EQUITY RESEARCH MODULE

National Stock Exchange of India Limited

 Table of Contents

Chapter Topic Page

No. No.
I Introduction to Equity Research and Economic Analysis 4
Investments An Overview: 5
Real Assets Vs Financial Assets 6
The Informational Role of Financial Markets 8
Corporate Governance and Corporate Ethics 11
Recent Trends 12
Equity Research -An Overview: 15
Types of Research: 18
Time Value of Money Basics: 24
Concept of Risk Return Trade Off: 34
Overview of the Investment Process: 36
Economic Analysis: 37
Inflation, Interest Rates, and Stock Prices: 40
II Industry and Company Analysis 43
What is an Industry? 44
Rationale for Industry Analysis: 44
Steps in Industry Analysis: 46
Frame-Work for Industry Analysis: 46
Porters Five Forces: 54
Company Analysis: 56
Understanding Financial Statements and Analysis: 59
Major Financial Statements: 60
III Valuation of Stocks and Firms 79
What is a Growth Company? 80
What is a Growth Stock? 80
What is a Defensive Company? 81
What is a cyclical company? 81
What is a speculative company? 82
Value Stocks Vs Growth Stocks 82
Cost of Capital (Kc): 83
Weighted Average Cost Of Capital WACC: 83
Cost of Debt (Kd): 83
Cost of Equity (Ke): 84
Capital Asset Pricing Model (CAPM): 84
CAPM and its Limitations: 86
Theory of Valuation: 89
Form of Returns: 89
Valuation of Bonds: 91
Valuation of Preferred Share: 92
Approaches to the Valuation of Equity Share: 93
Discounted Cash Flow Valuation Approach- Why and When? 94
Relative Valuation Techniques: Why and When to Use? 95
Discounted Cash Flow (DCF) Valuation Techniques: 95
The Dividend Discount Model (DDM): 96
Present Value of Operating Free Cash Flows: 96

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 Present Value of Free Cash Flows to Equity: 97
Relative Valuation: 97
Reasons for Popularity and potential pitfalls: 98
Advantages and Disadvantages: 99
Further Classification of Relative Valuation Models: 100
Applicability of multiples and limitations 102
IV Report Writing and Presentation 105
Points to be kept in mind while preparing an equity research report: 106
Template for the Equity Research Report: 107
Sources of Information: 109
Validation: 109
Expert / Legal Opinion: 109
References: 135
Appendix Useful Formulas 136
Nominal Rate 136
Effective Rate 136
Flat Rate 137
Rule of 72 137
Rule of 69 137
Continuous Compounding 138
Continuous Discounting 138
DuPont analysis 139
ROE analysis 139
High Turnover Industries 139
High margin industries 140
High leverage industries 140
ROA and ROE ratio 140
Time series analysis 142
Cross series analysis 142

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3
Chapter-I

Introduction to Equity Research and

Economic Analysis

4
Investments An Overview:

For most of your life, you will be earning and spending money. Rarely, though, will your current
money income exactly balances with your consumption desires. Sometimes, you may have more
money than you want to spend; at other times, you may want to purchase more than you can
afford. These imbalances will lead you either to borrow or to save to maximize the long-run
benefits from your income. When current income exceeds current consumption desires, people
tend to save the excess. They can do any of several things with these savings. One possibility is
to put the money under mattress or bury it in the backyard until some future time when
consumption desires exceed current income. When they retrieve their savings from the mattress
or backyard, they have the same amount they saved.

Another possibility is that they can give up the immediate possession of these savings for a
future larger amount of money that will be available for future consumption. This tradeoff of
present consumption for a higher level of future consumption is the reason for saving. What you
do with the savings to make them increase over time is investment. Those who give up
immediate possession of savings (that is, defer consumption) expect to receive in the future a
greater amount than they gave up. Conversely, those who consume more than their current
income (that is, borrowed) must be willing to pay back in the future more than they borrowed.

The rate of exchange between future consumption (future dollars) and current consumption
(current rupees) is the pure rate of interest. Both peoples willingness to pay this difference for
borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate
referred to as the pure time value of money. This interest rate is established in the capital market
by a comparison of the supply of excess income available (savings) to be invested and the
demand for excess consumption (borrowing) at a given time. If you can exchange Rs.100 of
certain income today for Rs. 104 of certain income one year from today, then the pure rate of
exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent
(104/100 1). The investor who gives up Rs.100 today expects to consume Rs. 104 of goods and
services in the future. This assumes that the general price level in the economy stays the same.

This price stability has rarely been the case during the past several decades when inflation rates
have varied over a period of time with an average of about eight percent a year from 1970 to
2010. If investors expect a change in prices, they will require a higher rate of return to
compensate for it. For example, if an investor expects a rise in prices (that is, he or she expects
inflation) at the rate of 3 percent during the period of investment, he or she will increase the
required interest rate by 3 percent. Further, if the future payment from the investment is not
certain, the investor will demand an interest rate that exceeds the pure time value of money plus
the inflation rate. The uncertainty of the payments from an investment is the investment risk. The
additional return added to the nominal, risk-free interest rate is called a risk premium. In our
previous example, the investor would require more than Rs106 one year from today to
compensate for the uncertainty.
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Specifically, the term investments the current commitment of dollars for a period of time in order
to derive future payments that will compensate the investor for (1) the time the funds are
committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments. The
investor can be an individual, government, a pension fund, or a corporation. Similarly, this
definition includes all types of investments, including investments by corporations in plant and
equipment and investments by individuals in stocks, bonds, commodities, or real estate. This text
emphasizes investments by individual investors. In all cases, the investor is trading a known
dollar amount today for some expected future stream of payments that will be greater than the
current outlay. At this point, we have answered the questions about why people invest and what
they want from their investments. They invest to earn a return from savings due to their deferred
consumption. They want a rate of return that compensates them for the time, the expected rate of
Inflation and the uncertainty of the return. A central question of this material is how investors
select investments that will give them their required rates of return.

In other words, an investments the current commitment of money or other resources in the
expectation of reaping future benefits. For example, an individual might purchase shares of stock
anticipating that the future proceeds from the shares will justify both the time that her money is
tied up as well as the risk of the investment. The time you will spend studying this text (not to
mention its cost) also is an investment. You are forgoing either current leisure or the income you
could be earning at a job in the expectation that your future career will be sufficiently enhanced
to justify this commitment of time and effort. While these two investments differ in many ways,
they share one key attribute that is central to all investments: You sacrifice something of value
now, expecting to benefit from that sacrifice later.

Real Assets Vs Financial Assets

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function of
the real assets of the economy: the land, buildings, equipment, and knowledge that can be used
to produce goods and services. In contrast to such real assets are financial assets such as stocks
and bonds. Such securities are no more than sheets of paper or, more likely, computer entries and
do not contribute directly to the productive capacity of the economy. Instead, these assets are the
means by which individuals in well-developed economies hold their claims on real assets.
Financial assets are claims to the income generated by real assets (or claims on income from the
government).If we cannot own our own auto plant (a real asset), we can still buy shares in
General Motors or Toyota (financial assets) and, thereby, share in the income derived from the
production of automobiles.

While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. Individuals can choose between consuming
their wealth today or investing for the future. If they choose to invest, they may place their
wealth in financial assets by purchasing various securities. When investors buy these securities
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from companies, the firms use the money so raised to pay for real assets, such as plant,
equipment, technology, or inventory. So investors returns on securities ultimately come from
the income produced by the real assets that were financed by the issuance of those securities.

More on Financial Assets

It is common to distinguish among three broad types of financial assets: debt, equity, and
derivatives. Fixed-income or debt securities promise either a fixed stream of income or a stream
of income that is determined according to a specified formula. For example, a corporate bond
typically would promise that the bondholder will receive a fixed amount of interest each year.
Other so-called floating-rate bonds promise payments that depend on current interest rates. For
example, a bond may pay an interest rate that is fixed at two percentage points above the rate
paid on U.S. Treasury bills. Unless the borrower is declared bankrupt, the payments on these
securities are either fixed or determined by formula. For this reason, the investment performance
of debt securities typically is least closely tied to the financial condition of the issuer.

Nevertheless, debt securities come in a tremendous variety of maturities and payment provisions.
At one extreme, the money market refers to fixed-income securities that are short-term, highly
marketable, and generally of very low risk. Examples of money market securities are U.S.
Treasury bills or bank certificates of deposit (CDs). In contrast, the fixed-income capital market
includes long-term securities such as Treasury bonds, as well as bonds issued by federal
agencies, state and local municipalities, and corporations. These bonds range from very safe in
terms of default risk (for example, Treasury securities) to relatively risky (for example, high
yield or junk bonds). They also are designed with extremely diverse provisions regarding
payments provided to the investor and protection against the bankruptcy of the issuer. We will
take a first look at these securities and undertake a more detailed analysis in later chapters.

Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the
corporation. Equity holders are not promised any particular payment. They receive any dividends
the firm may pay and have prorated ownership in the real assets of the firm. If the firm is
successful, the value of equity will increase; if not, it will decrease. The performance of equity
investments, therefore, is tied directly to the success of the firm and its real assets. For this
reason, equity investments tend to be riskier than investments in debt securities.

Derivative securities such as options and futures contracts provide payoffs that are determined by
the prices of other assets such as bond or stock prices. For example, a call option on a share of
Intel stock might turn out to be worthless if Intels share price remains below a threshold or
exercise price such as Rs30 a share, but it can be quite valuable if the stock price rises above
that level. 2 Derivative securities are so named because their values derive from the prices of
other assets. For example, the value of the call option will depend on the price of the stock. Other
important derivative securities are futures and swap contracts. Derivatives have become an
integral part of the investment environment. One use of derivatives, perhaps the primary use, is
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to hedge risks or transfers them to other parties. This is done successfully every day, and the use
of these securities for risk management is so commonplace that the multitrillion-dollar market in
derivative assets is routinely taken for granted.

Derivatives also can be used to take highly speculative positions, however. Every so often, one
of these positions blows up, resulting in well-publicized losses of hundreds of millions of dollars.
While these losses attract considerable attention, they are in fact the exception tithe more
common use of such securities as risk management tools.

Derivatives will continue to play an important role in portfolio construction and the financial
system. In addition to these financial assets, individuals might invest directly in some real assets.
For example, real estate or commodities such as precious metals or agricultural products are real
assets that might form part of an investment portfolio.

The Informational Role of Financial Markets

In a capitalist system, financial markets play a central role in the allocation of capital resources.
Investors in the stock market ultimately decide which companies will live and which will die. If
a corporation seems to have good prospects for future profitability, investors will bid up its stock
price. The companys management will find it easy to issue new shares or borrow funds to
finance research and development, build new production facilities, and expand its operations.
The nearby box provides an illustration of this process.

As Facebooks stock price surpassed Rs45 a share in 2012, it was able to expand and initiate
many new business prospects. If, on the other hand, a companys prospects seem poor, investors
will bid down its stock price. The company will have to downsize and may eventually disappear.
The process by which capital is allocated through the stock market sometimes seems wasteful.
Some companies can be hot for a short period of time, attract a large flow of investor capital,
and then fail after only a few years.

But that is an unavoidable aspect of economic progress. It is impossible to accurately predict in

advance which ventures will succeed and which will fail. But the stock market encourages
allocation of capital to those firms that appear at the time to have the best prospects. Many smart,
well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on
the stock market. Stock prices reflect their collective judgment.

Consumption Timing

Some individuals in an economy are earning more than they currently wish to spend. Others, for
example, retirees, spend more than they currently earn. How can you shift your purchasing
8
power from high-earnings periods to low-earnings periods of life? One way is to store your
wealth in financial assets. In high-earnings periods, you can invest your savings in financial
assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide
funds for your consumption needs. By so doing, you can shift your consumption over the
course of your lifetime, thereby allocating your consumption to periods that provide the greatest
satisfaction. Thus, financial markets allow individuals to separate decisions concerning current
consumption from constraints that otherwise would be imposed by current earnings.

Allocation of Risk

Virtually all real assets involve some risk. When GM builds its auto plants, for example, it
cannot know for sure what cash flows those plants will generate. Financial markets and the
diverse financial instruments traded in those markets allow investors with the greatest taste for
risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on
the sidelines. For example, if Maruti Udyong Ltd., (MUL) raises the funds to build its auto plant
by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can
buy shares of stocking MUL, while the more conservative ones can buy MUL bonds. Because
the bonds promise to provide a fixed payment, the stockholders bear most of the business risk
but reap potentially higher rewards. Thus, capital markets allow the risk that is inherent to all
investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their
investments. When investors are able to select security types with the risk-return characteristics
that best suit their preferences, each security can be sold for the best possible price. This
facilitates the process of building the economys stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organization is
well suited to small businesses and, in fact, was the most common form of business organization
before the Industrial Revolution. Today, however, with global markets and large-
scaleproduction, the size and capital requirements of firms have skyrocketed. For example, in
2006General Electric listed on its balance sheet about Rs71billion of property, plant, and
equipment,
and total assets in excess of Rs660 billion. Corporations of such size simply cannot exist as
owner-operated firms. GE actually has about 650,000 stockholders with an ownership stake in
the firm proportional to their holdings of shares. Such a large group of individuals obviously
cannot actively participate in the day-to-day management of the firm. Instead, they elect a board
of directors which in turn hires and supervises the management of the firm.

This structure means that the owners and managers of the firm are different parties. This gives
the firm a stability that the owner-managed firm cannot achieve. For example, if some
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stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to
other investors, with no impact on the management of the firm. Thus, financial assets and the
ability to buy and sell those assets in the financial market sallow for easy separation of
ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds holding
hundreds of thousands of shares to small investors who may hold only a single share, agree on
the objectives of the firm? Again, the financial markets provide some guidance. All may agree
that the firms management should pursue strategies that enhance the value of their shares. Such
policies will make all shareholders wealthier and allow them all to better pursue their personal
goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted
to engage in activities not in the best interest of shareholders. For example, they might engage in
empire building or avoid risky projects to protect their own jobs or over consume luxuries such
as corporate jets, reasoning that the cost of such perquisites is largely borne by the shareholders.

These potential conflicts of interest are called agency problems because managers, who are hired
as agents of the shareholders, may pursue their own interests instead. Several mechanisms have
evolved to mitigate potential agency problems. First, compensation plans tie the income of
managers to the success of the firm. A major part of the total compensation of top executives is
typically in the form of stock options, which means that the managers will not do well unless the
stock price increases, benefiting shareholders. (Of course, weve learned more recently that
overuse of options can create its own agency problem. Options can create an incentive for
managers to manipulate information to prop up stock price temporarily, giving them a chance to
cash out before the price returns to a level reflective of the firms true prospects.

Second, while boards of directors are sometimes portrayed as defenders of top management, they
can, and in recent years increasingly do, force out management teams that are underperforming.
The chief executives of Viacom, Boeing, Fannie Mae, 3 Hewlett-Packard, and Bristol-Myers
Squibb all have been replaced in recent years. Even boards in Europe, which traditionally have
been viewed as more management-friendly, have become more willing to force out
underperforming managers: for example, senior management at Deutsche Telekom, Shell, and
Vivendi Universal have recently been replaced. Third, outsiders such as security analysts and
large institutional investors such as pension funds monitor the firm closely and make the life of
poor performers at the least uncomfortable.

Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in
monitoring management, unhappy shareholders in principle can elect a different board. They can
do this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to
vote the shares of other shareholders) to take control of the firm and vote in another board.
However, this threat is usually minimal. Shareholders who attempt such a fight have to use their
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own funds, while management can defend itself using corporate coffers. Most proxy fights fail.
The real takeover threat is from other firms. If one firm observes another underperforming, it can
acquire the underperforming business and replace management with its own team. The stock
price should rise to reflect the prospects of improved performance, which provides incentive for
firms to engage in such takeover activity.

Corporate Governance and Corporate Ethics

Weve argued that securities markets can play an important role in facilitating the deployment of
capital resources to their most productive uses. But for markets to effectively serve this purpose
there must be enough transparency for investors to make well-informed decisions. If firms can
mislead the public about their prospects, then much can go wrong. Despite the many mechanisms
to align incentives of shareholders and managers, the three years between 2000 and 2002 were
filled with a seemingly unending series of scandals that collectively signaled a crisis in corporate
governance and ethics. For example, the telecom firm WorldCom overstated its profits by at least
Rs3.8 billion by improperly classifying expenses as investments. When the true picture emerged,
it resulted in the largest bankruptcy in U.S. history.

The second-largest U.S. bankruptcy was Enron, which used its now notorious special purpose
entities to move debt off its own books and similarly present a misleading picture of its
financial status. Unfortunately, these firms had plenty of company. Other firms such as Rite Aid,
HealthSouth, Global Crossing, and Qwest Communications also manipulated and misstated their
accounts to the tune of billions of dollars. And the scandals were hardly limited to the U.S.
Parmalat, the Italian dairy firm, claimed to have a Rs4.8 billion account at Bank of America that
turned out not to exist, and in the end the size of its bankruptcy will likely rival those of World-
Com or Enron. In India too, we have most recently Satyam scam which jolted the entire country.

These episodes suggest that agency and incentive problems are far from solved. Other scandals
of that period included systematically misleading and overly optimistic research reports put out
by stock market analysts (their favorable analysis was traded for the promise of future
investment banking business, and analysts were commonly compensated not for their accuracy
or insight, but for their role in garnering investment banking business frothier firms) and
allocations of initial public offerings to corporate executives as a quid pro quofor personal favors
or the promise to direct future business back to the manager of the IPO.

What about the auditors who were supposed to be the watchdogs of the firms? Here too,
incentives were skewed. Recent changes in business practice made the consulting businesses of
these firms more lucrative than the auditing function. For example, Enrons (now defunct)auditor
Arthur Andersen earned more money consulting for Enron than auditing it; given its incentive to
protect its consulting profits, it should not be surprising that it, and other auditors, were overly
lenient in their auditing work. In 2002, in response to the spate of ethics scandals, Congress
passed the Sarbanes-Oxley Act, which attempts to tighten the rules of corporate governance.
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 For example, the Act requires corporations to have more independent directors, that is, more
directors who are not themselves managers (or affiliated with managers). The Act also requires
each CFO to personally vouch forth corporations accounting statements, creates a new oversight
board to oversee the auditing of public companies, and prohibits auditors from providing various
other services to clients.

Wall Street and its regulators are seeking ways to restore credibility. There is (admittedly
belated) recognition that markets require trust to function. In the wake of the scandals, the value
of reputation and straightforward incentive structures has increased. Ultimately, a firms
reputation for integrity is key to building long-term relationships with its customers and is
therefore one of its most valuable assets. Indeed, the motto of the London Stock Exchange. Is
My word is my bond. Every so often firms forget this lesson, but in the end, investments in
reputation are in fact good business practice.

Recent Trends
Four important trends have changed the contemporary investment environment:
(1) Globalisation,
(2) Securitisation,
(3) Financial engineering, and
(4) Information and computer networks.

Globalisation

If a wider range of investment choices can benefit investors, why should we limit ourselves to
purely domestic assets? Increasingly efficient communication technology and the dismantling of
regulatory constraints have encouraged globalization in recent years. U.S. investors commonly
can participate in foreign investment opportunities in several ways:

(1) Purchase foreign securities using American Depository Receipts (ADRs), which are
domestically traded securities that represent claims to shares of foreign stocks;

(2) Purchase foreign securities that are offered in dollars;

(3) Buy mutual funds that invest internationally; and

(4) Buy derivative securities with payoffs that depend on prices in foreign security markets.

Brokers who act as intermediaries for American Depository Receipts purchase an inventory of
stock from some foreign issuer. The broker then issues an American Depository Receipt that
represents a claim to some number of those foreign shares held in inventory. The ADR is
denominated in dollars and can be traded on U.S. stock exchanges but is in essence no more than
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a claim on a foreign stock. Thus, from the investors point of view, there is no more difference
between buying a British versus a U.S. stock than there is in holding a Massachusetts based
company compared with a California-based one. Of course, the investment implications may
differ: ADRs still expose investors to exchange-rate risk.

World Equity Benchmark Shares (WEBS) are a variation on ADRs. WEBS use the same
depository structure to allow investors to trade portfolios of foreign stocks in a selected country.
Each WEBS security tracks the performance of an index of share returns for a particular country.
WEBS can be traded by investors just like any other security and thus enable U.S. investors to
obtain diversified portfolios of foreign stocks in one fell swoop.

A giant step toward globalization took place in 1999 when 11 European countries replaced their
existing currencies with a new currency called the euro.7The idea behind the euro is that a
common currency will facilitate trade and encourage integration of markets across national
boundaries. Figure 1.1 is an announcement of a debt offering in the amount of 500 million Euros.
(In June 2007, the euro was worth about Rs1.35; the symbol for the euro is .)

Securitisation

In 1970, mortgage pass-through securities were introduced by the Government National

Mortgage Association (GNMA, or Ginnie Mae). These securities aggregate individual home
mortgages into relatively homogeneous pools. Each pool acts as backing for a GNMA pass
through security. Investors who buy GNMA securities receive prorated shares of all the principal
and interest payments made on the underlying mortgage pool.

For example, the pool might total Rs100 million of 8%, 30-year conventional mortgages. The
banks that originated the mortgages continue to service them (receiving fee-for-service), but they
no longer own the mortgage investment; they pass the cash flows from the underlying mortgages
through to the GNMA security holders. Pass-through securities represent a tremendous
innovation in mortgage markets.

The securitization of mortgages means mortgages can be traded just like other securities.
Availability of funds to homebuyers no longer depends on local credit conditions and is no
longer subject to local banks potential monopoly powers; with mortgage pass-through trading in
national markets, mortgage funds can flow from any region (literally worldwide) to wherever
demand is greatest.

Securitization also expands the menu of choices for the investor. Whereas it would have been
impossible before 1970 for investors to invest in mortgages directly, they now can purchase
mortgage pass-through securities or invest in mutual funds that offer portfolios of such securities.
Other loans that have been securitized into pass-through arrangements include car loans, student
loans, home equity loans, credit card loans, and debts of firms.
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Securitization also has been used to allow U.S. banks to unload their portfolios of shaky loans to
developing nations. So-called Brady bonds (named after former Secretary of Treasury Nicholas
Brady) were formed by securitizing bank loans to several countries in shaky fiscal condition. The
U.S. banks exchanged their loans to developing nations for bonds backed by those loans. The
payments that the borrowing nation would otherwise make to the lending bank were directed
instead to the holder of the bond. These bonds could be traded in capital markets. Therefore, if
they chose to, banks could remove these loans from their portfolios simply by selling the bonds.

Financial Engineering:

Financial engineering refers to the creation of new securities by unbundlingbreaking up and

allocating the cash flows from one security to create several new securitiesor by bundling
combining more than one security into a composite security. Such creative engineering of new
investment products allows one to design securities with custom-tailored risk attributes. Boise
Cascade, with the assistance of Goldman, Sachs and other underwriters, has issued a hybrid
security with features of preferred stock combined with various call and put option contracts.
The security is structured as preferred stock for four years, at which time it is converted into
common stock of the company. However, the number of shares of common stock into which the
security can be converted depends on the price of the stock in four years, which means that the
security holders are exposed to risk similar to the risk they would bear if they held option
positions on the firm.

Often, creating a security that appears to be attractive requires the unbundling of an asset. A
mortgage pass-through certificate is unbundled into classes. Class 1 receives only principal
payments from the mortgage pool, whereas Class 2 receives only interest payments. The process
of bundling and unbundling is called financial engineering, which refers to the creation and
design of securities with custom-tailored characteristics, often regarding exposures to various
sources of risk. Financial engineers view securities as bundles of (possible risky) cash flows that
may be carved up and rearranged according to the needs or desires of traders in the security
markets.

Computer Networks

The Internet and other advances in computer networking have transformed many sectors of the
economy and few more so than the financial sector. These advances will be treated in greater
detail in Chapter 3, but for now we can mention a few important innovations: online trading,
online information dissemination, and automated trade crossing. Online trading connects a
customer directly to a brokerage firm. Online brokerage firms can process trades more cheaply
and therefore can charge lower commissions. The average commission for an online trade is
below 0.7%, compared to more than 1% at full-service brokers. The Internet has also allowed
14
vast amounts of information to be made cheaply and widely available to the public. Individual
investors today can obtain data, investment tools, and even analyst reports that just a decade ago
would have been available only to professionals.

