Derivatives

FUNDAMENTAL
ANALYSIS
Workbook
NSE Certified Capital Market Professional
(NCCMP)
(A Joint Certificate course from ______________________________
and
The National Stock Exchange of India Limited)
CONTENTS
Sl No Particulars Page No
1 Chapter 1 : Introduction 02
2 Chapter 2 : Fundamental Analysis 17
3 Chapter 3 : Value Investing 39
4 Chapter 4 : Valuation of Stocks 59
5 Chapter 5 : Portfolio Management 78
Copyright 2010 by National Stock Exchange of India Ltd. (NSE) Exchange Plaza, Bandra Kurla Complex, Bandra (East),
-1- Mumbai 400 051 INDIA
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CHAPTER 1
INTRODUCTION
WHY INVEST IN SHARES?
Studies have proved, time and again, that shares (or equities) are among the best long-term
investments in the financial market place. They tend to outperform government bonds, corporate
bonds, property and many other types of assets.
Share prices can fluctuate, therefore, buying shares is not without risk, but in the long term, they
have the ability to generate good returns. For instance, if you want to double your money in a year,
buying shares is not the best way to do it. But if you want to invest for long-term, say, ten or 20
years, shares may be a rewarding investment.
Shares are designed to provide investors with two types of return: annual income and long-term
capital growth.
Most shares offer income in the form of dividends, which are typically paid twice a year. Dividends
can be seen as a reward for shareholders. They are paid when a company is profitable and has cash
in the bank after it has satisfied all its obligations.
In most cases, the more profitable a company is, the higher the dividend payments. If a company is
making substantial amounts of money and making significant dividend payments, it is usually
considered a good investment resulting in a rise of share price.
Investors may buy shares specifically for income. Many companies generate substantial amounts of
cash every year. They may use some of that money for general corporate purposes, such as paying
rent and wage bills, and they may use some of the money to invest in equipment, research, and
development. A proportion of this money may be paid to investors as dividend. As dividends are
usually paid out twice a year, they can provide investors with a regular income. Companies that
pay generous dividends are known as income stocks.
Some companies have heavy investment programs so they plough their profits back into the
business. These companies are often at an early stage of their development and are keen to expand
and grow. They are known as growth businesses as investors pay in anticipation of future growth in
these companies. Long-term capital growth comes about when a share price increases over a period
of time, despite short-term fluctuations.
Whats so good about shares?
1. Shares are easy to understand
A share is basically a part-ownership in a company. These companies are real businesses that
provide the products and services we come across every day - like the bank, the phone company,
the mining company, or the supermarket.
2. Shares can provide better returns in the long-term
History demonstrates that shares, as a long-term investment, have the potential to provide better
returns after tax than any other major investment. However, you should be aware that past
performance is no guarantee of future returns.
3. You can diversify your investment
Volatility (or risk) is the chance of your investment increasing or decreasing in value. All
investments carry some volatility. You can reduce the volatility of your shares portfolio by investing
in a number of quality companies, rather than limit them. This is called diversification of your
portfolio.
Diversification is spreading your money across a range of investments. If youre the kind of investor
who likes a good nights sleep as well as strong returns, diversification is vital.
Historically, investors have been able to reduce the overall volatility of their portfolio and improve
overall returns by investing in a diversified mix of shares.
4. Shares are a long-term investment
Investors that have made money from shares tend to be the ones who have held onto their
investment regardless of the ups and downs for longer periods. They view share investment as a
get-rich-slow schemeas shares pay off higher than most other investments in the long-term.
5. Shares can be tax effective
Investing in shares can also be an efficient way of generating tax-effective income thanks to
dividend imputation!1
6. Shares are liquid
If you invest directly in shares and need to access your money in a hurry, it's relatively simple to
sell your shares. In fact, you can normally buy and sell the same shares many times in just a day.
Its also relatively easy to sell any indirect investment in shares by redeeming (i.e. selling) units in a
managed fund investment. Compare this with owning property - youd be doing well to buy and sell
a property in a month.
With shares, its also easy to buy or sell a part of your portfolio; whereas with a property, you cant
sell just the bathroom or the kitchen.
7. With shares you can start small
You dont need to have a lot of money to invest in shares. You can start with as little as Rs. 500.
Whats not so good about shares?

Shares can decrease in value.
The volatility of shares can make people nervous. However, volatility is usually only a problem if
you are investing for the short-term with a view to making a quick profit (speculating), or investing
in inferior companies, or if not diversifying.
History has shown that investors with a diverse portfolio of quality shares who invest for the long-
term generally come out on top.
1
Companies typically distribute dividends from their net income, i.e., the profits after tax. Dividend
imputation simply allows shareholders to claim tax breaks on the dividend received from post-tax income.
TIME VALUE OF MONEY
Concept
The Time Value of Money (TVM) is an important concept in financial management. It can be used to
compare various investment alternatives and to examine financial assets like loans, mortgages,
leases, savings, and annuities.
TVM is based on the concept that a rupee that you have today is worth more than the promise or
expectation that you will receive a rupee in the future. Money that you hold today is worth more
because you can invest it and earn interest. After all, you should receive some compensation for
foregoing spending. For instance, you can invest your rupee for one year at a 7% annual interest
rate and accumulate 1.07 at the end of the year. You can say that the future value of the rupee is
1.07 given a 7% interest rate and a one-year period. It follows that the current value of the 1.07 you
expect to receive in one year is 1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or
receipts promised in the future can be converted to an equivalent value today. Conversely, you can
determine the value to which a single sum or a series of future payments will grow to at a future
date.
Time Lines
One of the most important tools in time value analysis is the time line, which is used by analysts to
help visualize what is happening in a particular problem and then to help set up the problem for a
solution. To illustrate the time line concept, consider the following diagram:
Time: 0 1 2 3 4 5
Time 0 is the beginning of the period, Time 1 is one period from the beginning, or the end of Period
1; Time 2 is two periods from the beginning, or the end of Period 2; and so on. Thus, the numbers
above the tick marks represent end-of-period values. Often the periods are years, but other time
intervals such as semi-annual periods, quarters, or months can be used too. If each period on the
time line represents a year, the interval from the tick mark corresponding to 0 to the tick mark
corresponding to 1 would be Year 1; the interval from 1 to 2 would be Year 2, and so on. Note that
each tick mark corresponds to the end of one period as well as the beginning of the next period. In
other words, the tick mark at Time 1 represents the end of Year 1, and it also represents the
beginning of Year 2 because Year 1 has just passed.
Cash flows are placed directly below the tick marks, and interest rates are shown directly above the
time line. Unknown cash flows, which you are trying to find in the analysis, are indicated by
question marks. Now consider the following time line:
Time: 0 1 2 3 4 5
10%
Cash Flows: -1000 ?
Here the interest rate for each of the five periods is 10 percent; a single amount (or lump sum) cash
outflow is made at Time 0; and the Time 5 value is an unknown inflow. Since the initial Rs. 1000 is
an outflow (an investment), it has a minus sign. Since the Period 5 amount is an inflow, it does not
have a minus sign, which implies a plus sign. No cash-flow is observed at times 1 and 2 in the
above representation.
Future Value of a Single Deposit
We have already discussed that a rupee in hand today is worth more than a rupee to be received in
the future because if you had it now, you could invest it, earn interest, and end up with more than
one Rupee in the future. The process of going from todays values, or present values (PVs), to future
values (FVs) is called compounding. To illustrate, suppose you deposit Rs. 1000 in a bank that pays
10 percent interest each year. How much would you have at the end of one year?
To begin, we define the following terms:
PV = present value, or beginning amount, in your account.

i = interest rate the bank pays on the account per year.
INT = Amount of Interest
FVn = future value, or ending amount, of your account at the end of n years.
n = number of periods involved in the analysis.
FVn = FV1 = PV + INT
= PV + PV (i)
= PV (1+i)
= 1000(1+0.10)
= 1100
Thus, the future value (FV) at the end of one year, FV 1, equals the present value multiplied by 1
plus the interest rate, so you will have Rs.1100 after one year.
What would you end up with if you left Rs.1000 in your account for five years? Here is a time line
set up to show the amount at the end of each year:
Time: 0 1 2 3 4 5
10%
Cash Flows: -1000

FV1=? FV2=? FV3=? FV4=? FV5=?
FV5 = FV4 (1+i)
= FV3 (1+i) (1+i)
= FV2 (1+i) (1+i) (1+i)
= FV1 (1+i) (1+i) (1+i) (1+i)
= PV (1+i) (1+i) (1+i) (1+i) (1+i)
= PV (1+i)5
In general, the future value of an initial lump sum at the end of n years can be found by applying
the following Equation:
FVn = PV (1+i)n
In the above case Future value at the end of year 5 = 1000 (1+0.10)5 = Rs. 1610.51
Present Value of a Single Deposit
From the future value example, we saw that an initial amount of 1000 invested at 10 percent per
year would be worth 1610.51 at the end of five years. The Rs. 1000 is defined as the present value,
or PV, of Rs. 1610.51 due in five years when the opportunity cost rate is 10 percent. If the price of
the security were less than 1000, you should buy it, because its price would then be less than the
1000 you would have to spend on a similar-risk alternative to end up with 1610.51 after five years.
Conversely, if the security cost is more than 1000, you should not buy it, because you would have
to invest only 1000 in a similar-risk alternative to end up with 1610.51 after five years. If the price
were exactly 1000, then you h you could either buy the security or turn it down. Therefore, 1000
is defined as the securitys fair, or equilibrium, value.
In general, the present value of a cash flow due n years in the future is the amount which, if it were
on hand today, would grow to equal the future amount. Since 1000 would grow to 1610.51 in five
years at a 10 percent interest rate, 1000 is the present value of 1610.51 due in five years when the
opportunity cost rate is 10 percent.
Finding present values is called discounting, and it is the reverse of compounding if you know the
PV, you can compound to find the FV, while if you know the FV, you can discount to find the PV.
When discounting, you would follow these steps:
Time: 0 1 2 3 4 5
10%
PV= ? 1610.51
To develop the discounting equation, we begin with the future value equation
FVn = PV (1+i)n
To find out the PV, we can rearrange the equation:
PV = FVn / (1+i)n
In the above case Present value = 1610.51/ (1+0.10)5 = 1000 Rs.
Solving for Interest Rate and Time
There are four variables in the above equationsPV, FV, i, and n and if you know the values of any
three, you can easily find the value of the fourth.
Solving for i
Suppose you can buy a security at a price of 1000, and it will pay you 1610.51 after five years.
Here you know PV, FV, and n, and you want to find i, the interest rate you would earn if you
bought the security. Such problems are solved as follows:
Time: 0 1 2 3 4 5
i =?
-1000 1610.51
FVn = PV (1+i)n
1610.51 = 1000 (1+i)5
1610.51 / 1000 = (1+i)5
1.61051 = (1+i)5
(1.61051)1/5 = 1+i
1.1 = 1+i
i = 0.01 = 10%
Therefore, the interest rate is 10 percent.
Solving for n
Suppose you invest Rs. 1000 at an interest rate of 10 percent per year. How long will it take your
investment to grow to 1610.51? You know PV, FV, and i, but you do not know n, the number of
periods.
Time: 0 10% 1 2 n-2 n-1 n=?
-1000 1610.51
FVn = PV (1+i)n
1610.51 = 1000 (1+0.1)n
1610.51 / 1000 = (1+0.1)n
1.61051 = (1+0.1)n
LN (1.61051) = LN(1+0.1)n
n = 5 Years (Approx.)
Therefore, 5 is the number of years it takes for 1000 to grow to 1610.51 if the interest rate is 10
percent.
RISK AND RETURN
Investors purchase financial assets such as shares of stock because they desire to increase their
wealth, i.e., earn a positive rate of return on their investments. The future, however, is uncertain;
investors do not know what rate of return their investments will eventually realize.
In finance, we assume that individuals base their decisions on what they expect to happen and
their assessment of how likely it is that what actually occurs will be close to what they expected to
happen. When evaluating potential investments in financial assets, these two dimensions of the
decision making process are called expected return and risk.
Risk and Return
Investors are usually concerned with two principal properties inherent in securities:
a. The return that can be expected from holding a security.

b. The risk that the return that is achieved will be less than the expected return.
Investors want to maximize expected returns subject to their tolerance risk.
Investment Return and Its Measurement
Investors want to maximize expected returns subject to their tolerance for risk. Return is the key
here and the principal reward in the investment process. It is the major component used by
investors while comparing different investment avenues. Measuring historical returns allows
investors to assess how well they have done, and it plays a part in the estimation of future,
unknown returns.
One should understand the difference between two widely used terms, Realized Returns and
Expected returns.
Expected Return
The future is uncertain. Investors do not know with certainty whether the economy will be growing
rapidly or be in recession. As such, they do not know what rate of return their investments will
yield. Therefore, they base their decisions on the anticipated future.
The expected rate of return on a stock represents the mean of a probability distribution of possible
future returns on the stock.
Realized returns are after the fact return that was earned (or could have been earned). Realized
returns in the past thus constitute historical data.
1 n
ri rit
n t 1
rit = Realized Return generated by the ith stock in time period t.
Expected Return on the other hand is our expectation from future. It is the return from an asset
that investors anticipate they will earn over future period. This predicted return, may or may not
occur.
n
E (r )i pi ri
i 1
E (r )i = Expected Return on asset i

P(i ) = Probability of ith state to occur.
r(i ) = Expected Return for the ith stock
Arithmetic Mean
The arithmetic average, customarily designated by the symbol X (X bar)
X
X
n
or the sum of each the values being considered divided by the total number of values. The
arithmetic average return is appropriate as a measure of the central tendency of a number of
returns calculated for a particular time, such as a year. However, when percentage changes in
value over time are involved, the arithmetic mean of these changes can be misleading.
For example, suppose an investor purchased a stock in Year 1 for Rs.50 and it rose to Rs.100 by
year-end. This is a 100 percent return [(100-50)/50]. Then the stock went from Rs.100 at the start
of Year 2 to Rs.50 at the end of that year. The return for Year 2 is -50 percent [(50-100)/100)]. The
arithmetic average return is 25 percent [(+ 100-50)/2)]. But, realistically, if an investor bought a
stock for Rs.50 and held it two years and it was still at Rs.50, clearly there is no return at all.
Geometric Mean
A different average is needed to describe accurately the true rate of return over multiple periods.
The geometric average return measures compound, cumulative returns over time. It is used in
investments to reflect the realized change in wealth over multiple periods.
The geometric average is defined as the nth root of the product, i.e., resulting from multiplying a
1
series of returns together G [(1 R1 )(1 R2 )......(1 Rn )] n 1
where:
R = total return
n = number of periods
Note that adding 1.0 to each return (R) produces what we call a return relative. If the return for a
period is 10 percent (.10), then the return relative is 1.10. The investor has received Rs.1.10 relative
to each Rs.1 invested. If the return for a period is -15 percent (-.15) then the return relative is .85 (1
.15). Return relatives are used in calculating geometric average returns because negative total
returns cannot be used in the math.
For our stock that started at Rs.50, rose to Rs.100, and then dropped to Rs.50 over a two-
year period, the geometric return would be calculated as follows:
Return relative, Year 1 = 1.00 + 1.00 = 2.00 Year 2 = -0.50+ 1.00= 0.50
And
1
G [(2.0) * (05)] 2 1
1
G [1.0] 2 1
=0.00
The geometric average reflects compound, cumulative returns over time.
MEASURING INVESTMENT RETURNS
The rate of return of an investment is a simple concept in the case of a one-period investment. It is
simply the total proceeds derived from the investment per rupee initially invested. Proceeds must be
defined broadly to include both cash distributions and capital gains. For stocks, total returns are div-
idends plus capital gains. For bonds, total returns are coupon or interest paid plus capital gains.
To set the stage for discussing the more subtle issues that follow, let us start with a trivial example.
Consider a stock paying a dividend of Rs.2 annually that currently sells for Rs.50. You purchase the
stock today and collect the Rs.2 dividend, and then you sell the stock for Rs.53 at year-end. Your rate
of return is
TOTAL PROCEEDS INCOME CAPITAL GAIN 2 3

