5.50%

The company has recently paid a dividend of Rs. 90. Calculate the intrinsic value per share using the
multi-stage dividend model.
A. 4,727.92
B. 4,977.95
C. 5,724.34
Answers
1. A is correct. We can write down the following information:
D1 9.01
gc 3.55%
ke 9.80%
V0 = 9.01 ÷ (9.80% - 3.55%) = 144.16
B is incorrect because it takes D0 in the numerator rather than D1. C is incorrect because it uses
the weighted average cost of capital, not the cost of equity.
2. A is correct.
𝐷0 (1+𝑔𝑐 ) 𝐷1
𝑉0 = =
(𝑘𝑒 −𝑔𝑐 ) 𝑘𝑒 −𝑔𝑐
An increase in the numerator and a decrease in the denominator results in a higher value.
3. C is correct.
g = ROE × Retention Rate = 12% × 35% = 4.20%
We can write down the following information:
D1 10.50
gc 4.20%
ke 6.60%
V0 = 10.50 ÷ (6.60% - 4.20%) = 437.50
A is incorrect because it takes D1 × (1 + g) in the numerator. We already have D1, and so we do not
need to calculate it. B is incorrect because it takes the weighted average cost of capital, not the
cost of equity.
4. A is correct.
g = ROE × (1 – Payout Rate) = 15.50% × (1 – 65%) = 5.43%

We want to solve for V4. This means we must use the following formula:
V4 = D5 ÷ (ke - gc)
D5 = D4 × (1 + g) = 21 × (1 + 5.43%) = 22.14
V4 = 22.14 ÷ (12.00% - 5.43%) = 336.72
Now we must discount this back to today
V0 = V4 ÷ (1 + ke)4 = 336.72 ÷ (1 + 12.00%)4 = 213.99
B is incorrect because it takes the payout rate instead of the retention rate to calculate g. C is
incorrect because it does not discount V4 back to today.
5. C is correct. All else held constant; a decrease in the cost of equity increases the share value. The
denominator reduces, and so the share value increases.
6. B is correct.
We can calculate the dividends as follows:
D0 90.00
D1 97.83 90.0000 × 1.087
D2 105.07 97.8300 × 1.074
The price at the end of Year 2 is:
V2 = D2 × (1 + gT) ÷ (ke - gT) = 5,542.41
The cash flows are:
D0 90.00
D1 97.83 90.0000 × 1.087
D2 105.07 97.8300 × 1.074
V2 5,542.41 105.07 × (1.055) ÷ (7.50% - 5.50%)

The present value can be calculated as:
Year 1 2
Cash Flow 97.83 5,647.48
Discount Rate 7.50% 7.50%
Present Value 97.83 ÷ (1 + 7.50%)1 5,647.48 ÷ (1 + 7.50%)2

Calculation
Present Value 91.00 4,886.95
The sum of the present value is Rs. 4,977.95, and this is the intrinsic value. A is incorrect because
it uses the incorrect formula for the Gordon Growth Model (it takes D2 instead of D3 in the
numerator). C is incorrect because it does not discount V3.
LOS 52i: Identify characteristics of companies for which the constant growth or a
multistage dividend discount model is appropriate.
Remember the assumptions of the Gordon Growth Model. The company should have a constant (or
predictable and stable) growth rate and cost of equity. This is most likely to be observed with large,
mature, non-cyclical companies that pay dividends. These companies have established themselves and do
not have that much earnings volatility.
Companies may also pay dividends but grow at varying rates for some time. It is possible that a company
experiences very high growth rates for a few years, which reduces to a sustainable growth rate. In this
case, a multi-stage model can be combined with a Gordon Growth Model.
For instance, a company may grow at 10.00% in Year 1, 7.50% in Year 2, 6.00% in Year 3 and then is
expected to grow at a constant growth rate of 3.50% for the rest of its life. A multi-stage model can be
used from Year 1 to Year 3, and then a Gordon Growth Model can be used to account for the perpetual
growth from Year 4 onwards.
The 3-stage model accounts for another twist in the varying earnings growth. The three stages are:
➢ Growth.
➢ Transition.
➢ Maturity.
Each stage may have a constant growth rate but only for a few years.
For instance, the growth stage may have a constant growth rate of 10.00% for 3 years, the transition
period may have a growth rate of 7.50% for the next 5 years, and then the sustainable long-term growth
rate may be 4.00% after the transition phase.
We saw some version of this when we calculated the multi-stage dividend model and combined it with
the Gordon Growth Model. That is, each year had a different growth rate until we reached the final year
with a sustainable growth rate.
Also, note that dividend estimates of companies that do not yet pay dividends may be inaccurate. In cases
where the future dividends cannot be known, the FCFE model is more appropriate. Earnings growth can
be estimated and then applied to the net income to find the FCFE for future periods.
In cases where even earnings are unpredictable (or will be negative for long periods before turning
positive), a relative valuation (multiples-based valuation) may be more appropriate.
1. It is most appropriate to value a company with stable growth rates and stable dividends by
A. Multi-stage dividend discount model