Electronic communication networks that allow direct trading among investors have exploded in
recent years. These networks allow members to post buy or sell orders and to have those orders
automatically matched up or crossed with orders of other traders in the system without benefit
of an intermediary such as a securities dealer.

Equity Research -An Overview:

Companies constantly produce large amounts of information regarding their financial status,
their success in business markets and their current investments. Much of this information is
required for legal purposes, but it also provides necessary data for the stock market. Most
investors do not have the time or resources to follow this massive amount of company
information. Equity research analysts work to compile this data, along with relevant market
information, to provide investors with useful recommendations.

Definition
In stock market terms, "equity" refers to ownership of a business, which a business can sell as
shares to interested investors. An equity research analyst specializes in examining what shares
are for sale, what shares are selling well and what companies appear to be growing and will be
worthwhile investments. Equity research analysts also track which stocks are falling so they can
point out trends and provide useful information to brokers and investors. Analysts spend much of
their time analyzing individual stocks, especially stocks that have earned a lot of interest due to
changing value. They look at the company that issued the stock and its history, and then analyze
the company's industry as a whole and what major changes are influencing it. The analyst will
then look at businesses similar to the company they are studying to find information about
overall value and average earnings for that kind of business.

Role of Equity Research Analysts:

Equity research analysts have many different jobs. Once they have compiled information, many
use basic formulas and programs to create financial models of specific companies and industries,
or ratios that show important facts about a business's financial standing. Many follow up these
models by writing reports for investors summarizing their findings. Some may tap into
independent sources and contacts to keep up on recent events. All research analysts must ensure
they use only publicly available knowledge and not illegal, insider information. Equity research
analysts tend to be influenced by current events, and many tend to make recommendations based
on market activity. This means that as the market changes, analysts' attitudes also change to

15
mirror current interest. This can create a tendency for some analysts to become myopic, only
reporting on popular news and backing certain stocks because they are trendy in the short term.

Types
There are two basic types of equity research analysts. The first type works for major brokerage
firms on Wall Street and are interested primarily in highly liquid stocks, big cap shares and other
high-profit investment data. The other type of analyst is independent, providing information for
all types of stocks for their firms as needed.
Hence, the role of equity research analysts is to study the companies, analyzing its financial
statements, products, management, market share, and analyze the quantitative and qualitative
aspects with the main objective of arriving logical and informed decisions about where to invest
and on what stocks to invest?

By and large fee-based research analysts or the firms have the following characteristics:

1. Equity research analysts provide analytical and unbiased services.

2. Normally they are paid an annual fee in cash and normally they do not accept any form
of equity, which may cause conflicts of interest.
3. They provide full disclosure of the relationship between the company and the research
analysts /firm, so investors can evaluate objectivity.

Generally, an equity research analyst is expected to possess the following skill sets.

a. Good understanding about the Global Economies and various macro and micro factors
that will affect the economies of the various countries
b. Excellent knowledge about the various industries, their business models, different phases
of the business life cycles.
c. Aptitude towards number crunching. Skill to analyse the financial statements namely
profit and loss account, balance sheet, cash flow statement and draw inferences about the
financial status and performance of the firm.
d. Clarity in oral and written communication

Market Participants who will avail the services of Equity Research Analysts:

There are basically three categories of participants in the securities market namely, the issuers of
securities, investors in securities and the intermediaries, such as merchant bankers, brokers etc.

16
As far as the debt (bond) market is concerned, as it is predominantly a wholesale market, with
dominant institutional investor participation. The investors in the debt markets are mainly banks,
financial institutions, mutual funds, provident funds, pension funds, insurance companies and
corporate. With the growing number of market participants, the growth in volume of securities
transactions, the reduction in transaction costs, the significant improvements in transparency and
safety have enhanced the requirement of services of equity research analysts many fold in the
Indian securities market.
Table
TableNo.1.1
No.1
Market Participants in Securities Market
Market Participants 2009 2010 As on Sep 30, 2010
Securities Appellate Tribunal (SAT) 1 1 1
Regulators* 4 4 4
Depositories 2 2 2
Stock Exchanges
With Equities Trading 20 20 20
With Debt Market Segment 2 2 2
With Derivative Trading 2 2 2
With Currency Derivatives 3 3 4
Brokers (Cash Segment) 9,628 9,772 10,018
Corporate Brokers (Cash Segment) 4,308 4,424 4,618
Brokers (Equity Derivatives) 1,587 1,705 1,902
Brokers (Currency Derivatives) 1,154 1,459 1,811
Sub-brokers 60,947 75,577 81,713
FIIs 1626 1713 1726
Portfolio Managers 232 243 250
Custodians 16 17 17
Registrars to an issue & Share Transfer Agents 71 74 68
Primary Dealers 18 20 20
Merchant Bankers 134 164 184
Bankers to an Issue 51 48 52
Debenture Trustees 30 30 27
Underwriters 19 5 6
Venture Capital Funds 132 158 168
Foreign Venture Capital Investors 129 143 150
Mutual Funds 44 47 48
Collective Investment Schemes 1 1 1
Source: SEBI, RBI
* DCA, DEA, RBI & SEBI.

17
Types of Research:

There are broadly three types of equity research that are in practice.

A: Fundamental Analysis:

This is the very popular methods of analysis amongst the analysts. Under this method of analysis
a share is evaluated by its intrinsic value by examining related economic, financial and other
qualitative and quantitative factors. This is also called as a top-down approach wherein first the
economies of the various countries were analyzed followed by an analysis of the industries and
then the companies. The whole idea here is that by analyzing the economies of various countries
one can identify the counties economies which are booming or nearing booming and then within
those countries what are the industries which are in the growth part of their life cycle and then
the companies which are really doing well within those industries. For instance by analyzing the
various economies of the world as of now, one can identify two economies (among other
countries) as emerging economies like India and China. Having identified the economy the
researcher needs to zoom further what are the industries within these economies are doing well.
For instance auto, information technology, telecom and pharmaceutical industries are considered
to be in their growth phase in these countries. Then the analysts further investigates what are the
companies within these industries are doing well comparing to other players in the market and
then takes a call to invest in those companies.

Exhibit No.1.1

18
Source: Adopted from Reilly and Brown, 8th Edition

B. Technical Analysis

This is the second branch of analysis where in the stock price movements are largely predicted
by analyzing statistics generated by market activity, such as past prices and volume. No attempt
is made to measure a share's intrinsic value, but instead use charts and other tools to identify
patterns that can suggest future direction of price.

Exhibit No.1.2

Source: Adopted from Reilly and Brown, 8th Edition

C: Quantitative Analysis:

This is a method that attempts to understand the behavior of stock price movement through
complex mathematical and statistical modeling. By assigning a numerical value to variables,
quantitative analysts try to replicate reality mathematically. The tools that are largely used over
here are stochastic processing, optimization, artificial neural network, economy-physics, applied
mathematics and the like

Major Classification of Stocks:

Stocks were classified in different manner in the literature. Let us discuss some of the most
common classifications of shares. Please be noted that the term stock and share are used
interchangeably.

19
Equity Stock / Common Stock:

Equity is a stock or any other security representing an ownership interest. On a

company's balance sheet, the amount of the funds contributed by the owners (the stockholders)
plus the retained earnings (or losses). It is also referred to as "shareholders' equity". In finance, in
general, you can think of equity as ownership in any asset after all debts associated with that
asset are paid off.

Preferred Stock:

A class of ownership in a company that has a higher claim on the assets and earnings than
common stock. Preferred stock generally has a dividend that must be paid out before dividends
to common stockholders and the shares usually do not have voting rights.
The precise details as to the structure of preferred stock are specific to each corporation.
However, the best way to think of preferred stock is as a financial instrument that
has characteristics of both debt (fixed dividends) and equity (potential appreciation). There are
further classifications within preferred stock such as cumulative preference shares, non-
cumulative preference shares, convertible preference shares, non-convertible preference shares,
participating and non-participating preference shares.

When a company issues preferred stock, it generally creates an obligation to pay a fixed dividend
on the stock. Accounting rules have conventionally not viewed preferred stock as debt because
the failure to meet preferred dividends does not result in bankruptcy. At the same time, the fact
the preferred dividends are cumulative makes them more onerous than common equity. Thus,
preferred stock is viewed in accounting as a hybrid security, sharing some characteristics with
equity and some with debt. Preferred stock is valued on the balance sheet at its original issue
price, with any cumulated unpaid dividends added on. Convertible preferred stock is treated
similarly, but it is treated as equity on conversion. However, the focus of this course is on equity
shares only.

NSE Classification of Shares:

The National Stock Exchange classifies stocks broadly under six categories namely A, B, T, S,
TS and Z. The classification stocks are being done on the basis of their size, liquidity and
exchange compliance and, in some cases, also the speculative interest in them.

A Group Highly Liquid:

a) These are the most liquid shares among the whole lot of shares that are listed in the NSE.

20
 b) These are companies which are rated excellent in all aspects; Market capitalization is one
key factor in deciding which scrip should be classified in Group A.
c) Volumes are high and trades are settled under the normal rolling settlement (i.e. to say
intraday buy-sell deals are netted out).
d) These are best fit for a novice investors portfolio considering that information about
them is extensively available. For instance, all the 30 stocks which constitute Sensex are
A grade stocks.

T Group Trade to Trade:

a) The stocks that fall under the trade-to-trade settlement system of the exchange come
under this category.
b) Each trade here is seen as a separate transaction and theres no netting-out of trades as in
the normal rolling system.
c) The trader needs to pay to take delivery for his/her buys and deliver shares for his/her
sells, both on the second day following the trade day (T+2).
For instance, suppose Mr. A bought 100 shares of T grade shares and sold another 100
of it on the same day. Then, for the shares Mr. A had bought, he would have to pay the
exchange in two days. As for the other bunch that Mr. A sold, Mr. A should deliver the
shares by T+2 days, for the exchange to deliver it to the one who bought it. to produce
delivery shares against the sale made would be considered as short sales. The exchange
will, in that case, on the T+3rd day, debit an amount that is 20 per cent higher than the
scrips closing price that day. This means unless the scrips price falls more than 20 per
cent from the price of your sale transaction, you would have to pay a penalty for the short
sale so made. Even so, there will be no credit made to you in the case of substantial fall in
the share price. The exchange will, instead, credit the gain to its investor fund. Stocks are
regularly moved in and out of trade-to-trade settlement depending on the speculative
interest that governs them.

S Group Small and Medium

a) These are shares that fall under the NSEs Indonext segment.
b) The NSE Indonext comprises small and medium companies that are listed in the regional
stock exchanges (RSE).
c) S grade companies are small and typically ones with turnover of Rs 5 Crore and tangible
assets of Rs 3 Crore. Some also have low free-float capital with the promoter holding as
high as 75 per cent.
d) Besides their smaller size, the other risk that comes with investing in them is low
liquidity. Owing to lower volumes, these stocks may also see frenzied price movements.

21
TS Group A Mix of T and S Groups:

a) Stocks under this category are but the S grade stocks that are settled on a trade-to-trade
basis owing to surveillance requirements.
b) This essentially means that these counters may not come with an easy exit option, as
liquidity will be low and intraday netting of buy-sell trades isnt allowed either.

Z Group Caution

a) Z grade stocks are companies that have not complied with the exchanges listing
requirements or ones that have failed to redress investor complaints.
b) This grade also includes stocks of companies that have dematerialization arrangement
with only one of the two depositories, Central Depository Services (India) Ltd (CDSL)
and National Securities Depositories Ltd (NSDL).
c) These stocks may perhaps be the riskiest in terms of various grades accorded. For one,
not much information would be available in the public domain on these companies,
making it tough to track them. Second, the low media coverage that keeps them relatively
hidden from public scrutiny also makes them more vulnerable to insider trading. Third,
these companies already have a poor score in redressing investor complaints.

B Group Left Over

a) This category comprises stocks that dont fall in any of the other groups.

b) These counters see normal volumes and are settled under the rolling system; in all
respects these stocks resemble their counterparts in A but for their size; typically, stocks
of mid- and small market capitalization come under this grade.

SLB Group
a) Securities Exchange Board of India, in 2007, has announced the introduction of Securities
Lending & Borrowing Scheme (SLBS).
b) Securities Lending & Borrowing provides a platform for borrowing of securities to
enable settlement of securities sold short.
c) There are 207 companies in the SLB list; Investors can sell a stock which he/she does not
own at the time of trade.
d) All classes of investors, viz., retail and institutional investors, are permitted to short sell.

Other Classifications

The F Group represents the Fixed Income Securities.

22
 Trading in Government Securities by the retail investors is done under the G group.

Classification Based on the Market Capitalization:

What is market capitalization?

Market capitalization is often known as market cap or m-cap which is the total value of the
shares outstanding in the market on a particular point of time. It could be computed with the
following formula:

Price per share * Number of tradable shares

For instance, the market capitalisaiton of ACC shares as on 22nd November 2012 is computed as
below:

Rs.1390 * 1854649499 = Rs.25,928 crores

Large Cap or Big Cap:

Generally companies with a market capitalization value of more than Rs10 billion are classified
as large cap. The term large cap is abbreviation of the term large market capitalization

Mid Cap:

Companies with a market capitalization between Rs2 and Rs10 billion are known as Mid Cap.
Mid cap is an abbreviation for the term "middle capitalization"

Small Cap:
Normally, the companies with a market capitalization of between Rs300 million and Rs2 billion
are known as small cap. Small cap is an abbreviation for the term "small capitalization"

A word of caution to be kept in mind is that these classification as above are only
approximations that change over time. Also, the exact definition of these terms can vary among
the various participants in the investment business.

23
Time Value of Money Basics:

The time value of money is a mathematically based recognition that money received today is worth
more than an equal amount of money received months or years in the future. Why so, because of the
concept of interest.
What is interest?
Interest is the reward given for the sacrifice made i.e. by sacrificing the current consumption
someone is anticipating a higher amount.
Concept of Present value and Future Value:

Present value (PV) ), represents the rupee value today of a future amount, or the amount you
would invest today at a given interest rate for a specified time period to equal the future amount.

Future value (FV), the value of a present amount at a future date, is calculated by applying
compound interest over a specific time period.

Generally, financial managers prefer present value to future value because they typically make
decisions at time zero, before the start of a project.

Rationale to know the above mentioned concepts:

a) Most financial decisions involve costs & benefits that are spread out over time.

b) Time value of money allows comparison of cash flows from different periods.

Would it be better for a company to invest Rs.100,000 in a financial

instrument that would return a total of Rs.200,000 after one year, or
one that would return Rs.200,000 after two years? Assuming both
instruments has the same rate of return.

The answer for the above question is a function of the prevailing rate of interest.

Simple Interest: In simple interest no interest on interest. Let us understand this through a simple
example.

Year 1: 5% of Rs.100 = Rs.5 + Rs.100 = Rs.105

Year 2: 5% of Rs.100 = Rs.5 + Rs.105 = Rs.110

Year 3: 5% of Rs.100 = Rs.5 + Rs.110 = Rs.115

24
 Year 4: 5% of Rs.100 = Rs.5 + Rs.115 = Rs.120

Year 5: 5% of Rs.100 = Rs.5 + Rs.120 = Rs.125

Compound Interest: In compound interest, one earns interest on interest.

Year 1: 5% of Rs.100.00 = Rs.5.00 + Rs.100.00= Rs.105.00

Year 2: 5% of Rs.105.00 = Rs.5.25 + Rs.105.00= Rs.110.25

Year 3: 5% of Rs.110.25 = Rs.5 .51+ Rs.110.25= Rs.115.76

Year 4: 5% of Rs.115.76 = Rs.5.79 + Rs.115.76= Rs.121.55

Year 5: 5% of Rs.121.55 = Rs.6.08 + Rs.121.55= Rs.127.63

Nominal and Effective Interest Rate:

The nominal interest rate is the stated or contractual rate of interest charged by a lender or
promised by a borrower. The effective interest rate is the rate actually paid or earned. In general,
the effective rate > nominal rate whenever compounding occurs more than once per year.

Effective Annual Interest Rate = (1 + k/m) m -1

For example, what is the effective rate of interest on your credit card if the nominal rate is
18% per year, compounded monthly?

Effective Annual Interest Rate = (1 + .18/12) 12 -1

Effective Annual Interest Rate = 19.56%

How to compute Present Value and Future Value?

Present value is the current dollar value of a future amount of money, and it is based on the
idea that a rupee today is worth more than a dollar tomorrow. Calculating present value is
also known as discounting. The discount rate is often also (crudely) referred to as the
opportunity cost, the discount rate, the required return, or the cost of capital.

There are multiple methods of computing present value such as using the equations, using the
financial tables and use of spreadsheets (Excel)

Single amount cash flow refers to an individual, stand alone, value occurring at one point in
time. An annuity consists of an unbroken series of cash flows of equal dollar amount occurring
over more than one period. A mixed stream is a pattern of cash flows over more than one time
period and the amount of cash associated with each period will vary.

Compounding of interest occurs when an amount is deposited into a savings account and the
interest paid after the specified time period remains in the account, thereby becoming part of the

25
principal for the following period. The general equation for future value in year n (FVn) can be
expressed using the specified notation as follows:

FVn = PV x (1+i)n

A decrease in the interest rate lowers the future amount of a deposit for a given holding period,
since the deposit earns less at the lower rate. An increase in the holding period for a given
interest rate would increase the future value. The increased holding period increases the future
value since the deposit earns interest over a longer period of time.

The present value, PV, of a future amount indicates how much money today would be equivalent
to the future amount if one could invest that amount at a specified rate of interest. Using the
given notation, the present value (PV) of a future amount (FVn) can be defined as follows:

1
PV FV
(1 i) n

An increasing required rate of return would reduce the present value of a future amount, since
future dollars would be worth less today. Looking at the formula for present value in question 5,
it should be clear that by increasing the i value, which is the required return, the present value
interest factor would decrease, thereby reducing the present value of the future sum.

Present value calculations are the exact inverse of compound interest calculations. Using
compound interest, one attempts to find the future value of a present amount; using present
value, one attempts to find the present value of an amount to be received in the future.

An ordinary annuity is one for which payments occur at the end of each period.

An annuity due is one for which payments occur at the beginning of each period.

The ordinary annuity is the more common. For otherwise identical annuities and interest rates,
the annuity due results in a higher future value because cash flows occur earlier and have more
time to compound.

The present value of an ordinary annuity, PVAn, can be determined using the formula:

PVAn = PMT x (PVIFAi%,n)

where:

PMT = the end of period cash inflows

PVIFA = the present value interest factor of an annuity for interest rate i and n
periods.

26
The PVIFA is related to the PVIF in that the annuity factor is the sum of the PVIFs over the
number of periods for the annuity. For example, the PVIFA for 5% and 3 periods is 2.723, and
the sum of the 5% PVIF for periods one through three is 2.723 (.952 + .907 + .864).

The FVIFA factors for an ordinary annuity can be converted for use in calculating an annuity due
by multiplying the FVIFAi%,n by 1 + i.

The PVIFA factors for an ordinary annuity can be converted for use in calculating an annuity due
by multiplying the PVIFAi%,n by 1 + i.

A perpetuity is an infinite-lived annuity. The factor for finding the present value of a perpetuity
can be found by dividing the discount rate into 1.0. The resulting quotient represents the factor
for finding the present value of an infinite-lived stream of equal annual cash flows.

The future value of a mixed stream of cash flows is calculated by multiplying each year's cash
flow by the appropriate future value interest factor. To find the present value of a mixed stream
of cash flows multiply each year's cash flow by the appropriate present value interest factor.
There will be at least as many calculations as the number of cash flows.

As interest is compounded more frequently than once a year, both (a) the future value for a given
holding period and (b) the effective annual rate of interest will increase. This is due to the fact
that the more frequently interest is compounded, the greater the future value. In situations of
intra-year compounding, the actual rate of interest is greater than the stated rate of interest.

Continuous compounding assumes interest will be compounded an infinite number of times per
year, at intervals of microseconds. Continuous compounding of a given deposit at a given rate of
interest results in the largest value when compared to any other compounding period.

The nominal annual rate is the contractual rate that is quoted to the borrower by the lender. The
effective annual rate, sometimes called the true rate, is the actual rate that is paid by the
borrower to the lender. The difference between the two rates is due to the compounding of
interest at a frequency greater than once per year.

APR is the Annual Percentage Rate and is required by truth in lending laws to be disclosed to
consumers. This rate is calculated by multiplying the periodic rate by the number of periods in
one year. The periodic rate is the nominal rate over the shortest time period in which interest is
compounded. The APY, or Annual Percentage Yield, is the effective rate of interest that must be
disclosed to consumers by banks on their savings products as a result of the truth in savings
laws. These laws result in both favorable and unfavorable information to consumers. The good
news is that rate quotes on both loans and savings are standardized among financial institutions.
The negative is that the APR, or lending rate, is a nominal rate, while the APY, or saving rate, is
an effective rate. These rates are the same when compounding occurs only once per year.

The size of the equal annual end-of-year deposits needed to accumulate a given amount over a
certain time period at a specified rate can be found by dividing the interest factor for the future

27
value of an annuity for the given interest rate and the number of years (FVIFA i%,n) into the
desired future amount. The resulting quotient would be the amount of the equal annual end-of-
year deposits required. The future value interest factor for an annuity is used in this calculation:

FVn
PMT
FVIFAi%, n

Amortizing a loan into equal annual payments involves finding the future payments whose
present value at the loan interest rate just equals the amount of the initial principal borrowed.
The formula is:

PVn
PMT
PVIFAi%, n

Either the present value interest factor or the future value interest factor can be used to find the
growth rate associated with a stream of cash flows.

The growth rate associated with a stream of cash flows may be found by using the following
equation, where the growth rate, g, is substituted for k.
FVn
PV
(1 g)

To find the rate at which growth has occurred, the amount received in the earliest year is divided
by the amount received in the latest year. This quotient is the PVIFi%;n. The growth rate
associated with this factor may be found in the PVIF table. To find the interest rate associated
with an equal payment loan, the Present Value Interest Factors for a one rupee Annuity Table
would be used.

To determine the interest rate associated with an equal payment loan, the following equation may
be used:
PVn = PMT x (PVIFAi%,n)

Solving the equation for PVIFAi%,n we get:

PVn
PVIFA i %, n
PMT

Then substitute the values for PVn and PMT into the formula, using the PVIFA Table to find the
interest rate most closely associated with the resulting PVIFA, which is the interest rate on the
loan.

To find the number of periods it would take to compound a known present amount into a known
future amount you can solve either the present value or future value equation for the interest
factor as shown below using the present value:

28
 PV = FV x (PVIFi%,n)

Solving the equation for PVIFi%,n we get:

PV
PVIF i %, n
FV

Then substitute the values for PV and FV into the formula, using the PVIF Table for the known
interest rate find the number of periods most closely associated with the resulting PVIF.
The same approach would be used for finding the number of periods for an annuity except that
the annuity factor and the PVIFA (or FVIFA) table would be used. This process is shown below.

PVn = PMT x (PVIFAi%,n)

Solving the equation for PVIFAi%,n we get:

PVn
PVIFA i %, n
PMT

Let us move onto understand the important concepts of Risk and Return:

What is risk?

Risk, for most of us, refers to the likelihood that in lifes games of chance, we will receive an
outcome that we will not like. For instance, the risk of driving a car too fast is getting a speeding
ticket, or worse still, getting into an accident. Websters dictionary, in fact, defines risk as
exposing to danger or hazard. Thus, risk is perceived almost entirely in negative terms. In
finance, our definition of risk is both different and broader. Risk, as we see it, refers to the
likelihood that we will receive a return on an investment that is different from the return we
expected to make. Thus, risk includes not only the bad outcomes, i.e., returns that are lower than
expected, but also good outcomes, i.e., returns that are higher than expected. In fact, we can refer
to the former as downside risk and the latter is upside risk; but we consider both when measuring
risk. In fact, the spirit of our definition of risk in finance is captured best by the Chinese symbols
for risk, which are reproduced below:

29
The first symbol is the symbol for danger, while the second is the symbol for opportunity,
making risk a mix of danger and opportunity. It illustrates very clearly the tradeoff that every
investor and business has to make between the higher rewards that come with the opportunity
and the higher risk that has to be borne as a consequence of the danger. Much of this chapter can
be viewed as an attempt to come up with a model that best measures the danger in any
investment and then attempts to convert this into the opportunity that we would need to
compensate for the danger. In financial terms, we term the danger to be risk and the
opportunity to be expected return.