.10 OR10 %
INITIAL INVESTMENT 50 50
Another way to derive the rate of return that is useful in the more difficult multi period case is to
set up the investment as a discounted cash flow problem. Call r the rate of return that equates the
present value of all cash flows from the investment with the initial outlay. In our example, the stock
is purchased for Rs.50 and generates cash flows at year-end of Rs.2 (dividend) plus Rs.53 (sale of
stock). Therefore, we solve 50 = (2 + 53)/ (1 + r) to find again that r = 10%.
The expected benefits or returns to be received from an investment come in the form of the cash
flows the investment generates.
n
Conventionally, we measure the expected cash flow, X, as follows: X XiP ( Xi )
i 1
Where n = number of possible stats of the economy.
Xi = the cash flow in the ith state of the economy.
P (Xi) = the probability of ith cash flow
Consider the probability distribution for the returns on stocks A and B provided below.
State Probability Return on Return on
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
3 20% 20% -10%
In this probability distribution, there are four possible states of the world. For example, state 1 may
correspond to a recession. A probability is assigned to each state. The probability reflects how likely
it is that the state will occur. The sum of the probabilities must equal 100%, indicating that
something must happen.
Given a probability distribution of returns, the expected return can be calculated using the
following equation:
N
E[ R] piRi
i 1
- 10 - Mumbai 400 051 INDIA
Where
E[R] = the expected return on the stock,
N = the number of states,
pi = the probability of state i, and
Ri = the return on the stock in state i.
Expected Return on Stocks A and B
Stock A
ERA = .20(5%)+.30(10%)+.30(15%)+.20(20%) = 12.5%
Stock B
ERB = .20(50%)+.30(30%)+.30(10%)+.20(-10%) = 20%
So we see that Stock B offers a higher expected return than Stock A. However, that is only part of
the story; we haven't yet considered risk.
Risk and Its Types
Risk in holding securities is generally associated with the possibility that realized returns will be
less than the returns that were expected. The source of such disappointment is the failure of
dividends (interest) and/or the securitys price to materialize as expected.
Forces that contribute to variations in return price or dividend (interest) constitute elements of
risk. Some influences are external to the firm, cannot be controlled, and affect large numbers of
securities. Other influences are internal to the firm and are controllable to a large degree. In
investments, those forces that are uncontrollable, external, and broad in their effect are called
sources of systematic risk. Conversely, controllable, internal factors somewhat peculiar to
industries and/or firms are referred to as sources of unsystematic risk.
Systematic Risk
This risk refers to that portion of total variability in return caused by factors affecting the prices of
all securities. Economical, political, and sociological changes are sources of systematic risk. Their
effect is to cause prices of nearly all individual common stocks and/or all individual bonds to move
together in the same manner.
Unsystematic Risk
Unsystematic risk is that portion of total risk that is unique or peculiar to a firm or an industry,
above and beyond that affecting securities markets in general. Factors such as management
capability, consumer preferences, and labor strikes can cause unsystematic variability of returns
for a companys stock. Because these factors affect one industry and/or one firm, these are
examined separately for each company
Measurement of Risk
Volatility
Of all the ways to describe risk, the simplest and possibly most accurate is the uncertainty of a
future outcome. The anticipated return for some future period is known as the expected return,
and as discussed earlier, the actual return over some past period is known as the realized return.
The simple fact that dominates investing is that the realized return on an asset with any risk
attached to it may be different from what was expected.
Volatility may be described as the range of movement (or price fluctuation) from the expected level
of return. For instance, the more a stock goes up and down in price, the more volatile that stock
tends to be. Because wide price swings create more uncertainty of an eventual outcome, increased
volatility can be equated with increased risk. Being able to measure and determine the past
volatility of a security is important in that it provides some insight into the riskiness of that
security as an investment.
Standard Deviation
Since the return an investor will earn from investing is not known, it must be estimated. An
investor may expect the TR (total return) on a particular security to be 10 percent for the coming
year, but in truth this is only a "point estimate."
It is important for investors to be able to quantify and measure risk. To calculate the total risk
associated with the expected return, the variance or standard deviation is commonly used. This is a
measure of the spread or dispersion in the probability distribution; that is, a measurement of the
dispersion of a random variable around its mean. Since variance, volatility and risk can in this
context be used synonymously, the larger the dispersion, the larger the variance or standard
deviation and larger the standard deviation, the more uncertain the outcome.
The standard deviation gives a measure of average difference between the expected value and the
actual value of a random variable (or unseen state of nature).
The formula for Expected (ex-ante) P(n X ) 2
Where n = a possible outcome
X = the expected outcome.
P = the probability (or likelihood) of the difference between n and X occurring.
n
1
Historical (ex-post) = n (r
t 1
it ri ) 2
rit = Realized Return generated by the ith stock in time period t.
ri = Average Return of ith stock.
Consider the expected return we have calculated earlier. The expected return on Stock A was found
to be 12.5% and the expected return on Stock B was found to be 20%.
Given an asset's expected return, its variance can be calculated using the following equation:
Var ( R) 2 i 1 Pi ( Ri E[ R])2
N
Where
N = the number of states,
pi = the probability of state i,
Ri = the return on the stock in state i, and
E[R] = the expected return on the stock.
The standard deviation is calculated as the positive square root of the variance
SD( R) 2 ( 2 )1/ 2
Variance and Standard Deviation on
Stocks A and B
Note: ERA = 12.5% and ERB = 20%
Stock A
A2 = .20(.05-.125)2 + .30(.10-.125)2+.30(.15-.125)2+.20(.20-.125)2 = .00263
Stock B
B2 = .20(.50-.20)2+.30(.30-.20)2+.30(.10-.20)2+.20(-.10-.20)2 = .04200
Although Stock B offers a higher expected return than Stock A, it is riskier also since its variance
and standard deviation are greater than Stock A's. This, however, is only part of the picture
because most investors choose to hold securities as part of a diversified portfolio.
Beta
Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Therefore, Beta measures non-diversifiable risk.
Beta is a relative measure of risk: the risk of an individual stock relative to the market portfolio of
all stocks. It shows how the price of a security responds to market forces. Higher-beta stocks mean
greater volatility and are therefore considered to be riskier, but are in turn supposed to provide a
potential for higher returns; low-beta stocks pose less risk but also lower returns. In the same way
a stock's beta shows its relation to market shifts, it is also used as an indicator for required returns
on investment (ROI). If the market with a beta of 1 has an expected return increase of 8%, a stock
with a beta of 1.5 should increase return by 12%. An asset with a beta of 0 means that its price is
not at all correlated with the market; that asset is independent. A positive beta means that the
asset generally follows the market. A negative beta shows that the asset inversely follows the
market; the asset generally decreases in value if the market goes up.
Covim
IM
m2
where IM = Beta of security with market
Covim = Covariance between security and market
m2 = Variance of market returns
OR
i
IM im
m
Where im = Coefficient of Correlation between security and market returns
Risk Return Trade off
It is widely accepted that the major determinant of the required return on the asset (or the rate to
be applied to a stream of receipts to capitalize its value) is its degree of risk. Risk refers to the
probability that the return and, therefore, the value of an asset or security may have alternative
outcomes. Risk is the uncertainty (today) surrounding the eventual outcome of an event which will
occur in the future.
Example: When tossing a coin, some one is not sure exactly what the outcome will be. The
outcome may mean the Tail or the Head, so there is a concept of risk. Similarly, in a football match,
three outcomes can be experienced: win, lose or draw. In a business too, the same can happen
regarding the expected return on the investments in various sectors.
To summarize, in Financial Analysis, the risk/return trade-off states that financial decisions that
subject stockholders to more risk must offer a higher expected return. Risk aversion is the
tendency to try to avoid risky situations unless adequate compensation is offered.
Example: The risk adverse individual faced with two events each having the same expected
outcome will choose the outcome with a lower level of risk.
INTRODUCTION TO FUNDAMENTAL ANALYSIS
Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really
investing if you aren't performing fundamental analysis. Because the subject is so broad, its tough
to know where to start. Though there are an endless number of investment strategies that are very
different from each other, almost all make use of the fundamentals that drive asset prices. The
biggest part of fundamental analysis involves delving into financial statements. Also known as
quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other
financial aspects of a company. Fundamental analysts look at this information to gain insight on a
company's future performance. A good part of this tutorial will be spent learning about the balance
sheet, income statement, cash flow statement and how they all fit together. But there is more than
just number crunching when it comes to analyzing a company. This is where qualitative analysis
comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company.
What is Fundamental Analysis?
The Very Basics When talking about stocks, fundamental analysis is a technique that attempts to
determine a securitys value by focusing on underlying factors that affect a company's actual
business and its future prospects. On a broader scope, you can perform fundamental analysis on
industries or the economy as a whole. The term simply refers to the analysis of the economic well-
being of a financial entity as opposed to only its price movements. Fundamental analysis serves to
answer questions, such as:
Is the companys revenue growing?
Is it actually making a profit?
Is it in a position strong-enough to outrun its competitors in the future?
Is it able to repay its debts?
Is management trying to "cook the books"?
Of course, these are very involved questions, and there are literally hundreds of others you might
have about a company. It all really boils down to one question: Is the companys stock a good
investment? Think of fundamental analysis as a toolbox to help you answer this question. Note:
The term fundamental analysis is used most often in the context of stocks, but you can perform
fundamental analysis on any security, from a bond to a derivative. As long as you look at the
economic fundamentals, you are doing fundamental analysis.
Fundamentals: Quantitative and Qualitative
You could define fundamental analysis as researching the fundamentals, but that doesnt tell you
much unless you know what fundamentals are. As we mentioned in the introduction, the big
problem with defining fundamentals is that it can include anything related to the economic well-
being of a company. Obvious items include things like revenue and profit, but fundamentals also
include everything from a companys market share to the quality of its management. The various
fundamental factors can be grouped into two categories: quantitative and qualitative.
Quantitative capable of being measured or expressed in numerical terms.

Qualitative related to or based on the quality or character of something, often as
opposed to its size or quantity.
In our context, quantitative fundamentals are numeric, measurable characteristics about a

business. Its easy to see how the largest source of quantitative data are the financial statements.
You can measure revenue, profit, assets and more with great precision. Turning to qualitative
fundamentals, these are the less tangible factors surrounding a business - things such as the
quality of a companys board members and key executives, its brand-name recognition, patents or
proprietary technology.
Quantitative meets Qualitative Neither qualitative nor quantitative analysis is inherently better
than the other. Instead, many analysts consider qualitative factors in conjunction with the hard,
quantitative factors. Take the Coca-Cola Company, for example. When examining its stock, an
analyst might look at the stocks annual dividend payout, earnings per share, P/E ratio and many
other quantitative factors. However, no analysis of Coca-Cola would be complete without taking
into account its brand recognition. Anybody can start a company that sells sugar and water, but
few companies on earth are recognized by billions of people. Its tough to put your finger on exactly
what the Coke brand is worth, but you can be sure that its an essential ingredient contributing to
the companys ongoing success.
The Concept of Intrinsic Value
Before we get any further, we have to address the subject of intrinsic value. One of the primary
assumptions of fundamental analysis is that the price on the stock market does not fully reflect a
stocks real value. After all, why would you be doing price analysis if the stock market were
always correct? In financial jargon, this true value is known as the intrinsic value. For example,
lets say that a companys stock was trading at 20. After doing extensive homework on the
company, you determine that its real worth is 25. In other words, you determine the intrinsic value
of the firm to be 25. This is clearly relevant because an investor wants to buy stocks that are
trading at prices significantly below their estimated intrinsic value. This leads us to the second
major assumption of fundamental analysis: In the long run, the stock market will reflect the
fundamentals. There is no point in buying a stock based on intrinsic value if the price never
reflected that value. Nobody knows how long the long run really is. It could be days or years. This
is what fundamental analysis is all about. By focusing on a particular business, an investor can
estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a
discount. If all goes well, the investment will pay off over time as the market catches up to the
fundamentals. The big unknowns are:
1) You dont know if your estimate of intrinsic value is correct; and
2) You dont know how long it will take for the intrinsic value to be reflected in the marketplace.
Criticisms of Fundamental Analysis
The biggest criticisms of fundamental analysis come primarily from two groups: proponents of
technical analysis and believers of the efficient market hypothesis. Technical analysis is the other
major form of security analysis. Put simply, technical analysts base their investments (or, more
precisely, their trades) solely on the price and volume movements of securities. Using charts and a
number of other tools, they trade on momentum, not caring about the fundamentals. While it is
possible to use both techniques in combination, one of the basic tenets of technical analysis is that
the market discounts everything. Accordingly, all news about a company already is priced into a
stock, and therefore a stocks price movements give more insight than the underlying fundamental
factors of the business itself.
Followers of the efficient market hypothesis, however, are usually in disagreement with both
fundamental and technical analysts. The efficient market hypothesis contends that it is essentially
impossible to produce market-beating returns in the long run, through either fundamental or
technical analysis. The rationale for this argument is that, since the market efficiently prices all
stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or
technical) analysis would be almost immediately whittled away by the markets many participants,
making it impossible for anyone to meaningfully outperform the market over the long term.
CHAPTER 2
FUNDAMENTAL ANALYSIS
Economic Analysis
The stock market does not operate in a vacuum. It is an integral part of the whole economy of a
country, more so in a free economy like that of the United States and to some extent in a mixed
economy like ours.
To gain an insight into the complexities of the stock market one needs to develop a sound economic
understanding and be able to interpret the impact of important economic indicators, which may be
studied to assess the national economy as a whole. The leading indicators predict what is likely to
happen to an economy. Perfect examples of leading indicators are the unemployment position,
rainfall and agricultural production, fixed capital investment, corporate profits, money supply,
credit position, and the index of equity share prices.
Then there are the coincidental indicators, which highlight the current position. Some examples of
coincidental indicators are Gross National Product, Index of Industrial Production, money market
rates, interest rates, and reserve funds with commercial banks.
TABLE 1: Economic indicators and their impact on the stock market

Indicator Favorable impact Unfavorable impact
Gross National Product High growth rate Slow growth rate