B. Gordon Growth Model
C. Multi-stage dividend discount model combined with a Gordon Growth Model
2. If a company is expected to have varying growth rates in their growth, transition and mature
phase and the analyst can predict the fixed amount of time that these growth rates will persist,
then the most appropriate model is the
A. 3-stage model
C. Multi-stage model
3. A company pays no dividend and is not expected to pay dividends in the near future. The most
appropriate model is the
A. FCFE model
C. Multi-stage model
Answers
1. B is correct. If dividend and dividend growth is not volatile, then the Gordon Growth Model is
most appropriate. The multi-stage model is most appropriate for companies with varying
expected growth rates.
2. A is correct. The 3-stage model assumes that the varying growth rates will persist for a fixed
amount of time. If the amount of time for each growth rate can be predicted, then the multi-stage
model can be combined with a Gordon Growth Model.
3. A is correct. It does not make sense to use a dividend-based model if the company is not expected
to pay dividends. Although the FCFE is the capacity to pay dividends, it is not the actual dividend
paid.
LOS 52j: Explain the rationale for using price multiples to value equity, how the price to
earnings multiple relates to fundamentals, and the use of multiples based on
comparable.
We saw earlier that dividend discount models are highly sensitive to inputs of the cost of equity and
growth rates. The same is true for FCFE models because FCFE models follow the same fundamental
principle – that a company’s value can be determined using the expected cash flows.
A multiples-based approach does not require such inputs. Following are common multiples that an
analyst may use:
➢ Price-to-earnings (P/E).
➢ Price-to-cash-flow (P/CF).
➢ Price-to-sales (P/S).
➢ Price-to-book value (P/B).
Like we saw previously that a price multiple like the P/E ratio tells us about the multiple of earnings per
share that an investor is willing to pay for the company. The same logic applies to all other multiples-based
ratios. Note that these multiples are sensitive to market-based factors because we are now considering
the market value of the shares and not just the intrinsic value.
These multiples are then compared to multiples of other companies in the same peer group, a benchmark
index, or the same company’s historical multiples to see how the multiples have changed over time.
A cross-sectional comparison is when the multiples are compared to other companies in a peer group or
when the multiple is compared to a benchmark index. A time-series comparison is when the multiple of
the same company or index is compared to itself over some time (i.e., its historical multiples).
Let us see how this works in practice. Recall that we made a peer group for TVS Motor Company Ltd. as
follows:
1. Hero MotoCorp Ltd.
2. Bajaj Auto Ltd.
3. Eicher Motors Ltd.

An analyst may compile the following data for a relative valuation for the peer group. Data has been
collected directly from Morningstar India as on 12th July 2021.
Company P/E P/CF P/S P/B
TVS Motors Ltd 47.91 24.73 1.65 7.44
Hero MotoCorp Ltd 19.84 14.09 2.10 3.76
Bajaj Auto Ltd. 23.79 37.04 4.24 4.24
Eicher Motors Ltd. 55.08 43.29 8.56 6.48
Peer Group Mean 36.66 29.79 4.14 5.48
Peer Group Median 35.85 30.89 3.17 5.36
Peer Group Minimum 19.84 14.09 1.65 3.76
Peer Group Maximum 55.08 43.29 8.56 7.44
This example illustrates that different multiples of the same company can be compared to similar
multiples of companies in the same peer group. In general, multiples that are below the peer group
industry mean or median are preferred (note that the median may be a better representative of the
average in cases where one multiple significantly increases or decreases the total).
Let us compare the median P/E to TVS Motor Company’s P/E. TVS Motor Company’s P/E is greater than
the peer group median, and so we can say that its P/E is relatively overvalued. There is no specific
interpretation that can justify this difference because there are many factors that can affect the
company's price and earnings. Growth companies typically have a higher P/E than value companies.
On the other hand, TVS Motor Company’s P/S ratio is the lowest in the industry group. It is relatively
undervalued from a price-to-sales perspective. This suggests that the broad market is paying a lower
multiple for their sales than they are for others. Note that the ratios compiled above are on a trailing
basis. This means that the price has been compared to the previous period's fundamentals (like earnings,
cash flow, sales, and book value). This could either be the last 12 months - or trailing twelve months (TTM)
- or as per the latest annual reports.
As an analyst, you are interested in the future prospects of the company. So, you may use a forward or
leading value in the denominator. The forward P/E, for example, will use the current share price and divide
it by the expected earnings of the next twelve months. Note that this will produce a different ratio than
the TTM ratios. We will see how this works in the next LOS.
Watch about the P/E ratio for a more intuitive understanding of the P/E multiple. Remember that the
same logic can be applied to other ratios like P/S, P/B, P/FCF and P/CFO.
1. The P/E of a stock is 40.00, and the P/E of the index is 20.15. On a relative valuation basis, the
stock is most likely
A. Overvalued
B. Undervalued
C. Fairly valued
2. The least likely motivation to use price multiples is to
A. Compare the multiples to the company’s historical multiple

B. Compare the multiples to the industry average multiple
C. Compare the multiples to the company’s historical financial ratios
3. An analyst uses the last year’s EPS to calculate the P/E ratio. This is an example of a
A. Forward multiple
B. Leading multiple
C. Lagging multiple
4. Suppose there are only two companies in a peer group with extremely similar sales figures. The
price-to-sales ratio of Company X is less than the price-to-sales ratio of Company Y. The most likely
interpretation is that
A. Investors are indifferent towards the price of Company Y relative to its sales per share
B. Investors are paying a discount on the price of Company Y relative to its sales per share
C. Investors are paying a premium on the price of Company Y relative to its sales per share
Answers
1. A is correct. If a company's multiple is higher than a benchmark or group of stocks, then it is
relatively overvalued. If a multiple of a company is lower than a benchmark or group of stocks,
then it is relatively undervalued.
2. C is correct. It makes no logical sense to compare the price multiples of a stock to the financial
ratios of a company. Financial ratios are based purely on the company's fundamental
performance and have nothing to do with price dynamics. A and B are accurate because price
multiples account for price dynamics and how they are related to the fundamentals of a company.
These are compared to multiples of other companies in the same peer group, a benchmark index,
or the same company’s historical multiples.
3. C is correct. Any fundamental which uses the last or trailing period’s figures is a lagging multiple.
The fundamentals “lag” the share price because the fundamentals are past data while the share
price is current data. A and B mean the same thing. These multiples use estimated fundamentals.
4. C is correct. The P/S ratio is calculated as price divided by the sales per share. A higher P/S ratio
(if sales are extremely similar) indicates that investors are paying a higher price for a similar level
of sales. So, since Company Y’s P/S ratio is higher, investors pay a premium on their sales per
share.
LOS 52k: Calculate and interpret the following multiples: price to earnings, price to an
estimate of operating cash flow, price to sales, and price to book value.
Now we will see how these multiples are calculated, looking deeper into what they mean.
We will use the latest financial information for TVS Motor Corporation from Morningstar itself to see how
the ratios were calculated.
The exact numbers may vary based on rounding errors or differences in methodology, but this example
will give a fair understanding of how these multiples are calculated in practice.
Details Amount (Rs. Million)
Sales 1,72,710.00
Net Income 5,940.00
Operating Cash Flow (CFO) 11,510.00
Free Cash Flow (FCF) 2,230.00
Book Value of Equity 42,150.00
We must convert all of this information into a per-share basis. We want to be able to compare the price
per share to factors like earnings per share or sales per share. There are 475.09 million shares outstanding,
and so each of these figures must be divided by 475.09.
Details Amount
Sales per share 363.53
Net Income per share 12.50
Operating Cash Flow (CFO) per share 24.23
Free Cash Flow (FCF) per share 4.69
Book Value of Equity per share 88.72