What makes the measurement of risk and expected return so challenging is that it can vary
depending upon whose perspective we adopt. When analyzing Boeings risk, for instance, we
can measure it from the viewpoint of Boeings managers. Alternatively, we can argue that
Boeings equity is owned by its stockholders and that it is their perspective on risk that should
matter. Boeings stockholders, many of whom hold the stock as one investment in a larger
portfolio, might perceive the risk in Boeing very differently from Boeings managers, who might
have the bulk of their capital, human and financial, invested in the firm.

We will argue that risk in an investment has to be perceived through the eyes of investors in the
firm. Since firms like Boeing often have thousands of investors, often with very different
perspectives, we will go further. We will assert that risk has to be measured from the perspective
of not just any investor in the stock, but of the marginal investor, defined to be the investor most
likely to be trading on the stock at any given point in time. The objective in corporate finance is
the maximization of firm value and stock price. If we want to stay true to this objective, we have
to consider the viewpoint of those who set the stock prices, and they are the marginal investors.

Equity Risk and Expected Return

To demonstrate how risk is viewed in corporate finance, we will present risk analysis in three
steps. First, we will define risk in terms of the distribution of actual returns around an expected
return. Second, we will differentiate between risk that is specific to one or a few investments and
risk that affects a much wider cross section of investments. We will argue that in a market where
the marginal investor is well diversified, it is only the latter risk, called market risk that will be
rewarded. Third, we will look at alternative models for measuring this market risk and the
expected returns that go with it.

Defining Risk
Investors who buy assets expect to earn returns over the time horizon that they hold the asset.
Their actual returns over this holding period may be very different from the expected returns and
it is this difference between actual and expected returns that is source of risk. For example,
assume that you are an investor with a 1-year time horizon buying a 1-year Treasury bill (or any
other default-free one-year bond) with a 5%expected return. At the end of the 1-year holding
period, the actual return on this investment will be 5%, which is equal to the expected return.

30
The Components of Risk

When an investor buys stock or takes an equity position in a firm, he or she is exposed to many
risks. Some risk may affect only one or a few firms and it is this risk that we categorize as firm-
specific risk. Within this category, we would consider a wide range of risks, starting with the risk
that a firm may have misjudged the demand for a product from its customers; we call this project
risk. For instance, if one analyse Boeings investment in a Super Jumbo jet. This investment is
based on the assumption that airlines want a larger airplane and are will be willing to pay a
higher price for it. If Boeing has misjudged this demand, it will clearly have an impact on
Boeings earnings and value, but it should not have a significant effect on other firms in the
market. The risk could also arise from competitors proving to be stronger or weaker than
anticipated; we call this competitive risk. For instance, assume that Boeing and Airbus are
competing for an order from Quantas, the Australian airline.

The possibility that Airbus may win the bid is a potential source of risk to Boeing and perhaps a
few of its suppliers. But again, only a handful of firms in the market will be affected by it.
Similarly, the Home Depot recently launched an online store to sell its home improvement
products. Whether it succeeds or not is clearly important to the Home Depot and its competitors,
but it is unlikely to have an impact on the rest of the market. In fact, we would extend our risk
measures to include risks that may affect an entire sector but are restricted to that sector; we call
this sector risk. For instance, a cut in the defense budget in the United States will adversely
affect all firms in the defense business, including Boeing, but there should be no significant
impact on other sectors, such as food and apparel. What is common across the three risks
described above project, competitive and sector risk is that they affect only a small sub-set of
firms.

There is other risk that is much more pervasive and affects many if not all investments. For
instance, when interest rates increase, all investments are negatively affected, albeit to different
degrees. Similarly, when the economy weakens, all firms feel the effects, though cyclical firms
(such as automobiles, steel and housing) may feel it more. We term this risk market risk.

Finally, there are risks that fall in a gray area, depending upon how many assets they affect. For
instance, when the dollar strengthens against other currencies, it has a significant impact on the
earnings and values of firms with international operations. If most firms in the market have
significant international operations, it could well be categorized as market risk. If only a few do,
it would be closer to firm-specific risk.

How do we measure risk?

Different versions of risk are usually measured by calculating the standard deviation of
the historical returns or average returns of a specific investment. Generally, a high standard

31
deviation indicates a high degree of risk. This is the crude way of measuring risk, of course more
refined methods of risks are available in the literature.

Further Classifications of Risk:

a) Systematic Risk / Market Risk

b) Fundamental Risk / Non Systematic Risk / unique risk

Systematic risk or market risk are those risks that affect the overall stock market, which cant be
avoided (through diversification) such as interest rates, recession, rise inflation, wars and the
like. The sub-division of systematic risks is given below:

i) Purchasing Power Risk: It is the risk that the return on an investment will be
reduced in significant measures by inflation. Such risk is applicable to fixed income
investment, particularly short dated ones, such as money market and stable value
funds, the historically low yields of which are most vulnerable to inflation over time.
Intermediate and longer term bonds do not escape purchasing power risk, either.

ii) Risk: This is the risk that interest rate changes will affect securities' value. Rising
interest rates force down bond prices. Stock prices are negatively affected since
borrowing costs tend to rise and bonds become more attractive due to their higher
yields.

iii) Exchange Rate Risk: It is the risk of a change between the value of a dollar and the
value of a foreign currency in which the investment is made. Such risk exists in
international funds. As an example, a U.S. dollar based investor keeps score in dollars
and will receive less of a return on his or her investment, all else being equal, if the
dollar strengthens relative to the foreign currency. The foreign currency returns
translate into fewer dollars. By contrast, a weak dollar benefits the dollar based
investor.

iv) Reinvestment Risk: It is the risk that earnings from current investments will not be
able to be reinvested at a yield equal or superior to the yield on those current
investments. As an example, if an issuer calls a bond yielding 8% in a decreasing
interest rate environment, the bondholder is faced with having to reinvest at a lower
rate.

b) Fundamental Risk / Non-Systematic Risk:

Fundamental risks are by and large related or arising out of the business. Normally, by means
of diversification such risks could be avoided.

32
 i) Business Risk: It is the risk that the business in which one invests experiences
downturns or even fails due to any number of factors. Examples would be the delay
of a product rollout, key employee turnover, etc.

ii) Liquidity and Marketability Risk: If an investment is liquid if it can be converted into
cash quickly with minimal effect upon its value. Liquid investments are typically
more desirable in consequence and more marketable. Less liquid or illiquid
investments may or may not be marketable and, as a result, are better suited for
investors with little or no need for near term liquidity. Investments in real estate (not
securitized), private equity funds, hedge funds, any private placement, thinly traded
stocks, all manner of distressed securities and private ventures are subject to such
risks. Suitability requirements often exist. (e.g. investor accreditation rules).

iii) Financial Risk: It refers to the effect that a firm's capital structure may have upon its
profitability. For example, large amounts of debt can act as a double edged sword,
both increasing a firm's return on its equity (ROE) and possibly reducing it as well.
Also termed event risk, financial risk can result from an event that impacts the credit
quality such as leveraged buyouts, mergers, acquisitions, share buybacks, de
capitalizations, recapitalizations and restructurings.

Concept of Risk Return Trade Off:

The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-
risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are
associated with high potential returns. According to the risk-return tradeoff, invested money can
render higher profits only if it is subject to the possibility of being lost. Because of the risk-
return tradeoff, one must be aware of that his personal risk tolerance when choosing
investments for his own portfolio. Taking on some risk is the price of achieving returns;
therefore, if one wants to make money, he / she can't cut out all risk. The goal instead is to find
an appropriate balance between the risk and return.

Beta and its relevance in Equity Research:

As discussed earlier, the concept of risk is hard to pin down and factor into stock analysis and
valuation. One of the most popular indicators of risk is a statistical measure called beta. Stock
analysts use this measure all the time to get a sense of stocks' risk profiles. While beta does say
something about price risk, it has its limits for investors looking for fundamental risk factors.

Beta () is a measure of a stock's volatility in relation to the market. By definition, the market has
a beta of 1.0, and individual stocks are ranked according to how much they deviate from the
market. A stock that swings more than the market over time has a beta above 1.0. If a stock
moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be
riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower

33
returns. Beta is a key component for the capital asset pricing model (CAPM), which is used to
calculate cost of equity. All things being equal, the higher a company's beta is, the higher its cost
of capital.

Where:

a = Beta value of asset a

Cov (ra, rp) = Covariance between stock a return and the market return
Var (rp) = Variance of the market return
Interpretations of beta are explained in the following table:
Table No.1.2

Value
Interpretation Example
of Beta

Asset generally moves in the opposite Gold, which often moves opposite to the
<0
direction as compared to the index movements of the stock market

Movement of the asset is uncorrelated Fixed-yield asset, whose growth is unrelated to

=0
with the movement of the benchmark the movement of the stock market

Stable, "staple" stock such as a company that

Movement of the asset is generally in
0<< makes soap. Moves in the same direction as
the same direction as, but less than the
1 the market at large, but less susceptible to day-
movement of the benchmark
to-day fluctuation.

Movement of the asset is generally in

the same direction as, and about the A representative stock, or a stock that is a
=1
same amount as the movement of the strong contributor to the index itself.
benchmark

Movement of the asset is generally in Volatile stock, such as a tech stock, or stocks
>1 the same direction as, but more than the which are very strongly influenced by day-to-
movement of the benchmark day market news.

34
Equity beta basically measures how volatile a given stocks price movement tends to be relative
to the overall markets movements. This considers companys capital structure i.e. if a company
has mode debt then it tends to be more volatile. Contrary to this we should know the other term
known as Asset Beta. This measure how volatile the underlying business is, irrespective of
capital structure. Here the beta is computed after stripping out the capital structure.

Asset beta = Equity Beta / (1+ (1-tax rate) * (debt / equity ratio))

Asset beta is important because we can compare companies and not have the comparison be
affected by their capital structure choices.

Concept of Intrinsic Value:

The actual value of a company or an asset is based on an underlying perception of its true value
including all aspects of the business, in terms of both tangible and intangible assets and other
factors. This value may or may not be the same as the current market value. Investors use a
variety of analytical techniques in order to estimate the intrinsic value of shares in hopes of
finding investments where the true value of the investment exceeds its current market value. For
example, investors will look at both qualitative (business model, governance, target market
factors etc.) and quantitative (ratios, financial statement analysis, etc.) aspects of a business in
order to arrive at the fair value than the value depicted in the stock market.

Introduction to Security Valuation:

Investors always want to select investments that will provide a rate of return that compensates
his / her for your time, the expected rate of inflation, and the risk involved. To help them to find
these investments, let us focus on the theory of valuation by which one can derive the value of an
investment using their required rate of return.

We consider the investment decision processes, which are the top-down, three-step approach.
Although it is recognized that this process can provide abnormal positive returns if the analyst is
superior, and this is a preferable approach where in one initially consider the aggregate economy
and market, then examine alternative global industries, and finally analyze individual firms and
their stocks.

35
Overview of the Investment Process:
Exhibit No.1.3

Source: Adopted from Reilly and Brown, 8th Edition.

Economic Analysis:

A top-down analysis of a firms prospects must start with the global economy. The international
economy might affect a firms export prospects, the price competition it faces from foreign
competitors, or the profits it makes on investments abroad. Certainly, despite the fact that the
economies of most countries are linked in a global macro economy, there is considerable
variation in economic performance across countries at any time. Consider, for example, Table
12.1, which presents data on several major economies. The table documents striking variation in
growth rates of economic output. For example, while the Chinese economy grew by 10.4% in
2006 (see last column), output in Japan grew by only 1.6%. Similarly, there has been
considerable variation in stock market returns in these countries in recent years.

The macro economy is the environment in which all firms operate. The importance of the
macroeconomic determining investment performance could be understood well, if we the level
of the S&P 500 stock price index to estimates of earnings per share of the S&P500 companies.
The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock
price to earnings per share varies with factors such as interest rates, risk, inflation rates, and other
variables, the graph does illustrate that, as a general rule, the ratio has tended to be in the range
of 12 to 25. Given normal price-to-earnings ratios, we would expect the S&P 500 Index to fall
within these boundaries. While the earnings-multiplier rule clearly is not perfectnote the
dramatic increase in the P/E multiple in the 1990sit also seems clear that the level of the broad
market and aggregate earnings do trend together. Thus, the first step in forecasting the
performance of the broad market is to assess the status of the economy as a whole.

The ability to forecast the macro economy can translate into spectacular investment performance.

36
But it is not enough to forecast the macro economy well. One must forecast it better than ones
competitors to earn abnormal profits. In this section, we will review some of the key economic
terms used to describe the state of the macro economy.

Monetary and fiscal policy measures enacted by various agencies of national governments
influence the aggregate economies of the respective countries. The resulting economic conditions
influence all industries and companies within the economies. Fiscal policy initiatives, such as tax
credits or tax cuts, can encourage spending, whereas additional taxes on income, gasoline,
cigarettes, and liquor can discourage spending. Increases or decreases in government spending
on defense, on unemployment insurance or retraining programs, or on highways also influence
the general economy. All such policies influence the business environment for firms that rely
directly on such government expenditures. In addition, we know that government spending has a
strong multiplier effect. For example, increases in road building increase the demand for
earthmoving equipment and concrete materials. As a result, in addition to construction workers,
the employees in those industries that supply the equipment and materials have more to spend on
consumer goods, which raise the demand for consumer goods, which affects another set of
suppliers.

Monetary policy produces similar economic changes. A restrictive monetary policy that reduces
the growth rate of the money supply reduces the supply of funds for working capital and
expansion for all businesses. Alternatively, a restrictive monetary policy that targets interest rates
would raise market interest rates and therefore firms costs and make it more expensive for
individuals to finance home mortgages and the purchase of other durable goods, such as autos
and appliances. Monetary policy therefore affects all segments of an economy and that
economys relationship with other economies.

Any economic analysis requires the consideration of inflation. Inflation causes differences
between real and nominal interest rates and changes the spending and savings behavior of
consumers and corporations. In addition, unexpected changes in the rate of inflation make it
difficult for firms to plan, which inhibits growth and innovation. Beyond the impact on the
domestic economy, differential inflation and interest rates influence the trade balance between
countries and the exchange rate for currencies.

In addition to monetary and fiscal policy actions, such events as war, political upheavals in
foreign countries, or international monetary devaluations produce changes in the business
environment that add to the uncertainty of sales and earnings expectations and therefore the risk
premium required by investors. It is difficult to conceive of any industry or company that can
avoid the impact of macroeconomic developments that affect the total economy. Because
aggregate economic events have a profound effect on all industries and companies within these
industries, these macroeconomic factors should be considered before industries are analyzed.

37
Unemployment Rate:
The unemployment rate is the percentage of the total labor force (i.e., those who are either
working or actively seeking employment) yet to find work. The unemployment rate measures the
extent to which the economy is operating at full capacity. The unemployment rate is a statistic
related to workers only, but further insight into the strength of the economy can be gleaned from
the employment rate of other factors of production. Analysts also look at the factory capacity
utilization rate, which is the ratio of actual output from factories to potential output.

Inflation:

Inflation is the rate at which the general level of prices is rising. High rates of inflation often are
associated with overheated economies, that is, economies where the demand for godsend
services is outstripping productive capacity, which leads to upward pressure on prices. Most
governments walk a fine line in their economic policies. They hope to stimulate their economies
enough to maintain nearly full employment, but not so much as to bring on inflationary
pressures. The perceived trade-off between inflation and unemployment is at the heart of many
macroeconomic policy disputes. There is considerable room for disagreement as tithe relative
costs of these policies as well as the economys relative vulnerability to these pressure sat any
particular time.

Interest Rates:

High interest rates reduce the present value of future cash flows, thereby reducing the
attractiveness of investment opportunities. For this reason, real interest rates are key
determinants of business investment expenditures. Demand for housing and high-priced
consumer durables such as automobiles, which are commonly financed, also is highly sensitive
to interest rates because interest rates affect interest payments. In Section 12.3 we will examine
the determinants of real interest rates.

Sentiment:

Consumers and producers optimism or pessimism concerning the economy is important

determinants of economic performance. If consumers have confidence in their future income
levels, for example, they will be more willing to spend on big-ticket items. Similarly, businesses
will increase production and inventory levels if they anticipate higher demand frothier products.
In this way, beliefs influence how much consumption and investment will be pursued and affect
the aggregate demand for goods and services.

Fluctuations in security markets are related to changes in the aggregate economy. The price of
most bonds is determined by the level of interest rates, which are influenced by overall economic

38
Activity and Reserve Bank of Indias policy. Individual stock prices reflect investor expectations
about an issuing firms performance in terms of earnings, cash flow, and the investors required
rate of return. This performance is likewise affected by the overall performance of the economy.
In its monitoring of business cycles, the National Council of Applied Economic Research
(NCAER) has examined the relationship of alternative economic series to the behavior of the
entire economy and has classified numerous economic series into three groups: leading,
coincident, and lagging indicator series. Further, extensive analysis of the relationship between
the economy and the stock market has shown that stock prices are one of the better leading
indicator series.

There are two possible reasons why stock prices lead the economy. One is that stock prices
Reflect expectations of earnings, dividends, and interest rates. As investors attempt to estimate
these future variables, their stock price decisions reflect expectations for future economic
activity, not current activity. A second possible reason is that the stock market reacts to various
leading indicator series, the most important being corporate earnings, corporate profit margins,
interstates, and changes in the growth rate of the money supply. Because these series tend to lead
the economy, when investors adjust stock prices to reflect expectations for these leading
economic series, it makes stock prices a leading series as well.

Because stock prices lead the aggregate economy, our macroeconomic approach to market
analysis concentrates on economic series that lead the economy by more than stock prices do.
First, let us discuss cyclical indicators includes:

a) Leading indicators
b) Coincident indicators
c) Lagging indicators

Leading indicators economic series that usually reach peaks or troughs before corresponding
peaks or troughs in aggregate economy activity

Coincident indicators economic series that have peaks and troughs that roughly coincide with
the peaks and troughs in the business cycle

Lagging indicators economic series that experience their peaks and troughs after those of the
aggregate economy

Selected series economic series that do not fall into one of the three main groups

Apart from the above, another popular index is known as Diffusion Indexes.

It indicates how pervasive a given movement in a series. Diffusion index values are measured by
computing the % of reporting units in a series that indicate a given result. For example, if 100
39
cos constitute the sample reporting new orders for equipment, the diffusion index for this series
would indicate what proportion of 100 cos was reporting higher orders during an expansion. In
addition knowing that aggregate new orders are increasing, it is helpful to know whether 55% or
95% of the companies in the sample are reporting higher orders. This information on the
pervasiveness of the increase in new orders would help you to project the future length and
strength of an expansion.

Other Economic Variables and stock prices:

The following variables to be significant in stock returns:
Growth in industrial production
Changes in the risk premium
Twists in the yield curve
Measures of unanticipated inflation
Changes in expected inflation during periods of volatile inflation

Inflation, Interest Rates, and Stock Prices:

The relationship between inflation, interest rates, and stock prices is not direct and consistent.
The reason is that the cash flows from stocks can change along with inflation and interest rates,
and we cannot be certain whether this change in cash flows will augment or offset the change in
interest rates.

The Positive Scenario:

Interest rates rise due to an increase in the rate of inflation, and corporate earnings likewise
experience an increase in growth because firms are able to increase prices in line with cost
increases. In this case, stock prices might be fairly stable because the negative effect of an
increase in the required rate of return is partially or wholly offset by the increase in the growth
rate of earnings and dividends, which means that the returns on stock increase in line with the
rate of inflation.

Mild Negative Scenario:

Interest rates increase due to inflation, but expected cash flows change very little or not at all
because firms are not able to increase prices in response to higher costs. This would cause a
decline in stock prices similar to what happens with a bond. The required rate of return would
increase, but the growth rate of dividends would be constant. As a result, the spread discussed in
would widen and stock prices would decline.

Very Negative Scenario:

Interest rates increase due to inflation, while cash flows decline because the inflation that caused
the rise in interest rates has a negative impact on earnings. For example, during 1981 to 1982,
interest rates increased and remained high during a period of economic decline, which caused
sales and earnings to decline. Alternatively, one can envision a period of inflation wherein the
40
costs of production increase, but many firms are not able to increase prices, which causes a
decline in profit margins. The impact of this set of events can be disastrous. Given this scenario,
stock prices will experience a significant decline because cost will increase as growth declines,
causing a large increase in the spread.

In contrast to these scenarios, one can envision a comparable set of scenarios when inflation and
interest rates decline. The relationship between inflation, interest rates, and stock prices is not as
direct or consistent as the relationship between interest rates and bonds. There is ample evidence
of a strong and consistent relationship between economic activity and the stock market, although
stock prices consistently seem to turn from four to nine months before the economy does.

Therefore, to project the future direction of the stock market using the macroeconomic approach,
one must either forecast economic activity about twelve months ahead or examine economic
indicator series that lead the economy by more than stock prices do. Recent studies of the
relationship between the money supply and stock prices have indicated a significant relationship
but typically found that stock prices generally turn before the money supply does.

*****

End of the chapter Questions:

1. Discuss the overall purpose people have for investing. Define investment.

2. As a student, are you saving or borrowing? Why?

3. Divide a persons life from ages 20 to 70 into 10-year segments and discuss the
likely saving or borrowing patterns during each period.

4. Discuss why you would expect the saving-borrowing pattern to differ by

occupation (for example, for a doctor versus a plumber).

5. Suppose you discover a treasure chest of Rs.10 billion in cash while digging the
agriculture land
a. Is this a real or financial asset?
b. Is society any richer for the discovery?
c. Are you wealthier?
d. Can you reconcile your answers to ( b) and ( c )? Is anyone worse off
as a result of the discovery?

6. Financial engineering has been disparaged as nothing more than paper shuffling.
Critics argue that resources used for rearranging wealth (that is, bundling and
unbundling financial assets) might be better spent on creating wealth (that is,
creating real assets). Evaluate this criticism.

41
7. Are any benefits realized by creating an array of derivative securities from various
primary securities?

8. Discuss the advantages and disadvantages of the following forms of managerial

compensation in terms of mitigating agency problems, that is, potential conflicts
of interest between managers and shareholders.
a. A fixed salary.
b. Stock in the firm.
c. Call options on shares of the firm.

9. We noted that oversight by large institutional investors or creditors is one

mechanism to reduce agency problems. Why dont individual investors in the firm
have the same incentive to keep an eye on management?

42
 CHAPTER II

INDUSTRY AND
COMPANY ANALYSIS

43
Industry analysis is the second step as we progress toward selecting specific firms and stocks for
our investment portfolio. As the first step, in Chapter 1, we discussed the microanalysis of the
stock market to decide whether the expected rate of return from investing in common stocks was
equal to or greater than our required rate of return.

What is an Industry?
An industry is a group of companies which produce similar goods and/or services.
Until recently (and often still), industries were classified by Standardized Industrial
Classification (SIC) codes, but this was replaced by the North American Industry
Classification System (NAICS, http://www.census.gov/epcd/www/naics.html) which is
much more detailed than SIC.
SIC codes were 4-digit, while the NAICS uses 6 digits for a much finer, and more useful,
breakdown of industries.
NAICS will also facilitate comparisons of companies in the US, Canada, and Mexico (it
was developed by all three countries for this purpose).
Classification by compustat (www. compustat.com)
Another popular Classification by CMIE(www.cmie.com)

Rationale for Industry Analysis:

Equity research analysts perform industry analysis because they believe it helps them isolate
investment opportunities that have favorable return-risk characteristics. Infact, it is a part of
three-step, top-down plan for valuing individual companies and selecting stocks for inclusion in
our portfolio. Based up on the large number of empirical evidences it was found that Industry
analysis is important and necessary to uncover these substantial performance differences that will
help identify both unprofitable and profitable opportunities.

Industry Performance over Time:

Whether individual industries that perform well in one time period would continue to perform
well in subsequent time periods or at least outperform the aggregate market in the later time
period. It was found that almost no association in individual industry performance year to year or
over sequential rising or falling markets. These time-series studies imply that past performance
alone does not help project future industry performance. The results do not, however, negate the
usefulness of industry analysis. They simply confirm that variables that affect industry
performance change over time and each year it is necessary to project the future performance for
individual industries on the basis of future estimates of these relevant variables.