General employment position Full or almost full Underemployment and
employment unemployment
Domestic savings rate High Low
Interest rates Low High
Tax rates Low High
Foreign exchange position High Low
Balance of trade Positive Negative
Balance of payments Positive Negative
Deficit financing Low High
Inflation Low High
Agricultural production High Low
Industrial production High Low
Power supply High Low
Freight movement of railways High Low
New house construction High Low
What is an economic indicator?
An economic indicator is simply any economic statistic, such as the unemployment rate, GDP, or
the inflation rate, which indicate how well the economy is doing and how well the economy is going
to do in the future. Economic Indicators can have one of three different relationships to the
economy:
Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the same
direction as the economy. Therefore, if the economy is doing well, this number is usually
increasing, whereas if we are in a recession this indicator is decreasing. The Gross
Domestic Product (GDP) is an example of a procyclic economic indicator.
Counter cyclic: A counter-cyclic (or countercyclical) economic indicator is one that moves
in the opposite direction as the economy. The unemployment rate gets larger as the
economy gets worse so it is a counter-cyclic economic indicator.
Acyclic: An acyclic economic indicator is one that is not related to the health of the
economy and is generally of little use. The number of Expos hit in a year generally has no
relationship to the health of the economy, so we can say it is an acyclic economic indicator.
Economic Indicators can be leading, lagging, or coincident which indicates the timing of their
changes relative to how the economy as a whole changes.
1. Leading: Leading economic indicators are indicators which change before the economy
changes. Stock market returns are a leading indicator of the economy, as the stock market
usually begins to decline before the economy declines and improves before the economy
begins to pull out of a recession. Leading economic indicators are the most important type
for investors as they help predict what the economy will be like in the future.
2. Lagged: A lagged economic indicator is one that does not change direction until a few
quarters after the economy does. The unemployment rate is a lagged economic indicator, as
unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
3. Coincident: A coincident economic indicator is one that simply moves at the same time the
economy does. The Gross Domestic Product is a coincident indicator.
Different Economic Indicators and their impacts
Gross Domestic Product (GDP)
The Gross Domestic Product (GDP) is the primary indicator used to gauge the health of a country's
economy. It represents the total value of all goods and services produced over a specific time period
- one can think of it as the size of the economy. GDP is commonly used as an indicator of the
economic health of a country as well as to gauge a country's standard of living.
It is the monetary value of all the finished goods and services produced within a country's borders
calculated on an annual basis. It includes all of private and public consumption, government
outlays, investments and exports less imports that occur within a defined territory.
In layman terms GDP can be simply defined and calculated as what everybody in a particular
country has earned or spent. GDP of a country comprises of all the goods and services that are
produced and aggregated irrespective of the way of consumption, i.e., bartered or exchanged for
money. Gross Domestic Product is thus essentially a product concept to measure the production of
goods and services, but in common parlance it is also accepted as an income concept because it is
equivalent to value added, which is the summation of incomes of factors of production land,
labor, capital and entrepreneurship that help to produce output.
Thus GDP covers everything what an economy is all about which makes it one of the most
important economic indicators. Gross Domestic Product includes production within national
borders regardless of whether the labor and property inputs are domestically or foreign owned.
The GDP is a key factor in determining other economic indicators as well. National output has its
impact on the money markets, interest rates etc. GDP by income and by expenditure are calculated
at market prices and are published each quarter, two months after the reference period.
GDP is one of the primary measures used by decision-makers, financial and other institutions to
evaluate the health of the economy. An increase in real GDP is interpreted as a sign that the
economy is doing well, while a decrease indicates that the economy is not working at its
full capacity.
Inflation
Inflation is a sustained increase in the general price level of goods and services, usually over a time
period, like a year; and can be equivalently seen as a decrease in the purchasing power of the
currency. To put in the simplest of words it is the increase in the prices, which one has to pay while
buying goods or services. It is one of the most important and basic indicators, which directly or
indirectly affect the state of economy, and other macro economic indicators in a considerable
manner. This is because inflation results in the increase in prices so every other factor is bound to
be affected by it. In fact it is a two-way effect: inflation rates are affected but these factors as well
like interest rates, oil prices, monetary policies etc.
Example: An inflation of 3% would result in the price of a good to rise up to Rs.103 if it was Rs.100
earlier. Looking it from a different angle we can say that with the same amount of money, Rs.100
one will be able to buy only 97% of the goods or services.
The question which comes to our mind when we talk of inflation is what causes it. What are the
factors that cause the prices to rise? There hasnt been any pre-defined specific set of factors, which
can be said to cause inflation because there are too many to think of. But the two most common
and accepted phenomenon are the demand-pull inflation and cost-push inflation.
Demand-pull inflation happens when there is more demand than supply. It means that the prices
will go up because buyers are more than the sellers. On the other hand, cost-push inflation occurs
when the cost of the company goes up forcing them to increase the prices. Costs may go up for
several reasons like increase in prices of inputs, increase in taxes etc.
Inflation is commonly perceived to be bad for the economy. But this is not necessarily true. An
inflation rate of 3-4% is generally considered to be good for the economy. Inflation implies that the
economy is growing. Conversely, the lack of inflation is a sign that the economy is weakening.
Inflation affects different people in different ways. It also depends on whether inflation is
anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are
expecting (anticipated inflation), then we can compensate and the cost isn't high. However a
problem arises when there is unanticipated inflation, Creditors lose and debtors gain if the lender
does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-
free loan. People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living. Internationally, if the domestic inflation rate is greater
than that of other countries, domestic products become less competitive.
There are many factors which determine the interest rates. Interest rates in India are normally
determined on the basis of wholesale price index (WPI). Inflation rate is determined on the basis of
prices of basket of primary products. These products are food, oil, and lubricants etc. These
products form the primary basket, on the basis of whose prices inflation rate is determined.
Significance of Inflation
1. As we have discussed earlier, inflation rate can be good as well as bad for the economy. A
very high or very low inflation rate is bad for an economy. High inflation with associated
high volatility in relative prices, and high nominal interest rates causes investors to shorten
horizons, thereby hurting growth. High inflation also erodes the value of the public
treasury and public finances, reducing the impact of government spending on growth. Low
inflation rates especially if it is a deflation causes a downward spiral of contracting output.
As consumers start postponing purchases it causes industries to cut back production.
2. Inflation needs to be regulated at times when it is not at the desirable rate. The most
common measure of regulating inflation rates is through monetary policies and interest
rates. Among other activities, the monetary authority increases or decreases the flow of
money through the system with open market operations. If the economy is in a depressed
mode and the rate of inflation has come down steeply, the monetary authority resorts to a
buying of government securities thereby giving a push to a depressed economy. If
otherwise, the monetary authority resorts to selling of government securities.
3. Interest rates The monetary authority uses this tool sparingly and under extreme
circumstances. In a low inflation and low growth regime to give a necessary push, the
Central Bank resorts to a decrease in interest rates. The interest rate reduction leads an
increase in the consumer spending and at the same time an increase in the investment in
the economy. This imbibes a feel-good factor in the economy and gives a vital growth
impetus. The Central Bank resorts to interest rate rise in case inflation is growing at an
alarming rate and the economy is over boiling.
Interest Rates
The rate of interest sounds like a very simple term in its literal sense. It is indeed a very simple
term though with a large impact. It is a very important area of discussion and one of the chief
economic indicators. Interest rates in a country are determined by the central bank through its
monetary policies. To be precise, the size and rate of growth of money supply determines the
interest rate that is prevailing in the country. Interest rates and inflation also have a very close
relation with each affecting the other in a comprehensive manner. Bank rate, Repo, and the reverse
repo rates are all types of interest rates.
Interest rates rise when the money supply is less in the economy and falls when the money supply
is more. Interest rates are also used to curb the effect of inflation especially when the inflation is
high. Interest rates can rise, which would curb the inflation to some extent. RBI does not raises the
interest rates, (the lending and borrowing rates in the market) but regulates the CRR, the cash
reserve ratio2, the bank rate which is the rate at which banks borrow from the central bank, and
the repo rate, which is the borrowing rate from the central bank, in the overnight money markets.
Credit Policies
The Reserve Bank of India (RBI) is the central bank of India, and was established on April 1, 1935
in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office is
located at Mumbai since inception. Though originally privately owned, since nationalization in
1949, RBI is fully owned by the Government of India. Some of its main objectives are regulating the
issue of bank notes, managing Indias foreign exchange reserves, operating Indias currency and
credit system with a view to secure monetary stability and developing Indias financial structure in
line with national socio-economic objectives and policies.
2
Cash Reserve Ratio is the portion of deposits banks are mandated to keep with the RBI as cash. It currently
stands at 5.75%.
The RBI acts as a banker to Central/State governments, commercial banks, state cooperative
banks and some financial institutions. It formulates and administers monetary policy with a view to
promote stability of prices while encouraging higher production through appropriate deployment of
credit. The RBI plays an important role in maintaining the exchange value of the Rupee and acts as
an agent of the government in respect of Indias membership of IMF. The RBI also performs a
variety of developmental and promotional functions.
The Stock Market: The markets move to the tune of RBI because of the link between the interest
rates and capital market yields. The RBI policies have maximum impact on volatile foreign
exchange and stock markets.
Foreign Investment
Foreign Investment is basically generated when one nation invests in another by selling to it more
than what it buys. Foreign investment can be freely channeled into all sectors except for the
following sectors: agriculture (excluding floriculture, horticulture, development of seeds, animal
husbandry & cultivation of vegetables, mushrooms etc. under controlled conditions and services
related to agro & allied sectors), plantations (other than tea plantations), atomic energy, gas
pipelines, courier services, trading and lottery and gambling. In most of the sectors, foreign
investors can go through the Automatic Route without need for approvals. The investor has to
merely keep the Reserve Bank of India informed of the flow of funds and issue of shares. Full
capital account convertibility is also allowed for foreign investors.
FDI
Foreign direct investment (FDI) is the movement of capital across national frontiers in a manner
that grants the investor control over the acquired asset. It is different from portfolio investment,
because in that, such control is not offered. Firms, which source FDI, are known as Multi-National
Enterprises (MNEs). FDI is usually seen as a strong catalyst to economic growth. There are several
reasons that foreign direct investment has a significant impact on economic growth. In particular,
foreign direct investment (FDI) impacts five variables domestic investment, technology,
employment generation and labor skills, the environment, and export competitiveness.
FII
An FII, or Foreign Institutional Investor, is an investor or investment fund that is from or

registered in a country outside of the one in which it is currently investing. Institutional investors
include hedge funds, insurance companies, pension funds and mutual funds. Large portion of the
FII inflows come in broadly through four to five categories. The first comes through India-dedicated
funds (which are raised from investors with a specific mandate to invest in the Indian markets). The
second category of investments comes in as part of the allocation to India from emerging market
funds. The third segment of inflows is through hedge funds. Further, there are long-term pension
funds which take 5-7 year calls. The fast-growing Indian market is increasingly being considered as
an attractive destination for Foreign Institutional Investors (FIIs). To trade in the Indian markets,
an FII must register with the market regulator SEBI, the Securities and Exchange Board of India.3
One of the major market regulations pertaining to FIIs involves placing limits on FII ownership in
Indian companies.
3
While it is also possible to trade in the market via off-shore access products (also called Off-shore
Derivative Instruments) offered by foreign brokerage houses, the trend has increasingly been
towards direct registration with SEBI.
Increased FII participation has been one of the factors responsible for the high level of transparency
and corporate governance standards among the corporate sector in India. Such transparency also
benefits the shareholders, both retail and institutional, to a large extent.
To invest their capital in the stock market, i.e., portfolio investment, there are certain formalities an
FII has to fulfill. They need to register themselves with SEBI with a fee of $10,000. In case of FDI
though, it involves a lot more formalities, starting with authorization by the Government of India.
There are different FDI limits for different sectors that are allowed by the government. Most FDI are
allowed on the automatic route- only to inform the Central Bank within 30 days of remittances.
Some are allowed through FIPB. In this case prior Government approval is needed and decision is
generally taken within 4-6 weeks.
Most FDI goes into manufacturing automobiles, engineering, telecom, electronics, and chemicals.
Upto 100% is allowed in these sectors.
The US Factor: Will it have an Impact on India?
A surplus of deficits: A trade deficit simply means that US imports more than export. The net result of this is
that more money flows out of the country than flowing in. Prior to 1980, the United States was a net exporter,
selling more goods overseas than it imported. However, over the last 25 years, the situation has reversed. The
trade deficit today has grown to record levels (now almost 6% of gross domestic product), with the biggest
import-export imbalances coming from China, Japan and Southeast Asian nations.
If we talk about budget deficit then it is where US spends more than its earning and have to borrow to fill the
gap. So people there rely on credit cards to get through a budget deficit; the federal government issues Treasury
bonds to finance its shortfall.
What has changed over the last 25 years is that foreign governments, rather than U.S. citizens, have been buying
this U.S. debt (in the form of Treasury). Now, approximately half of this country's debt is held outside the
United States, primarily by China, Japan and Southeast Asian nations.
Until recently, none of this was a problem. These creditor nations, with whom the U.S. also had its largest trade
imbalances, were happy to buy-up extra government debt. The system worked. Folks here bought their exports,
and they bought our debt. American consumers benefited from the flow of inexpensive goods, and foreign
creditors benefited both from their return on investment and the continued consumption of their goods. This
global interdependency helped to kept interest rates low and the dollar relatively strong.
Through the 90s, as US trade deficit grew, budget deficits made up only a small percentage of their GDP. They
were easily able to service our debt. But war, tax cuts, and Hurricane Katrina changed all that. The combination
of a weighty budget deficit and a record trade deficit has made these creditor nations nervous about loading up
on too much U.S. debt. It's reasonable to think that China, Japan, and Southeast Asia may soon choose to
diversify their investments and stop buying US debt.
Competition for oil: The US is by far the largest consumer of oil, buying almost a quarter of the total supply. But
as China and India emerge as world economic players, they are demanding significantly more oil for autos and
industry. In fact, China has become the No. 2 world consumer of oil. And with a population almost four times
than US (and yet, only slightly larger than India's), there's increasingly more demand for oil and natural
resources.
At the same time, the potential to increase the global oil supply may be more limited than in the past. Saudi
Arabia and other oil-exporting countries are already producing close to capacity. Static supply and increased
demand will inevitably cause energy prices to rise. Like budget surpluses, cheap energy and natural resources
are unlikely to return anytime soon.
So, if foreign countries stop buying US debt, that will cause long-term bond prices to drop, interest rates to rise
and the dollar to fall. Excess demand for energy and natural resources from China and India will likely spur a
rise in U.S. inflation rates. Higher interest rates and inflation coupled with a weak dollar make long-term bonds a
risky investment with very little upside. Investors looking to invest new money in fixed income will be better off
investing in short-term bonds.
The impact on the overall stock market is less clear some sectors will benefit while others will struggle. The
drop in long-term bond prices may be harmful to certain types of financial firms, for example. Rising oil prices
may help energy companies but hurt manufacturing, while a falling dollar may make many of products more
competitive overseas.
INDUSTRY ANALYSIS
LIFE CYCLE OF AN INDUSTRY
The second phase of fundamental analysis consists of a detailed analysis of a specific industry; its
characteristics, past record, present state and future prospects. The purpose of industry analysis is
to identify those industries with a potential for future growth, and to invest in equity shares of
companies selected from such industries.
Every industry, and company within a particular industry, undergoes a life-cycle with four distinct
phases as shown in chart: (a) pioneering stage, (b) expansion stage, (c) stagnation stage, and (d)
declining stage. From a fundamental perspective, one can benefit by investing in an industry only
in its pioneering and expansion stages. One should get out of industries which have reached a
stagnation stage before they lapse into decline. The specific phase of an industry can be understood
in terms of its sales (volume and value) and profitability.
Sales Stagnation
Stage
Expansion
Stage
Declining
Stage
Pioneering
Stage
Invest Disinvest
Years
Chart 1: Life cycle of an industry and investment approach
Industries doing well today may be faced with stagnation and decline in future as a result of
changes in social habits (e.g., the film industry is bound to suffer with the growing popularity of
pirated VCDs), or from changes in statutory controls (e.g., the Indian Liquor Industry has been a
victim of uncertain state-level policies on prohibition), or from excess capacity and consequent cut-
throat competition, or as a result of rising prices. Such analytical insights into various industries
are essential for investors.
Let us discuss each stage of a typical industry life cycle:
1. Pioneering Stage: The first stage in the industrial life cycle of a new industry where the
technology as well as the product are relatively new and have not reached the state of
perfection. In these early days it may actually make losses. At this time there may also not be
many companies in the industry. One must understand that the initial 5 to 10 years are the
most critical period. At this time the companies have the greatest chance of failing. It takes
time to establish companies and new products. There may be losses and the need for large
injections of capital. This stage is characterized by a rapid growth in demand for output of
the industry. In such a scenario, weak firms are ultimately eliminated and a lesser number of
businesses survive this stage.
2. Expansion Stage: Once an industry is established it enters expansion stage. As the industry
grows many new companies enter the industry. Here each company finds a market for itself
and develops its own strategies to sell and maintain its position in market. The competition
among the surviving companies brings about improved product at lower prices. At this stage
investors can get high reward at a low risk since demand is far more than the supply. These
companies are quite attractive for investment purposes. Companies will earn increasing
amounts of profits and pay attractive dividend.
Note: This is the time to invest in emerging blue chip companies.
3. Stagnation Stage: This is the third stage in industry life cycle. Here in this stage the growth
of industry stabilizes. Ability of the industry to grow appears to have been lost. Sales may be
increasing though at a slower rate than that experienced by competitive industries or the
over-all economy. Two important reasons for this transition are changes in social habits and
development of improved technology. Sometimes an industry may stagnate only for a short
period. By the introduction of a technological innovation or a new product, it may resume a
process of growth, thereby starting a new cycle. Therefore, an investor has to monitor the
industry developments constantly and with diligence. An investor should dispose of his
holdings in an industry which begins to pass from the expansion stage to the stagnation
stage because what is to follow is the declining stage.
Note: During this phase, things tend to slow down sometimes with an emphasis on
increasing profit rather than achieving growth. Debts are normally re-paid out of
internal accruals. However, maturity slowly degenerates into stagnation and
sometimes even creeps into decline. When a company enters the maturity phase,
it is time for the smart investor to quit.
4. Declining Stage: Eventually, the industry declines. This occurs when its products are no
longer popular. The risk at this time in investing in these companies is high but the returns
are low, even negative. An investor should get out of the industry before the onset of the
declining stage.
Note: As a typical mature company loses its competitive nerve, it declines over a period
of time into bankruptcy and winding up. At this bleak stage, there will be no
takers for the scrip.
SWOT ANALYSIS
Evaluation of an industry should encompass four critical areas:
1. What are the strengths of the industry?