Now we can apply these numbers to the price per share to find the respective multiples.
Given that the price when this data was collected was Rs. 601.40, we can divide 601.40 by each of these
fundamental factors to find the multiples.
P/S 1.65
P/E 48.10
P/CFO 24.82
P/FCF 128.13
P/B 6.78
We have calculated these multiples based on the financial year ended 2021 (FY21). Note that a company
will release their earnings on a quarterly basis. So, when all of the first quarter’s data has been updated
(i.e., the data is available for Q1 FY22), the analyst may use the TTM.
The TTM will take the sum total of revenues, earnings, and cash flows from Q2 FY21 to Q1 FY22 (i.e., from
June 2021 to May 2022, given that the company’s fiscal year ends on 31st March). The balance sheet,
however, is stated as on a specific date. So, you cannot add the book value of equity in the same way. The
book value of equity for calculating the P/B will simply be the book value as on the reporting date.
We have already seen the interpretation of these multiples before. For example, a P/B of 6.78 implies that
an investor of TVS Motor Company is willing to pay 6.78x of the book value of the company to buy a share.
We have provided two measures of cash flow - cash flow from operations and free cash flow. Note that
FCF does not necessarily mean FCFE. It can also mean free cash flow to the firm (FCFF). This is simply the
free cash flow available to all capital providers (i.e., debt providers and equity providers).
Fundamentals-Based Multiples
There is another way of calculating the P/E ratio of a company. This method uses the fundamentals of a
company (earnings and dividends) to assess at what P/E ratio the company should trade.
We use price multiples like the P/E ratio to compare the P/E ratio of one firm to another. These are price
multiples based on comparables. By contrast, price multiples based on fundamentals tell us what the
multiple should be, based on some valuation model. So, price multiples based on fundamentals are not
dependent on the current market price of other companies to establish value.
Let us revisit the Gordon Growth Model to see how this works. If we can assume that the intrinsic value
of the company is a representation of its price, then:
P0 = D1 ÷ (ke - gc)
Now we want to find the forward P/E. That is, we want P0/E1. When we divide both sides by E1, we get:
P0/E1 = (D1 /E1) ÷ (ke - gc)
Notice the numerator of the right-hand side, D1/E1. This is the expected dividend divided by the expected
earnings. In other words, it is the proportion of earnings that are paid out as dividends.
Suppose the expected earnings are Rs. 100 and the expected dividend is Rs. 10. We can say that the
dividend payout ratio is D1/E1 = 1 ÷ 100 = 10.00%.
So, an analyst can calculate the forward P/E if they know the next period’s earnings and the next period’s
expected dividends. It is also called the justified P/E because it is “justified” by a company's expected
fundamentals (dividends and earnings).
It is also important to note that forward ratios depend on the analyst’s estimates of earnings and
dividends. Unlike trailing ratios, the next period’s earnings and dividends are unknown.
It is also called a leading P/E ratio because it is based on expected dividends and earnings rather than
trailing dividends and earnings. The trailing ratios are also called lagging ratios.
Remember that forward ratios tell us about the P/E at which the company should trade. Notice that this
type of calculation does not require price data at all. It requires information regarding earnings, dividends,
cost of equity and the growth rate.
So, let us assume that TVS Motor Corporation’s expected earnings per share for the next twelve months
is Rs. 14.00 and the expected dividend per share is Rs. 6.00 (in other words, the dividend payout ratio is
42.86%). Let us assume that the cost of equity is 11.60% and the sustainable growth rate is 5.00%.
The justified P/E is:
(6/14) ÷ (11.60% - 5.00%) = 6.49
We have calculated the P/E at the current price as 48.10, and so from a justified P/E perspective, the stock
is very overvalued. But remember that the trailing P/E is extremely subjective to market conditions.
Also, note that the leading P/E ratio is the current share price divided by the expected earnings per share
over the next twelve months.
The leading P/E is:
601.40 ÷ 14.00 = 42.96
Central banks worldwide have pumped in a significant amount of liquidity since April 2020. Liquidity has
inflated the P/E ratio for several companies. Think of it like inflation – there is too much money chasing
too few stocks. For example, the NIFTY P/E ratio peaked in February 2021 when it reached 41.23. This
means that investors, on average, were willing to pay 41.23 times the weighted average earnings of the
NIFTY 50 companies.
Given that the observed P/E ratios are very subjective to factors out of the company’s control, there can
be vast differences between the justified P/E and the trailing P/E.
The fundamentals can also be compared across companies. We can observe the following relationships
for the justified P/E ratio (all else held constant):
➢ The higher the dividend payout ratio, the higher the numerator and the higher the justified P/E.
➢ The higher the cost of equity, the higher the denominator and the lower the justified P/E.
➢ The higher the growth rate, the lower the denominator and the higher the justified P/E.
But in reality, one factor can affect another. For example, if a company pays out too much of its earnings
as dividends, then it will have a lower retention rate in subsequent years. A lower retention rate reduces
the sustainable growth rate. This is called the dividend displacement of earnings. One cannot actually
know how much the dividend payout ratio in one period will affect growth in the next.
Also, if the companies wanted to increase their justified P/E ratio, they would just pay out all of their
earnings as dividends (recall the first relationship). This is practically unsustainable.
Multiples Based on Comparables
We already saw this in the previous LOS when we compared all the multiples in the peer group. Let us
revisit that table and dig deeper into it.
Company P/E P/CF P/S P/B
TVS Motors Ltd 47.91 24.73 1.65 7.44
Hero MotoCorp Ltd 19.84 14.09 2.10 3.76
Bajaj Auto Ltd. 23.79 37.04 4.24 4.24
Eicher Motors Ltd. 55.08 43.29 8.56 6.48
Peer Group Mean 36.66 29.79 4.14 5.48
Peer Group Median 35.85 30.89 3.17 5.36