Performance of the Companies within an Industry:

Various research studies were designed to determine whether there is consistency in the
performance of companies within an industry. If all the firms within an industry performed
consistently during a specified time period, investors would not need company analysis. In such

44
a case, industry analysis alone would be enough because once you selected a profitable industry;
you would know that all the stocks in that industry would do well. It was found wide dispersion
in the performance among companies in most industries. There is enough evidence of an industry
effect in specific industries, such as oil or autos, but most stocks showed a small industry effect
that has been declining over a period of time.

What is the implication of dispersion within Industries?

There are some observers who have contended that industry analysis is useless because all firms
in an industry do not move together. Obviously, consistent firm performance in an industry
would be ideal because you would not need to do company analysis. For industries that have a
strong, consistent industry influence, such as oil, gold, steel, autos, and railroads, one can reduce
the extent of company analysis after the industry analysis. Most analysts do not expect such a
strong industry influence, which means that a thorough company analysis is still necessary. Even
for industries that do not have a strong industry influence, industry analysis is valuable because it
is much easier to select a superior company from a good industry than to find a good company in
a poor industry. By selecting the best stocks within a strong industry, you avoid the risk that your
analysis and selection of a good company will be offset by poor industry performance.

Differences in Industry Risk:

(1) Does risk differ among industries during a given time period?
(2) Are industry risk measures stable over time?
It was found that the dispersion of risk found a wide range of risk among different industries at a
point in time, and the differences in industry risk typically widened during rising and falling
markets. The results on the analysis of risk stability were positiveanalysis of the risk measures
for individual industries over time indicated that they were reasonably stable over time. These
findings indicate that although risk measures for different industries showed substantial
dispersion during a period of time, individual industries risk measures are stable over time.
This means that the analysis of industry risk is necessary, but this analysis of risk is useful when
one attempt to estimate the future risk for an industry.

Following are the major take away from the various research works that are dealing with
industry analysis are:
During any time period, the returns for different industries vary within a wide range,
which means that industry analysis is an important part of the investment process.
The rates of return for individual industries vary over time, so we cannot simply
extrapolate past industry performance into the future.
The rates of return of firms within industries also vary, so analysis of individual
companies in an industry is a necessary follow-up to industry analysis.
During any time period, different industries risk levels vary within wide ranges, so we
must examine and estimate the risk factors for alternative industries.
Risk measures for different industries remain fairly constant over time, so the historical
risk analysis is useful when estimating future risk.
45
Steps in Industry Analysis:

How one should you structure your industry analysis? In our previous analysis of the economy
and the aggregate equity market for the country, we contended that it is necessary to examine the
macro economy for two related reasons.
First, although the security markets tend to move ahead of the aggregate economy, it is
recognized that the markets are driven by what happens in the economythat is, security
markets reflect the strength or weakness of the economy.
Second, most of the variables that drive the valuation models for the security markets are macro
variables such as interest rates, GDP, and corporate earnings.
The point is, the industry analysis process is similarit contains first a macro analysis of the
industry in order to derive a very clear understanding of how this industry relates to the business
cycle and what economic variables drive this industry in terms of success or failure. This part
of the process will make the second component easier and better. The second component is a
microanalysis of the industry that involves deriving a specific valuation for the industry using the
several valuation techniques introduced earlier. As noted, if we have done our macro analysis
so that we thoroughly understand the industry, estimating the valuation inputs of a discount rate
and expected growth for earnings and cash flows (both the rate and the duration of growth)
should be relatively easy.

Frame-Work for Industry Analysis:

1. The business cycle and industry sectors

2. Structural economic changes and alternative industries
3. Evaluating an industrys life cycle
4. Analysis of the competitive environment in an industry
THE BUSINESS CYCLE AND INDUSTRY SECTORS
Economic trends can and do affect industry performance. By identifying and monitoring key
assumptions and variables, we can monitor the economy and gauge the implications of new
information on our economic outlook and industry analysis. Recall that in order to beat the
market on a risk-adjusted basis, we must have forecasts that differ from the market consensus
and we must be correct more often than not.
Economic trends can take two basic forms:
Cyclical changes that arise from the ups and downs of the business cycle; and
Structural changes that occur when the economy is undergoing major change in how it
functions.

For example, excess labor or capital may exist in some sectors whereas shortages of labor and
capital exist elsewhere. The downsizing of corporate America during the 1990s, transitions
from socialist to market economies in Eastern Europe, and the transition in the United States
from a manufacturing to a service economy are all examples of structural change. Industry
analysts must examine structural economic changes for the implications they hold for the
46
industry under review. It is believed that industry performance is related to the stage of the
business cycle. What makes industry analysis challenging is that every business cycle is different
and those who look only at history miss the evolving trends that will determine future market
performance. Switching from one industry group to another over the course of a business cycle is
known as a rotation strategy. When trying to determine which industry groups will benefit from
the next stage of the business cycle, investors need to identify and monitor key variables related
to economic trends and industry characteristics.

Exhibit No.2.1

The above exhibit presents a stylized graphic of which industry groups typically perform well in
the different stages of the business cycle. Toward the end of a recession, financial stocks rise in
value because investors anticipate that banks earnings will rise as both the economy and loan
demand recover. Brokerage houses become attractive investments because their sales and
earnings are expected to rise as investors trade securities, businesses sell debt and equity, and
there is an increase in mergers during the economic recovery. These industry selections assume
that when the recession ends there will be an increase in loan demand, housing construction, and
security offerings.

Once the economy begins its recovery, consumer durable firms that produce expensive consumer
items, such as cars, personal computers, refrigerators, lawn tractors, and snow blowers become
attractive investments because a reviving economy will increase consumer confidence and
personal income. Once businesses recognize the economy is recovering, they begin to think
about modernizing, renovating, or purchasing new equipment to satisfy rising demand and
reduce costs. Thus, capital goods industries such as heavy equipment manufacturers, machine
tool makers, and airplane manufacturers become attractive. Cyclical industries whose sales rise
and fall along with general economic activity are attractive investments during the early stages of
an economic recovery because of their high degree of operating leverage, which means that they

47
benefit greatly from the sales increases during an economic expansion. Industries with high
financial leverage likewise benefit from rising sales volume.

Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to
outstrip supply. Basic materials industries such as oil, metals, and timber, which transform raw
Materials into finished products, become investor favorites. Because inflation has little influence
on the cost of extracting these products and they can increase prices, these industries experience
higher profit margins.

During a recession, some industries do better than others. Consumer staples, such as
pharmaceuticals, food, and beverages, outperform other sectors during a recession because,
although overall spending may decline, people still spend money on necessities so these
defensive industries generally maintain their values. Similarly, if a weak domestic economy
causes a weak currency, industries with large export components to growing economies may
benefit because their goods become more cost competitive in overseas markets.

We have identified certain industries that typically make attractive investments over the course
of the business cycle. Generally, investors should not invest based upon the current economic
environment because the efficient market has already incorporated current economic news into
security prices. Rather, it is necessary to forecast important economic variables at least thereto
six months in the future and invest accordingly.

As discussed in the earlier chapter, higher inflation is generally negative for the stock market,
because it causes higher market interest rates, it increases uncertainty about future prices and
costs, and it harms firms that cannot pass their cost increases on to consumers. Although these
adverse effects are true for most industries, some industries benefit from inflation. Natural
resource industries benefit if their production costs do not rise with inflation, because their
output will likely sell at higher prices. Industries that have high operating leverage may benefit
because many of their costs are fixed in nominal terms whereas revenues increase with inflation.
Industries with high financial leverage may also gain because their debts are repaid in cheaper
rupees. Banks generally benefit from volatile interest rates, because stable interest rates lead to
heavy competitive pressures that squeeze their interest margins. High interest rates clearly harm
the housing and the construction industry, but they might benefit industries that supply the loans.
High interest rates also benefit retirees whose income is dependent on interest income.
Therefore, the performance of consumer cyclical industries will be affected by changes in
consumer sentiment and by consumers willingness and ability to borrow and spend money.

Lifestyle:
Lifestyles deal with how people live, work, form households, consume, enjoy leisure, and
educate themselves. Consumer behavior is affected by trends and fads. The rise and fall of jeans,
designer jeans, chinos, and other styles in clothes illustrate the sensitivity of some markets to
changes in consumer tastes. The increase in divorce rates, dual-career families, population shifts
48
away from cities, and computer-based education and entertainment have influenced numerous
industries, including housing, automobiles, convenience and catalog shopping, services, and
home entertainment.

Demographics:
Influences other than the economy are part of the business environment. Demographics, changes
In technology, and political and regulatory environments will affect the cash flow and risk
prospects of different industries. Demographics also include the geographical distribution of
people, the changing ethnic mix in a society, and changes in income distribution. Wall Street
industry analysts carefully study demographic trends and attempt to project their effect on
different industries and firms. The changing age and education profile of Indians has
implications for resource availability; namely, availability of labour force of entry-level workers
leading to an increase in productivity and more employment especially in software industries this
is good for the financial services industry, which offers assistance to those who want to invest
their savings.

Technologies:
Trends in technology can affect numerous industry factors including the product or service and
how it is produced and delivered. There are literally dozens of examples of changes that have
taken or are taking place due to technological innovations. For example, demand has fallen for
carburetors on cars because of electronic fuel-injection technology. The engineering process has
changed because of the advent of computer-aided design and computer-aided manufacturing.
Perpetual improvement of designs in the semiconductor and microprocessor industry has made
that industry a difficult one to evaluate. Innovations in process technology allowed steel mint
mills to grow at the expense of large steel producers. Advances in technology allow some plant
sites and buildings to generate their own electricity, bypassing their need for power from the
local electric utility. Trucks have reduced railroads market share in the long-distance carrier
industry, and planes, not trains, now mainly carry people long distances. The information
superhighway is becoming a reality and may lead to linkages between telecommunications and
cable television systems.

Changes in technology have spurred capital spending in technological equipment as firms try to
use microprocessors and software as a means to gain competitive advantages. The future effect
of the Internet is astronomical. The retailing industry is a user of new technology. Some
forecasters envision relationship merchandising, in which customer databases will allow closer
links between retail stores and customer needs. Rather than doing market research to focus on
aggregate consumer trends, specialized retailers can offer products that particular consumer
segments desire in the locations that consumers prefer. Technology may allow retailers to
become more organizationally decentralized and geographically diversified.

Major retailers use bar-code scanning, which speeds the checkout process and allows the firm to
track inventory. Use of customer credit cards allows firms to track customer purchases and send
49
custom-made sales announcements. Electronic data interchange (EDI) allows the retailer to
electronically communicate with suppliers to order new inventory and pay accounts payable.
Electronic funds transfer allows retailers to move funds quickly and easily between local banks
and headquarters.

Politics and Regulations:

As political change reflects social values, todays social trend may be tomorrows law,
regulation, or tax. The industry analyst needs to project and assess political changes relevant to
the industry under study. Some regulations and laws are based on economic reasoning. Due to
utilities positions as natural monopolies, their rates must be reviewed and approved by a
regulatory body. Some regulation involves social ends. For example, the Food and Drug
Administration protects consumers by reviewing new drugs. Public and worker safety concerns
spurred creation of the Consumer Protection awareness which lead to Consumer Protection Act,
1986, and the various Environmental Protection Acts and the like. Notably, heavy regulation of
an industry can result in increasing a firms costs and restricting entry into the industry.

Understanding Industry Life Cycle:

An insightful analysis when predicting industry sales and trends in profitability is to view the
industry over time and divide its development into stages similar to those that humans progress
through as they move from birth to adolescence to adulthood to middle age to old age. The
number of stages in this industry life cycle analysis can vary based on how much detail one want.

Exhibit No.2.2

Source: Adopted from Reilly and Brown, 8th Edition.

50
A five-stage model would include:

1. Pioneering development
2. Rapid accelerating growth
3. Mature growth
4. Stabilization and market maturity
5. Deceleration of growth and decline

ExhibitNo.2.2shows the growth path of sales during each stage. The vertical scale in logs reflects
rates of growth, whereas the arithmetic horizontal scale has different widths representing
different, unequal time periods. To estimate industry sales, you must predict the length of time
for each stage. This requires answers to such questions as: How long will an industry grow at an
accelerating rate (Stage 2)? How long will it be in a mature growth phase (Stage 3) before its
sales growth stabilizes (Stage 4) and then declines (Stage 5)?

Besides being useful when estimating sales, this analysis of an industrys life cycle also can
provide some insights into profit margins and earnings growth, although these profit measures do
not necessarily parallel the sales growth. The profit margin series typically peaks very early in
the total cycle and then levels off and declines as competition is attracted by the early success of
the industry. To illustrate the contribution of life cycle stages to sales estimates, let us see these
stages and their effects on sales growth and profits:

Examine the biotechnology industry and you will find many firms with high rates of investment,
high rates of return on investment, and very low dividends as a percentage of profits. Do the
same for the electric utility industry and you will find lower rates of return, lower investment
rates, and higher dividend payout rates.

Why should this be?

The biotech industry is still new. Recently available technologies have created opportunitiesfor
the highly profitable investment of resources. New products are protected by patents, and profit
margins are high. With such lucrative investment opportunities, firms find it advantageousto put
all profits back into the firm. The companies grow rapidly on average.Eventually, however,
growth must slow. The high profit rates will induce new firms to enter the industry. Increasing
competition will hold down prices and profit margins. New technologies become proven and
more predictable, risk levels fall, and entry becomes even easier. As internal investment
opportunities become less attractive, a lower fraction of profits is reinvested in the firm. Cash
dividends increase.
FIGURE 12.11
Ultimately, in a mature industry, we observe cash cows, firms with stable dividends and cash
flows and little risk. Their growth rates might be similar to that of the overall economy.
Industries in early stages of their life cycles offer high-risk/high-potential-return investments.
Mature industries offer lower risk, lower return combinations. This analysis suggests that a
typical industry life cycle might be described by four stages: a start-up stage characterized by
extremely rapid growth; a consolidation stage characterized by growth that is less rapid but still
51
faster than that of the general economy; a maturity stage characterized by growth no faster than
the general economy; and a stage of relative decline, in which the industry grows less rapidly
than the rest of the economy, or actually shrinks. This industry life cycle is illustrated in Exhibit
No.2.2. Let us turn to an elaboration of each of these stages.

Pioneering development:
The early stages of an industry are often characterized by a new technology or product, such as
VCRs or personal computers in the 1980s, cell phones in the 1990s, or flat-screen televisions
today. At this stage, it is difficult to predict which firms will emerge as industry leaders. Some
firms will turn out to be wildly successful, and others will fail altogether. Therefore, there is
considerable risk in selecting one particular firm within the industry.

For example, in the flat-screen television industry, there is still a battle among competing
technologies, such as LCD versus plasma screens, and it is still difficult to predict which firms
or technologies ultimately will dominate the market. At the industry level, however, sales and
earnings will grow at an extremely rapid rate since the new product has not yet saturated its
market.

For example, in 1990 very few households had cell phones. The potential market for the product
therefore was huge. In contrast to this situation, consider the market for a mature product like
refrigerators. Almost all households in India already have refrigerators, so the market for this
good is primarily composed of households replacing old refrigerators. Obviously, the growth rate
in this market in the next decade will be far lower than for flat-screen TVs.

Rapid accelerating growth:

After a product becomes established, industry leaders begin to emerge. The survivors from the
start-up stage are more stable, and market share is easier to predict. Therefore, the performance
of the surviving firms will more closely track the performance of the overall industry. The
industry still grows faster than the rest of the economy as the product penetrates the marketplace
and becomes more commonly used.

Mature growth:
At this point, the product has reached its potential for use by consumers. Further growth might
merely track growth in the general economy. The product has become far more standardized, and
producers are forced to compete to a greater extent on the basis of price. This leads to narrower
profit margins and further pressure on profits. Firms at this stage sometimes are characterized as
cash cows, firms with reasonably stable cash flow but offering little opportunity for profitable
expansion. The cash flow is best milked from rather than reinvested in the company.

We pointed to VCRs as a start-up industry in the 1980s. By the mid-1990s it was a mature
industry, with high market penetration, considerable price competition, low profit margins, and
52
slowing sales. By the late 1990s, VCR sales were giving way to DVD players, which were in
their own start-up phase. By today, one would have to judge DVDs as already having entered a
maturity stage, with standardization, price competition, and considerable market penetration.

Deceleration of growth and decline:

In this stage, the industry might grow at less than the rate of the overall economy, or it might
even shrink. This could be due to obsolescence of the product, competition from new products,
or competition from new low-cost suppliers, as illustrated by the steady displacement of VCRs
by DVDs.
At which stage in the life cycle are investments in an industry most attractive? Conventional
wisdom is that investors should seek firms in high-growth industries. This recipe for success is
simplistic, however. If the security prices already reflect the likelihood for high growth, then it is
too late to make money from that knowledge. Moreover, high growth and fat profits encourage
competition from other producers. The exploitation of profit opportunities brings about new
sources of supply that eventually reduce prices, profits, investment returns, and finally, growth.
This is the dynamic behind the progression from one stage of the industry life cycle to another.
The famous portfolio manager Peter Lynch makes this point in One Upon Wall Street. He says:
Many people prefer to invest in a high-growth industry, where theres a lot of sound and fury.
Not me. I prefer to invest in a low-growth industry. . . . In a low-growth industry, especially one
thats boring and upsets people [such as funeral homes or the oil-drum retrieval business], theres
no problem with competition. You dont have to protect your flanks from potential rivals . . . and
this gives [the individual firm] the leeway to continue to grow.

In fact, Lynch uses an industry classification system in a very similar spirit to the lifecycle
approach we have described. He places firms in the following six groups:

1. Slow Growers:

Large and aging companies that will grow only slightly faster than the broad economy. These
firms have matured from their earlier fast-growth phase. They usually have steady cash flow and
pay a generous dividend, indicating that the firm is generating more cash than can be profitably
reinvested in the firm.

2. Stalwarts:

Large, well-known firms like Coca-Cola or Colgate-Palmolive. They grow faster than the slow
growers but are not in the very rapid growth start-up stage. They also tend to be in noncyclical
industries that are relatively unaffected by recessions.

53
3. Fast Growers:

Small and aggressive new firms with annual growth rates in the neighborhood of 20 to 25%.
Company growth can be due to broad industry growth or to an increase in market share in a more
mature industry.

4. Cyclicals:

These are firms with sales and profits that regularly expand and contract along with the business
cycle. Examples are auto companies, steel companies, or the construction industry.

5. Turnarounds:

These are firms that are in bankruptcy or soon might be. If they can recover from what might
appear to be imminent disaster, they can offer tremendous investment returns. A good example
of this type of firm would be Chrysler in 1982, when it required a government guarantee on its
debt to avoid bankruptcy. The stock price rose fifteen-fold in the next five years.

6. Asset Plays:

These are firms that have valuable assets not currently reflected in the stock price. For example,
a company may own or be located on valuable real estate that is worth as much or more than the
companys business enterprises. Sometimes the hidden asset can be tax-loss carry forwards.
Other times the assets may be intangible. For example, a cable company might have a valuable
list of cable subscribers. These assets do not immediately generate cash flow and so may be more
easily overlooked by other analysts attempting to value the firm.

Porters Five Forces:

Let us understand Porters concept of competitive strategy is described as the search by a firm
for a favorable competitive position in an industry. To create a profitable competitive strategy, a
firm must first examine the basic competitive structure of its industry because the potential
profitability of affirm is heavily influenced by the profitability of its industry. After determining
the competitive structure of the industry, you examine the factors that determine the relative
competitive position of a firm within its industry. In this section, we consider the competitive
forces that determine the competitive structure of the industry. In the next chapter, our discussion
of company analysis will cover the factors that determine the relative competitive position of a
firm within its industry.

Porter believes that the competitive environment of an industry (the intensity of competition
among the firms in that industry) determines the ability of the firms to sustain above-average
rates of return on invested capital. As shown in Exhibit No.2.3, he suggests that five competitive
forces determine the intensity of competition and that the relative effect of each of these five
factors can vary dramatically among industries.

54
Exhibit No.2.3

1. Rivalry among the existing competitors.

For each industry analyzed, you must judge if the rivalry among firms is currently intense and
growing, or if it is polite and stable. Rivalry increases when many firms of relatively equal size
compete in an industry. When estimating the number and size of firms, be sure to include foreign
competitors. Further, slow growth causes competitors to fight for market share and increases
competition. High fixed costs stimulate the desire to sell at the full capacity, which can lead to
price cutting and greater competition. Finally, look for exit barriers, such as specialized facilities
or labor agreements. These can keep firms in the industry despite below-average or negative
rates of return.

2. Threat of new entrants.

Although an industry may have few competitors, you must determine the likelihood of firms
entering the industry and increasing competition. High barriers to entry, such as low current
prices relative to costs, keep the threat of new entrant slow. Other barriers to entry include the
need to invest large financial resources to compete and the availability of capital. Also,
substantial economies of scale give a current industry member an advantage over a new firm.
Further, entrants might be discouraged if success in the industry requires extensive distribution
channels that are hard to build because of exclusive distribution contracts. Similarly, high costs
of switching products or brands, such as those required to change a computer or telephone
system, keep competition low. Finally, government policy can restrict entry by imposing
licensing requirements or limiting access to materials (lumber, coal). Without some of these
barriers, it might be very easy for competitors to enter an industry, increasing the competition
and driving down potential rates of return.

3. Threat of substitute products:

Substitute products limit the profit potential of an industry because they limit the prices firms in
an industry can charge. Although almost everything has a substitute, you must determine how
close the substitute is in price and function tithe product in your industry. As an example, the
55
threat of substitute glass containers hurts the metal container industry. Glass containers kept
declining in price, forcing metal container prices and profits down. In the food industry,
consumers constantly substitute between beef, pork, chicken, and fish. The more commodity like
the product, the greater the competition and the lower the profit margins.

4. Bargaining power of buyers:

Buyers can influence the profitability of an industry because they can bid down prices or demand
higher quality or more services by bargaining among competitors. Buyers become powerful
when they purchase a large volume relative to the sales of a supplier (e.g., Wal-Mart, Home
Depot). The most vulnerable firm is a one customer firm that supplies a single large
manufacturer, as is common for auto parts manufacturers or software developers. Buyers will be
more conscious of the costs of items that represent a significant percentage of the firms total
costs. This consciousness increases if the buying firm is feeling cost pressure from its customers.
Also, buyers who know a lot about the costs of supplying an industry will bargain more
intenselyfor example, when the buying firm supplies some of its own needs and buys from the
outside.

5. Bargaining power of suppliers:

Suppliers can alter future industry returns if they increase prices or reduce the quality of the
product or the services they provide. The suppliers are more powerful if they are few and if they
are more concentrated than the industry to which they sell and if they supply critical inputs to
several industries for which few, if any, substitutes exist. In this instance, the suppliers are free to
change prices and services they supply to the firms in an industry. When analyzing supplier
bargaining power, be sure to consider labors power within each industry. An investor needs to
analyze these competitive forces to determine the intensity of the competition in an industry and
assess the effect of this competition on the industrys long-run profit potential. One should
examine each of these factors and develop a relative competitive profile for each industry. You
need to update this analysis of an industrys competitive environment overtime, because an
industrys competitive structure can and will change over time.

Company Analysis:

At this point, you have made two decisions about your investment in equity markets. First, after
analyzing the economy you have decided what percent of your portfolio should be invested in
common stocks. Second, after analyzing various industries, you have identified those that appear
to offer above-average risk-adjusted performance over your investment horizon. The final
questions in the fundamental analysis procedure are:
(1) Which are the best companies within these desirable industries? and
(2) Are their stocks underpriced?

In order to answer the question number one, we need to understand the concept of SWOT
analysis and related aspects.
56
SWOT ANALYSIS:

This is the most renowned tool for audit and analysis of the overall strategic position of the
business and its environment. Its key purpose is to identify the strategies that will create a firm
specific business model that will best align an organizations resources and capabilities to the
requirements of the environment in which the firm operates. In other words, it is the foundation
for evaluating the internal potential and limitations and the probable/likely opportunities and
threats from the external environment. It views all positive and negative factors inside and
outside the firm that affect the success. A consistent study of the environment in which the firm
operates helps in forecasting/predicting the changing trends and also helps in including them in
the decision-making process of the organization.

SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats. By definition,

Strengths (S) and Weaknesses (W) are considered to be internal factors over which you have
some measure of control. Also, by definition, Opportunities (O) and Threats (T) are considered
to be external factors over which you have essentially no control.

An overview of the four factors (Strengths, Weaknesses, Opportunities and Threats) is given
below:

Strengths:

Strengths are the qualities that enable us to accomplish the organizations mission. These are the
basis on which continued success can be made and continued/sustained. Strengths can be either
tangible or intangible. These are what you are well-versed in or what you have expertise in, the
traits and qualities your employees possess (individually and as a team) and the distinct features
that give your organization its consistency. Strengths are the beneficial aspects of the
organization or the capabilities of an organization, which includes human competencies, process
capabilities, financial resources, products and services.

Weaknesses:

Weaknesses are the qualities that prevent us from accomplishing our mission and achieving our
full potential. These weaknesses deteriorate influences on the organizational success and growth.
Weaknesses are the factors which do not meet the standards we feel they should meet.
Weaknesses in an organization may be depreciating machinery, insufficient research and
development facilities, narrow product range, poor decision-making, etc. Weaknesses are
controllable. They must be minimized and eliminated. For instance - to overcome obsolete
machinery, new machinery can be purchased. Other examples of organizational weaknesses are
huge debts, high employee turnover, complex decision making process, narrow product range,
large wastage of raw materials, etc.

57
Opportunities:

Opportunities are presented by the environment within which our organization operates. These
arise when an organization can take benefit of conditions in its environment to plan and execute
strategies that enable it to become more profitable. Organizations can gain competitive
advantage by making use of opportunities. Organization should be careful and recognize the
opportunities and grasp them whenever they arise. Selecting the targets that will best serve the
clients while getting desired results is a difficult task. Opportunities may arise from market,
competition, industry/government and technology. Increasing demand for telecommunications
accompanied by deregulation is a great opportunity for new firms to enter telecom sector and
compete with existing firms for revenue.

Threats:

Threats arise when conditions in external environment jeopardize the reliability and profitability
of the organizations business. They compound the vulnerability when they relate to the
weaknesses. Threats are uncontrollable. When a threat comes, the stability and survival can be at
stake. Examples of threats are - unrest among employees; ever changing technology; increasing
competition leading to excess capacity, price wars and reducing industry profits, etc.

SWOT Analysis Framework:

Exhibit No.2.4

Limitations of SWOT Analysis:

SWOT Analysis is not free from its limitations. It may cause organizations to view
circumstances as very simple because of which the organizations might overlook certain key
strategic contact which may occur. Moreover, categorizing aspects as strengths, weaknesses,
opportunities and threats might be very subjective as there is great degree of uncertainty in
market. SWOT Analysis does stress upon the significance of these four aspects, but it does not
tell how an organization can identify these aspects for itself.
58
There are certain limitations of SWOT Analysis which are not in control of management. These
include:

a. Price increase;
b. Inputs/raw materials;
c. Government legislation;
d. Economic environment;
e. Searching a new market for the product which is not having overseas market due to
import restrictions; etc.

Internal limitations may include:

a. Insufficient research and development facilities;

b. Faulty products due to poor quality control;
c. Poor industrial relations;
d. Lack of skilled and efficient labour and the like.

Understanding Financial Statements and Analysis:

What is the need to understand and analyze financial statements?

To answer this very reasonable question, we need to recall the process of investing. Early on, the
point was made that our ultimate goal is to construct a portfolio of investments that will provide
rates of return that are consistent with the risk involved with the portfolio. In turn, to determine
the expected rates of return on alternative assets, it is necessary to estimate the future value of
the asset since a major component of the rate of return is the change in value for the asset over
time. Therefore, the crux of investments is valuation! While we will consider alternative
valuation models in the next chapter, you are already aware from prior coursework that the value
of any earning asset is the present value of the expected cash flows generated by the asset.
Therefore, to estimate the value of an asset, you must derive an estimate of
(1) the discount rate for the asset (your required rate of return) and
(2) its expected cash flows.

The point is, the main source of information that will help you make these two estimates is the
financial statements. To derive an estimate of your required rate of return, you need to
understand the business and financial risk of the firm, which is specifically considered in this
chapter. To estimate future cash flows, you must understand the composition of cash flows and
what will contribute to the short-run and long-run growth of this series. Financial statements are
also the main source of information when deciding whether to lend money to a firm (invest in its
bonds) or to buy warrants or options on a firms stock. We will also discuss about the financial
ratios and how to use them effectively. Financial statements are intended to provide information

59
on the resources available to management, how these resources were financed, and what the firm
accomplished with them.

Corporate shareholder annual and quarterly reports include three required financial statements:
the balance sheet, the income statement, and the statement of cash flows. In addition, reports that
must be filed with the Securities and Exchange Board of India (SEBI) carry detailed information
about the firm, such as information on loan agreements and data on product line and subsidiary
performance. Information from the basic financial statements can be used to calculate financial
ratios and to analyze the operations of the firm to determine what factors influence a firms
earnings, cash flows, and risk characteristics.

Major Financial Statements:

The Income Statement

The income statement or profit and loss account is a summary of the profitability of the firm
over a period of time, such as a year. It presents revenues generated during the operating period,
the expenses incurred during that same period, and the companys net earnings or profits, which
are simply the difference between revenues and expenses. It is useful to distinguish among four
broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing
the product sold by the firm; general and administrative expenses, which correspond to overhead
expenses, salaries, advertising, and other costs of operating the firm that are not directly
attributable to production; interest expense on the firms debt; and taxes on earnings owed to
federal and local governments.

60
Table No.2.1 presents a 2012 income statement for Tata Steel Ltd.
Table No.2.1
Tata Steel Ltd
Income Statement for the year ended
31st March 2012
Mar 12
(Rs.in Crs)
INCOME :
Sales Turnover 37,005.71
Excise Duty 3,072.25
Net Sales 33,933.46
Other Income 1,397.44
Stock Adjustments 220.72
Total Income 35,551.62
EXPENDITURE :
Raw Materials 8,223.89
Power & Fuel Cost 1,990.16
Employee Cost 3,047.26
Other Manufacturing Expenses 4,555.30
Selling and Administration Expenses 3,240.10
Miscellaneous Expenses 2,038.93
Less: Pre-operative Expenses Capitalised 478.23
Total Expenditure 22,617.41
Operating Profit 12,934.21
Interest 1,925.42
Gross Profit 11,008.79
Depreciation 1,151.44
Profit Before Tax 9,857.35
Tax 3,115.11
Fringe Benefit tax 0
Deferred Tax 45.82
Reported Net Profit 6,696.42
Extraordinary Items 603.66
Adjusted Net Profit 6,092.76
Adjst. below Net Profit -174.17
P & L Balance brought forward 16,639.46
Appropriations 2,016.67
P & L Balance carried down 21,145.04
Dividend 1,165.46
Preference Dividend 0
Equity Dividend % 120
Earnings Per Share-Unit Curr 67.07
Earnings Per Share(Adj)-Unit Curr
Book Value-Unit Curr 541.7
Source: www.capitaline.com

61
 At the top are revenues from standard operations. Next come operating expenses, the costs
incurred in the course of generating these revenues, including a depreciation allowance. The
difference between operating revenues and operating costs is called operating income. Income
from other, primarily nonrecurring, sources is then added to obtain earnings before interest and
taxes (EBIT),which is what the firm would have earned if not for obligations to its creditors and
the tax authorities. EBIT is a measure of the profitability of the firms operations abstracting
from any interest burden attributable to debt financing. The income statement then goes on to
subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax due
the government is subtracted to arrive at net income, the bottom line of the income statement.

The Balance Sheet

While the income statement provides a measure of profitability over a period of time, the
balance sheet provides a snapshot of the financial condition of the firm at a particular time.
The balance sheet is a list of the firms assets and liabilities at that moment. The difference in
assets and liabilities is the net worth of the firm, also called stockholders equity or, equivalently,
shareholders equity. Like income statements, balance sheets are reasonably standardized in
presentation. Table No.2.2 is Tata Steels balance sheet for year-end 2012.

62
Table No.2.2
Tata Steel Ltd
Balance Sheet as on 31st March 2012

Rs in Cr
SOURCES OF FUNDS :
Share Capital 971.41
Reserves Total 51,649.95
Equity Share Warrants 0
Equity Application Money 0.17
Total Shareholders Funds 52,621.53
Secured Loans 1,915.47
Unsecured Loans 24,256.78
Total Debt 26,172.25
Other Liabilities 4,342.35
Total Liabilities 83,136.13
APPLICATION OF FUNDS :
Gross Block 23,485.63
Less : Accumulated Depreciation 11,986.17
Less:Impairment of Assets 133.2
Net Block 11,366.26
Lease Adjustment 0
Capital Work in Progress 16,058.49
Investments 50,282.52
Current Assets, Loans & Advances
Inventories 4,858.99
Sundry Debtors 904.08
Cash and Bank 3,946.99
Loans and Advances 1,950.27
Total Current Assets 11,660.33
Less : Current Liabilities and Provisions
Current Liabilities 10,018.18
Provisions 2,066.24
Total Current Liabilities 12,084.42
Net Current Assets -424.09
Miscellaneous Expenses not written off 0
Deferred Tax Assets 1,017.27
Deferred Tax Liability 1,987.78
Net Deferred Tax -970.51
Other Assets 6,823.46
Total Assets 83,136.13
Contingent Liabilities 4,861.47
source:www.capitlaline.com

63
The first section of the balance sheet gives a listing of the assets of the firm. Current assets are
presented first. These are cash and other items such as accounts receivable or inventories that
will be converted into cash within one year. Next comes a listing of long-term or fixed assets,
which usually consists primarily of the companys property, plant, and equipment. The liability
and shareholders equity section is arranged similarly. Listed first are short-term or current
liabilities, such as accounts payable, accrued taxes, and debts that are due within one year. Long-
term debt and other liabilities due in more than a year follow. The difference between total assets
and total liabilities is shareholders equity. This is the net worth or book value of the firm.
Shareholders equity is divided into par value of stock, capital surplus (additional paid-in
capital), and retained earnings, although this division is usually unimportant. Briefly, par value
plus capital surplus represents the proceeds realized from the sale of stock to the public, while
retained earnings represent the buildup of equity from profits plowed back into the firm. Even if
the firm issues no new equity, book value will increase each year due to reinvested earnings.

The Statement of Cash Flows

The income statement and balance sheets are based on accrual methods of accounting, which
means revenues and expenses are recognized at the time of a sale even if no cash has yet been
exchanged. In contrast, the statement of cash flows recognizes only transactions in which cash
changes hands. For example, if goods are sold now, with payment due in 60 days, the income
statement will treat the revenue as generated when the sale occurs, and the balance sheet will be
immediately augmented by accounts receivable, but the statement of cash flows will not
recognize the transaction until the bill is paid and the cash is in hand.

64
Table No.2.3 shows the statement of cash flows for Tata Steel for the year 2012.

Table No.2.3
Tata Steel Ltd

Cash Flow Statement For the Year Ended 31-03-12

(Rs in Crs)
Cash and Cash Equivalents at Beginning of the year 4102.52
Net Cash from Operating Activities 10256.47
Cash Flow From Operating Activities
Net Profit before Tax & Extraordinary Items 9857.35
Adjustment For
Depreciation 1151.44
Interest (Net) 1061.59
Dividend Received -117.5
P/L on Sales of Assets 52.98
P/L on Sales of Invest -511.01
Prov. & W/O (Net) 1.7
P/L in Forex 283.59
Others 48.82
Total Adjustments (PBT & Extraordinary Items) 1971.61
Op. Profit before Working Capital Changes 11828.96
Adjustment For
Trade & 0th receivables 1425.86
Inventories -905.23
Trade Payables 1205.36
Total (OP before Working Capital Changes) 1725.99
Cash Generated from/(used in) Operations 13554.95
Direct Taxes Paid -3298.48
Total-others -3298.48
Cash Flow before Extraordinary Items 10256.47
Net Cash Used in Investing Activities -2859.11
Cash Flow from Investing Activities
Investment in Assets :
Purchased of Fixed Assets -7059.2
Sale of Fixed Assets 9.19
Financial/Capital Investment :
Purchase of Investments -2597.33
Sale of Investments 2802.29
Interest Received 447.5
Dividend Received 117.5
Inter Corporate Deposits 3420.94
Net Cash Used in Financing Activities -7599.35
Cash Flow From Financing Activities
Proceeds:
Proceeds from Issue of shares (incl share premium) 536.12
Proceed from 0ther Long Term Borrowings 2317.43
Payments:
Of the Long Tem Borrowings -8212.56
Dividend Paid -1151.06
Interest Paid -1593.2
Others 503.92
Net Cash Used in Financing Activities -7599.35
Net Inc/(Dec) in Cash and Cash Equivalent -201.99
Cash and Cash Equivalents at End of the year 3900.53
Source:www.capitaline.com

65
The first entry listed under cash flows from operations is net income. The following entries
modify that figure for components of income that have been recognized but for which cash has
not yet changed hands. Increases in accounts receivable, for example, mean income has been
claimed on the income statement, but cash has not yet been collected. Hence, increases in
accounts receivable reduce the cash flows realized from operations in this period. Similarly,
increases in accounts payable mean expenses have been incurred, but cash has not yet left the
firm. Any payment delay increases the companys net cash flows in this period.

-Another major difference between the income statement and the statement of cash flows
involves depreciation, which accounts for a substantial addition in the adjustment section of the
statement of cash flows in Table No.2.3. The income statement attempts to smooth large
capital expenditures over time. The depreciation expense on the income statement is a way of
doing this by recognizing capital expenditures over a period of many years rather than at the
specific time of those expenditures. In contrast, the statement of cash flows recognizes the cash
implication of a capital expenditure when it occurs. It will ignore the depreciation expense
over time but will account for the full capital expenditure when it is paid.

Rather than smooth or allocate expenses over time, as in the income statement, the statement of
cash flows reports cash flows separately for operations, investing, and financing activities. This
way, any large cash flows such as those for big investments can be recognized as such without
affecting the measure of cash flow generated by operating activities. The second section of the
statement of cash flows is the accounting of cash flows from investing activities. These entries
are investments in the assets necessary for the firm to maintain or enhance its productive
capacity.

Accounting Vs Economic Earnings

Stock valuation models (which we will discuss shortly) require a measure of economic earnings
or sustainable cash flow that can be paid out to stockholders without impairing the productive
capacity of the firm. In contrast, accounting earnings are affected by several conventions
regarding the valuation of assets such as inventories (e.g., LIFO versus FIFO treatment) and by
the way some expenditure such as capital investments are recognized over time (as depreciation
expenses). We will discuss problems with some of these accounting conventions in greater detail
later in the chapter. In addition to these accounting issues, as the firm makes its way through the
business cycle, its earnings will rise above or fall below the trend line that might more accurately
reflect sustainable economic earnings. This introduces an added complication in interpreting net
income figures. One might wonder how closely accounting earnings approximate economic
earnings and, correspondingly, how useful accounting data might be to investors attempting to
value the firm.

In fact, the net income figure on the firms income statement does convey considerable
information concerning a firms products. We see this in the fact that stock prices tend to
increase when firms announce earnings greater than market analysts or investors had anticipated.
66
Profitability measures focus on the firms earnings. To facilitate comparisons across firms, total
earnings are expressed on a per-dollar-invested basis. So return on equity (ROE), which
measures profitability for contributors of equity capital, is defined as (after-tax) profits divided
by the book value of equity. Similarly, return on assets (ROA), which measures profitability for
all contributors of capital, is defined as earnings before interest and taxes divided by total assets.
Not surprisingly, ROA and ROE are linked, but as we will see shortly, the relationship between
them is affected by the firms financial policies.

Let us focus more into the Ratio Analysis and its relevance:

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values
taken from a companys financial statements. Often used in accounting, there are many standard
ratios used to try to evaluate the overall financial condition of a corporation or other
organization. Financial ratios may be used by managers within a firm, by current and
potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use
financial ratios to compare the strengths and weaknesses in various companies. If shares in a
company are traded in a financial market, the market price of the shares is used in certain
financial ratios.

Ratios are classified differently by different experts in the literature. Let us discuss few
interesting classification which are essential for research analysts.

Activity Ratios:
Companies will typically try to turn their production into cash or sales as fast as possible because
this will generally lead to higher revenues. Such ratios are frequently used when performing
fundamental analysis on different companies. The total assets turnover ratio and inventory
turnover ratio are two popular examples of activity ratios used widely across most industries.
Average collection period:

The above ratio basically measures in an average within how many days the credit sales are
being collected from the customers. For example, the average credit periods of credit given to
customers are 40 days and average collection period shows 60 days, it shows some deficiency
with our collection process or mechanics.

Average payment period:

67
Average payment period basically measures in average how many days of credit being given by
our suppliers to pay their bills.
Asset turnover ratio:

This ratio measures how effectively the assets were being used by the company for generating
sales. For instance if the asset turnover ratio is 10x, which means that with an asset base Rs.10,
sales were generated to the tune of 10 times i.e.Rs.100.
Stock turnover ratio:

This is a ratio showing how many times a company's inventory is sold and replaced over a
period. This ratio should be compared against industry averages. A low turnover implies poor
sales and, therefore, excess inventory. A high ratio generally implies strong sales.

Solvency Ratio:
One of many ratios used to measure a company's ability to meet long-term obligations. The
solvency ratio measures the size of a company's after-tax income, excluding non-cash
depreciation expenses, as compared to the firm's total debt obligations. It provides a
measurement of how likely a company will be to continue meeting its debt obligations.
The measure is usually calculated as follows:

Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a
solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the
lower a company's solvency ratio, the greater the probability that the company will default on its
debt obligations.

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial
leverage.

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Debt Ratio:

In the above ratio, generally the term liabilities means and includes only liabilities payable to
the outsiders (external liability). This ratio indicates how much is the value of the assets that the
company holds against the liabilities payable to the outsiders.

Long-term Debt to Equity Ratio:

The above ratio indicates the companys long term debt (including the value of leases) to the
average share-holders equity.

Interest Coverage Ratio:

This ratio basically explains how many times a companys earnings covers its interest expenses.
Normally, this ratio is considered by the lenders in order to assess the financial soundness of the
company with reference it repayment capacity.

Or

Market ratios or Valuation Ratios:

Market ratios measure investor response to owning a company's stock and also the cost of
issuing stock. These are concerned with the return on investment for shareholders, and with the
relationship between return and the value of an investment in companys shares.

Earnings Per Share (EPS)

69
Earnings per share are generally considered to be the single most important variable in
determining a share's price. It is also a major component used to calculate the price-to-earnings
valuation ratio. For example, assume that a company has a net income of Rs25 million. If the
company pays out Rs1 million in preferred dividends and has 10 million shares for half of the
year and 15 million shares for the other half, the EPS would be Rs1.92 (24/12.5). First, the
Rs1million is deducted from the net income to get Rs24 million, then a weighted average is
taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the
earnings (net income) in the calculation. Two companies could generate the same EPS number,
but one could do so with less equity (investment) - that company would be more efficient at
using its capital to generate income and, all other things being equal, would be a "better"
company. Investors also need to be aware of earnings manipulation that will affect the quality of
the earnings number. It is important not to rely on any one financial measure, but to use it in
conjunction with statement analysis and other measures.

Dividend Payout Ratio:

The percentage of earnings paid to shareholders in dividends. calculated as:

The payout ratio provides an idea of how well earnings support the dividend payments. More
mature companies tend to have a higher payout ratio.

Price Earning Ratio or P/E Ratio:

A valuation ratio of a company's current share price compared to its per-share earnings.
It is calculated as:

Market Value per Share

Earnings per Share (EPS)

For example, if a company is currently trading at Rs43 a share and earnings over the last 12
months were Rs1.95 per share, the P/E ratio for the stock would be 22.05 (Rs43/Rs1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
70
estimates of earnings expected in the next four quarters (projected or forward P/E). A third
variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

This ratio is also sometimes known as "price multiple" or "earnings multiple".

Forward P/E Ratio:

A measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation.
While the earnings used are just an estimate and are not as reliable as current earnings data, there
is still benefit in estimated P/E analysis. The forecasted earnings used in the formula can either
be for the next 12 months or for the next full-year fiscal period. This is also referred to as
"estimated price to earnings".

The estimated P/E of a company is often used to compare current earnings to estimated future
earnings. If earnings are expected to grow in the future, the estimated P/E will be lower than the
current P/E. This measure is also used to compare one company to another with a forward-
looking focus.

Trailing P/E Ratio:

The sum of a company's price-to-earnings, calculated by taking the current stock price and
dividing it by the trailing earnings per share for the past 12 months. This measure differs from
forward P/E, which uses earnings estimates for the next four quarters.

The trailing P/E ratio is calculated as follows:

This is the most commonly used P/E measure because it is based on actual earnings and,
therefore, is the most accurate. However, stock prices are constantly moving while earnings
remain fixed. As a result, forward P/E can sometimes be more relevant to investors when
valuating a company.

Dividend Yield:

A financial ratio that shows how much a company pays out in dividends each year relative to its
share price. In the absence of any capital gains, the dividend yield is the return on investment for
a stock. Dividend yield is calculated as follows:

71
Dividend yield is a way to measure how much cash flow you are getting for each dollar invested
in an equity position - in other words, how much "bang for your buck" you are getting from
dividends. Investors who require a minimum stream of cash flow from their investment portfolio
can secure this cash flow by investing in stocks paying relatively high, stable dividend yields.

To better explain the concept, refer to this dividend yield example: If two companies both pay
annual dividends of Rs1 per share, but ABC company's stock is trading at Rs20 while XYZ
company's stock is trading at Rs40, then ABC has a dividend yield of 5% while XYZ is only
yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement
his or her income would likely prefer ABC's stock over that of XYZ.

Price to Book Ratio (P/B) or Price to Book Value (PBV) Ratio:

A ratio used to compare a stock's market value to its book value. It is calculated by dividing the
current closing price of the stock by the latest quarter's book value per share. This is also known
as the "price-equity ratio". It is computed as below:

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that
something is fundamentally wrong with the company. As with most ratios, be aware that this
varies by industry. This ratio also gives some idea of whether you're paying too much for what
would be left if the company went bankrupt immediately.

Price Earnings to Growth (PEG) Ratio:

A ratio used to determine a stock's value while taking into account earnings growth. The
calculation is as follows:

PEG is a widely used indicator of a stock's potential value. It is favored by many over the
price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG
means that the stock is more undervalued. Keep in mind that the numbers used are projected and,
therefore, can be less accurate. Also, there are many variations using earnings from different
time periods (i.e. one year vs. five year). Be sure to know the exact definition your source is
using.

72
 Table No.2.4
Tata Steel Ltd - Key Financial Ratios
Mar-12
Leverage Ratios:
Debt-Equity Ratio 0.55
Long Term Debt-Equity Ratio 0.46
Liquidity Ratio:
Current Ratio 0.85
Turnover Ratios:
Fixed Assets 1.6
Inventory 8.4
Debtors 55.73
Interest Cover Ratio 6.12
Return on Capital Employed (%) 14.51
Return On Net Worth (%) 13.45
Valuation Ratios:
Price Earning (P/E) 7.01
Price to Book Value ( P/BV) 0.87
Price/Cash EPS (P/CEPS) 5.96
EV/EBIDTA 5.25
Market Cap/Sales 1.23
Source: www.capitaline.com

End of the Chapter Questions:

1. Why would you expect a relationship between economic activity and stock price
movements?
2. At a lunch with some business associates, you discuss the reason for the relationship
between the economy and the stock market. One of your associates contends that she has
heard that stock prices typically turn before the economy does. How would you explain
this phenomenon?

3. Explain the following statements:

(a) There is a strong, consistent relationship between money supply changes and stock
prices,
(b) Money supply changes cannot be used to predict stock price movements.

4. You are informed of the following estimates: nominal money supply is expected to grow
at a rate of7 percent, and GDP is estimated to grow at 4 percent. Explain what you think
will happen to stock prices during this period and the reason for your expectation.

73
5. The current rate of inflation is 3 percent, and long-term Treasury bonds are yielding 7
percent. You estimate that the rate of inflation will increase to 6 percent. What do you
expect to happen to long term bond yields?

6. Some observers contend that it is harder to estimate the effect of a change in interest rates
on common stocks than on bonds. Discuss this contention.