2. What are its vulnerabilities?
3. What are the opportunities available to it?
4. What are the threats faced by it?
Such a comprehensive analysis is obviously not a simple exercise. You need to evaluate an industry
with the help of all the financial and non-financial data you have access to. Relevant questions
which may be asked in conducting an industry analysis are suggested below for illustrative
purpose:
1. Are the sales of the industry growing or are they stagnant in relation to the growth in
GNP?
2. What are the profit margins enjoyed by the industry? What is the important cost
component? How likely is it to go up? What is the overall Return on Investment (ROI) for
the industry?
3. Does the success or failure of the industry depend upon any single factor? If so, it could
be very risky. In the past, the impressive success of certain companies in the Ferro-
silicon industry was due to the availability of power from certain state electricity boards
at cheap rates.
4. Is the industry dominated by one or two major companies? Are they Indian or
multinational companies?
5. What is the impact of taxation on the industry? Is the industry crippled by excessive
doses of excise duties and other forms of direct and/or indirect taxes?
6. Is the industry affected very strongly by business cycles?
7. Are there any rigorous statutory controls in matters of raw material allotment, price
controls or distribution controls, etc.?
8. Is the industry highly competitive? How are the new entrants faring? Is it necessary to
spend large sums of money on advertising, sales, distribution, etc.?
9. Is there sufficient export potential? Is it being fully exploited? Are international prices
comparable to domestic prices?
10. Is the industry highly technology oriented? What is the present stage of technological
advance in the field?
11. How does the stock market estimate the industry? How are the leading scripts in the
industry evaluated by the stock market?
The market evaluation of an industry can be assessed by referring to the industry-wise equity index
published by the financial dailies. Industry analysis can be of immense help to an investor. When a
particular industry is enjoying a boom, the leaders as well as the laggards benefit. Similarly, when
a particular industry is in the doldrums the marginal firms become extinct and the leaders suffer
as well. An intelligent investor, therefore, has to make a detailed industry analysis before he
decides to buy or sell shares of a company in that industry.
KEY CHARACTERISTICS OF INDUSTRY ANALYSIS
In an industry analysis, any number of key characteristics must be considered at some point by
analyst. These characteristics include:
1. Past sale and earning performance.

2. Labor conditions within the industry.
3. Attitude of government towards the industry.
4. Competitive conditions.
5. Stock prices of firms in the industry relative to their earnings.
Past sale & earning performance

One of the most effective steps in forecasting is looking at the chronological performance of sales
and earnings. This record of the industry is crucial for calculation of average levels and stability of
performance in sales and earnings. These records are also used to calculate growth rate apart from
sales earnings, and analyst must also consider the cost structure of the industry i.e. fixed and
variable cost. The higher the fixed cost, the greater is the sales volume required to be achieve
break-even point and vice versa. With an in-depth knowledge and understanding of past behavior,
an analyst is able to assess better the performance of future.
Permanence of the Industry
Another Important factor in industry analysis is the relative permanence of the industry.
Permanence of industry is related to the products and technology of the industry. In an age of rapid
technological advancement, the study of the degree of permanence has become a vital step in the
study analysis. If an analyst feels that the need for a particular industry will vanish in future, then
it will be foolish to invest there.
Example: Evolution in the automobile industry caused a decline in the importance of carriage and
buggy whip.
Attitude of Government towards Industry

It is important for the analyst to consider the role that the government will play in the industry.
Will it provide or will it restrain the industrys development through restrictive legislation and legal
enforcement? As the government becomes more influential in regulating business and advocating
consumer protection, the performance of the industry might be affected. Profits of the industry can
be substantially lowered. And sometimes, the importance of industry declines because of legal
restrictions placed on it. On the other hand, the Government can definitely assist selected
industries.
Labour conditions
If an analyst deals with labour intensive production processes or mechanized capital intensive
processes where labour performs crucial operations, a detailed study of labour conditions is called
for. In these industries the possibility of strikes loom as an important factor to be dealt with. If
strikes occur, it deeply affects the profit and the costumer goodwill of the company. And at the end
it will affect the performance of the industry.
Stock Prices of firms in industry

Having evaluated the various characteristics of past sales and earnings, industry performance,
government attitude, labour conditions, and industry competitive conditions, an analyst reaches a
considered investment decision. However even through all the indications are favorable, it does not
imply the fund must be invested immediately. An analyst must also study current prices of the
securities and calculate the risk and returns of the concerned industry.
MICHAEL PORTERs FIVE FORCES MODEL
COMPETITIVE FORCES AND INDUSTRY PROFITABILITY
Michael Porter of Harvard Business School identified five competitive forces that determine industry
profitability:
Entry of new competitors.

The threat of substitutes.
The bargaining power of the buyers.
The bargaining power of the suppliers.
The rivalry among the existing competitors.
According to Porter, the collective strength of these five competitive forces determines the ability of
a firm in an industry to earn, on average, rates of return on investment in excess of the cost of
capital. The five forces enumerated above determine industry profitability because they influence
the prices, costs and required investment of firms in an industry the elements of return on
investment.
Chart 4: The Five Competitive Forces
The Five Competitive Forces are typically described as follows:
1. Bargaining Power of Suppliers: The term 'suppliers' comprises all sources for inputs that
are needed in order to provide goods or services. Supplier bargaining power is likely to be
high when:
The market is dominated by a few large suppliers rather than a fragmented source
of supply,
There are no substitutes for the particular input,
The suppliers customers are fragmented, so their bargaining power is low,
The switching costs from one supplier to another are high,
There is the possibility of the supplier integrating forwards in order to obtain
higher prices and margins. This threat is especially high when The buying industry
has a higher profitability than the supplying industry,
Forward integration provides economies of scale for the supplier,
The buying industry hinders the supplying industry in their development (e.g.
reluctance to accept new releases of products),
The buying industry has low barriers to entry.
Note: In such situations, the buying industry often faces a high pressure on margins
from their suppliers. The relationship to powerful suppliers can potentially reduce strategic
options for the organization.
2. Bargaining Power of Customers: Similarly, the bargaining power of customers determines
how much customers can impose pressure on margins and volumes. The customer bargaining
power is likely to be high when:
They buy large volumes, there is a concentration of buyers,

The supplying industry comprises a large number of small operators,
The supplying industry operates with high fixed costs,
The product is undifferentiated and can be replaces by substitutes,
Switching to an alternative product is relatively simple and is not related to high
costs,
Customers have low margins and are price-sensitive,
Customers could produce the product themselves,
The product is not of strategically importance for the customer,
The customer knows about the production costs of the product, and
There is a possibility for the customer integrating backwards.
3. Threat of New Entrants: The competition in an industry will be the higher; the easier it is
for other companies to enter this industry. In such a situation, new entrants could change
major determinants of the market environment (e.g. market shares, prices, customer loyalty)
at any time. There is always a latent pressure for reaction and adjustment for existing
players in this industry. The threat of new entries will depend on the extent to which there
are barriers to entry. These are typically:
Economies of scale (minimum size requirements for profitable operations),

High initial investments and fixed costs,
Cost advantages of existing players due to experience curve effects of operation
with fully depreciated assets,
Brand loyalty of customers,
Protected intellectual property like patents, licenses etc,
Scarcity of important resources, e.g. qualified expert staff,
Access to raw materials is controlled by existing players,
Distribution channels are controlled by existing players,
Existing players have close customer relations, e.g. from long-term service
contracts,
High switching costs for customers, and
Legislation and government action.
4. Threat of Substitutes: A threat from substitutes exists if there are alternative products with
lower prices of better performance parameters for the same purpose. They could potentially
attract a significant proportion of market volume and hence reduce the potential sales volume
for existing players. This category also relates to complementary products. Similar to the
threat of new entrants, the treat of substitutes is determined by factors like:
Brand loyalty of customers,

Close customer relationships,
Switching costs for customers,
The relative price for performance of substitutes, and
Current trends.
5. Competitive Rivalry between Existing Players: This force describes the intensity of
competition between existing players (companies) in an industry. High competitive pressure
results in a market pressure on prices and margins that affects profitability. Competition
between existing players is likely to be high when:
There are many players of about the same size,

Players have similar strategies
There is not much differentiation between players and their products, hence, there
is much price competition
Low market growth rates (growth of a particular company is possible only at the
expense of a competitor), and
Barriers for exit are high (e.g. expensive and highly specialized equipment).
The five competitive forces determine industry profitability because these influence the
components of return on investment. The strength of each of these factors is a function of
industry structure. The important elements of industry structure are shown in the figure below.
This figure shows all the elements of industry structure that affect competition within an
industry
COMPANY ANALYSIS NON FINANCIAL
At the final stage of fundamental analysis, the investor analyses the company. It is imperative that
one should look at the politico-economic analysis and the industry analysis before a company is
analyzed because a companys performance is the reflection of the economy, the political situation,
and the industry.
Even though a particular industry may be thriving, certain companies in that industry may not be
doing very well. On the other hand, it is quite likely that a few companies would do well despite the
rest of the companies in that industry facing difficulties. Hence, selecting individual companies for
investment based on the industry performance is terribly tricky.
There are two major components of company analysis: financial and non-financial. A good analyst
tries to give a balanced weightage to both these aspects. Overemphasis on either may lead to
distorted analysis.
The different issues regarding a company that should be examined are:
a. The Management.
b. The Company.
c. The Annual Report.
d. Ratios.
e. Cash Flow.
Here at this point of time we would be discussing non financial aspects. Financial aspects will be
dealt with in the next chapter.
THE MANAGEMENT Non Financial Aspect
One of the most important factors one should consider when investing in a company is its
management. It is upon the quality, competence and vision of management that the future of the
company rests. A good, competent management can do wonders with a company while a weak,
inefficient management can destroy a thriving company. In India, managements can be broadly
divided into two types:
1. Family Management: These companies are managed by members of the controlling

family. The chairman or the CEO is usually a member of the ruling family and the Board
of Directors has those who are closely connected to the family. The policies are decided by
the ruling family and some of the policies may not necessarily be in the shareholders best
interest.
However, now in the current scenario there has been some change in the way family
controlled businesses are managed. Earlier it used to be very orthodox, autocratic,
traditional, rigid, and averse to change. Such is not the situation now. The sons and
grandsons of the founding fathers have been educated at the best business schools around
the world and exposed to a variety of modern methods of management. So consequently, in
many such companies, although the man at the helm is a successor of the family, his
subordinates are graduates of business schools i.e., professional managers.
To an extent this combines the better of two worlds and many such businesses are very
successful.
2. Professional Management: Professionally managed companies are those that are
managed exclusively by employees. In these companies the CEO often does not have any
financial stake in the company. He is at the helm of affairs because of competence, ability,
and experience.
The professional manager is a career employee and he remains in power as long as he is

fulfilling his commitments and meeting his targets. So he is result-oriented and his aim is
often short-term i.e., meeting the annual budget. He is generally not driven by loyalty
towards company. As he is a professional, he is usually aware of the latest trends in
management and tries to implement them.
Professionally managed companies are usually well organized, growth-oriented and good
performers. Investors are the recipients of regular dividends and bonus issues.
However, there is often a lack of long-term commitment and sometimes a lack of loyalty.
This is because the professional manager has to step down in time, to retire, and he cannot
therefore enjoy the fruit of his labor forever. Other reasons can include a search for a better
career opportunity because of which they often change jobs.
Analysis: It would be unfair to state that one should invest in professionally managed companies
only. An investor must in addition look for:
i. Integrity of management. If someone has a doubt about the integrity of the management he
should not invest in such a company. Investor should check who the major shareholders of
the company because there are some managements who have a track-record of
manipulating share prices.
ii. Competence of management. One must have a look at the track-record of the management.
One should check the growth figures of companies under the said management.
iii. Management rating by its peer in the industry. One must check the recognition antecedents
of the management by the industry.
iv. Performance during adverse period. During good times everyone does well. One should
check how tactfully the management was able to drive the company during the adverse
phases. One who can manage well during bad times will definitely do well during better
times.
v. Innovativeness of management. Investors should know how open, innovative, and tactful
the management is. This should be dynamic and current.
vi. Investors should stay away from investing in companies that are yet to professionalize
because in such companies decisions are made on the whims of the CEO and not always
with the good of the company in mind.
vii. One should avoid investing in family managed business if there is some family feud going
on because at the end of day whoever may win the feud, it is shareholders who loose.
General Analysis of Companies
TABLE 1: A framework for general (non-financial) analysis of companies

Aspects Review Questions
History, How old is the company? Who are the promoters? Is it family managed
Promoters and or professionally managed? What is the public image and reputation of
Management the company, its promoters and its products?
Technology, Does the company use relevant technology? Is there any foreign
Facilities and collaboration? Where is the unit located? Are the production facilities
Production well balanced? Is the size the right economic size? What are the
production trends? What is the raw material position? Is the process
power- intense? Are there adequate arrangements for power?
Product range, What is the companys product range? Are there any cash cows among
Marketing, Selling the product portfolio? How distribution-effective is the marketing
and Distribution network? What is the brand image of the products? What is the market
share enjoyed by the products in the relevant segments? What are the
effects and costs of sales promotion and distribution?
Industrial How important is the labour component? What is the labour situation
relations, in general?
Productivity and
Personnel
Environment Are there any statutory controls on production, price, distribution, raw
material, etc? Is there any major legal constraint? What are the
government policies on the industry (domestic as well as related to
imports and exports of the final products and raw materials)?
SWOT Analysis
Positive Negative
Strengths Weaknesses
Latest Technology Loose controls
Lower delivered Cost Untrained labour force
Internal
Established products Strained cash flows

Committed manpower Poor product quality
Advantageous location Family funds
Strong finances Poor public image
Well- known brand names
Opportunities Threats
Growing domestic demand Price War
External
Expanding export markets Intensive competition

Cheap labour Undependable component
Booming capital markets Suppliers
Low interest rates Infrastructure bottlenecks
Power cuts.
Chart 1: SWOT analysis

Numerous non-financial aspects of a company have to be evaluated by investors. An investor
should take qualitative impression of a company; such information may be gathered from various
sources like a prospectus, a stock exchange, annual reports of the company, news papers and
magazine reports, etc. A useful framework is suggested in Table 1. There could be various other
aspects (e.g., research and development, new licenses issued, imports of foreign goods, emergences
of substitutes, etc.), which may be included in such an analysis.
A very useful tool of the company analysis is SWOT analysis which examines the strengths,
Weaknesses, Opportunities, and Threats in the specific context of a company, whereas
opportunities and threats are incumbent upon the external environment. A typical SWOT analysis
is presented in Chart 1.
EXAMPLE OF SWOT ANALYSIS (Steel Authority of India limited)4
Steel Authority of India Limited (SAIL) is engaged in the business of manufacturing and marketing
steel and its allied products. SAIL is India's largest steel company with 13.5 million tons of hot
metal capacity and a market share of 30%. The company is at competitive advantage because of its
vertically integrated operations, helping it achieve benefits from economies of scale. However, the
emergence of large companies will increase the competitive pressures on the SAIL and may force
the group to compete on price, endangering already pressure margins even further.
4
Source: Datamonitor.
Strengths Weaknesses
Largest steel company Government control

Broad product mix Weak exports
Proximity to iron mines
Opportunities Threats
Growing domestic demand Consolidation in the global steel industry