Peer Group Minimum 19.84 14.09 1.65 3.76
Peer Group Maximum 55.08 43.29 8.56 7.44
A comparables-based (comps-based) approach is when the price multiples are compared to a benchmark
like an index, peer group averages, industry averages (cross-sectional comparison) or the stock’s own
historical average (time series comparison).
If companies in the peer group are truly comparable and have similar sources of revenue, risk, scale, and
growth, then the law of one price may come into action. This law states that assets with similar payoffs
should trade at a similar price (or, in this case, at similar multiples).
Another ratio is the PEG ratio (P/E ratio divided by the growth). This accounts for the earnings
growth of a company over a period of time. So, if two companies in the same peer group are
expected to have different growth rates (or have had different growth rates in the past), then the
PEG ratio may be more suitable. You can think about it as a P/E ratio that is standardized for the
growth factor.
The P/S ratio is especially important for cyclical and loss-making companies. If a company has negative
or volatile earnings, then the trend of the P/E ratio will not be very informational. It is likely that a company
that uses a high degree of leverage will have volatile earnings. They may perform extremely well in some
periods, but earnings reduce at a higher rate than sales when sales reduce. It is typical to value companies
in the embryonic stage using the P/S ratio since they are likely to have negative or volatile earnings and
cash flows.
However, there are a few disadvantages of using the comparables method.
➢ We saw that a stock’s trailing price multiple could be extremely different from its justified
multiple.
➢ Differences in IFRS or GAAP (different accounting methods) can make multiples incomparable,
and adjustments may have to be made. This is especially true when two companies are from
different countries.
➢ Price multiples for cyclical companies can be volatile depending on economic cycles.
1. Calculate the P/E multiple and a cash flow-based multiple based on the following information.
Details Amount (Rs.)
EBIT 5,000 million
Net Income 1,300 million
Cash Flow from Operations 980 million
Price per share 95
Number of Shares Outstanding 500 million
A. P/E multiple: 9.50; Cash flow based-multiple: 48.47

B. P/E multiple: 36.54; Cash flow based-multiple: 9.50
C. P/E multiple: 36.54; Cash flow based-multiple: 48.47
2. An analyst finds that the historical average P/E of a stock is 45.00. The stock is currently trading
at a P/E of 35.75. Based on this information, the stock is
A. Overvalued against its historical P/E

B. Fairly valued against its historical P/E
C. Undervalued against its historical P/E
3. A leading P/E multiple indicates