7. Prepare a table showing the percentage change for each of the last 10 years in
(a) the Consumer Price Index (all items),
(b) nominal GDP,
(c) real GDP (in constant dollars), and
(d) the GDP deflator.

8. Discuss how much of nominal growth was due to real growth and how much was due to
inflation.

9. There has been considerable growth in recent years in the use of economic analysis in
investment management. Further significant expansion may lie ahead as financial
analysts develop greater skills in economic analysis and these analyses are integrated
more into the investment decision-making process. The following questions address the
use of economic analysis in the investment decision making process:
a. Differentiate among leading, lagging, and coincident indicators of economic
activity, and give an example of each.
b. Indicate whether the leading indicators are one of the best tools for achieving
above-average investment results.
Briefly justify your conclusion.

10. Interest rate projections are used in investment management for a variety of purposes.
Identify three significant reasons why interest rate forecasts may be important in reaching
investment conclusions.
11. Assume you are a fundamental research analyst following the automobile industry for a
large brokerage firm. Identify and briefly explain the relevance of three major economic
time series, economic indicators, or economic data items that would be significant to
automotive industry and company research.

12. What monetary and fiscal policies might be prescribed for an economy in a deep
recession?

13. Unlike other investors, you believe the Government is going to dramatically loosen
monetary policy. What would be your recommendations about investments in the
following industries?
a. Gold mining
74
 b. Construction
14. If you believe the U.S. dollar is about to depreciate more dramatically than do other
investors, what will be your stance on investments in Indian auto producers?

15. According to supply-side economists, what will be the long-run impact on prices of a
reduction in income tax rates?
16. Consider two firms producing DVDs. One uses a highly automated robotics process,
while the other uses human workers on an assembly line and pays overtime when there
is heavy production demand.
a. Which firm will have higher profits in a recession? In a boom?

17. Here are four industries and four forecasts for the macro economy. Choose the industry
that you would expect to perform best in each scenario.
Industries: Housing construction, health care, gold mining, steel production.
Economic Forecasts:
i) Deep recession: Falling inflation, falling interest rates, falling GDP.
ii) Superheated economy: Rapidly rising GDP, increasing inflation and
interest rates.
Iii) Healthy expansion: Rising GDP, mild inflation, low unemployment.
iv) Stagflation: Falling GDP, high inflation.
18. In which stage of the industry life cycle would you place the following industries?
a. Oil well equipment.
b. Computer hardware.
c. Computer software.
d. Genetic engineering.
e. Railroads.

19. For each pair of firms, choose the one that you think would be more sensitive to the
business cycle.
a. General Autos or General Pharmaceuticals.
b. Friendly Airlines or Happy Cinemas.

20. Choose an industry and identify the factors that will determine its performance in the next
three years. What is your forecast for performance in that time period?

75
Problems for Practice:

The Balance Sheet of

ABC Co is given below
Rs (000) Rs (000)
Cash & Near Cash 1648 Accounts Payable 3141
Marketable Securities 159 Short term Borrowings 4462
Accounts Receivable 1666 Other Short term liabilities 1037
Other Current Assets 2017 Current Liabilities 8640
Current Assets 6380 Long term Borrowings 687
Long term investments 1863 Other long term Liabilities 1415
Depreciable Fixed Assets 5486 Non-current liabilities 2102
Non-depreciable Fixed Assets 199
Accumulated Depreciation 2016 Share Capital (Paid-in) 3060
Net Fixed Assets 3669 Retained Earnings 5343
Other Assets 7233 Shareholder Equity 8403
Total Assets 19145 Total Liabilities & Equity 19145

1. Consider the assets on ABCs balance sheet and answer the following questions:

a. Looking at the assets that ABC has on its balance sheet, which assets are likely
to be assessed closest to market value? Explain.

b. ABC has net fixed assets of Rs.3,669 million. Can you estimate how much ABC paid
for these assets? Is there any way to know the age of these assets?

c. ABC seems to have far more invested in current assets, rather than fixed assets.
Is this significant? Explain.

d. In the early 1980s, ABC sold off its bottling operations, with the bottlers becoming
independent companies. How would this action have impacted the assets onABCs
balance sheet? (The manufacturing plants are most likely to be part of the bottling
operations)

2. Examine the liabilities on ABCs balance sheet.

a. Based upon the balance sheet, how much interest-bearing debt does ABC have
outstanding. (You can assume that other short term liabilities represent sundry
payables, and other long term liabilities represent health care and pension obligations.)

b. Based upon the balance sheet, how much did ABC obtain in equity capital
when it issued stock originally to the financial markets?

c. Is there any significance to the fact that retained earnings is much larger than the
original paid-in capital?

76
 d. The market value of ABCs equity is Rs140 billion. What is the book value of
equity in ABC? Why is there such a large difference between the market value of
equity and the book value of equity?

3. ABCs most valuable asset is its brand name. Where in the balance sheet do yousee its value?
Is there any way to adjust the balance sheet to reflect the value of this asset?

4. Assume that you have been asked to analyze ABCs working capital management.

a. Estimate the net working capital and non-cash working capital for ABC.

b. Estimate the firms current ratio.

c. Estimate the firms quick ratio.

d. Would you draw any conclusions about the riskiness of ABC as a firm by
looking at these numbers? Why or why not?

ABC's income statements for 2009 and

2010 are summarized below
2009 2010
Rs (000) Rs (000)
Net Revenues 18868 18813
Cost of Goods Sold 6,105 5,562
Selling, G & A Expenses 7,852 8,284
Earnings before interest and taxes 5,001 4,967
Interest Expenses 258 277
Non-operating Gains 1,312 508
Income Tax Expenses 1,926 1,665
Net Income 4,129 3,533
Dividends 1,387 1,480

The following questions relate to ABCs income statement.

5. How much operating income did ABC earn, before taxes, in 1998? How does this
compare to how much ABC earned in 1997? What are the reasons for the differences?

6. The biggest expense for ABC is advertising, which is part of the selling, general and
administrative expenses. A large portion of these expenses are designed to build up
ABCs brand name. Should advertising expenses be treated as operating expenses or are
they really capital expenses? If they are to be treated as capital expenses, how would you
capitalize them? (Use the capitalization of R&D as a guide.)

7. What effective tax rate did ABC have in 1998? How does it compare with what they paid
in 1997 as an effective tax rate? What might account for the difference?

77
8. You have been asked to assess the profitability of ABC, as a firm. To that end, estimate
the pre-tax operating and net margins in 1997 and 1998 for the firm. Are there any
conclusions you would draw from the comparisons across the two years.

9. The book value of equity at ABC in 1997 was Rs7,274 million. The book value of
interest-bearing debt was Rs3,875 million. Estimate:

a. the return on equity (beginning of the year) in 1998

b. the pre-tax return on capital (beginning of the year) in 1998

c. the after-tax return on capital (beginning of the year) in 1998, using the effective tax
rate in 1998.

10. SeeSaw Toys reported that it had a book value of equity of Rs1.5 billion at the end of
1998 and 100 million shares outstanding. During 1999, it bought back 10 million shares
at a market price of Rs40 per share. The firm also reported a net income of Rs150 million
for1999, and paid dividends of Rs50 million.

a. Estimate the book value of equity at the end of 1999

b. Estimate the return on equity, using beginning book value of equity.

c. Estimate the return on equity, using the average book value of equity.

78
 CHAPTER NO.III

Valuation of Stocks and

Firms
ANALYSIS OF FINANCIAL RATIOS

79
This chapter is titled Valuation of Stocks and Firms to convey the idea that the common stocks
of good companies are not necessarily good investments. The point is, after analyzing a company
and deriving an understanding of its strengths and risks, you need to compute the fundamental
intrinsic value of the firms stock and compare the intrinsic value of a stock to its market value to
determine if the companys stock should be purchased. The stock of a wonderful firm with
superior management and strong performance measured by sales and earnings growth can be
priced so high that the intrinsic value of the stock is below its current market price and should
not be acquired. In contrast, the stock of a company with less success based on its sales and
earnings growth may have a stock market price that is below its intrinsic value. In this case,
although the company is not as good, its stock could be the better investment. The classic
confusion in this regard concerns growth companies versus growth stocks. The stock of a growth
company is not necessarily a growth stock. Recognition of this difference is absolutely essential
for successful investing.

What is a Growth Company?

Observers have historically defined growth companies as those that consistently experience
above-average increases in sales and earnings. This definition has some limitations because
many firms could qualify due to certain accounting procedures, mergers, or other external events.
In contrast, financial theorists define a growth company as a firm with the management ability
and the opportunities to make investments that yield rates of return greater than the firms
required rate of return. This required rate of return is the firms weighted average cost of capital
(WACC). As an example, a growth company might be able to acquire capital at an average cost
of 10 percent and yet have the management ability and the opportunity to invest those funds at
rates of return of 15 to 20 percent. As a result of these investment opportunities, the firms sales
and earnings grow faster than those of similar risk firms and the overall economy. In addition, a
growth company that has above-average investment opportunities should, and typically does,
retain a large portion of its earnings to fund these superior investment projects (i.e., they have
low dividend payout ratios).

What is a Growth Stock?

Growth stocks are not necessarily shares in growth companies. A growth stock is a stock with a
higher rate of return than other stocks in the market with similar risk characteristics. The stock
achieves this superior risk-adjusted rate of return because at some point in time the market
undervalued it compared to other stocks. Although the stock market adjusts stock prices
relatively quickly and accurately to reflect new information, available information is not always
perfect or complete. Therefore, imperfect or incomplete information may cause a given stock to
be undervalued or overvalued at a point in time. If the stock is undervalued, its price should
eventually increase to reflect its true fundamental value when the correct information becomes
available. During this period of price adjustment, the stocks realized return will exceed the
required return for a stock with its risk, and, during this period of adjustment, it will be
80
considered a growth stock. Growth stocks are not necessarily limited to growth companies. A
future growth stock can be the stock of any type of company; the stock need only be undervalued
by the market.

The fact is, if investors recognize a growth company and discount its future earnings stream
properly, the current market price of the growth companys stock will reflect its future earnings
stream. Those who acquire the stock of a growth company at this correct market price will
receive a rate of return consistent with the risk of the stock, even when the superior earnings
growth is attained. In many instances, overeager investors tend to overestimate the expected
growth rate of earnings and cash flows for the growth company and, therefore, inflate the price
of a growth companys stock. Investors who pay the inflated stock price will earn a rate of return
below the risk-adjusted required rate of return, despite the fact that the growth company
experiences the above-average growth of sales and earnings. Several studies that have examined
the stock price performance for samples of growth companies have found that their stocks
performed poorlythat is, the stocks of growth companies have generally not been growth
stocks.

What is a Defensive Company?

Defensive companies are those whose future earnings are likely to withstand an economic
downturn. One would expect them to have relatively low business risk and not excessive
financial risk. Typical examples are public utilities or grocery chainsfirms that supply basic
consumer necessities. There are two closely related concepts of a defensive stock. First, a
defensive stocks rate of return is not expected to decline during an overall market decline, or
decline less than the overall market. A stock with low or negative systematic risk (a small
positive or negative beta) may be considered a defensive stock according to this theory because
its returns are unlikely to be harmed significantly in a bear market.

What is a cyclical company?

A cyclical companys sales and earnings will be heavily influenced by aggregate business
activity. Examples would be firms in the steel, auto, or heavy machinery industries. Such
companies will do well during economic expansions and poorly during economic contractions.
This volatile earnings pattern is typically a function of the firms business risk (both sales
volatility and operating leverage) and can be compounded by financial risk.

A cyclical stock will experience changes in its rates of return greater than changes in overall
market rates of return. In terms of the CAPM, these would be stocks that have high betas. The
stock of a cyclical company, however, is not necessarily cyclical. A cyclical stock is the stock of
any company that has returns that are more volatile than the overall marketthat is, high-beta
stocks that have high correlation with the aggregate market and greater volatility.

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What is a speculative company?

A speculative company is one whose assets involve great risk but that also has a possibility of
great gain. A good example of a speculative firm is one involved in oil exploration. A
speculative stock possesses a high probability of low or negative rates of return and a low
probability of normal or high rates of return. Specifically, a speculative stock is one that is
overpriced, leading to a high probability that during the future period when the market adjusts
the stock price to its true value, it will experience either low or possibly negative rates of return.
Such an expectation might be the case for an excellent growth company whose stock is selling at
an extremely high price/earnings ratioi.e., it is substantially overvalued.

Some analysts also divide stocks into growth stocks and value stocks. As we have discussed,
growth stocks are companies that will have positive earnings surprises and above-average risk
adjusted rates of return because the stocks are undervalued. If the analyst does a good job in
identifying such companies, investors in these stocks will reap the benefits of seeing their stock
prices rise after other investors identify their earnings growth potential.

Value Stocks Vs Growth Stocks

Value stocks are those that appear to be undervalued for reasons other than earnings growth
potential. Value stocks are usually identified by analysts as having low price-earning or price-
book value ratios. Notably, in these comparisons between growth and value stocks, the
specification of a growth stock is not consistent with our preceding discussion. In these
discussions, a growth stock is generally specified as a stock of a company that is experiencing
rapid growth of sales and earnings (e.g., Intel and Microsoft). As a result of this company
performance, the stock typically has a high P/E and price-book-value ratio. Unfortunately, the
specification does not consider the critical comparison between intrinsic value and market price.

Apart from the above this chapter describes the ways stock market analysts try to uncover
mispriced securities. The models presented are those used by fundamental analysts, those
analysts who use information concerning the current and prospective profitability of a company
to assess its fair market value. Fundamental analysts are different from technical analysts, who
essentially use trend analysis to uncover trading opportunities. We start with a discussion of
alternative measures of the value of a company. From there, we progress to quantitative tools
called dividend discount models that security analysts commonly use to measure the value of a
firm as an ongoing concern.

The purpose of fundamental analysis is to identify stocks that are mispriced relative to some
measure of true value that can be derived from observable financial data. Of course, true value
can only be estimated. In practice, stock analysts use models to estimate the fundamental value
of a corporations stock from observable market data and from the financial statements of the
firm and its competitors. These valuation models differ in the specific data they use and in the
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level of their theoretical sophistication. But at their heart, most of them use the notion of
valuation by comparables: They look at the relationship between price and various determinants
of value for similar firms, and then extrapolate that relationship to the firm in question.

The Internet makes it convenient to obtain relevant data. For Indian companies, the Securities
and Exchange Board of India provides information available to the public at its web site
www.sebi.gov.in. The SEBI requires all public companies to file registration statements, periodic
reports, and other forms electronically through. Many Web sites, such as finance.yahoo.com,
also provide analysis and data derived from the SEBI reports.

Before moving into the theory of valuation, let us understand some important terms such as cost
of capital, weight average cost of capital popularly known as WACC, cost of preferred stock,
cost of debt, and computing expected rate of return through universally agreed model known as
capital asset pricing model.

Cost of Capital (Kc):

The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This is the rate of return that a firm would receive if it
invested in a different vehicle with similar risk.

Weighted Average Cost Of Capital WACC:

A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources - common stock, preferred stock, bonds and any other long-term
debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk. The WACC equation is the cost of each capital component multiplied by its
proportional weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Cost of Debt (Kd):

The effective rate that a company pays on its current debt is known as cost of debt. This can be
measured in either before- or after-tax returns; however, because interest expense is deductible,
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the after-tax cost is seen most often. This is one part of the company's capital structure, which
also includes the cost of equity.

Kd = Interest * (1-Tax Rate)

A company will use various bonds, loans and other forms of debt, so this measure is useful for
giving an idea as to the overall rate being paid by the company to use debt financing. The
measure can also give investors an idea as to the riskiness of the company compared to others,
because riskier companies generally have a higher cost of debt. To get the after-tax rate, you
simply multiply the before-tax rate by one minus the marginal tax rate (before-tax rate x (1-
marginal tax)). If a company's only debt were a single bond in which it paid 5%, the before-tax
cost of debt would simply be 5%. If, however, the company's marginal tax rate were 40%, the
company's after-tax cost of debt would be only 3% (5% x (1-40%)).

Cost of Equity (Ke):

In financial literature, the return that stockholders require for a company. The traditional formula
for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership. Lets look at a very simple example: let's say
you require a rate of return of 10% on an investment in TI Cycles. The stock is currently trading
at Rs10 and will pay a dividend of Rs0.30. Through a combination of dividends and share
appreciation you require aRs1.00 return on your Rs10.00 investment. Therefore the stock will
have to appreciate by Rs0.70, which, combined with the Rs0.30 from dividends, gives you your
10% cost of equity.

Capital Asset Pricing Model (CAPM):

The capital asset pricing model, or CAPM, was developed by Treynor, Sharpe, Lintner, and
Mossin in the early 1960s, and further refined later. The model predicts the relationship between
the risk and equilibrium expected returns on risky assets. We will approach the CAPM in a
simplified setting. Thinking about an admittedly unrealistic world allows a relatively easy leap to
the solution. With this accomplished, we can add complexity to the environment, one step at a
time, and see how the theory must be amended. This process allows us to develop a reasonably
realistic and comprehensible model.
A number of simplifying assumptions lead to the basic version of the CAPM. The fundamental

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idea is that individuals are as alike as possible, with the notable exceptions of initial wealth and
risk aversion. The list of assumptions that describes the necessary conformity of investors
follows:

1. Investors cannot affect prices by their individual trades. This means that there are
many investors, each with an endowment of wealth that is small compared with
the total endowment of all investors. This assumption is analogous to the perfect
competition assumption of microeconomics.

2. All investors plan for one identical holding period.

3. Investors form portfolios from a universe of publicly traded financial assets, such
as stocks and bonds, and have access to unlimited risk-free borrowing or lending
opportunities.

4. Investors pay neither taxes on returns nor transaction costs (commissions and
service charges) on trades in securities. In such a simple world, investors will not
care about the difference between returns from capital gains and those from
dividends.

5. All investors attempt to construct efficient frontier portfolios; that is, they are
rational mean-variance optimizers.

6. All investors analyze securities in the same way and share the same economic
view of the world. Hence, they all end with identical estimates of the probability
distribution of future cash flows from investing in the available securities. This
means that, given a set of security prices and the risk-free interest rate, all
investors use the same expected returns, standard deviations, and correlations to
generate the efficient frontier and the unique optimal risky portfolio. This
assumption is called homogeneous expectations.

Obviously, these assumptions ignore many real-world complexities. However, they lead to some
powerful insights into the nature of equilibrium in security markets. A model that describes the
relationship between risk and expected return and that is used in the pricing of risky securities.

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The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure
(beta) that compares the returns of the asset to the market over a period of time and to the market
premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the
CAPM for all different risks (betas).Using the CAPM model and the following assumptions, we
can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the
beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).

CAPM and its Limitations:

The CAPM has two limitations: It relies on the theoretical market portfolio, which includes all
assets (such as real estate, foreign stocks, etc.), and it deals with expected as opposed to actual
returns. To implement the CAPM, we cast it in the form of an index model and use realized, not
expected, returns. An index model uses actual portfolios, such as the S&P 500, rather than the
theoretical market portfolio to represent the relevant systematic factors in the economy. The
important advantage of index models is that the composition and rate of return of the index is
easily measured and unambiguous.

In contrast to an index model, the CAPM revolves around the market portfolio. However,
because many assets are not traded, investors would not have full access to the market portfolio
even if they could exactly identify it. Thus, the theory behind the CAPM rests on a shaky real-
world foundation. But, as in all science, a theory may be viewed as legitimate if its predictions
approximate real-world outcomes with a sufficient degree of accuracy. In particular, the reliance
on the market portfolio shouldnt faze us if we can verify that the predictions of the CAPM are
sufficiently accurate when the index portfolio is substituted for the market.

We can start with one central prediction of the CAPM: The market portfolio is mean variance
efficient. An index model can be used to test this hypothesis by verifying that an index chosen to
be representative of the full market is a mean-variance efficient portfolio. Another aspect of the
CAPM is that it predicts relationships among expected returns, while all we can observe are
realized (historical) holding-period returns; actual returns in a particular holding period seldom,
if ever, match our initial expectations.

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Multifactor Models and CAPM

The index model introduced earlier in the chapter gave us a way of decomposing stock
variability into market or systematic risk, due largely to macroeconomic factors, versus firm
specific effects that can be diversified in large portfolios. In the index model, the return on the
market portfolio summarized the aggregate impact of macro factors. In reality, however,
systematic risk is not due to one source, but instead derives from uncertainty in many economy
wide factors such as business-cycle risk, interest or inflation rate risk, energy price risk, and so
on. It stands to reason that a more explicit representation of systematic risk, allowing for the
possibility that different stocks exhibit different sensitivities to its various facets, would
constitute a useful refinement of the single-factor model. It is easy to see that models that allow
for several systematic factors multifactor modelscan provide better descriptions of security
returns.

The Fama-French Three-Factor Model

Fama and French (1996) proposed a three-factor model that has become a standard tool for
empirical studies of asset returns. Fama and French add firm size and book-to-market ratio to the
market index to explain average returns. These additional factors are motivated by the
observations that average returns on stocks of small firms and on stocks of firms with a high
ratio of book value of equity to market value of equity have historically been higher than
predicted by the security market line of the CAPM. This observation suggests that size or the
book-to-market ratio may be proxies for exposures to sources of systematic risk not captured by
the CAPM beta, and thus result in return premiums. For example, Fama and French point out
that firms with high ratios of book to market value are more likely to be in financial distress and
that small stocks may be more sensitive to changes in business conditions. Thus, these variables
may capture sensitivity to macroeconomic risk factors.

How can we make the Fama-French (FF) model operational? To illustrate, we will follow the
same general approach that we applied for General Motors earlier, but now using the more
general model.
Collecting and processing data To create portfolios that track the size and book-to-market
factors, one can sort industrial firms by size (market capitalization or market cap) and by book-
to-market (B/M) ratio. The size premium is constructed as the difference in returns between
small and large firms and is denoted by SMB (small minus big). Similarly, the book-to-market
premium is calculated as the difference in returns between firms with a high versus low B/M
ratio, and is denoted HML (high minus low ratio).

Taking the difference in returns between two portfolios has an economic interpretation. The
SMB return, for example, equals the return from a long position in small stocks, financed with a
short position in the large stocks. Note that this is a portfolio that entails no net investment.
Davis, Fama, and French (2000) follow this sorting procedure.

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CAPM and the Real World:

In limited ways, portfolio theory and the CAPM have become accepted tools in the practitioner
community. Many investment professionals think about the distinction between firm specific and
systematic risk and are comfortable with the use of beta to measure systematic risk. Still, the
nuances of the CAPM are not nearly as well established in the community. For example, the
compensation of portfolio managers is not based on appropriate performance measures.

What can we make of this?

New ways of thinking about the world (that is, new models or theories) displace old ones when
the old models become either intolerably inconsistent with data or when the new model is
demonstrably more consistent with available data. For example, when Copernicus overthrew
the age-old belief that the Earth is fixed in the center of the Universe and that the stars orbit
about it in circular motions, it took many years before astronomers and navigators replaced old
astronomical tables with superior ones based on his theory. The old tools fit the data available
from astronomical observation with sufficient precision to suffice for the needs of the time. To
some extent, the slowness with which the CAPM has permeated daily practice in the money
management industry also has to do with its precision in fitting data, that is, in precisely
explaining variation in rates of return across assets. Lets review some of the evidence on this
score.

The CAPM was first published by Sharpe in the Journal of Finance (the journal of the American
Finance Association) in 1964 and took the world of finance by storm. Early tests by Black,
Jensen, and Scholes (1972) and Fama and MacBeth (1973) were only partially supportive of the
CAPM: average returns were higher for higher-beta portfolios, but the reward for beta risk was
less than the predictions of the simple theory.

While this sort of evidence against the CAPM remained largely within the ivory towers of
academia, Rolls (1977) paper A Critique of Capital Asset Pricing Tests shook the practitioner
world as well. Roll argued that since the true market portfolio can never be observed, the CAPM
is necessarily untestable. The publicity given the now classic Rolls critique resulted in
popular articles such as Is Beta Dead? that effectively slowed the permeation of portfolio
theory through the world of finance. This is quite ironic since, although Roll is absolutely correct
on theoretical grounds, some tests suggest that the error introduced by using a broad market
index as proxy for the true, unobserved market portfolio is perhaps not the greatest of the
problems involved in testing the CAPM.