Growth in global demand Competition from China Price volatility
Rising steel prices
Strengths
Largest steel company
SAIL is India's largest steel company with 13.5 million tons of hot metal capacity and a market
share of 30%. The company has a high level of vertical integration and it is self-sufficient in iron
ore. It produces both basic and special steel products for domestic construction, engineering,
power, railway, automotive and defense industries and for sale in export markets. The company's
main steel products include flat products, structural, rail products, and tubular products. SAIL has
five steel plants, three alloy steel plants and three power plant joint venture companies and
research and development. In addition, it has two subsidiary companies. The company plans to
raise its annual hot metal capacity to 20 million tons by 2011-12.The company is at competitive
advantage because of its vertically integrated operations, helping it achieve benefits from economies
of scale.
Broad product mix
SAIL has a broad product mix, with flat steel products contributing to about 51% of its total volume
and long steel products about 35%. While other products like pipes, Electrical sheets, Tin plates
contributes 25%, saleable steel 6% and Secondary products 6% respectively. The company targets
steel consuming segments such as projects/infrastructure, tube makers, cold rollers, oil & gas,
railways, machinery, re-rollers, wire drawing. The product mix also caters to the entire gamut of the
mild steel business- flat products in the form of plates, HR coils/sheet, CR coils/sheets,
plain/corrugated galvanized sheets, long products comprising rails, structural, wire rods, merchant
products. In addition, pipes (ERW & SW), electrical steel sheets and tin plates also form part of the
rich product-mix of SAILs mild steel business.
Leveraging its wide product mix, the company has been able to target a diverse range of industries
such as construction, engineering, power, railway, automotive and defense. A balanced and broad
product mix reduces the business risk of the company and also helps it increase its cross-selling
opportunities.
Proximity to iron mines
Indian iron ore reserves, estimated at 11,000 million tons of hematite ore are among the largest in
the world. Principal iron ore output comes from the rich fields along the Bihar-Orissa border, close
to most of SAIL's steel plants. In fact, Orissa with over 25% of Iron ore reserves accounts for 10% of
Indias steel production capacity. Iron accounts for about 11% of SAIL's total raw material cost. The
companys plants are located in areas which are close to the seaport, making them ideal for import
and export activity. Proximity to such rich reserves reduces fluctuations in supply and
transportation costs making the company cost competitive.
Weaknesses
Government control
SAIL still remains influenced to a large extent by government control. The Indian government owns
about 86% of the outstanding shares of the company. Consequently, the company suffers from slow
decision making, often influenced by political motivation. As a result, the company has not been
able to match the aggressive expansion by the private players such as Tata Steel. Also, due to
government control, salary levels at SAIL are well below the levels being offered by private players.
This has resulted in SAIL losing to private players in attracting talent.
Weak exports
Despite being the largest steel producer in India, SAIL has a weak presence in the international
market. Tata Steel, a competitor of SAIL increased its exports. In contrast, SAIL's exports reduced
from INR 13,419.5 million (approximately $322.06 million) in fiscal 2005 to INR 10,969.9 million
(approximately $263.27 million) in the fiscal 2006 by 18.8%. In fiscal year 2006, SAIL derived
96.6% of its revenues from the domestic markets, which makes it over dependent on the domestic
market and increases its business risk.
Opportunities
Growing domestic demand
During 2006-07, the Indian GDP is estimated to have grown by 9.4% and domestic steel demand
growth is expected to be around 8.8%. In India substantial investments have been planned in
infrastructure development in the country, especially in construction of highways, bridges, airports,
seaports, oil and gas pipelines, drinking water supply pipelines. The consumption of steel is
expected to increase by about 3 to 4 million tons per annum for the next few years and exceed 50
million tons by 2010. It is also predicted that foreign direct investment would be the tune of $15
billion in the 2007 as against $8.4 billion in the fiscal 2006 and a net portfolio investment inflow of
$12.5 billion. With this entire positive trend, the per capita steel consumption in the country which
is currently 33 kg as compared to the world average of around 180 kg signifies significant scope for
increased penetration. SAIL is the largest player at present and is well positioned to gain from the
positive market outlook.
Growth in global demand
The demand for steel in the western markets especially, the US is on the rise. Demand for steel is
expected to increase at 4-5% annually in the next two years. Accelerated infrastructure activity in
CIS, a housing boom in the US, and white goods resurgence in Europe are backing this growth in
steel demand. Export offers to India from CIS countries have increased by about 4-5%. SAIL could
benefit from this increase in global demand for steel if it places more emphasis on exports.
Rising steel prices
Steel prices in India are rising. The strength in the steel prices is due to the decline in domestic
steel inventories, increasing raw material prices and firmer import prices accompanied by a lack of
export offers from traditional import sources like the CIS countries. The global steel prices have
also been on the rise with prices increasing significantly in regions like china and CIS countries.
The strengthening steel prices will increase the revenue prospects for the company.
Threats
Consolidation in the global steel industry
Consolidation in steel industry has increased against the backdrop of increasing overcapacity and
protectionist tariffs. Steel prices after reaching historic heights in early 2005 underwent a
correction towards the end of 2005 owing to de-stocking in inventories and changeover of China
from a net importer to a net exporter. The ongoing consolidation in the steel industry has added to
higher prices. In 2002, seven steel companies controlled about 53% of the market with substantial
overcapacity. But the competitive landscape has totally altered in 2006. The Mittal, US Steel, and
Nucor together control 55% of the US market and new development in 2007, Tata steel acquired
Anglo-Dutch Corus Group for more than $12 billion while another Indian company Essar Global
acquired Canadian steelmaker Algoma Steel for $1.63 billion in cash. The emergence of large
companies will increase the competitive pressures on the SAIL and may force the group to compete
on price, endangering already pressure margins even further.
Competition from China
China is now a net exporter of steel due to domestic overcapacity in supplies. Chinese companies
have started establishing their presence in various international markets. As a result, low cost steel
producers from India such as Tata Steel are facing intense competition.
Price volatility
Global steel prices have been extremely volatile. For instance, the price of cold rolled steel coil rose
from $613 per ton in January 2006 to a high of $704 per ton in August 2006 and thereafter fell to
$654 per ton in February 2007.Volatile movement of steel prices could adversely affect the exports
of the company's steel products. So any future downward movement in steel prices could increase
imports and make India a dumping ground for low cost steel producers in the Asian region.
Source: DATAMONITOR
QUALITY - PRICE MATRIX
The ultimate success in equity investment comes from your ability to choose and buy good scrips at
the right price and at the right time, and also from the equally important ability to sell them at the
right price and at the right time.
The quality of scrip can be determined in terms of rewards to shareholders by way of dividends,
rights shares, bonus shares and capital appreciation. In the chart below we present a simple
framework for easy understanding.
PRICE LQ HQ
HP HP
Yesterdays Blue chips Emerging Blue chips
MQ
MP
Evergreen Super stocks
LQ
HQ
LP
LP
Non Blue chips Turnaround stock
QUALITY
Chart 7: Quality and Price Matrix
Low Quality, Low - Price (LQLP): The non-blue chips

These are not quite blue chips. These shares are of low quality and hence are quoted at low prices.
Just ignore them until there is an upswing in their fortunes. Till then, they are duds.
You should not buy something simply because it is cheap. Remember, what appears cheap may
ultimately prove very expensive.
High Quality, Low - Price (HQLP): Turnaround stocks
These are high quality stocks but quoted at relatively low prices because the market is yet to
recognize their true worth. They are blue chips in the making. You should pick them up as soon as
you spot them, before their price shoot up to high levels.
It is in these HQLP shares that one can make a real killing! Often, they represent certain special
situations like a turn around after a bad period, takeovers, change of management etc. Relative to
their earnings potential, their market price is low. They have not yet attracted the wide attention of
the market. One way to recognize them is that their price/earnings (P/E) ratio i.e. market price
divided by earnings per share is relatively low when compared to the aggregate P/E ratio of the
market as a whole and of that particular industry.
Low Quality, High - Price (LQHP): Yesterdays blue chips
You can call these the stocks with the hangover effect. Once they had the market on a high but
they are more or less banking on their past glory now. Once this fact is recognized, the market
downgrades such stocks and their prices tumble. Such scrips should be sold fast. Do not look at
such a share again until the company returns to the growth track.
Medium Quality, Medium - Price (MQMP): Evergreen super stock
These are steady scrips. They can last for two to three generations fairly intact. Hold on to them.
Dont be in a hurry to sell them, not withstanding temporary ups and downs.
High Quality, High - Price (HQHP): Emerging blue chips
The current stars are popular and command a high price. As long as their glamour last, such
shares perform well in the market. Hold on to them. But be careful, partial booking of profits at
high price may be desirable.
CHAPTER 3
VALUE INVESTING
Introduction to Accounting
Accounting, a lawyer once wrote, is similar to looking at the road through the rearview mirror it
tells you where youve been and what have already happened, but not where you are going.
Finance, however is looking forward it is a plan to assist you in getting to where you want to go.
Accounting
The accounting field has existed longer in history than the finance field. In the simplest terms,
accounting relates to preparation of accounting records, preparation, analyzing and interpretation
of financial statements.
Relevance: Financial Information is capable of making a difference in a decision. Relevant

information helps users form more accurate predictions about the future, or allows them to better
understand how past economic events have affected the business.
Timeliness: Information that is available to decision makers while it is fresh and capable of
influencing their decisions.
Reliability: Financial information that is reasonably free of errors and bias and faithfully
represents what it purports to represent. Reliable financial information is factual, truthful, and
unbiased.
Comparability: Financial information must be measured and reported in a similar manner across
companies. Comparability allows analysts to identify real economic similarities and differences
among diverse companies, because those differences and similarities are not obscured by
accounting methods or disclosure practices.
Consistency: The same accounting methods are used to describe similar events from period to
period. Consistency allows analysts to identify trends and turning points in the economic condition
and performance of a company over time, because the trends are not obscured by changes in
accounting methods of disclosure practices.
The accountants primary function is to develop and provide data measuring the performance of the
firm, assessing its financial position, and paying taxes. The accountant is responsible for preparing
financial statements such as the income statement, balance sheets, and cash flows. It is normally
passive work, in the sense that, the work has a very independent nature to it such as preparing
forms and financial statements.
Finance An Introduction
The study of finance consists of three interrelated areas (i) money and capital markets (ii)
investments, which focuses on the decisions of individual and financial and other institutions as
they choose securities for their investments portfolios, and (iii) managerial finance (business
finance) which involves the actual management of the firm. In general the three areas are inter-
related.
Money and Capital Markets: These include all institutions or organizations that are involved in
financial intermediation between savers (those who have surplus money) and borrowers (those who
have deficit of funds). These include banks and non-bank financial institutions, insurance
companies, stock markets, brokerage and dealers firms, savings and loans and institutions, and
credit unions etc. Working in these institutions requires knowing both the micro and macro
operations including changes interest rates, fiscal policies, monetary policies, and business
operations. The institutions by themselves are also firms and they behave like any other firm, for
profit maximization.
Investment: This involves determining where to make investments from individuals to companies,
and determining the optimal mix of securities and other investments. Knowledge of investment
analysis is very important in order to decide whether a project is financially, economically and
socially viable.
Managerial Finance: Managerial finance is important to all types of businesses, whether they are
public or private, deals with financial services or are manufacturers. Issues related to managerial
finance range from decisions regarding expanding a business to choosing what types of securities
to issue or finance and what type of investments to undertake.
Managerial finance also involves analyzing the performance of the firm in order to forecast its
future performance. It involves making decisions regarding working capital issues such as level of
inventory, cash holding, credit levels, etc. It requires the need to know how to raise funds from the
money and capital markets. It involves decisions regarding whether to merge or acquire a firm, how
much of the generated funds should be distributed or reinvested. Managerial finance touches upon
money and capital markets, and investments.
The field of finance integrates concepts from economics and a number of other related areas. The
central goal of finance is the relationship of risk and return. It reminds an investor that there are
no free lunches. For whatever decisions made there is a trade-off to make in term of the risks and
the returns. For example, an accountant may wish to change the accounting method for reporting
inventories. Such a change has its risk and returns to the firms financial performance. To the
overall economy the change in accounting policy may send a message (signals) to the market about
the efficiency and effectiveness of the firms operations, hence affecting the performance of the
share price in the capital market.
A financial manager has to link the interactions of financing and investment decisions open to the
organization. Table 1 below shows the functions of financial manager.
The financial manager or consultant places primary emphasis on decision making. It uses the
financial statements prepared by accountants to make decisions about the firms financial
condition and to advise others about possible losses and profits. In some cases, finance is more a
type of leadership position. A financial manager has to deal not only with finance, but also with
economics, accounting, statistics, math, and management. For example, people working with
stocks and bonds have to understand and analyze how the underlying companies are performing.
How a given company is going to perform during recession? Should they sell or buy stocks or
bonds. How a decrease in the interest rate may affect the projects a company has in that country.
Finance also deals a lot with risk. Enhanced risk can be countered by being hedged by Derivative
Securities. Risk managers are in great demand everywhere. Most finance majors find jobs in banks
and other financial institutions, government, real estate, consultant companies, insurance,
investment companies, stock market exchanges, fundraising, and any firm that needs someone to
make financial decisions.
Introduction to Financial Statements
Financial statements, as used in corporate business houses, refer to a set of reports and schedules
which an accountant prepares at the end of a period of time for a business enterprise. The financial
statements are the means with the help of which the accounting system performs its main function
of providing summarized information about the financial affairs of the business.
These statements comprise of

1. Balance Sheet or Position Statement.
2. Profit and Loss Account or Income Statement.
Of course, in addition to the above, a business may also prepare:

1. A Statement of Retained Earnings.
2. A Statement of Changes in Financial position.
These give a full view of the financial affairs of an undertaking. In India, every company has to
present its financial statements in the form and contents as prescribed under Section 211 of the
Companies Act 1956. The significance of these statements is given below:
Balance Sheet or Position Statement: The balance sheet is a statement showing the
nature and amount of a companys assets on one side and liabilities and capital on the
other. In other words, the balance sheet shows the financial conditions or state of affairs of
a company at the end of a given period, usually at the end of an year. In its simplest form,
a balance sheet shows how the money has been made available to the business of the
company and how the money is employed in the business.
Profit and Loss Account or Income Statement: Earning profit is the principal objective of
all business enterprises and the Profit and Loss account or Income statement is the
document which indicates the extent of success achieved by a business in meeting this
objective. Profits are of primary importance to the Board of directors in evaluating the
management of a company, to shareholders or potential shareholders in making
investment decisions and to banks and other creditors in judging the loan repayment
capacities and abilities of the company. It is because of this that the profit and loss or
income statement is regarded as the primary statement and commands a careful scrutiny
by all interested parties. It is prepared for a particular period which is mentioned along
with the title of these statements, which includes the name of the business firm also.
Statement of Retained Earnings: This statement is also known as Profit and Loss
Appropriation Account and is generally a part of the Profit and Loss Account. This
statement shows how the profits of the business for the accounting period have utilized or
appropriated towards reserves and dividend and how much of the same is carried forward
to the next period. The term retained earnings means the accumulated excess of earnings
over losses and dividends. The balance shown by Profit and Loss Account is to be
transferred to the Balance Sheet through this statement after making necessary
appropriations.
Statement of Changes in Financial Position: This is a statement which summarizes for

the period, the cash made available to finance the activities of an organization and the uses
to which such cash have been put. This statement is also known as Cash Flow Statement
which summarizes the changes in cash inflows and outflows, by showing the various
sources and applications of cash.
ANALYSIS OF FINANCIAL STATEMENTS
Introduction to Financial Statement Analysis
Published financial statements are the only source of information about the activities and affairs of
a business entity available to the public, shareholders, investors and creditors and the
governments. These groups are interested in the progress, position and prospects of such entity in
various ways. But these statements howsoever, correctly and objectively prepared, by themselves
do not reveal the significance, meaning and relationship of the information contained therein. For
this purpose, financial statements have to be carefully studied, dispassionately analyzed and
intelligently interpreted. This enables a forecasting of the prospects for future earnings, ability to
pay interest, debt maturities both current as well as long-term and probability of sound financial
and dividend policies.
According to Myers, the financial statement analysis is largely a study of relationship among the
various financial factors in business as disclosed by a single set of statements and a study of the
trend of these factors as shown in a series of statements.
Thus, analysis of financial statements refers to the treatment of information contained in the
financial statement in a way so as to afford a full diagnosis of the profitability and financial position
of the firm concerned.
The process of analyzing financial statements involves the rearranging, comparing and measuring
the significance of financial and operating data. Such a step helps to reveal the relative significance
and effect of items of the data in relation to the time period and/or between two organizations.
Interpretation, which follows analysis of financial statements, is an attempt to reach to logical

conclusion regarding the position and progress of the business on the basis of analysis. Thus,
analysis and interpretation of financial statements are regarded as complimentary to each other.
Types of Financial Statement Analysis
A distinction may be drawn between various types of financial analysis either on the basis of
material used for the same or according to the modus operandi of the analysis.
a) According to Nature of the Analyst and the Material used.