A. The P/E multiple of the market leader in the peer group
B. The P/E multiple at which the company should trade currently
C. The P/E multiple at which the company has traded historically
Use the following information for questions 4 and 5:
Details Amount
Price per share 50
Latest dividends per share 2.50
Latest earnings per share 14.10
Expected dividend per share 3.00
Expected earnings per share 15.00
Return on Equity 12.50%
Sustainable growth rate 10.00%
4. Calculate the trailing P/E ratio.
A. 3.55
B. 20.00
C. 0.05
5. Calculate the justified P/E ratio.
A. 4.00
B. 1.20
C. 3.64
6. The dividend displacement of earnings most likely describes
A. The potential decrease in growth rate if a company has a low dividend payout
B. The potential decrease in growth rate if a company has a high dividend payout
C. The potential increase in growth rate if a company has a high dividend payout
7. It is most appropriate to use which of the following for a company that is subject to high
cyclicality?
A. P/E multiple
B. P/S multiple
C. P/CFO multiple
Answers
1. C is correct. The P/E multiple divides the price per share by the earnings per share.
Earnings per Share = Net Income ÷ Number of Shares Outstanding = 1,300 ÷ 500 = Rs. 2.6 per
share
P/E = 95 ÷ 2.6 = 36.54
A cash flow multiple is either the P/CFO multiple or the P/FCF multiple. The CFO (cash flow from
operations) per share is 980 ÷ 500 = 1.96
So, the P/CFO multiple is 95 ÷ 1.96 = 48.47
The other options calculate a multiple based on the EBIT rather than net income or cash flow from
operations. This is neither the P/E nor a cash flow-based multiple.
2. C is correct. If a multiple is lower than a benchmark multiple (like a historical multiple, peer group
average, or index multiple), it is considered undervalued relative to the benchmark.
3. B is correct. A leading P/E multiple uses the justified approach. The multiple is “justified” by the
fundamentals of a company. These fundamentals like the dividend payout ratio, the dividend
growth rate and the cost of equity determine the leading P/E ratio.
4. A is correct. The trailing P/E ratio uses the current price divided by the trailing earnings (either
annual or last 12 months).
P/E = 50 ÷ 14.10 = 3.55
B is incorrect because it takes the price divided by the dividend per share. C is incorrect because
it takes the dividend per share divided by the price (this is the dividend yield).
5. C is correct. Justified P/E = P0/E1 = (D1 /E1) ÷ (ke - gc) = (3/15) ÷ (15.50% - 10.00%) = 3.64
A is incorrect because it takes: P0/E1 = (D1/E1) × (1 + g) ÷ (ke - gc). B is incorrect because it uses the
Gordon Growth Model and then divides this by the share price.
6. B is correct. The dividend displacement logic is as follows: a company pays out many dividends,
then it has a low retention rate. If the retention rate is low, then growth is low.
Recall g = ROE × Retention Rate.
7. B is correct. The earnings and cash flows of a company that is subject to high cyclicality will be
volatile. It will depend highly on the economic cycle, or factors like seasonal demand can cause
earnings volatility. It is best to use the P/S multiple in this case.
LOS 52l: Describe enterprise value multiples and their use in estimating equity value.
Enterprise value (EV) measures the total value of a company. It can be understood as the amount of
money it would cost to acquire a company.
If a company wants to buy another company, it will have to buy its stock and its debt (i.e. all of its assets).
But any cash or short-term investments should be excluded from this total of the company’s value.
Suppose you have a business that has Rs. 100 worth of stationery and Rs. 10 worth of cash. The total value
of these items is Rs. 110. If someone wants to purchase your entire business for cash, then they would
pay you Rs. 110. But they have effectively paid only Rs. 100 because the cash component cancels out.
In other words, the company's most liquid assets reduce the effective cost of acquiring another
company’s assets.
So, the EV can be calculated as follows:
EV = Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Debt − Cash
and Short-Term Investments
This is most useful for companies that have significantly different capital structures. Suppose there are
two companies with a total enterprise value of Rs. 100 million each. If Company A is fully funded by equity,
then practically all of the EV comes from equity. But if Company B has raised some debt and the market
value of this debt is Rs. 40 million, then the market value of equity is around 60 million. So, it is unfair to
compare the two company's values-based only on equity valuation methods. The EV considers the total
company’s value, not just the equity portion. That is a key difference between the relative valuation
methods that we saw before.
We used the stock price as a numerator for multiples, so we can use the EV to calculate certain multiples.
But when we use the EV as a numerator, we must also use a denominator that accounts for differences in
capital structure. EBITDA (earnings before interest, taxes, depreciation, and amortization) is one of the
most appropriate metrics to use in this case. This is because EBITDA is the closest that one can get to the
operating cash flows of a company, and it accounts for the earnings of all providers of capital. Even the
EBIT (earnings before interest and taxes) is an appropriate measure because it calculates earnings before
debtholders are paid.
Advantages of using the EBITDA or EBIT is that these metrics can be positive while net income can be
negative. A highly leveraged company, for example, may have a significant amount of interest payments.
So, EBIT can be positive, but when interest and taxes are subtracted from EBIT to get net income, the net
income may turn out to be negative. Negative denominators are not informational in relative valuation
methods.
But there are a few drawbacks of the EV/EBITDA multiple. Although EBITDA is the closest proxy for the
operating cash flow, it may still include some income or expenses that are not cash-based.
Also, the market value of debt is not as readily available as the market value of equity. If a company’s debt
is not actively traded (or not traded at all), then the market value of debt may need to be estimated. In
this case, an analyst is most likely to use the market value of bonds of similar companies and then adjust
them for certain differences. The book value is not an accurate estimate of the market value of debt if the
market conditions have changed since the bonds were first issued.
Let us continue with TVS Motor Company and analyze their EV/EBITDA multiple.
The EV as per Morningstar (as on 12th July 2021) is Rs. 391,770 million, and the TTM EBITDA is Rs. 21,050
million. The EV/EBITDA multiple is therefore 18.61. This means that, in theory, if a competitor wanted to
buy the company (or at least a part of the company), they would have to buy it at a valuation of Rs.
391,770 million, and they would have to pay 18.61 times the company’s EBITDA. In reality, transactions
take place on a cash-free and debt-free basis rather than on the EV.
Let us look at how the EV is calculated and how the EV/EBITDA multiple may be interpreted.
Suppose the following information has been provided for a hypothetical company:
Details Amount (Rs. million)
EBITDA 300
Market Value of Common Stock 3,000
Market Value of Preferred Stock 1,000
Market Value of Debt 500
Book Value of Common Stock 750
Book Value of Preferred Stock 500
Book Value of Debt 300
Cash on Hand 30
Short-Term Investments 15
Common Stock Outstanding 150
Remember that the EV uses market values and so the EV is calculated as:
EV = 3,000 + 1,000 + 500 - (30 + 15) = Rs. 4,455 million
The EV/EBITDA multiple is therefore 4,455 ÷ 300 = 14.85.
Now suppose that we have a comparable EV/EBITDA multiple of the industry average. Instead of
calculating the company’s EV/EBITDA multiple, we want to use the company’s EBITDA and assess the
market value of equity by using this information.
Suppose the industry average EV/EBITDA is 15.15. In the EV/EBITDA formula, we have the following
information:
15.15 = EV ÷ 300
EV = 15.15 × 300 = Rs. 4,545 million.
This means that if the company’s EV/EBITDA multiple expands to 15.15, then the company’s EV will be Rs.
4,545 million (holding the EBITDA constant).
But this is not the market value of a common stock.
Recall the EV formula and insert the missing information:
4,545 = Market Value of Common Stock + 1,000 + 500 - (30 + 15)
Market Value of Common Stock = Rs. 3,090 million. Notice that this is an increase from Rs. 3,000 million.
Note that there is an assumption underlying this calculation. It means that if everything else is held
constant and if the EV/EBITDA multiple increases, then the increase can be most likely attributed to an
increase in the market value of a common stock.
If we want to find the price per share, then we can simply divide this figure by the total number of common
stock outstanding.
Share price = 3,090 ÷ 150 = 20.60
Details Amount (Rs. Million)
Enterprise Value 5,000
Earnings before Interest, Tax, Depreciation and 650