Fama and French (1992) published a study that dealt the CAPM an even harsher blow. They
claimed that once you control for a set of widely followed characteristics of the firm, such as the
size of the firm and its ratio of market value to book value, the firms beta (that is, its systematic
risk) does not contribute anything to the prediction of future returns.

88
Fama and French and several others have published many follow-up studies of this topic. We
will review some of this literature later in the chapter, and the nearby box discusses recent
controversies about the risk-return relationship. However, it seems clear from these studies that
beta does not tell the whole story of risk. There seem to be risk factors that affect security returns
beyond betas one-dimensional measurement of market sensitivity. In fact, in the next section of
this chapter, we will introduce a theory of risk premiums that explicitly allows for multiple risk
factors.

Liquidity, a different kind of risk factor, has been ignored for a long time. Although first
analyzed by Amihud and Mendelson as early as 1986, it is yet to be accurately measured and
incorporated in portfolio management. Measuring liquidity and the premium commensurate with
illiquidity is part of a larger field in financial economics, namely, market structure. We now
know that trading mechanisms on stock exchanges can affect the liquidity of assets traded on
these exchanges and thus significantly affect their market value.

In limited ways, portfolio theory and the CAPM have become accepted tools in the practitioner
community. Many investment professionals think about the distinction between firm specific and
systematic risk and are comfortable with the use of beta to measure systematic risk. Still, the
nuances of the CAPM are not nearly as well established in the community. For example, the
compensation of portfolio managers is not based on appropriate performance measures.

Theory of Valuation:

You may recall from your studies in accounting, economics, or corporate finance that the value
of an asset is the present value of its expected returns. Specifically, you expect an asset to
provide a stream of returns during the period of time you own it. To convert this estimated
stream of returns to a value for the security, you must discount this stream at your required rate
of return. This process of valuation requires estimates of

(1) the stream of expected returns and

(2) the required rate of return on the investment.

An estimate of the expected returns from an investment encompasses not only the size but also
the form, time pattern, and the uncertainty of returns, which affect the required rate of return.

Form of Returns:
The returns from an investment can take many forms, including earnings, cash flows, dividends,
interest payments, or capital gains (increases in value) during a period. We will consider several
alternative valuation techniques that use different forms of returns. As an example, one common
stock valuation model applies a multiplier to a firms earnings, whereas another valuation model
computes the present value of a firms operating cash flows, and a third model estimates the
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present value of dividend payments. Returns or cash flows can come in many forms, and you
must consider all of them to evaluate an investment accurately.

Time Pattern and Growth Rate of Returns:

You cannot calculate an accurate value for a security unless you can estimate when you will
receive the returns or cash flows. Because money has a time value, you must know the time
pattern and growth rate of returns from an investment. This knowledge will make it possible to
properly value the stream of returns relative to alternative investments with a different time
pattern and growth rate of returns or cash flows.

Uncertainty of Returns (Cash Flows):

You will recall from Chapter 1 that the required rate of return on an investment is determined by
(1) the economys real risk-free rate of return, plus
(2) the expected rate of inflation during the holding period, plus
(3) a risk premium that is determined by the uncertainty of returns.

All investments are affected by the risk-free rate and the expected rate of inflation because these
two variables determine the nominal risk-free rate. Therefore, the factor that causes a difference
in required rates of return is the risk premium for alternative investments. In turn, this risk
premium depends on the uncertainty of returns or cash flows from an investment. We can
identify the sources of the uncertainty of returns by the internal characteristics of assets or by
market-determined factors. Earlier, we subdivided the internal characteristics for a firm into
business risk (BR), financial risk (FR), liquidity risk (LR), exchange rate risk (ERR), and country
risk (CR). The market-determined risk measures are the systematic risk of the asset, its beta, or
its multiple APT factors.

To ensure that you receive your required return on an investment, you must estimate the intrinsic
value of the investment at your required rate of return and then compare this estimated intrinsic
value to the prevailing market price. You should not buy an investment if its market price
exceeds your estimated value because the difference will prevent you from receiving your
required rate of return on the investment. In contrast, if the estimated value of the investment
exceeds the market price, you should buy the investment.
In summary:

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Dont Buy

For example, assume you read about a firm that produces athletic shoes and its stock is listed on
the National Stock Exchange (NSE). Using one of the valuation models we will discuss and
making estimates of earnings, cash flow, and growth based on the companys annual report and
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other information, you estimate the companys stock value using your required rate of return as
Rs. 20 a share. After estimating this value, you look in the paper and see that the stock is
currently being traded at Rs.15 a share. You would want to buy this stock because you think it is
worth Rs.20 a share and you can buy it for Rs. 15 a share. In contrast, if the current market price
were Rs.25 a share, you would not want to buy the stock because, based upon your valuation, it
is overvalued.

The theory of value provides a common framework for the valuation of all investments.
Different applications of this theory generate different estimated values for alternative
investments because of the different payment streams and characteristics of the securities. The
interest and principal payment son a bond differ substantially from the expected dividends and
future selling price for a common stock. The initial discussion that follows applies the discounted
cash flow method to bonds, preferred stock, and common stock. This presentation demonstrates
that the same basic model is useful across a range of investments. Subsequently, because of the
difficulty in estimating the value of common stock, we consider two general approaches and
numerous techniques for the valuation of stock.

Valuation of Bonds:
Calculating the value of bonds is relatively easy because the size and time pattern of cash flows
from the bond over its life are known. A bond typically promises:
1. Interest payments every six months equal to one-half the coupon rate times the face value
of the bond;
2. The payment of the principal on the bonds maturity date
As an example, in 2003, a Rs.10,000 bond due in 2018 with a 10 percent coupon will pay Rs.500
every six months for its 15-year life. In addition, the bond issuer promises to pay the Rs.10,000
principal at maturity in 2018. Therefore, assuming the bond issuer does not default, the investor
knows what payments (cash flows) will be made and when they will be made.

Applying the valuation theory, which states that the value of any asset is the present value of
its cash flows, the value of the bond is the present value of the interest payments, which we can
think of as an annuity of Rs. 500 every six months for 15 years, and the present value of the
principal payment, which in this case is the present value of Rs.10,000 in 15 years. The only
unknown for this asset (assuming the borrower does not default) is the required rate of return that
should be used to discount the expected stream of returns (cash flows). If the prevailing nominal
risk-free rate is 9 percent and the investor requires a 1 percent risk premium on this bond because
there is some probability of default, the required rate of return would be 10 percent. The present
value of the interest payments is an annuity for 30 periods (15 years every six months) at one-
half the required return (5 percent):
Rs.500 15.3725 = Rs7,686 (Present Value of Interest Payments at 10 Percent)
The present value of the principal is likewise discounted at 5 percent for 30 periods:
Rs.10,000 0.2314 = Rs.2,314 (Present Value of the Principal Payment at 10 Percent)

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This can be summarized as follows:
Present Value of Interest Payments Rs.500 15.3725 = Rs.7,686
Present Value of Principal Payment Rs. 10,000 0.2314 = 2,314
Total Value of Bond at 10 Percent = Rs.10,000
This is the amount that an investor should be willing to pay for this bond, assuming that the
required rate of return on a bond of this risk class is 10 percent. If the market price of the bond
is above this value, the investor should not buy it because the promised yield to maturity at this
higher price will be less than the investors required rate of return.
Alternatively, assuming an investor requires a 12 percent return on this bond, its value
would be:
Rs.500 13.7648 = Rs.6,882
Rs.10,000 0.1741 = 1,741
Total Value of Bond at 12 Percent = Rs.8,623
This example shows that if you want a higher rate of return, you will not pay as much for an
asset; that is, a given stream of cash flows has a lower value to you. As before, you would
compare this computed value to the market price of the bond to determine whether you should
invest in it or not.

Valuation of Preferred Share:

The owner of a preferred share receives a promise to pay a stated dividend, usually each year,
for an infinite period. Preferred stock is perpetuity because it has no maturity. As was true with
a bond, stated payments are made on specified dates although the issuer of this stock does not
have the same legal obligation to pay investors as do issuers of bonds. Payments are made only
after the firm meets its bond interest payments. Because this reduced legal obligation increases
the uncertainty of returns, investors should require a higher rate of return on a firms preferred
stock than omits bonds. Although this differential in required return should exist in theory, it
generally does not exist in practice because of the tax treatment accorded dividends paid to
corporations. Since, preferred stock is perpetuity, its value is simply the stated annual dividend
divided by the required rate of return on preferred stock (kp) as follows:

V = Dividend / Kp

Assume a preferred stock has a Rs.100 par value and a dividend of Rs.8 a year. Because of the
expected rate of inflation, the uncertainty of the dividend payment, your required rate of return
on this stock is 9 percent. Therefore, the value of this preferred stock to you is:
V = 8/.09 = Rs.88.89
Given this estimated value, you would inquire about the current market price to decide whether
you would want to buy this preferred stock. If the current market price is Rs.95, you would
decide against a purchase, whereas if it is Rs.80, you would buy the stock. Also, given the
market price of preferred stock, you can derive its promised yield. Assuming a current market
price of Rs.85, the promised yield would be:

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Kp= Dividend / Price
= Rs.8/Rs.85
= 0.09411

Approaches to the Valuation of Equity Share:

Valuation of Bonds and Preferred Shares are relatively easy when comparing with that of equity
shares. Owing to the complexity and importance of valuing common stock, various techniques
for accomplishing this task have been devised over time. These techniques fall into one of two
general approaches:

(1) the discounted cash flow valuation techniques, where the value of the stock is estimated
based upon the present value of some measure of cash flow, including dividends, operating cash
flow, and free cash flow; and

(2) the relative valuation techniques, where the value of a stock is estimated based upon its
current price relative to variables considered to be significant to valuation, such as earnings, cash
flow, book value, or sales.

Exhibit No.3.1 provides a visual presentation of the alternative approaches and specific
techniques.
Exhibit No.3.1

Source: Adopted from Reilly and Brown, 8th Edition

An important point is that both of these approaches and all of these valuation techniques have
several common factors. First, all of them are significantly affected by the investors required
rate of return on the stock because this rate becomes the discount rate or is a major component of
the discount rate. Second, all valuation approaches are affected by the estimated growth rate of
the variable used in the valuation techniquefor example, dividends, earnings, cash flow, or
sales. As noted in the efficient market discussion, both of these critical variables must be
estimated. As a result, different analysts using the same valuation techniques will derive different

93
estimates of value for a stock because they have different estimates for these critical variable
inputs.

The following discussion of equity valuation techniques considers the specific models and the
theoretical and practical strengths and weaknesses of each of them.

Discounted Cash Flow Valuation Approach- Why and When?

Discounted cash flow valuation techniques are obvious choices for valuation because they are
the epitome of how we describe valuethat is, the present value of expected cash flows. The
major difference between the alternative techniques is how one specifies cash flowthat is, the
measure of cash flow used. The cleanest and most straightforward measure of cash flow is
dividends because these are clearly cash flows that go directly to the investor, which implies that
you should use the cost of equity as the discount rate. However, this dividend technique is
difficult to apply to firms that do not pay dividends during periods of high growth, or that
currently pay very limited dividends because they have high rate of return investment
alternatives available. On the other hand, an advantage is that the reduced form of the dividend
discount model (DDM) is very useful when discussing valuation for a stable, mature entity
where the assumption of relatively constant growth for the long term is appropriate.

The second specification of cash flow is the operating free cash flow, which is generally
described as cash flows after direct costs (cost of goods and S, G & A expenses) and before any
payments to capital suppliers. Because we are dealing with the cash flows available for all capital
suppliers, the discount rate employed is the firms weighted average cost of capital
(WACC).This is a very useful model when comparing firms with diverse capital structures
because you determine the value of the total firm and then subtract the value of the firms debt
obligations to
arrive at a value for the firms equity.

The third cash flow measure is free cash flow to equity, which is a measure of cash flows
available to the equity holder after payments to debt holders and after allowing for expenditures
to maintain the firms asset base. Because these are cash flows available to equity owners, the
appropriate discount rate is the firms cost of equity. Beyond being theoretically correct, these
models allow a substantial amount of flexibility in terms of changes in sales and expenses that
implies changing growth rates over time. Once you understand how to compute each measure of
cash flow, you can estimate cash flow for each year by constructing a pro forma statement for
each year or you can estimate overall growth rates for the alternative cash flow values as we will
demonstrate with the DDM.

A potential difficulty with these cash flow techniques is that they are very dependent on the two
significant inputs(1) the growth rates of cash flows (both the rate of growth and the duration
of growth) and (2) the estimate of the discount rate. As we will show in several instances, a small
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change in either of these values can have a significant impact on the estimated value. This is a
critical realization when using any theoretical model: Everyone knows and uses the same model,
but it is the inputs that are criticalGIGO: garbage in, garbage out!

Relative Valuation Techniques: Why and When to Use?

As noted, a potential problem with the discounted cash flow valuation models is that it is
possible to derive intrinsic values that are substantially above or below prevailing prices
depending on how you adjust your estimated inputs to the prevailing environment. An advantage
of the relative valuation techniques is that they provide information about how the market is
currently valuing stock at several levelsthat is, the aggregate market, alternative industries,
and individual stocks within industries. Following this chapter, which provides the background
for these two approaches, we will demonstrate the alternative relative valuation ratios for the
aggregate market, for an industry relative to the market, and for an individual company relative
to the aggregate market, to its industry, and to other stocks in its industry. The good news is that
this relative valuation approach provides information on how the market is currently valuing
securities. The bad news is that it is providing information on current valuation.

The point is, the relative valuation approach provides this information on current valuation, but it
does not provide guidance on whether these current valuations are appropriatethat is, all
valuations at a point in time could be too high or too low. For example, assume that the market
becomes significantly overvalued. For example, if you compare the value for an industry to the
very overvalued market, you might contend based on such a comparison that an industry is
undervalued relative to the market. Unfortunately, your judgment may be wrong because of the
benchmark you are usingthat is, you might be comparing a fully valued industry to a very
overvalued market. Put another way, the relative valuation techniques are appropriate to consider
under two scenarios:

1. You have a good set of comparable entitiesthat is, comparable companies that are similar
in terms of industry, size, and, it is hoped, risk.
2. The aggregate market and the companys industry are not at a valuation extremethat is,
they are not either seriously undervalued or overvalued.

Discounted Cash Flow (DCF) Valuation Techniques:

All the DCF valuation techniques are based on the basic valuation model, which asserts that the
value of an asset is the present value of its expected future cash flows as follows:

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As noted, the specific cash flows used will differ between techniques. They range from dividends
(the best-known model) to operating free cash flow and free cash flow to equity. We begin with a
fairly detailed presentation of the present-value-of-dividend model, referred to as the dividend
discount model (DDM), because it is intuitively appealing and is the best-known model. Also, its
general approach is similar to the other discounted cash flow models.

The Dividend Discount Model (DDM):

The dividend discount model assumes that the value of a share of common stock is the present
value of all future dividends as follows:

A technique for valuing the price of a stock by using predicted dividends and discounting them
back to present value. The idea is that if the value obtained from the DDM is higher than what
the shares are currently trading at, then the stock is undervalued. This technique has many
variations, and it doesn't work for companies that don't pay out dividends. For example one
variation is the supernormal dividend growth model which takes into account a period of high
growth followed by a lower, constant growth period. The principal behind the model is the net
present value of the cash flows. To get a growth number, one option is to take the return
on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio).

Present Value of Operating Free Cash Flows:

In this model, you are deriving the value of the total firm because you are discounting the
operating free cash flows prior to the payment of interest to the debt holders but after deducting
funds needed to maintain the firms asset base (capital expenditures). Also, because you are
discounting the total firms operating free cash flow, you would use the firms weighted average
cost of capital (WACC) as your discount rate. Therefore, once you estimate the value of the total
firm, you subtract the value of debt, assuming your goal is to estimate the value of the firms
equity.

The total value of the firm is equal to:

where:
Vj= value of firm j
n = number of periods assumed to be infinite
OFCFt= the firms operating free cash flow in period t.
WACCj = firm js weighted average cost of capital

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Present Value of Free Cash Flows to Equity:

The third discounted cash flow technique deals with free cash flows to equity, which would be
derived after operating free cash flows have been adjusted for debt payments (interest and
principle).Also, these cash flows precede dividend payments to the common stockholder. Such
cash flows are referred to as free because they are what is left after meeting all obligations to
other capital suppliers (debt and preferred stock) and after providing the funds needed to
maintain the firms asset base (similar to operating free cash flow).Notably, because these are
cash flows available to equity owners, the discount rate used is the firms cost of equity (k) rather
than the firms WACC.

where:
Vj= value of the stock of firm j
n = number of periods assumed to be infinite
FCFEt= the firms free cash flow to equity in period t.

Again, how an analyst would implement this general model depends upon the firms position in
its life cycle. That is, if the firm is expected to experience stable growth, analysts can use the
infinite growth model. In contrast, if the firm is expected to experience a period of temporary
supernormal growth, analysts should use the multistage growth model similar to the process used
with dividends and for operating free cash flow.

Relative Valuation:

In contrast to the various discounted cash flow techniques that attempt to estimate a specific
value for a stock based on its estimated growth rates and its discount rate, the relative valuation
techniques implicitly contend that it is possible to determine the value of an economic entity(i.e.,
the market, an industry, or a company) by comparing it to similar entities on the basis of several
relative ratios that compare its stock price to relevant variables that affect a stocks value, such as
earnings, cash flow, book value, and sales.

In relative valuation, we value an asset based upon how similar assets are priced in the market. A
prospective house buyer decides how much to pay for a house by looking at the prices paid for
similar houses in the neighborhood. A baseball card collector makes a judgment on how much to
pay for a Mickey Mantle rookie card by checking transactions prices on other Mickey Mantle
rookie cards. In the same vein, a potential investor in a stock tries to estimate its value by looking
at the market pricing of similar stocks. Embedded in this description are the three essential
steps in relative valuation.

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The first step is finding comparable assets that are priced by the market, a task that is easier to
accomplish with real assets like baseball cards and houses than it is with stocks. All too often,
analysts use other companies in the same sector as comparable, comparing a software firm to
other software firms or a utility to other utilities, but we will question whether this practice really
yields similar companies is an another question!.

The second steps scaling the market prices to a common variable to generate standardized prices
that are comparable. While this may not be necessary when comparing identical assets
(MickeyMantle rookie cards), it is necessary when comparing assets that vary in size or units.
Other things remaining equal, a smaller house or apartment should trade at a lower price than a
larger residence. In the context of stocks, this equalization usually requires converting the market
value of equity or the firm into multiples of earnings, book value or revenues.

The third and last step in the process is adjusting for differences across assets when comparing
their standardized values. Again, using the example of a house, a newer house with more updated
amenities should be priced higher than a similar sized older house that needs renovation. With
stocks, differences in pricing across stocks can be attributed to all of the fundamentals that we
talked about in discounted cash flow valuation. Higher growth companies, for instance, should
trade at higher multiples than lower growth companies in the same sector. Many analysts adjust
for these differences qualitatively, making every relative valuation a story telling experience;
analysts with better and more believable stories are given credit for better valuation.

There is a significant philosophical difference between discounted cash flow and relative
valuation. In discounted cash flow valuation, we are attempting to estimate the intrinsic value of
an asset based upon its capacity to generate cash flows in the future. In relative valuation, we are
making a judgment on how much an asset is worth by looking at what the market is paying for
similar assets. If the market is correct, on average, in the way it prices assets, discounted cash
flow and relative valuations may converge. If, however, the market is systematically over pricing
or under pricing a group of assets or an entire sector, discounted cash flow valuations can deviate
from relative valuations.

Reasons for Popularity and potential pitfalls:

Why is the use of relative valuation so widespread? Why do managers and analysts relate so
much better to a value based upon a multiple and comparables than to discounted cash flow
valuation? In this section, we consider some of the reasons for its popularity.

a. It is less time and resource intensive than discounted cash flow valuation:
Discounted cash flow valuations require substantially more information than relative valuation.
For analysts who are faced with time constraints and limited access to information, relative
valuation offers a less time intensive alternative.

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b. It is easier to sell:
In many cases, analysts, in particular, and sales people, in general, use valuations to sell stocks to
investors and portfolio managers. It is far easier to sell a relative valuation than a discounted cash
flow valuation. After all, discounted cash flow valuations can be difficult to explain to clients,
especially when working under a time constraint many sales pitches are made over the phone
to investors who have only a few minutes to spare for the pitch. Relative valuations, on the other
hand, fit neatly into short sales pitches. In political terminology, it is far easier to spin a relative
valuation than it is to spin a discounted cash flow valuation.

c. It is easy to defend:
Analysts are often called upon to defend their valuation assumptions in front of superiors,
colleagues and clients. Discounted cash flow valuations, with their long lists of explicit
assumptions are much more difficult to defend than relative valuations, where the value used for
a multiple often comes from what the market is paying for similar firms. It can be argued that the
brunt of the responsibility in a relative valuation is borne by financial markets. In a sense, we are
challenging investors who have a problem with a relative valuation to take it up with the market,
if they have a problem with the value.

d. Market Imperatives:
Relative valuation is much more likely to reflect the current mood of the market, since it
attempts to measure relative and not intrinsic value. Thus, in a market where all internet stocks
see their prices bid up, relative valuation is likely to yield higher values for these stocks than
discounted cash flow valuations. In fact, by definition, relative valuations will generally yield
values that are closer to the market prices than discounted cash flow valuations, across all stocks.
This is particularly important for those investors whose job it is to make judgments on relative
value and who are themselves judged on a relative basis. Consider, for instance, managers of
technology mutual funds. These managers will be judged based upon how their funds do relative
to other technology funds. Consequently, they will be rewarded if they pick technology stocks
that is under-valued relative to other technology stocks, even if the entire sector is over
valued.

Advantages and Disadvantages:

The strengths of relative valuation are also its weaknesses. First, the ease with which a relative
valuation can be put together, pulling together a multiple and a group of comparable firms can
also result in inconsistent estimates of value where key variables such as risk, growth or cash
flow potential are ignored.

Second, the fact that multiples reflect the market mood also implies that using relative valuation
to estimate the value of an asset can result in values that are too high, when the market is over
valuing comparable firms, or too low, when it is under valuing these firms.

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Third, while there is scope for bias in any type of valuation, the lack of transparency regarding
the underlying assumptions in relative valuations make them particularly vulnerable to
manipulation. A biased analyst who is allowed to choose the multiple on which the valuation is
based and to choose the comparable firms can essentially ensure that almost any value can be
justified.

Relative valuation is not as straightforward as it might appear on the surface. Which companies
are chosen as comparable companies and which multiples are used to determine value will have
a significant outcome on a company's relative valuation. When performing a relative valuation, a
company's sector should be used to determine the most logical multiple to use. For example,
price to cash flow for real estate and price to sales for retail.

Further Classification of Relative Valuation Models:

Analysts and investors are endlessly inventive when it comes to using relative valuation. Some
compare multiples across companies, while others compare the multiple of a company to the
multiples it used to trade in the past. While most relative valuations are based upon comparables,
there are some relative valuations that are based upon fundamentals.

I.Fundamentals versus Comparables

In discounted cash flow valuation, the value of a firm is determined by its expected cash flows.
Other things remaining equal, higher cash flows, lower risk and higher growth should yield
higher value. Some analysts who use multiples go back to these discounted cash flow models to
extract multiples. Other analysts compare multiples across firms or time, and make explicit or
implicit assumptions about how firms are similar or vary on fundamentals.

1. Using Fundamentals
The first approach relates multiples to fundamentals about the firm being valued growth rates in
earnings and cash flows, payout ratios and risk. This approach to estimating multiples is
equivalent to using discounted cash flow models, requiring the same information and yielding
the same results. Its primary advantage is to show the relationship between multiples and firm
characteristics, and allows us to explore how multiples change as these characteristics change.
For instance, what will be the effect of changing profit margins on the price/sales ratio? What
will happen to price-earnings ratios as growth rates decrease? What is the relationship between
price-book value ratios and return on equity?

2. Using Comparables
The more common approach to using multiples is to compare how a firm is valued with how
similar firms are priced by the market, or in some cases, with how the firm was valued in prior
periods. As we will see in the later chapters, finding similar and comparable firms is often a
challenge and we have to often accept firms that are different from the firm being valued on one
dimension or the other. When this is the case, we have to either explicitly or implicitly control
100
for differences across firms on growth, risk and cash flow measures. In practice, controlling for
these variables can range from the nave (using industry averages) to the sophisticated
(multivariate regression models where the relevant variables are identified and we control for
differences.).