1. External Analysis: It is made by those who do not have access to the detailed
records of the company. This group, which has to depend almost entirely on
published financial statements, includes investors, credit agencies and
governmental agencies regulating a business in nominal way. The position of
the external analyst has been improved in recent times owing to the
government regulations requiring business undertaking to make available
detailed information to the public through audited accounts.
2. Internal Analysis: The internal analysis is accomplished by those who have

access to the books of accounts and all other information related to business.
While conducting this analysis, the analyst is a part of the enterprise he is
analyzing. Analysis for managerial purposes is an internal type of analysis and
is conducted by executives and employees of the enterprise as well as
governmental and court agencies which may have regulatory and other
jurisdiction over the business.
b) According to Modus Operandi of Analysis.
1. Horizontal Analysis: When financial statements for a number of years are
reviewed and analyzed, the analysis is called horizontal analysis. As it is
based on data from year to year rather than one date or period of time as a
whole, this is also known as Dynamic Analysis. This is very useful for long-
term trend analysis and planning.
2. Vertical Analysis: It is frequently used for referring to ratios developed for one
date or for one accounting period. Vertical analysis is also called Static
Analysis. This is not very conducive to proper analysis of the firms financial
position and its interpretation, as it does not enable to study data in
perspective. This can only be provided by a study conducted over a number of
years so that comparisons can be affected.
Methods of Analyzing Financial Statements
The analysis of financial statements consists of a study of relationship and trends, to determine
whether or not the financial position and results of operations as well as the financial progress of
the company are satisfactory or unsatisfactory. The analytical methods or devices listed below are
used to ascertain or measure the relationships among the financial statements items of a single set
of statements and the changes that have taken place in these items as reflected in successive
financial statements. The fundamental objective of any analytical method is to simplify or reduce
the data under review to more understandable terms.
Analytical methods and devices used in analyzing financial statements are as follows:
a) Comparative Statements.
b) Common Size Statements.
c) Trend Ratios.
d) Ratio Analysis.
Comparative Financial Statement Analysis
These financial statements are so designed as to provide time perspective to the various elements of
financial position contained therein. These statements give the data for all the periods stated so as
to show:
1. Absolute money values of each item separately for each of the periods stated.
2. Increase and decrease in absolute data in terms of money values.
3. Increase and decrease in terms of percentages.
4. Comparison expressed in ratios.
5. Percentages of totals.
Such comparative statements are necessary for the study of trends and direction of movement in
the financial position and operating results. This calls for a consistency in the practice of preparing
these statements, otherwise comparability may be distorted. Comparative statements enable
horizontal analysis of figures.
COMPARATIVE BALANCE SHEET
A comparative balance sheet shows the balance of accounts of assets and liabilities on different
dates and also the extent of their increases or decreases between these dates throwing light on the
trends and direction of changes in the position over the periods. This helps in predicting about the
position of the business in future. A specimen of the comparative balance sheet is given below:
. Company Ltd.
Comparative Balance Sheet (as on 31st March, 2007 and 2008)
Assets 31.3.2007 31.3.2008 Increase (+) Increase (+)
Or Decrease (-) Or
In amounts Decrease (-)
In %age
Rs. Rs. Rs.
Current Assets
Cash in hand and at bank 118,000 10,000 (-) 108,000 (-) 92
Receivable on customers Account 209,000 190,000 (-) 19,000 (-) 9
and Bills
Inventory of materials, goods in 160,000 130,000 (-) 30,000 (-) 19
process and finished stock
Prepaid expenses 3,000 3,000 - -
Other current assets 29,000 10,000 (-) 19,000 (-) 66
Total Current Assets 519,000 343,000 (-) 176,000 (-) 34
Fixed Assets
Land and buildings 270,000 170,000 (-) 100,000 (-) 37
Plant and machinery 310,000 786,000 (+) 476,000 (+) 150
Furniture and fixtures 9,000 18,000 (+) 9,000 (+) 100
Other fixed assets 20,000 30,000 (+) 10,000 (+) 50
Total Fixed Assets 609,000 1004,000 (+) 395,000 (+) 65
Investments 46,000 59,000 (+) 13,000 (+) 28
Total Assets 1174,000 1406,000 (+) 232,000 (+) 20
Liabilities and Capital

Current Liabilities
Accounts payables (sundry trade 255,000 117,000 (-) 138,000 (-) 54
creditors and bills payable)
Other short-term liabilities 7,000 10,000 (+) 3,000 (+) 43
Total Current Liabilities 262,000 127,000 (-) 135,000 (+) 52
Debentures 50,000 100,000 (+) 50,000 (+) 100
Long-term loans on mortgage 150,000 225,000 (+) 75,000 (+) 50
Total Liabilities 462,000 452,000 (-) 10,000 (-) 2
Capital
Equity share capital 400,000 600,000 (+) 200,000 (+) 50
Reserve and surplus 312,000 354,000 (+) 42,000 (+) 13
Total Liabilities and Capital 1174,000 1406,000 (+) 232,000 (+) 20
Common Size Financial Statement Analysis
In comparative financial statements it is difficult to comprehend the changes over the years in
relation to total assets, total liabilities and capital or total net sales. This limitation of comparative
statements makes comparison between two or more firms of an industry impossible as there is no
common base of comparison for absolute figures. Again, for an interpretation of underlying causes
of changes over time period requires vertical analysis and this is not possible with comparative
statements.
Common size financial statements are those in which figures reported are
converted into percentages to some common base. For this, items in the
financial statements are presented as percentages or ratios to total of the
items and a common base for comparison is provided. Each percentage
shows the relation of the individual item to its respective total.
COMMON-SIZE INCOME STATEMENT
In a common size income statement the sales figure is assumed to be equal to 100 and all other
figures of costs or expenses are expressed as percentages of sales. A comparative income statement
for different periods helps to reveal the efficiency or otherwise of incurring any cost or expense. If it
is being prepared for two firms, it shows the relative efficiency of each cost item for the two firms.
A comparative common-size income statement for two firms in an industry is illustrated below:
Two Companies: Old Guards and Young Ones
Comparative Income Statement (period ending 31st March, 2008)
Old Guards Co. Young Ones Co.
Amount % Of Amount % Of
Rs. Sales Rs. Sales
(1) (2) (3) (4) (5)
Net sales 2538,000 100.0 970,000 100.0

Cost of goods sold 1422,000 56.0 475,000 49.0
Gross Profit on Sales 1116,000 44.0 495,000 51.0
Selling expenses 720,000 28.4 272,000 28.0

General and administrative expenses 184,000 7.2 97,000 10.0
Total Operating Expenses 904,000 35.6 369,000 38.0
Operating profit 212,000 8.4 126,000 13.0

Other income 26,000 1.0 10,000 1.0
238,000 9.4 136,000 14.0

Other expenses 40,000 1.6 29,000 3.0
Income before tax 198,000 7.8 107,000 11.0

Income tax 68,000 2.7 28,000 2.9
Net Income after tax 130,000 5.1 79,000 8.1
Trend Ratios Analysis
Trend Ratios can be defined simply as index numbers of the movements of the various financial
items in the financial statements for a number of periods, that is, a statistical device applied in the
analysis of financial statements to reveal the trend of the items with the passage of time. Trend
ratios show the nature and rate of movements in various financial factors. They provide a
horizontal analysis of comparative statements and reflect the behavior of various items with the
passage of time. Trend ratios can be graphically presented for a better understanding by the
management. They are very useful in predicting the behavior of the various financial factors in
future. However, it should be noted that conclusions should not be drawn on the basis of a single
trend. Trends of related items should be carefully studied, before any meaningful conclusion is
arrived at. Since trends are sometimes significantly affected by externalities, i.e. reasons
extraneous to the organizations, the analyst must give due weight age to such extraneous factors
like government policies, economic conditions, changes in income and its distribution, etc.
To gain insights into which direction the company is moving, a trend analysis should be performed.
A trend analysis indicates a firms performance over time and reveals whether its position is
improving or deteriorating relative to other companies in the industry. A trend analysis requires
that a number of different ratios be calculated over several years and plotted to yield a graphic
representation of the companys performance.
COMPUTATION OF TREND PERCENTAGES
For calculation of the trend of data shown in the financial statements, it is necessary to have
statements for a number of years, and then proceed as under:
1. Take one of the statements as the base with reference to which all other statements are to
be studied. While choosing the best statement, it should be chosen so that it belongs to a
normal year of business activities. Statement relating to an abnormal year should not be
selected as the base or the trend calculated will be meaningless.
2. Every item in the base statement is rebased, i.e., stated as 100.
3. Trend percentage of each item in other statement is calculated with reference to same item
in the base statement by using the following formula:
{Absolute Value of item (say cash) in other statements / Absolute Value of same item
(cash) in base statement} * 100
Illustration: From the following information extracted from the Balance Sheets of
Company Ltd. for four previous financial years; calculate the trend percentages
taking 2004-05 as the base year:
2004-05 2005-06 2006-07 2007-08

(Rs. In lakhs)
Current Assets:
Cash 200 240 400 220
Bank 260 300 200 240
Debtors 400 600 1,000 1,600
Stock 800 1,200 1,800 2,000
Fixed Assets:
Building 1,000 1,200 1,200 1,200
Plant and Machinery 2,000 2,400 2,400 2,800
4660 5,940 7,000 8,060
2004-05 2005-06 2006-07 2007-08
(Trend percentage)
Current Assets:
Cash 100 120.00 200.00 110.00
Bank 100 115.38 76.92 92.30
Debtors 100 150.00 250.00 400.00
Stock 100 150.00 225.00 250.00
Fixed Assets:
Building 100 120.00 120.00 120.00
Plant and Machinery 100 120.00 120.00 140.00
100 127.46 150.21 172.96
RATIO ANALYSIS
PROFITABILITY RATIOS
A measure of profitability is the overall measure of efficiency. In general terms of efficiency, a

business is measured by the input-output analysis. By measuring the out-put as a proportion of
the input and comparing result of similar other firms or periods the relative change in its
profitability can be established.
The income (output) as compared to the capital employed (input) indicates profitability of a firm.
Thus the chief profitability ratio is:
{Operating Profit (net margin)/Operating Capital Employed} x 100
Return on Investment: This ratio is also known as overall profitability ratio or return on capital
employed. The income (output) as compared to the capital employed (input) indicates the return on
investment. It shows how much the company is earning on its investment. This ratio is calculated
as follows:
Return on Investment = (Net Operating Profit x 100)/Capital Employed
Operating profit means profit before interest and tax. In arriving at the profit, interest on loans is
treated as a part of profit (but not the interest on bank overdraft or other short-term finance)
because loans themselves are part of the input, i.e., the capital employed and hence, the interest on
loans should also be part of the output and should not be excluded there from. All non-business
income or rather income not related to normal operations of the company should be excluded.
Thus, the profit figure shall be IBIT, i.e., Income Before Interest and Taxation (excluding non-
business income).
Capital employed comprises share capital and reserves and surplus, long-term loans minus non-
operating assets and fictitious assets. It can also be represented as net fixed assets plus working
capital (i.e., current assets minus current liabilities). Thus capital employed may comprise:
Share Capital + Reserve and Surplus + Long-term Loans Non-operating Assets Fictitious Assets
Return on Shareholders Funds: It is also referred to as return on net worth. In this case it is
desired to work out the profitability of the company from the shareholders point of view and it is
computed as follows:
{Net Profit after Interest and Tax/Shareholders Funds} x 100
Gross Profit Ratio or Gross Margin: Gross profit ratio expresses the relationship of gross profit to
net sales or turnover. Gross profit is the excess of the proceeds of goods sold and services rendered
during a period over their cost, before taking into account administration, selling and distribution
and financing changes. Gross profit ratio is expressed as follows:
{Gross Profit/Net Sales} x 100

Net Profit Ratio or Net Margin: {Net Profit/Net Sales} x 100
ACTIVITY RATIOS OR TURNOVER RATIOS
The ratios used to measure the effectiveness of the employment of resources are termed as activity
ratios. Since these ratios relate to the use of assets for generation of income through turnover they
are also known as turnover ratios, as we have seen already, the overall profitability of the business
depends on two factors i.e., (i) the rate of return on sales and (ii) the rate of return on capital
employed i.e., the speed at which the capital employed in the business relates. More efficient the
operations of an undertaking the quicker and more number of times the rotation is. Thus the
overall profitability ratio is calculated as Net Profit Ratio x Turnover Ratio. The net profit ratio has
already been discussed. Now the important turnover ratios as regards capital employed and assets
are discussed further.
Capital Turnover (Sales to Capital Employed) Ratio: This ratio shows the efficiency of capital
employed in the business and is calculated as follows:
Capital Turnover Ratio = (Net Sales/Capital Employed)
The higher the ratio the greater are the profits.
Total Assets Turnover Ratio: This ratio is ascertained by dividing the net sales by the value of
total assets. Thus,
Total Assets Turnover Ratio = (Net Sales/Total Assets)

FINANCIAL RATIOS
Financial statements of a firm are analyzed for ascertaining its profitability as well as its financial
position. A firm is said to be financially sound provided it is capable of meeting its commitments in
both the short-term and the long-term. Accordingly, the ratios to be computed for judging the
financial position are also known as solvency ratios and those that are specifically computed for
short-term solvency are known as liquidity ratios.
In a short period, typically within a year, a firm should be able to meet all its short-term obligations
i.e., current liabilities and provisions. It is current assets that yield funds in the short period
current assets are those assets which the firm can convert it into cash within one year. Current
assets should not only yield sufficient funds to meet current liabilities as they fall due but also to
enable the firm to carry on its day-to-day activities. The ratios to test the short-term solvency or
liquidity position of an enterprise are discussed further.
Current Ratio: Also known as the working capital ratio, this is one of the most widely used ratios
in financial statement analysis. It is the ratio of total current assets to current liabilities and is
calculated by dividing the current assets by current liabilities.
Current Ratio = (Current Assets/Current Liabilities)
Liquid Ratio: This ratio is also known as Quick Ratio or Acid Test Ratio. This ratio is calculated by
relating liquid or quick assets to current liabilities. Liquid assets mean those assets which are
immediately converted into cash without much loss. All current assets except inventories and
prepaid expenses are categorized as liquid assets. The ratio can be computed as:
Liquid Ratio = (Liquid Assets/Current Liabilities)
Debt-Equity Ratio: Debt-equity ratio is the relation between borrowed funds and owners capital in
a firm; it is also known as external-internal equity ratio. The debt-equity ratio is used to ascertain
the soundness of long-term financial policies of the business. Debt means long-term loans i.e.,
debentures or long-term loans from financial institutions. Equity means a shareholders funds i.e.,
preference share capital, equity share capital, reserves less loss and fictitious assets like
preliminary expenses. It is calculated in the following ways:
{Debts/Equity (Shareholders Funds)} Or