Amortization
The company has issued no preferred stock; the market value of debt is Rs. 1,000 million, and the value
of cash and short-term investments is Rs. 900 million.
1. Calculate the EV/EBITDA multiple.
A. 0.13x
B. 7.69x
C. 3.91x
2. The EV is the
A. Total market value of equity minus total market value of debt minus cash and short-term
investments
B. Total market value of debt and equity minus cash and short-term investments
C. Total book value of debt and equity minus cash and short-term investments
3. Another analyst claims that the multiple should be higher by a factor of 1.12. Calculate the new
EV/EBITDA multiple and state its most likely interpretation.
A. The analyst expects that investors should pay a higher EBITDA, given the EV, driving the
effective multiple downwards. That is why they have recommended a higher multiple
B. The analyst expects that investors should pay a higher EV per EBITDA, and that is why they
have recommended a higher multiple
C. The analyst expects that investors should pay a premium on the EBITDA, and so the multiple
must be adjusted downwards
4. Recall that the company has issued no preferred stock. If there are 10 million common shares
outstanding, then the share price using the original EV/EBITDA multiple is
A. Rs. 500 per share

B. Rs. 510 per share
C. Rs. 490 per share
5. The EV/EBITDA multiple is least likely preferred over the P/E multiple because
A. It is useful to compare companies with negative earnings

B. It is useful to compare companies with significantly different capital structures
C. It is useful to compare companies with extremely similar capital structures
Answers
1. B is correct. The EV/EBITDA multiple is simply the EV divided by the EBITDA: 5,000 ÷ 650 = 7.69x.
2. B is correct. EV = Market Value of Common Stock + Market Value of Preferred Stock + Market
Value of Debt − Cash and Short-Term Investments
EV is a measure of the acquisition cost of a company. The company’s value is the sum of the
market value of common stock, preferred stock, and debt. Cash and short-term investments are
the most liquid assets of a company, and they reduce the cost of acquisition. C is incorrect
because it is not the total book value; it is the total market value.
3. B is correct. The new EV/EBITDA multiple is simply 7.69 × 1.12 = 8.61. This means that the analyst
expects investors to pay a premium to the current EBITDA of the company. This is reflected as an
increase in the EV because when we rearrange the formula:
EV = EBITDA × EV ÷ EBITDA
If the EV/EBITDA multiple increases, then the EV increases (holding EBITDA constant)
4. C is correct.
EV = Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Debt −
Cash and Short-Term Investments
5,000 = Market Value of Common Stock + 0 + 1,000 – 900
Market Value of Common Stock = 5,000 – 1,000 + 900 = 4,900
Price per Share = Market Value of Common Stock ÷ Common Stock Outstanding = 4,900 ÷ 10 = Rs.
490 per share
A is incorrect because it uses the EV directly. This is not the market value of common stock. B is
incorrect because it adds debt and subtracts cash and short-term investments from the EV to find
the value of a common stock.
5. C is correct. If the capital structure is different, then there are two likely outcomes.
First, let us hold the EV of the two companies constant. The total market value of the company’s
common shares will contribute a different proportion towards the EV (i.e., total company value).
So, it is not beneficial to use the market value of common equity as the cost of acquisition – the
acquirer would have to buy all assets (debt and equity). Recall that the P/E ratio considers only
the price of common shares.
Now let us hold the EBITDA constant. The net income for these two companies will be different
because the more levered company will have a higher interest expense. So, even though the
operating earnings are similar, the net income will be very different just because of the interest
component. In some cases, it might even be negative even if EBITDA is positive. Both of these
situations do not reflect an accurate picture of company value relative to operating profits, so the
EV/EBITDA multiple may be preferred over the P/E multiple.
LOS 52m: Describe asset-based valuation models and their use in estimating equity
value.
Recall the fundamental accounting equation:

Total Equity = Total Assets - Total Liabilities
Asset-based models are based on the same principle, except that the equation takes the fair value of
assets and liabilities, not the book value.
Fair Value of Total Equity = Fair Value of Total Assets - Fair Value of Total Liabilities
The fair value is the price at which another party would buy the asset or liability. This may be readily
available for securities that are traded in a market, but the fair value is usually difficult to assess for non-
liquid assets.
The analyst may start with the book value of all items on the balance sheet and then make some
adjustments to find the fair value. Note that the fair value and book value are different in reality.
The analyst may value the assets at the depreciated value, the value adjusted for inflation, or the
estimated replacement value. The depreciated value is relatively easy to calculate, given that the analyst
has the depreciation schedule and depreciation history of the asset. The inflation-adjusted value may be
subjective depending on the impact of inflation on different assets. The replacement value is the closest
to the market value because this is the cost of replacing the old asset with a new asset at that point in
time.
It is even more difficult to assess the fair values for intangible assets. These may be on the balance sheet
or off the balance sheet. Intangibles only appear on the balance sheet if they have been acquired.
Internally generated intangibles like brand recognition or brand value do not appear on the balance sheet,
and these are even more difficult to estimate.
Workforce and management talent may also be an intangible asset in terms of the company's human
capital. Such gains and losses are not accounting gains and losses, but they do hold significant value. Even
customer relationship management is a valuable “asset” to a company, but its value will not show up in
the books of a company.
However, asset-based models may be useful for assessing the minimum or floor values of intangibles like
brand value or reputation.
Since asset-based models consider the current assets and liabilities of a company, an analyst may combine
such a model with a forward-looking model like a DCF.
Warren Buffett has always supported the view that the assets that a company holds at this point in time
are what generate company value. Companies with moats (such a strong asset base that they can keep
competitors at a distance) are favourable. But it is just as important to look at the expected cash flows
to find the intrinsic value. This is one philosophy that merges an asset-based approach to the DCF
valuation.
Recall that it is easier to use an asset-based model when short-term assets have easily available market
values. For example, banking and financial service companies will have a lot of financial assets like stocks,
bonds, or other such traded instruments. It is important to find the fair value of such assets rather than
the cost of purchase. Or a company could also own a base of natural resources like an oilfield. The oil price
can be observed from commodity markets and then applied to the characteristics of the oilfield and
potential cash flows from the oilfield.
It may be useful to value a private company using the asset-based model if they do not have stable
earnings or cash flows yet. A DCF model is most useful when the company has predictable or stable cash
flows and earnings, but this method may not work for younger companies that have not established
themselves yet.
Nevertheless, the asset-based model may be informational for publicly listed companies that use the fair
value financial reporting method.
Mark-to-market accounting is another term for fair value accounting. Suppose you buy a stock worth
Rs. 100 but its market value reduces to Rs. 90. Is your net worth Rs. 100 or Rs. 90? The mark-to-market
loss is Rs. 10, and your actual net worth is the fair market value of the asset, not the cost of the asset.
We will complete this section with an example of the asset-based model. Suppose the following
information has been provided regarding a company’s balance sheet.
Assets Amount (Rs. million)
Total Fixed Assets 5,400.00
Intangible Assets 700.00
Inventories 210.00
Trade Receivables 315.00
Short-Term Investments 125.00
Cash 27.00
Other Current Assets 235.00
Total Assets 7,012.00

Liabilities
Long-Term Borrowings 2,510.00
Trade Payables 256.00
Short-Term Borrowings 350.00
Total Liabilities 3,116.00
The fair value of the company’s fixed assets is 1.10 times its book value, and the fair value of the
company’s intangible assets is 0.9 times its book value. The fair value of the company’s long-term
borrowings is 1.20 times its book value.
i) Calculate the book value of equity.
The book value of equity is simply the total assets minus the total liabilities. No adjustments need
to be made.
Book Value of Total Equity = Total Book Value of Assets - Total Book Value of Liabilities
Book Value of Total Equity = 7,012 - 3,116 = Rs. 3,896 million.
ii) Calculate the fair value of equity.
Let us first look at the asset side. The fixed assets must be multiplied by 1.10, and the intangible
assets must be multiplied by 0.9.
Fair Value of Fixed Assets = 1.10 × 5,400 = Rs. 5,940 million
Fair Value of Intangible Assets = 0.9 × 700 = Rs. 630 million
Notice that the book value of all other assets does not change, and so we can calculate the book
value of all other assets as: 7,012 - 5,400 - 700 = Rs. 912 million. Here we have basically subtracted
the book value of fixed assets and intangible assets from the total book value of assets.
Now we can re-calculate the fair value of assets as:
Fair Value of Total Assets = 5,940 + 630 + 912 = Rs. 7,482 million.
Now let us look at the liabilities side. The book value of long-term borrowings must be multiplied
by 1.20.
Fair Value of Long-Term Borrowings = 2,510 × 1.20 = Rs. 3,012 million
The total book value of all other liabilities remains unchanged at Rs. 606 million.
Fair Value of Total Liabilities = 3,012 + 256 + 350 = Rs. 3,618 million
Therefore,
Fair Value of Equity = 7,482 - 3,618 = Rs. 3,864 million.
Notice that this is lower than the book value of equity because the increase in liabilities is more
than the increase in assets.
Details Book Value (Rs. million)
Fixed Assets 900
Other Non-Current Assets 300
Current Assets 750
Borrowings 670
Other Non-Current Liabilities 120
Current Liabilities 600
1. Calculate the book value of equity.
A. 560 million
B. 1,950 million
C. 1,160 million
2. An analyst claims that the fixed assets must be adjusted upwards by a factor of 1.15, and the
borrowings must be adjusted downwards by a factor of 0.96 to calculate the fair value of equity.
The fair value of equity after these adjustments is
A. 721.80 million
B. 695.00 million
C. 421.80 million
3. If the book value of an asset is adjusted upwards, it most likely means that
A. The asset has gained value in the market

B. The asset has become obsolete
C. The asset can bring in fewer cash flows, and so the value must increase to set off the decrease
4. Asset-based models are most likely effective when
A. A company has many intangible assets on its balance sheet

B. The fair value of assets is readily available
C. The assets are long-term and illiquid
Answers
1. A is correct.
Book Value of Equity = Total Book Value of Assets - Total Book Value of Liabilities = 1,950 - 1,390
= 560
B is incorrect because this is the total book value of assets. C is incorrect because it does not
consider current liabilities.
2. A is correct.
Total Fair Value of Assets = (900 × 1.15) + 300 + 750 = 2,085
Total Fair Value of Liabilities = (670 × 0.96) + 120 + 600 = 1,363.20
Total Fair Value of Equity = 2,085 - 1,363.20 = 721.80
B is incorrect because it does not adjust the liabilities. C is incorrect because it does not consider
other non-current assets.
3. A is correct. If the asset has increased in value, then the book value must be adjusted upwards.
This is a more accurate representation of the price that other parties would pay for the asset today.
B is incorrect because if an asset becomes obsolete, then its value must be written down. C is
incorrect because one of the main purposes of an asset is to generate cash flow. If the asset loses
the ability to generate cash flows, then it must be written down.
4. B is correct. Readily available values make it easier to find the fair value because these are
observable values. They do not need to be calculated, and assets and liabilities do not necessarily
have to be appraised or revalued. A is incorrect because it is difficult to assess the fair value of
intangible assets. Brand value, brand recognition or even the value of human capital is difficult to
evaluate. C is incorrect because the more the market participants that trade an asset, the more
liquid it is, and this gives a better understanding of its market value. Short-term investments that
show up on a company’s current assets are easier to value than long-term investments like real
estate.
Formulae 184
Formulae
Market Organization and Structure
1−intinal margin
• Margin call price =P0 (1−maintenance margin)
Security Market Indexes
𝑠𝑢𝑚 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒𝑠

• Price weighted index = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑖𝑛𝑑𝑒𝑥𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑓𝑜𝑟 𝑠𝑝𝑙𝑖𝑡𝑠
• Market capitalization weighted index = (𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑑𝑒𝑥 𝑠𝑡𝑜𝑐𝑘𝑠)/
(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑑𝑒𝑥 𝑠𝑡𝑜𝑐𝑘𝑠) × 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒
• Equal weighted index = (1 + 𝑎𝑣𝑒𝑟𝑎𝑔𝑒𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑑𝑒𝑥 𝑠𝑡𝑜𝑐𝑘𝑠 ×

𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑑𝑒𝑥 𝑣𝑎𝑙𝑢𝑒
Equity Valuation: Concepts and Basic Tools
𝐷
• Preferred stock valuation: 𝑃0 = 𝑘𝑝
𝑝
𝐷1 𝑃1
• One-period stock valuation model: 𝑃0 = +
1+𝑘𝑒 1+𝑘𝑒
𝐷1 𝐷0 ×(1+𝑔)
• Infinite period model: 𝑃0 = 𝑘 =
𝑒 −𝑔 𝑘𝑒 −𝑔
𝐷 𝐷 𝐷 𝑃
• Multistage model: 𝑃0 = (1+𝑘1 ) + (1+𝑘1 )^2 + . . … (1+𝑘1 )𝑛 + (1+𝑘𝑛 )𝑛
𝑒 𝑒 𝑒 𝑒
Where:
𝐷
o 𝑃𝑛 = 𝑘 𝑛+1
−𝑔
and 𝐷𝑛+1 is a dividend that will grow at the constant rate of 𝑔𝑐 forever
𝑒 𝑐
𝐷1
𝑃0
•
𝐸1
Earnings multiplier = =
𝐸1 𝑘−𝑔
• Expected growth rate: g = (retention rate)(ROE)
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

• Trailing P/E = 𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 12 𝑚𝑜𝑛𝑡ℎ𝑠
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

• Leading P/E = 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠
Formulae 185
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

• P/B ratio = 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
= 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Where:
Book value of equity = common shareholder’s equity = (total assets – total liabilities) – preferred
stock

• P/S ratio = 𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
= 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

• P/CF ratio = =
𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
• Enterprise value = market value of common and preferred stock + market value of debt – cash
and short term investments

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Weekday Weekend Sel

Authored by: Mohit Madhiwalla, Prabhjyot Taluja, Esha Vora

Market Organization and Structure

➢ The different types of orders and instructions

LOS 45a: Explain the main functions of the financial system.

The three main functions of the financial system are to:

3. Allow efficient capital allocation.

➢ There are low transaction costs.

➢ There is availability of information.

➢ Regulations ensure the execution of financial transactions and contracts.

➢ The lower the liquidity, the higher the rate.

➢ The higher the time to maturity, the higher the rate.

1. Which of the following is least likely a barrier to well-functioning financial markets?

2. Which of the following is most likely to discourage investors?

A. Variety of savings options

3. Low-interest rates most likely

LOS 45b: Describe classifications of assets and markets.

Private and Public

Primary Markets and Secondary Markets

Capital Market - Stock shares and Bonds

1. Real estate is least likely a

A. Alternative investment asset

A. Primary market transaction

3. A money market mutual fund scheme most likely invests in

A. Securities with very short maturities

➢ Long-term: Maturity of longer than five to ten years

➢ Intermediate-term: In the middle of the range of maturities for a security

➢ Governments: May issue bills (short-term) or bonds (long-term).

➢ Banks: Usually issue certificates of deposit (CDs).

Pooled Investment Vehicles

➢ Industrial metals: Steel, copper, aluminium.

➢ Agricultural products: Wheat, sugar.

➢ Energy products: Oil, natural gas.

➢ Credits for carbon reduction.

1. A hedge fund is most likely an example of

2. A futures contract is a(n)

A. Unregulated contract to trade an asset at some price in the future

3. Oil futures may be least likely used as a hedging tool for

A. A company that sells oil as its main source of revenue

A. Invest in stocks of companies that own real estate

➢ Guarantee of contracts: The completion of futures contracts, for example, is guaranteed by

4. A clearinghouse least likely

A. Provide trading limits

LOS 45e: Compare positions an investor can take in an asset.

When do these respective positions benefit the trader?

A. Short the underlying asset

A. Sell wheat today

A. Interest received by the client from the broker

4. The margin loan in a leveraged transaction is most likely

A. The additional funds required to maintain a leveraged position

5. Leverage most likely

A. Amplifies the losses but limits the gains

Initial Margin Requirement 35%

Number of Shares Purchased 750.00

Annual Dividend per Share Rs.1.00

Call Money Rate 3.00%

Commission per Share Rs. 0.10

Trade Value 33,750.00

(Share price x No. of shares) (₹45 x 750)

Initial Margin 11,812.50

(Initial Margin Requirement x Trade Value) (35% x 33,750)

(Trade Value – Initial Margin) (₹33,750 – 11,812.50)

But we have also paid a commission to buy these shares.