II. Cross Sectional versus Time Series Comparisons

In most cases, analysts price stocks on a relative basis by comparing the multiple it is trading to
the multiple at which other firms in the same business are trading. In some cases, however,
especially for mature firms with long histories, the comparison is done across time.

a. Cross Sectional Comparisons

When we compare the price earnings ratio of a software firm to the average price earnings ratio
of other software firms, we are doing relative valuation and we are making cross sectional
comparisons. The conclusions can vary depending upon our assumptions about the firm being
valued and the comparable firms. For instance, if we assume that the firm we are valuing is
similar to the average firm in the industry, we would conclude that it is cheap if it trades at a
multiple that is lower than the average multiple. If, on the other hand, we assume that the firm
being valued is riskier than the average firm in the industry, we might conclude that the firm
should trade at a lower multiple than other firms in the business. In short, you cannot compare
firms without making assumptions about their fundamentals.

b. Comparisons across time

If you have a mature firm with a long history, you can compare the multiple it trades today to the
multiple it used to trade in the past. Thus, Ford Motor company maybe viewed as cheap because
it trades at six times earnings, if it has historically traded at ten times earnings. To make this
comparison, however, you have to assume that your firm has not changed its fundamentals over
time. For instance, you would expect a high growth firms price earnings ratio to drop and its
expected growth rate to decrease overtime as it becomes larger. Comparing multiples across time
can also be complicated by changes in the interest rates over time and the behavior of the overall
market. For instance, as interest rates fall below historical norms and the overall market
increases, you would expect most companies to trade at much higher multiples of earnings and
book value than they have historically.

Applicability of multiples and limitations

The allure of multiples is that they are simple and easy to work with. They can be used to obtain
estimates of value quickly for firms and assets, and are particularly useful when there are a large
number of comparable firms being traded on financial markets and the market is, on average,
pricing these firms correctly. They tend to be more difficult to use to value unique firms, with no
obvious comparables, with little or no revenues and negative earnings.

101
By the same token, they are also easy to misuse and manipulate, especially when comparable
firms are used. Given that no two firms are exactly similar in terms of risk and growth, the
definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a
group of comparable firms to confirm his or her biases about a firms value. An illustration of
this is given below. While this potential for bias exists with discounted cash flow valuation as
well, the analyst in Discounted Cash Flow valuation is forced to be much more explicit about the
assumptions which determine the final value. With multiples, these assumptions are often left
unstated.

The other problem with using multiples based upon comparable firms is that it builds in errors
(over valuation or under valuation) that the market might be making in valuing these firms. For
instance, if the market has overvalued all computer software firms, using the average PE ratio of
these firms to value an initial public offering will lead to an overvaluation of its stock. In
contrast, discounted cash flow valuation is based upon firm-specific growth rates and cash flows,
and is less likely to be influenced by market errors in valuation.

Asset Based Valuation Models

There are some who add a fourth approach to valuation to the three that we describe in this
chapter. They argue that you can argue the individual assets owned by a firm and use that to
estimate its value asset based valuation models. In fact, there are several variants on asset
based valuation models. The first is liquidation value, which is obtained by aggregating the
estimated sale proceeds of the assets owned by a firm. The second is replacement cost, where
you evaluate what it would cost you to replace all of the assets that a firm has today.

While analysts may use asset-based valuation approaches to estimate value, we do not consider
them to be alternatives to discounted cash flow, relative or option pricing models since both
replacement and liquidation values have to be obtained using one or more of these approaches.
Ultimately, all valuation models attempt to value assets the differences arise in how we identify
the assets and how we attach value to each asset. In liquidation valuation, we look only at assets
in place and estimate their value based upon what similar assets are priced at in the market. In
traditional discounted cash flow valuation, we consider all assets including expected growth
potential to arrive at value. The two approaches may, in fact, yield the same values if you have a
firm that has no growth assets and the market assessments of value reflect expected cash flows.

Contingent Claim Valuation

Perhaps the most significant and revolutionary development in valuation is the acceptance, at
least in some cases, that the value of an asset may not be greater than the present value of
expected cash flows if the cash flows are contingent on the occurrence or non-occurrence of an
event. This acceptance has largely come about because of the development of option pricing
models. While these models were initially used to value traded options, there has been an
attempt, in recent years, to extend the reach of these models into more traditional valuation.
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There are many who argue that assets such as patents or undeveloped reserves are really options
and should be valued as such, rather than with traditional discounted cash flow models.

To conclude, there are three basic, though not mutually exclusive, approaches to valuation. The
first is discounted cash flow valuation, where cash flows are discounted at a risk-adjusted
discount rate to arrive at an estimate of value. The analysis can be done purely from the
perspective of equity investors, by discounting expected cash flows to equity at the cost of
equity, or it can be done from the viewpoint of all claimholders in the firm, by discounting
expected cash flows to the firm at the weighted average cost of capital. The second is relative
valuation, where the value of the equity in a firm is based upon the pricing of comparable firms
relative to earnings, cash flows, book value or sales. The third is contingent claim valuation,
where an asset with the characteristics of an option is valued using an option pricing model.
There should be a place for each among the tools available to any analyst interested in valuation.

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 Table No.3.1
International Comparison of Accounting Principles
Accounting Principle UK USA France Germany Netherlands Sweden

1. Consistence accounting principles and methods are applied on the

same basis from period to period Yes Yes Yes Yes Yes PP
2. Realization revenue is recognized when realization is
reasonably assured Yes Yes Yes Yes Yes Yes
3. Fair presentation of the financial statement is required Yes Yes Yes Yes Yes Yes
4. Historical cost convention departures from the historical
cost convention are disclosed Yes Yes Yes Yes Yes Yes
5. Accounting policies a change in accounting principles
and methods without a change in circumstances
is accounted for by a prior year adjustment Yes No Yes MP RF MP
6. Fixed assets revaluation in historical cost statements,
fixed assets are stated at an amount in excess
of cost which is determined at irregular intervals. MP No Yes No RF PP
7. Fixed assets revaluation when fixed assets are stated,
in historical cost statements, at an amount in
excess of cost, depreciation based on the revaluation amount
is charged to income. Yes No Yes No Yes Yes
8. Goodwill amortized MP Yes Yes Yes M Yes
9. Finance leases capitalized Yes Yes No No No Yes
10. Short-term marketablse securities at the lower of
cost or market value Yes Yes Yes Yes Yes Yes
11. Inventory values at the lower of cost or market value Yes Yes Yes Yes Yes Yes
12. Manufacturing overhead allocated to year-end inventory Yes Yes Yes Yes Yes Yes
13. Inventory costed using FIFO PP M M M M PP
14. Long-term debt included maturities longer than one year Yes Yes Yes No Yes Yes
15. Deferred tax recognized where accounting income and
taxable income arise at different times Yes Yes Yes No Yes No
16. Total pension fund assets and liabilities excluded from
a companys financial statements Yes Yes Yes No Yes Yes
17. Research and development expensed Yes Yes Yes Yes Yes Yes
18. General purpose (purely discretionary) reserves allowed No No Yes Yes Yes Yes
19. Offsetting-assets and liabilities are offset against each
other in the balance sheet only when a legal right
of offset exists Yes Yes Yes Yes Yes Yes
20. Unusual and extraordinary gains and losses are taken in
the income statement Yes Yes Yes Yes Yes Yes
21. Closing rate method of foreign currency translation employed Yes Yes Yes Yes Yes No
22. Currency translation gains or losses arising from trading
are reflected in current income Yes Yes MP MP MP MP
23. Excess depreciation permitted Yes No Yes Yes Yes Yes
24. Basic statements reflect a historical cost valuation
(no price level adjustment) Yes Yes Yes Yes M Yes
25. Supplementary inflation adjusted financial statements
adjusted MP MP No NO MP Yes
(a) less than 20% ownership - cost method Yes Yes Yes Yes No Yes
(b) 20 - 50% ownership -equity method Yes Yes Yes No Yes MP
(c) More than 50% full consolidation Yes Yes Yes Yes Yes Yes
27. Both domestic and foreign subsidiaries consolidated Yes Yes Yes M Yes Yes
Source: Adopted from Investment Valuation Damodaran, 2nd Edition

104
 CHAPTER NO.IV

Report Writing and

Presentation

105
Equity research is a report written by a brokerage or securities firm for its clients as a way to
help investors make decisions about where to invest resources. A written or electronic
communication that includes an analysis of equity securities of individual companies or
industries, and that provides information reasonably sufficient upon which to base an investment
decision. Readers of Equity Research, more so than anything else, are looking for you to identify
trends that make investment decisions easier to justify.

Points to be kept in mind while preparing an equity research report:

The report should be simple and to the point. It may seem obvious, but portfolio, pension-
fund managers and investors do not want to read something they don't understand. If your
research has identified a trend or a buy/sell opportunity, keep the communication simple
and easy to understand, but don't be condescending.

Issue the report in a timely manner. Late investment advice is of no value.

Concentrate on 5 main areas: 1) the company, 2) the industry, 3) government interest, 4)

market interest, and 5) investment ideas for clients. You can find this information in the
annual report and official SEBI and Exchange filings, company press releases, company
visits, industry studies, relevant government sources and the press.

Report the basics on the cover. The reader should know, immediately, the reason to read
the report. Include a paragraph that gives the client a reason to read your analysis, what
investors should think about the stock. What is the investment conclusion? What is new
and different from consensus estimates (read: other analysts).

Keep your audience engaged with a clear report design. The report should never be more
than 30 pages; always use charts and graphs to support your arguments, and use message
headings to help the reader navigate the document. Also edit the text for industry jargon
and passive verbs.

Discuss risks. This usually goes at the end of an equity research report, but you are
obligated as a research analyst to provide information on the risks involved in taking your
advice. Readers expect this section.

106
Template for the Equity Research Report:
Following is the proforma Equity research report. There may be slight changes with between the
research analysts, but by and large this is the template which is followed by many of the analysts
across the world.
Highlights
Investment summary
Historical financial
Industry analysis
Valuation
Business description
Other headings
Industry description and competitive position
Estimates
Investment risks
Disclosures
Under the Highlights section:
Tells the reader why they should read the report.
1-2 sentences per bullet.
Be clear and concise.
Investment summary section
Make a longer statement about your recommendation.
Make assertions that back up your recommendation.
Leave support of assertions to the body of report.
Valuation section
Used to justify your price target
Each of the models that you use should be presented.
Do not reiterate textbook material.
Risks to the price target should be included
Incorporate a sensitivity analysis of the valuation based on your computations.
Under Business Description Section:
Describe business, products, finances, and strategy of company.
Relative importance of segments and products.
Highlight important assets or liabilities.
Special situations/earnings interruptions
Mergers &Acquisitions if any
Restructurings effects/pay back expectations
Discontinued operations
What is the leverage?
Operating, fixed and variable costs
Value added
107
 How to manage downturn
Other headings
Use to make points that do not fit in the rest of the report
Contains for example:
Cost of capital calculations.
Dilution of shares analysis.
Large insider share-holdings details.
Industry description and competitive position:
Describe the industry
Where in cycle does
Who are the competitors
Describe how the industry excel
How has it performed in the previous cycles
Cyclical, Continuous growth
Industry Maturity
Effects of recession/ slow
What are the factors that affects the company the most
Demand Environment recovery
Forces affecting the industry
Elasticity of Demand
Speed of Product
Innovation
Rate of growth
Historical financial analysis
Must be ratio based using a bottoms-up using the DuPont and the leverage formulas.
Historical and comparison with industry.
How as the company performed and how well in comparison with industry.
Operating Performance
Analyze the company using the DuPont formula
Financial Performance
Comparing the company with its components.
Total Performance

Estimates section
Must be ratio based following leverage and DuPont-formula.
The analysis of the future should be done relating the company to its peers in the
industry.
Justify the assumptions made
Short run Total Performance
Long-run Performance
108
Sources of Information:
Having discussed the proforma research report, you should know where is the relevant
information available for writing the report in the manner as described above.

Public information
Returns / documents filed with SEBI and the stock exchanges
Annual Reports
Press Releases

Conversations with company management for detailed information

Establish relationships with new companies
Most meetings with companies done via phone; some in-person meetings
Obtain a better understanding of:
Trends
Leverage/margins
Efficiency programs
Costs - current, changes
Management team

Validation:

The information collected from multiple sources must be validated before doing any further
analysis. The validation could be done by confirming and reconfirming the data collected from
various sources.

Expert / Legal Opinion:

Whenever, the analysts fees that the data obtained is technical or if he feels that he is not
understanding the things in a proper manner, he should seek the help of the expert in the
respective field. For instance, when an analyst is writing a report about an oil company where in
lot of technical details regarding oil upstream, downstream, refining, transportation and the like
he should seek the help of an expert in this field in order to better understand and absorb.
Further, before releasing the final report the analyst should ensure that no legal issues should
arise out of the report. He should also seek a legal opinion and also write the caveat very clearly
stating that the contents of the reports are purely based on the personal opinion of the analyst
based on the information collected from multiple sources and assumptions.

A model Equity Research Report of Kotak Securities is appended below for your reference and
understanding:

109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
Source:http://www.kotaksecurities.com/pdf/morninginsightsample.pdf

134
References:

Bodie, Kane and Marcus, Essentials of Investments, 7th Edition, McGrwa Hill Irwin Series.

Reilly and Brown, Investment Analysis and Portfolio Management, 8th Edition, Thomson, South
Western.

Damodaran A, Investment Valuation Tools and Techniques for determining the value of any
asset 2nd Edition, Wiley & Sons, New York.

Websites:
www.nseindia.com accesses on 20th November 2012
www.baseindia.com accessed on 20th November 2012
www.investopedia.com accessed on 21st November 2012
www.ssrn.com accessed on 21st November 2012
www.ncaer.org accessed on 25th November 2012
www.tatasteeel.com accessed on 28th November 2012
www.accclimited.com accessed on 28th November 2012
www.capitaline.com accessed on 28th November 2012
www.kotaksecurities.com/pdf/morninginsightsample.pdf accessed on 1st December 2012

135
 Useful Formulas

Nominal Rate
Interest rate is the price for using someones money. In simple terms, if money is kept idle,
its value would get eroded by at least the rate of inflation. Anyone having surplus money
would try to earn at least the rate of inflation to be at par, but to grow in real terms of
wealth his money should increase beyond the rate of inflation. Thus, a lender would quote a
nominal rate, of interest, which would be;

N=R+I

Where,
N = Nominal Rate of Interest
R = Real Rate of Interest
I = Inflation

Assuming an inflation rate of 3% and a desired real rate of 4%, the nominal rate of interest
would be;

N=R+I
N = 4% + 3%
N = 7%

Effective Rate
Effective rate of interest is the rate which takes the effect of compounding. To put in simple
terms when the year is broken into smaller units like quarterly, monthly, etc and
compounding frequency is more than 1, than the nominal rate and effective rate starts
differing. The investor / borrower effectively starts receiving / paying more than what was
quoted (nominal rate).

Where,
i = Effective rate of interest
i(p) = Nominal rate if interest
p = Number of periods broken in a year (frequency)

Illustration-1

State Bank of India is quoting car loan at the rate of 12.5% for a period of 5 years. The loan
has to be repaid in equated monthly installments. Calculate the effective rate.

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Flat Rate

The rate at which interest is calculated on the original loan amount, irrespective of the
principal repayment, is called flat rate of interest. Unlike the effective rate which calculates
the interest on the reduced principal, the flat rate ignore the principal repayment and thus
the interest figure calculated turns out to be same as the first period interest.
Flat rate of interest is a gimmick used by the market to show a lower rate and charge a
higher rate. The flat rate can be converted into an effective rate by the following thumb
rule:

E = F x 2 x (n / n+1)

Where,
E = Effective rate on interest
F = Flat rate of interest
n = Number of installements

Illustration-2

Citi Bank offers personal loan for 5 years at a flat rate of 9.5% p.a. Calculate the effective
rate of interest if the loan is to be paid in equated monthly installments.
E = F x 2 x (n / n+1)
= 9.5 x 2 x (60 / 61)
E = 18.69%

Rule of 72
The rule of 72, is a simple thumb rule used for doubling period calculation.

For example what is the interest rate earned if the money is doubled in 5 years.

r = 72 / n
= 72 / 5
r = 14.4% (aprox)

or

For example, in how many years the money can be doubled if the rate of interest is 9%.
n = 72 / r
= 72 / 9
n = 8 years (aprox)

Rule of 69
Very similar to the rule of 72, a rule stating that an amount of money invested at r percent
per period will double as:-

n = 69/r (in percent) + .35 periods

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Continuous Compounding
Compounding is a process of calculating interest on interest at some intervals. Continuous
compounding is the process of calculating interest on interest for infinite times during the
life of investment. For calculating the continuous compounded value of investment we would
need the continuous compounding factor (CCF(r%,t))

CCF(r%,t) = ert

Where,
CCF(r%,t) =Continuous compounding factor for Rs 1 invested at the rate r for time t
e = Base to natural log (ln)

If the money is invested at any rate for a particular time period and compounded
continuously, the resultant would be highest future value. Therefore, an investor should
always insist on getting his money compounded continuously.

FV = PV x CCF(r%,t)

Illustration-14

Rahul wants to invest Rs 100000 for 5 years. The bank offers him an interest rate of
8.25%p.a. compounded continuously. Calculate the amount Rahul would get after 5 years.
FV = PV x CCF(8.25%,5)
= PV x ert
= 100000 x e0.0825 x 5
= 100000 X 1.5106
= 1,51,058.95

Hence, rahul would get an amount of Rs 1,51,058.95 after 5 years.

Continuous Discounting
Discounting is a process of calculating the reduction of interest at some intervals.
Continuous discounting is the process of calculating the reduction of interest for infinite
times during the life of investment. For calculating the continuous discounted value of future
cash flow we would need the continuous discounting factor (CDF(r%,t))

CDF(r%,t) = e-rt
Where,
CDF(r%,t) = Continuous compounding factor for Rs 1 invested at the rate r for time t
e = Base to natural log (ln)

If present value is calculated at any rate for a particular time period and discounted
continuously, the resultant would be lowest present value. Therefore, if you have to pay a
lump sum against some future liability, you should insist on getting this future value of
money discounted continuously.

PV = FV x CDF(r%,t)

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Illustration-15

Sushmita has to pay Kaveri Rs 3,65,000 after 4 years. Kaveri is in need of money and
wants the money now. Sushmita agrees but after continous discounting the money at the
rate of 14%p.a. calculate the amount of money that sushmita can pay now.

PV = FV x CDF(14%,4)
= FV x e-rt
= 365000 x e-0.14 x 4
= 365000 x 0.5712
= 2,08,491.31

Hence, Sushmita would only pay Rs 2,08,491.31 today.

DuPont analysis

DuPont analysis (also known as the dupont identity, DuPont equation, DuPont Model
or the DuPont method) is an expression which breaks ROE (Return On Equity) into three
parts.

The name comes from the DuPont Corporation that started using this formula in the 1920s.

Basic formula
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net
profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)

Profitability (measured by profit margin)

Operating efficiency (measured by asset turnover)
Financial leverage (measured by equity multiplier)

ROE analysis

The Du Pont identity breaks down Return on Equity (that is, the returns that investors
receive from the firm) into three distinct elements. This analysis enables the analyst to
understand the source of superior (or inferior) return by comparison with companies in
similar industries (or between industries).

The Du Pont identity, however, is less useful for some industries, such as investment
banking, that do not use certain concepts or for which the concepts are less meaningful.
Variations may be used in certain industries, as long as they also respect the underlying
structure of the Du Pont identity.

Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is
by definition true.

Examples

High Turnover Industries

Certain types of retail operations, particularly stores, may have very low profit margins on
sales, and relatively moderate leverage. In contrast, though, groceries may have very high
turnover, selling a significant multiple of their assets per year. The ROE of such firms may
be particularly dependent on performance of this metric, and hence asset turnover may be
studied extremely carefully for signs of under-, or, over-performance. For example, same
store sales of many retailers is considered important as an indication that the firm is

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deriving greater profits from existing stores (rather than showing improved performance by
continually opening stores).

High margin industries

Other industries, such as fashion, may derive a substantial portion of their competitive
advantage from selling at a higher margin, rather than higher sales. For high-end fashion
brands, increasing sales without sacrificing margin may be critical. The Du Pont identity
allows analysts to determine which of the elements is dominant in any change of ROE.

High leverage industries

Some sectors, such as the financial sector, rely on high leverage to generate acceptable
ROE. In contrast, however, many other industries would see high levels of leverage as
unacceptably risky. Du Pont analysis enables the third party (relying primarily on the
financial statements) to compare leverage with other financial elements that determine ROE
among similar companies.

ROA and ROE ratio

The return on assets (ROA) ratio developed by DuPont for its own use is now used by
many firms to evaluate how effectively assets are used. It measures the combined effects of
profit margins and asset turnover.[1]

The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2]
Decomposing the ROE into various factors influencing company performance is often called
the Du Pont system.[3]

Where
Net income = net income after taxes
Equity = shareholders' equity
EBIT = Earnings before interest and taxes

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This decomposition presents various ratios used in fundamental analysis.

The company's tax burden is (Net income Pretax profit). This is the proportion of
the company's profits retained after paying income taxes. [NI/EBT]
The company's interest burden is (Pretax income EBIT). This will be 1.00 for a firm
with no debt or financial leverage. [EBT/EBIT]
The company's operating income margin or return on sales (ROS) is (EBIT
Sales). This is the operating income per dollar of sales. [EBIT/Sales]
The company's asset turnover (ATO) is (Sales Assets).
The company's leverage ratio is (Assets Equity), which is equal to the firm's debt
to equity ratio + 1. This is a measure of financial leverage.
The company's return on assets (ROA) is (Return on sales x Asset turnover).
The company's compound leverage factor is (Interest burden x Leverage).

ROE can also be stated as:[4]

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor

Profit margin is (Net income Sales), so the ROE equation can be restated:

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Time series analysis comprises methods for analyzing time series data in order to extract
meaningful statistics and other characteristics of the data. Time series forecasting is the
use of a model to predict future values based on previously observed values. While
regression analysis is often employed in such a way as to test theories that the current
value of one time series affects the current value of another time series, this type of
analysis of time series is not called "time series analysis".

Time series data have a natural temporal ordering. This makes time series analysis distinct
from other common data analysis problems, in which there is no natural ordering of the
observations (e.g. explaining people's wages by reference to their respective education
levels, where the individuals' data could be entered in any order). Time series analysis is
also distinct from spatial data analysis where the observations typically relate to
geographical locations (e.g. accounting for house prices by the location as well as the
intrinsic characteristics of the houses). A stochastic model for a time series will generally
reflect the fact that observations close together in time will be more closely related than
observations further apart. In addition, time series models will often make use of the
natural one-way ordering of time so that values for a given period will be expressed as
deriving in some way from past values, rather than from future values (see time
reversibility.)

Methods for time series analyses may be divided into two classes: frequency-domain
methods and time-domain methods. The former include spectral analysis and recently
wavelet analysis; the latter include auto-correlation and cross-correlation analysis.

Additionally time series analysis techniques may be divided into parametric and non-
parametric methods. The parametric approaches assume that the underlying stationary
stochastic process has a certain structure which can be described using a small number of
parameters (for example, using an autoregressive or moving average model). In these
approaches, the task is to estimate the parameters of the model that describes the
stochastic process. By contrast, non-parametric approaches explicitly estimate the
covariance or the spectrum of the process without assuming that the process has any
particular structure.

Additionally methods of time series analysis may be divided into linear and non-linear,
univariate and multivariate.

Time series analysis can be applied to:

real-valued, continuous data
discrete numeric data
discrete symbolic data (i.e. sequences of characters, such as letters and words in
English language)

Cross series analysis comprises methods for analyzing the financial data across the
industry. Selection of a good company does not only qualify improvement over a period of
time (Time series analysis) but also a relatively better performance over the peer group
companies (Cross section analysis).

Thus, cross section analysis or vertical analysis serves an important filter to select a
company considered for investment for a long period.

Models like ROE and DU PONT can be used as structures to perform Time series analysis
and Cross section analysis.

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