{Debts/Long-term Funds (Shareholders Funds + Debts)}
MARKET TEST RATIOS
Market ratios are calculated generally in case of such companies whose shares and stocks are
traded in the stock exchanges. Shareholders, present and probable, are interested not only in the
profits of the company but also in the appreciation of the value of their shares in the stock market.
The value of shares in the stock market, besides other factors, also depends upon factors like the
dividends declared, earnings per share, the payout policy, etc., of the companies. The following
ratios reflect the effect of these factors on the market value of the shares.
Earning Per Share (EPS): The profit available to the equity shareholders on a per share basis is
calculated by EPS. This is calculated as under:
EPS = (Net profit After Pref. Dividend / No. of equity shares)
Price Earning Ratio: This ratio establishes relationship between the market price of the shares of
a company and its earning per share (EPS). It is calculated as under:
Price Earning Ratio (PER) = (Market value per equity share/Earning per share)
Ex: Assuming the market value of a share to be Rs.40 and the EPS Rs.6.66 per share as
calculated in EPS example above, then the PER comes to (Rs.40/6.66) or 6 times.
This ratio helps in predicting the future market value of the shares within reasonable limits. It also
helps in ascertaining the extent of under and over- valuation in the market price, thus pointing to
the effect of factors generated by the companys financial position.
ADVANTAGES OF RATIO ANALYSIS
Ratio analysis is a powerful tool of financial analysis. An absolute figure generally conveys no
meaning. It is seen that mostly figures assume importance only in the context of other information.
Ratios bring together figures which are significantly allied to one another to portray the cause and
effect relationship. The following advantages can be attributed to the technique of ratio analysis:
It helps to analyze and understand the financial health and trend of a business, its
past performance, and makes it possible to forecast the future state of affairs of the
business. They diagnose the organizational financial health by evaluating liquidity,
solvency, profitability etc. This helps the management to assess the financial
requirements and the capabilities of various business units.
Compares the performance of the business and the performance of similar types of
business.
Ratio analysis plays a significant role in cost accounting, financial accounting,
budgetary control, and auditing.
It helps in the identification, tracing, and fixing of the responsibilities of managerial
personnel at different levels.
It accelerates the institutionalization and specialization of financial management.
Accounting ratios summarize and systematize the accounting figures in order to
make them more understandable. They highlight the inter-relationship which
exists between various segments of the business expressed by accounting
statements.
LIMITATIONS OF RATIO ANALYSIS
Ratio analysis is a widely used technique to evaluate the financial position and performance of a
business. But these are subject to certain limitations:
Usefulness of ratios depends on the abilities and intentions of those who handle
them.
Ratios are worked out on the basis of money-values only. They do not take into
account the real values of various items involved.
Historical values (especially in balance sheet ratios) are considered in working out
the various ratios. Effects of changes in the price levels of various items are ignored
and to that extent the comparisons and evaluations of performance through ratios
becomes unrealistic and unreliable.
One particular ratio in isolation is not sufficient to review the whole business. A
group of ratios are to be considered simultaneously to arrive at any meaningful and
worthwhile opinion about the affairs of the business.
Since management and financial policies and practices differ from concern to
concern, similar ratios may not reflect similar state of affairs of different concerns.
Thus, comparisons of performance on the basis of ratios may be confusing.
Since ratios are calculated on the basis of financial statements which are
themselves affected greatly by the firms accounting policies and changes therein,
the ratios may not be able to bring out the real situation.
Ratios are only as accurate as the accounts on the basis of which these are
established. Therefore, unless the accounts are prepared accurately by applying
correct values to assets and liabilities, the statements prepared there from would
not be correct and the relationship established on that basis would not be reliable.
COMPANY ANALYSIS - FINANCIAL
Book Value per Share
Suppose the market price of a stock is Rs.60 per share, whether this value is too high, too low, or
just about right. One could compare the Rs.60 market price with the stockholders equity per share
reported in its most recent balance sheet which is called the book value per share.
Book Value Per Share = (Stockholders Equity - Preferred Stock) / Average Outstanding Shares
Somewhat similar to the earnings per share, but it relates the stockholder's equity to the number of
shares outstanding, giving the shares a raw value.
Book value per share has a respectable history in securities analysis. The classic book, Security
Analysis, by Benjamin Graham and David Dodd, puts a fair amount of emphasis on the book value
behind a share of stock.
Generally speaking, the market value of stocks is typically higher than their book values, since
book value is backed up by the assets of the Company. To illustrate this point, suppose a company
is to liquidate all its assets at the amounts reported in its balance sheet, then pay off all its
liabilities, and finally distribute the money left over to its stockholders. Each share of stock would
receive cash equal to the book value per share. So book value is a theoretical liquidation value per
share. The profit prospects of the company may be very dim; the stockholders may not see much
chance of improving profit performance in the near future. They may think that the company could
not sell off its assets at their book values and that no one would pay book value for the company as
a whole. Of course, most Companies do not plan to liquidate their assets and go out of business in
the foreseeable future. They plan to continue as a going concern and make a profit, at least for as
far ahead as they can see. Therefore the dominant factor in determining the market value of shares
is the earnings potential of the company, not the book value of its ownership shares. The best place
to start in assessing the earning potential of a company is its most recent earnings performance.
Let us assume you owned 10,000 shares of the company and were interested in buying someone
else shares. What price would you offer for his shares? On analyzing the financial statements of
the Company it is found that the company will probably improve its profit performance in the
future. So you might be willing to pay a higher per share for the stock, which is based on your
assessment of the future earnings potential of the Company. Therefore, the main factor driving the
market price of a stock is its earnings per share.
Earnings Per Share
Earnings per Share (EPS) is calculated as follows for the company:
Basic EPS = (Net Income available for shareholders) / (Total number of outstanding shares)
The numerator (top number) in the EPS ratio is net income available for common shareholders,
which equals bottom-line net income minus dividends paid to preferred stockholders of the
Company. Many Companies issue preferred stock shares that require a fixed amount of dividends
to be paid each year. The total of annual dividends to the preferred shareholders is deducted from
net income to determine net income available for the common shareholders.
For greater accuracy, a weighted average number of shares outstanding during the year should be
used to calculate EPS which takes into account that some shares may have been issued and
outstanding only part of the year. Also, a company may have reduced the number of its
outstanding shares during part of the year.
Basic and Diluted EPS
Basic EPS means that the actual number of common shares in the hands of shareholders is used as
the denominator for calculating EPS. If a company were to issue more shares, the denominator
would become larger and EPS would decrease. The larger number of shares would dilute EPS. In
fact many corporations have entered into contracts that oblige them to issue additional shares in
the future. These shares have not yet been issued, but the company is legally committed to issue
more shares in the future. In other words, there is the potential that the number of capital shares
will be inflated and net income will have to be divided over a larger number of stock shares.
Many companies award their high-level managers stock options that give them the right to buy
stock shares at fixed prices. These fixed purchase prices generally are set equal to the market price
at the time the stock options are granted. The idea is to give the managers an incentive to improve
the profit performance of the Company, which should drive up the market price of its shares. When
(and if) the market value of the shares rises, the managers exercise their rights and buy shares at
the lower prices fixed in their option contracts. Managers can make lakhs of rupees by exercising
their stock options. There is a wealth transfer from the non-management shareholders to some of
the management shareholders because the market price per share is lower than it would have been
if shares had not been issued to the managers.
The calculation of basic EPS does not recognize the additional shares that may be issued when
management stock options are exercised in the future. Also, some Companies issue convertible
bonds and convertible preferred shares that, at the option of the security holders, can be traded in
for common shares based on predetermined exchange rates. Conversions of senior securities into
shares of common shares also cause dilution of EPS.
To alert investors to the potential effects of management stock options and convertible securities, a
second EPS is calculated by certain companies, which is called the diluted EPS. This lower EPS
takes into account the effects on EPS that would be caused by the issue of additional common
shares under terms of management stock option plans and convertible securities (plus any other
commitments a Company has entered into that requires it to issue additional shares in the future).
Both basic EPS and diluted EPS (if applicable) are reported in the income statements of companies.
The diluted EPS is a more conservative figure.
Earnings multiples remain the most commonly used measures of relative value. Here we begin
with a detailed examination of the price earnings ratio and then move on to consider a variant that
is often used for technology firms the price earnings to growth ratio (PEG). We also look at value
multiples, and in particular, the value to EBITDA multiple and other variants of earnings multiples.
Price Earnings Ratio (PE)
The price-earnings multiple (PE) is the most widely used and misused of all multiples. Its simplicity
makes it an attractive choice in applications ranging from pricing initial public offerings to making
judgments on relative value, but its relationship to a firm's financial fundamentals is often ignored,
leading to significant errors in applications.
DEFINITIONS of PE RATIO
The price earnings ratio is the ratio of the market price per share to the earnings per share:
PE = Market Price per share / Earnings per share
The PE ratio is consistently defined, with the numerator being the value of equity per share and the
denominator measuring earnings per share, which is a measure of equity earnings. The biggest
problem with PE ratios is the variations on earnings per share used in computing the multiple. PE
ratios could be computed using current earnings per share, trailing earnings per share, forward
earnings per share, fully diluted earnings per share and primary earnings per share. EPS is usually
from the last four quarters (trailing P/E), but sometimes it can be taken from the 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.
With technology firms, the PE ratio can be very different depending upon which measure of
earnings per share is used. This can be explained by two factors:
a) The high growth in earnings per share at these firms: Forward earnings per share can be
substantially higher than trailing earnings per share, which, in turn, can be significantly
different from current earnings per share.
b) Management Options: Since technology firms tend to have far more employee options
outstanding, relative to the number of shares, the differences between diluted and primary
earnings per share tend to be large.
When the PE ratios of technology firms are compared, it is difficult to ensure that the earnings per
share are uniformly estimated across the firms for the following reasons:
Technology firms often grow by acquiring other firms, and they do not account for with
acquisitions the same way. Some do only stock-based acquisitions and use only pooling,
others use a mixture of pooling and purchase accounting, still others use purchase
accounting and write of all or a portion of the goodwill as in-process R&D. These different
approaches lead to different measures of earnings per share and different PE ratios.
Using diluted earnings per share in estimating PE ratios might bring the shares that are
covered by management options into the multiple, but they treat options that are deep in-
the-money or only slightly in-the-money as equivalent.
The expensing of R&D gives firms a way of shifting earnings from period to period, and
penalizes those firms that are spending more on research and development. Technology
firms that account for acquisitions with pooling and do not invest in R&D can have much
lower PE ratios than technology firms that use purchase accounting in acquisitions and
invest substantial amounts in R&D.
PE RATIOS AND EXPECTED EXTRAORDINARY GROWTH
The PE ratio of a high growth firm is a function of the expected extraordinary growth rate - the
higher the expected growth, the higher the PE ratio for a firm.
The PE ratio is much more sensitive to changes in expected growth rates when interest rates are
low than when they are high. The reason is simple. Growth produces cash flows in the future, and
the present value of these cash flows is much smaller at high interest rates. Consequently the
effects of changes in the growth rate on the present value tend to be smaller.
There is a possible link between this finding and how markets react to any earnings surprise from
technology firms. When a firm reports earnings that are significantly higher than expected (a
positive surprise) or lower than expected (a negative surprise), investors perceptions of the
expected growth rate for this firm can change concurrently, leading to a price effect. You would
expect to see much greater price reactions for a given earnings surprise, positive or negative, in a
low-interest rate environment than you would in a high-interest rate environment.
The PE ratio is a function of the perceived risk of a firm, and the effect shows up in the cost of
equity. A firm with a higher cost of equity will trade at a lower multiple of earnings than a similar
firm with a lower cost of equity. In general, a high PE suggests that investors are expecting higher
earnings growth in the future compared to companies with a lower PE. However, the PE ratio
doesn't tell us the whole story by itself. It's usually more useful to compare the PE ratios of
one company to other companies in the same industry, to the market in general or against the
company's own historical PE. It would not be useful for investors using the PE ratio as a basis for
their investment to compare the PE of a technology company (high PE) to a utility company (low PE)
as each industry has much different growth prospects.
The PE is sometimes referred to as the "multiple", because it shows how much investors are willing
to pay per rupee of earnings. If a company were currently trading at a multiple (PE) of 20, the
interpretation is that an investor is willing to pay Rs. 20 for Rs. 1 of current earnings.
It is important that investors note an important problem that arises with the P/E measure, and to
avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting
measure of earnings that is susceptible to forms of manipulation, making the quality of the PE only as
good as the quality of the underlying earnings number.
Price Earning Growth Ratio
Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to
identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE
ratios less than their expected growth rate are viewed as undervalued. In its more general form, the
ratio of PE ratio to growth is used as a measure of relative value, with a lower value believed to
indicate that a firm is under-valued. For many analysts, especially those tracking firms in high-
growth sectors, these approaches offer the promise of a way of controlling for differences in growth
across firms, while preserving the inherent simplicity of a multiple
DEFINITION OF THE PEG RATIO
The PEG ratio is defined to be the price earnings ratio divided by the expected growth rate in
earnings per share:
PEG ratio = PE ratio / Expected Growth Rate
For instance, a firm with a PE ratio of 20 and a growth rate of 10% is estimated to have a PEG ratio
of 2. The growth rate used in this estimate be the growth rate in earnings per share, rather than
operating income, because this is an equity multiple.
A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that
approaches two or goes higher than 2 is believed to be too high. This means that the price paid
appears to be much too high relative to the projected earnings growth.
The PEG is a widely employed indicator of a stock's possible true value. The PEG ratio of 1
represents a fair trade-off between the values of cost and the values of growth, indicating that a
stock is reasonably valued given the expected growth.
Given the many definitions of the PE ratio, which one should you use to estimate the PEG ratio?
The answer depends upon the base on which the expected growth rate is computed. If the expected
growth rate in earnings per share is based upon earnings in the most recent year (current
earnings), the PE ratio that should be used is the current PE ratio. If it based upon trailing
earnings, the PE ratio used should be the trailing PE ratio. The forward PE ratio should never be
used in this computation, since it may result in a double counting of growth.
Building upon the theme of uniformity, the PEG ratio should be estimated using the same growth
estimates for all firms in the sample. You should not, for instance, use 5-year growth rates for some
firms and 1-year growth rates for others. One way of ensuring uniformity is to use the same source
for earnings growth estimates for all the firms in the group.
Other Earnings Multiples
While the PE ratio and the PEG ratio may be the most widely used earnings multiples, there are
other earnings multiples that are also used by analysts. The first is a multiple of price to earnings
in a future year (say 5 or 10 years from now), the second is a multiple of price to earnings prior to
R&D expenses and the third is a multiple of value to EBITDA.
Enterprise Value to EBITDA
Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were
to acquire it. Enterprise value is a more accurate estimate of takeover cost than market
capitalization because it takes includes a number of important factors such as preferred stock,
debt, and cash reserves.
Enterprise value is calculated by adding a corporations market capitalization, preferred stock, and
outstanding debt together and then subtracting out the cash and cash equivalents found on the
balance sheet. (In other words, enterprise value is what it would cost you to buy every single share
of a companys common stock, preferred stock, and outstanding debt. The reason the cash is
subtracted is simple: once you have acquired complete ownership of the company, the cash
becomes yours). The components of Enterprise Value are as follows:
Market Capitalization: Frequently called market cap, the market capitalization of a stock is
calculated by taking the number of outstanding shares of common stock multiplied by the current
price-per-share.
Preferred Stock: Although it is technically equity, preferred stock can actually act as either equity
or debt, depending upon the nature of the individual issue. A preferred issue that must be
redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases,
preferred stock may have the right to receive a fixed dividend plus share in a portion of the profits
(this type is known as participating). Regardless, the existence represents a claim on the business
that must be factored into enterprise value.
Debt: Once youve acquired a business, youve also acquired its debt. If you purchased all of the
outstanding shares of a company for Rs. 10crore (the market capitalization), yet the business had 5
crores in debt, you would actually have expended Rs. 15crore; Rs. 10crore may have come out of
your pocket today, but you are now responsible for repaying the Rs. 5crore debt out of the cash
flow of the business cash flow that otherwise could have gone to other things.
Cash and Cash Equivalents: Once you have purchased a business, you own the cash that is
sitting in the bank. After acquiring complete ownership, you can simply take this cash and put it in
your pocket, replacing some of the money you expended to buy the business. In effect, it serves to
reduce your acquisition price; for that reason, it is subtracted from the other components when
calculating enterprise value.
The enterprise value to EBITDA multiple relates the total market value of the firm, net of cash, to
the earnings before interest, taxes and depreciation of the firm:
EV/EBITDA = (Market Value of Equity + Market Value of Debt Cash) / EBITDA
Why is cash netted out of firm value for this calculation? Since the interest income from the cash is
not counted as part of the EBITDA, not netting out the cash will result in an overstatement of the
true value to EBITDA multiple. The asset (cash) is added to value, but the income from the asset is
excluded from the income measure (EBITDA).
In the last two decades, this multiple has acquired a number of adherents among analysts for a
number of reasons. First, there are far fewer firms with negative EBITDA than there are firms with
negative earnings per share, and thus fewer firms are lost from the analysis. Second, differences in
depreciation methods across different companies some might use straight line while others use
accelerated depreciation can cause differences in operating income or net income but will not
affect EBITDA. Third, this multiple can be compared far more easily across firms with different
financial leverage the numerator is firm value and the denominator is a pre-debt earnings than
other earnings multiples. For all of these reasons, this multiple is particularly useful for firms in
sectors that require large investments in infrastructure with long gestation periods.
Leverage Analysis
We can define leverage as a multiplication of changes in sales into even larger changes in
profitability measures. Firms that use large amounts of operating leverage will find that their
earnings before interest and taxes will be more variable than those who do not. We would say that
such a firm has high business risk. Business risk is one of the major risks faced by a firm, and can
be defined as the variability of EBIT. The more variable a firms revenues, relative to its costs, the
more variable its EBIT will be. Also, the likelihood that the firm wont be able to pay its expenses
will be higher. As an example, consider a software company and a grocery chain. It should be
apparent that the future revenues of the software company are much more uncertain than those for
the grocery chain. This uncertainty in revenues causes the software company to have a much
greater amount of business risk than the grocery chain. The software companys management can
do little about this business risk; it is simply a function of the industry in which they operate.
Software is not a necessity of life. People do, however, need to eat. For this reason, the grocery
business has much lower business risk.
Business risk results from the environment in which the firm operates. Such factors as the
competitive position of the firm in its industry, the state of its labor relations, and the state of the
economy all affect the amount of business risk a firm faces. In addition, as we will see, the degree
to which the firms costs are fixed (as opposed to variable) will affect the amount of business risk.
To a large degree, these components of business risk are beyond the control of the firms managers.
In contrast, the amount of financial risk is determined directly by management. Financial risk
refers to the probability that the firm will be unable to meet its fixed financing obligations (which
includes both interest and preferred dividends). Obviously, all other things being equal, the more
debt a firm uses to finance its assets, the higher its interest cost will be. Higher interest costs lead
directly to a higher probability that the firm wont be able to pay. Since the amount of debt is
determined by managerial choice, management also determines the financial risk that a firm faces.
Managers need to be aware that they face both business risk and financial risk. If they are in an
industry with high business risk, they should control the overall amount of risk by limiting the
amount of financial risk that they face. Alternatively, firms that face low levels of business risk can
better afford more financial risk.
The Degree of Operating Leverage
Earlier we mentioned that a firms business risk can be measured by the variability of its earnings
before interest and taxes. Obviously, if a firms costs are all variable, then any variation in sales will
be reflected by exactly the same variation in EBIT. However, if a firm has some fixed expenses, EBIT
will be more variable than sales. We refer to this concept as operating leverage.
We can measure operating leverage by comparing the percentage change in EBIT to a given
percentage change in sales. This measure is called the degree of operating leverage (DOL):
DOL = % in EBIT/% in Sales
So, if a 10% change in sales results in a 20% change in EBIT, we would say that the degree of
operating leverage is 2. As we will see, this is a symmetrical concept. As long as sales are
increasing, a high DOL is desirable. However, if sales begin to decline, a high DOL will result in
EBIT declining at an even faster pace than sales. However, a more direct method of calculating the
DOL is to use the following equation:
DOL = (Sales-Variable Costs)/EBIT
The Degree of Financial Leverage
Financial leverage is similar to operating leverage, but the fixed costs that we are interested in are
the fixed financing costs. These are the interest expense and preferred dividends. We can measure
financial leverage by relating percentage changes in earnings per share (EPS) to percentage changes
in EBIT. This measure is referred to as the degree of financial leverage (DFL):
DFL = % in EPS/% in EBIT
As with the DOL, there is a more direct method of calculating the degree of financial leverage:
DFL = EBIT / [EBIT PD / (1-t)]
Where PD is the preferred dividends paid by the firm, and t is the tax rate paid by the firm. The
denominator requires some explanation. Since preferred dividends are paid out of after-tax rupees,
we must determine how many pre-tax rupees are required to meet this expense.
The Degree of Combined Leverage
Most firms make use of both operating and financial leverage. Since they are using two kinds of
leverage, it is useful to understand the combined effect. We can measure the total leverage
employed by the firm by comparing the percentage change in sales to the percentage change in
earnings per share. This measure is called the degree of combined leverage (DCL):
DCL = % in EPS/% in Sales
Therefore, the combined effect of using both operating and financial leverage is multiplicative rather
than simply additive. Managers should take note of this and use caution in increasing one type of
leverage while ignoring the other. They may end up with more total leverage than anticipated.
CHAPTER 4
VALUATION OF STOCKS
Concept
Fundamental analysis is based on the premise that each share has an intrinsic worth or value
which depends upon the benefits that the holder of a share expects to receive in future from the
share in the form of dividends and capital appreciation.
Intrinsic Value
Dividends Capital Appreciation
The investment decision of the fundamental analyst to buy or sell a share is based on a comparison
between the intrinsic value of a share and its current market price.
a) If the market price of a share is currently lower than its intrinsic value, such a share
would be bought because it is perceived to be under-priced.
b) A share whose current market price is higher than its intrinsic value would be
considered as overpriced and hence sold.
The fundamental analyst believes that the market price of a share is a reflection of its intrinsic
value. Though, in the short run, the market price may deviate from intrinsic value, in the long run
the price would move along with the intrinsic value of the share. The investment decision of the
fundamental analyst is based on this belief regarding the relationship between market price and
intrinsic value.
Source of Market and Intrinsic Value:
a) We can get market price of a share from the quotations of stock exchanges.
b) We can estimate the intrinsic value through the process of share valuation.
The present value model is used to estimate the intrinsic value of a share. The intrinsic value of a
share is the present value of all future cash flows to be received in respect of the ownership of that
share, computed at an appropriate discount rate i.e. Cost of Equity.
The major receipts that come from the ownership of a share are the annual dividends as well as the
sale proceeds of the share at the end of the holding period. These are to be discounted to find their
present value, using a discount rate that is the rate of return required by the investor, taking into
consideration the risk involved and the investor's other investment opportunities. Thus the intrinsic
value of a share is the present value of all the future benefits expected to be received from that
share. We have already discussed about the time value of money (in details) in the previous
chapter.
One Year Holding Period
It is easy to start share valuation with one year holding period assumption. Here an investor
intends to purchase a share now, hold it for one year and sell it off at the end of one year. In this
case, the investor would be expected to receive an amount of dividend as well as the selling price
after one year. The present value of the share may be expressed as:
D1 S1
So
(1 k ) (1 k )1
1
Where
D1 is the amount of dividend expected to be received at the end of year 1
S1 is the selling price expected to be realized on sale of the share at the end of year 1
k is the rate of return required by the investor.
For example, if an investor expects to get Rs. 5 as dividend from a share next year and
hopes to sell off the share at Rs. 50 after holding it for one year and if his required rate of
return is 20%, the present value of this share to the investor can be calculated as follows:
5.00 50.00
S0
1.201 1.201
= Rs. 4.17 + Rs. 41.67 = Rs. 45.84
This is the intrinsic value of the share. The investor would buy this share only if its current market
price is lower than this value.
Multiple Year Holding Period
An investor may hold a share for a certain number of years and sell it off at the end of his holding
period. In this case, he would receive annual dividends each year and the sale price of the share at
the end of the holding period. The present value of the share may be expressed as:
D1 D2 D3 D S
So ......... n nn
(1 k ) (1 k ) (1 k )
1 2 3
(1 k )
Where
D1, D2, D3, ..., Dn are the annual dividends to be received each year
Sn is the sale price at the end of the holding price
k is the investor's required rate of return
n is the holding period in years
For example, if an investor expects to get Rs. 3.50, Rs. 4 and Rs. 4.50 as dividend from a
share during the next three years and hopes to sell it off at Rs. 75 at the end of the third
year and if his required rate of return is 25 percent, the present value of this share to the
investor can be calculated as follows:
3.50 4.00 4.50 75

So
(1.25) (1.25) (1.25) (1.25)3
1 2 3
= 2.80 + 2.56 + 2.30 + 38.40 = Rs. 46.06
Time: 0 1 2 3
25%
PV =? 3.50 4.00 4.50 + 75.00

2.80
2.56
2.30 + 38.40
46.06
In order to use the present value model for share valuation, the investor has to forecast the future
dividends as well as the selling price of the share at the end of his holding period. It is not possible
to forecast these variables accurately. Hence this model is practically not very feasible.
In the case of most equity shares, the dividend per share grows because of the growth in earnings
of a company. In other words, equity dividends grow and are not constant over time. The growth
rate pattern of equity dividends have to be estimated. Different assumptions about the growth rate
patterns can be made and incorporated into the valuation models. Two assumptions that are
commonly used are:
a) Dividends grow at a constant rate in future, i.e. the constant growth assumption.
b) Dividends grow at varying rates in future, i.e. multiple growth assumption.
These two assumptions give rise to two modified versions of the present value model of share
valuation: (i) Constant growth model and (ii) Multiple growth model.
Constant Growth Model
In this model it is assumed that dividends will grow at the same rate (g) into the indefinite future
and that the discount rate k is greater than the dividend growth rate g. By applying the growth rate
(g) to the current dividend (Do), the dividend expected to be received after one year (D1) can be
calculated as:
Dl = Do(l + g)1
The dividend expected to be received after 2 years, 3 years, etc. can also be calculated from the
current dividend as:
D2 = Do(l + g)2
D3 = Do(l + g)3
Dn = Do(l + g)n
The present value model for share valuation may now be written as:
D0 (1 g )1 D0 (1 g ) 2 D0 (1 g ) n
So ..........
(1 k )1 (1 k ) 2 (1 k ) n
When 'n' approaches infinity, this formula can be simplified as:
D0 (1 g ) D
So or 1
kg kg
The constant growth model is also known as Gordon's share valuation model, named after the
model's originator, Myron J. Gordon. This is one of the most well-known and widely used valuation
models because of its simplicity. The model does not require forecasts of future dividends and
future selling price of the share. All that the model requires is a dividend growth rate assumption
and a discount rate. Both of these can be estimated without much difficulty. The growth rate may
be estimated from past growth rates of dividends and earnings. The discount rate is the investor's
required rate of return which is somewhat subjective and would depend upon the investor's
alternative investment opportunities and his perception of risk involved in purchasing the share.
To illustrate the application of the Gordon valuation model, let us consider an example. A company
has declared a dividend of Rs. 2.50 per share for the current year. The company has been following
a policy of enhancing its dividends by 10 percent every year and is expected to continue this policy
in future. An investor who is considering the purchase of the shares of this company has a
required rate of return of 15 percent.
The intrinsic value of the company's share can be calculated as:
D0 (1 g ) Rs.2.50(1.10) 2.75
So Rs.55
kg 0.15 0.10 0.05
The investor would be advised to purchase the share if the current market price is lower than Rs.
55.
Multiple Growth Model
The constant growth assumption may not be realistic in many situations. The growth in dividends
may be at varying rates. A typical situation for many companies may be that a period of
extraordinary growth (either good or bad) will prevail for a certain number of years, after which
growth will change to a level at which it is expected to continue indefinitely. This situation can be
represented by a two-stage growth model.
In this model, the future time period is viewed as divisible into two different growth segments, the
initial extraordinary growth period and the subsequent constant growth period. During the initial
period growth rates will be variable from year to year, while during the subsequent period the
growth rate will remain constant from year to year. The investor has to forecast the time N up to
which growth rates would be variable and after which the growth rate would be constant. This
would mean that the present value calculations will have to be spread over two phases, where one
phase would last until time N and the other would begin after time N to infinity.
The intrinsic value of the share is then the sum of the present values of two dividend flows: (i) the
flow from period 1 to N which we will call V 1 and (ii) the flow from period N + 1 to infinity, referred
to as V2. This means,
So = V 1 + V2
The growth-rates during the first phase of extraordinary growth are likely to be variable from year
to year. Hence, the expected dividend for each year during the first phase may be forecast
individually. The multiple-year holding period valuation model may be used for this first phase,
using the dividend forecasts developed for each of the years in the first phase. Then
D1 D2 Dn
V1 .......
(1 k ) (1 k )
1 2
(1 k ) n
This may be summarized as:
n
Dt
V1
t 1 (1 k )t
The second phase present value is denoted by V 2 and would be based on the constant growth
model, because the dividend growth is assumed to be constant during the second phase. The
position of the investor at time N after which the second phase commences can be viewed as a
point in time when he is forecasting a stream of dividends for time periods N + 1, N + 2, N + 3 and
so on which grow at a constant rate, g. The second phase dividends would be:
Dn+1 = Dn(1+g)1
Dn+2 = Dn(1+g)2
Dn+3 = Dn(1+g)3
and so on to infinity.
The present value of the second phase stream of dividends from period N + 1 to infinity can be
calculated using Gordon share valuation model as:
Dn (1 g )
kg
It may be noted that this value is the present value at time N of all future expected dividends from
time period N + 1 to infinity. When this value has to be viewed at time 'zero', it must be discounted
to provide the present value at 'zero' time for the second phase dividend stream. When so
discounted the present value of the second phase dividend stream viewed at 'zero' time may be
expressed as:
Dn (1 g )
V2
(k g )(1 k ) n
The present values of the two phases, V1 and V2, may be added to provide the intrinsic value of the
share that has a two-stage growth. The summation procedure of the two phases may be expressed
as:
n
Dt Dn (1 g )
S0
t 1 (1 k ) (k g )(1 k ) n
t
To illustrate the two-stage growth model, let us consider an example.
A company paid a dividend of Rs. 1.75 per share during the current year. It is expected to pay a
dividend of Rs. 2 per share during the next year. Investors forecast a dividend of Rs. 3 and Rs.
3.50 per share respectively during the two subsequent years. After that it is expected that
annual dividends will grow at 10 percent per year into an indefinite future.
If the investor's required rate of return is 20 percent, the intrinsic value of the share can be
calculated as shown below.
In this, the dividend growth rate is variable up to the 3rd year. From the 4th year onwards
dividend growth rate is constant. V1 would be the present value of dividends receivable during
the first three years and can be calculated as:
2 3 3.50
V1 Rs.5.78
(1.2) (1.2) (1.2)3
1 2
Now, V2 would be the present value at time 'zero' of dividends receivable from the 4th year to
infinity. This is calculated as:
3.50(1.1) 3.85
V2 Rs.22.28
(0.20 0.10)(1.2) 3
(0.10)(1.2)3
The intrinsic value of the share is the sum of the two present values V1 and V2: So = V1 + V2 =
5.78 + 22.28 = Rs. 28.06
4 10% Div Growth
Time: 0 1 2 3 up to infinity
20%
PV =? 2.00 3.00 3.50 3.50 * 1.1
1.67
2.08
3.50 * 1.1 / (0.20-0.10) = 38.50
+
24.31
DISCOUNT RATE 28.06
The discount rate used in the present value models is the investor's required rate of return. This
has to take into consideration the time value of money as well as the risk of the security in which
investment is proposed to be made. The time value of money is usually represented by the risk-free
interest rate such as those on government securities. A premium is added to this risk-free interest
rate to account for the risk to be borne by the investor by investing in the particular share. The
riskier the investment, the greater will be the risk premium that the investor will require. The
assessment of risk and the estimation of risk premium required are usually done by investors on a
subjective basis. Though other objective methods are available for the purpose, they are not
popularly used. Thus the investor's required rate of return would comprise the risk-free interest
rate plus a risk premium. We will discuss how to determine the cost of equity later on.
Multiplier Approach to Share Valuation
Many investors and analysts value shares by estimating an appropriate multiplier for the share.
The price-earnings ratio (P/E ratio) is the most popular multiplier used for the purpose.
The price-earnings ratio is given by the expression:
P/E ratio = Share price / earnings per share
The intrinsic value of a share is taken as the current earnings per share or the forecasted future
earnings per share multiplied by the appropriate P/E ratio for the share. For example, if the
current EPS of a share is Rs. 8 and if the investor feels that the appropriate P/E ratio for the share
is 12, then the intrinsic value of the share would be taken as Rs.96. Investment decision to buy or
sell the share would be taken after comparing this intrinsic value with the current market price of
the share.
A major difficulty for the analyst using the multiplier approach to share valuation is the
determination of an appropriate price-earnings ratio for the share. Different approaches may be
adopted for the determination of the appropriate P/E ratio. It may be arrived at by the analyst on a
subjective basis based on his evaluation of various fundamental factors relating to the company.
The major factors considered would be the growth rate in earnings and the risk factor. The higher
the expected growth and the lower the risk, the greater would be the appropriate price-earnings
ratio for the share.
Another approach would be to use the historical P/E ratios of the company itself or the P/E ratios
of other companies in the same industry. In the first case, the mean of the historical P/E ratios of
the company in the past may be taken as the appropriate P/E ratio for share valuation. In the
latter case, the median P/E ratio of companies in the same industry may be taken as the
appropriate P/E ratio.
Regression Analysis
Still another approach to the determination of an appropriate P/E ratio is a statistical approach.
The broad determinants of share prices such as earnings, growth, risk, and dividend policy may be
used to estimate the appropriate P/E ratio with the help of statistical analysis. The analyst
identifies the factors (known as independent variables) which influence the share price (the
dependent variable) and then ascertains the relationship between these factors and the share price.
The relationship that exists at any point in time between the share price or price-earnings ratio and
the set of specified determining variables can be estimated using multiple regression analysis. The
resulting regression equation measures the simultaneous impact of the determining variables on
the price-earnings ratio. This equation can be used to arrive at the appropriate P/E ratio for the
share. By substituting the values of the determining variables for a share, the appropriate P/E ratio
for the share can be easily calculated.
One of the earliest attempts to use multiple regressions to explain price earnings ratios, which
received wide attention, was the Whitbeck-Kisor model.5 Whitbeck and Kisor set out to measure the
relationship of the P/E ratio of a stock to its dividend policy, growth and risk. They used dividend
pay-outs, earnings growth rates and the variation (standard deviation) of growth rates to measure
the determining variables. Then, using multiple regression analysis to define the average
relationship between each of these variables and price earnings ratios, they found (as of June 8,
1962) that
P/E ratio = 8.2 + 1.5 (earnings growth rate) + 0.067 (dividend pay out rate) -0.2
(standard deviation in growth rate)
The numbers in the equation are the regression coefficients. 8.2 is the constant term and the other
numbers represent the weight age of the respective independent variables or factors influencing the
P/E ratio.
This equation could be used to determine the appropriate P/E ratio of a stock. For example, if there
is a share with a growth forecast of 7 percent, dividend pay out of 40 percent and standard
deviation in growth rate amounting to 12, the appropriate P/E ratio for this share would be
8.2 + 1.5(7) + 0.067(40) - 0.2(12) = 18.98
5
Whitbeck, V., Kisor, M. (1963), "A new tool in investment decision making", Financial Analysts Journal,
Vol. May/June pp.55-62.
Many models of this nature have been developed since then. A major drawback of these regression
models is that they are appropriate only for the time period used and the sample used.
Share valuation is an integral part of fundamental analysis. It was Benjamin Graham and David
Dodd who pioneered the development of systematic methods of security evaluation in their book
Security Analysis published in 1934. Share valuation deals with the determination of the
theoretical or normative price of a share, the price that a share should sell for, better known as the
intrinsic value of the share. This price is then compared with the actual price of the share
prevailing in the market to arrive at the appropriate investment decision. Share valuation, however,
is a difficult exercise. Different approaches may be adopted for the purpose, but all of them require
forecasts of fundamental data about companies. No valuation model can produce good results if the
forecasts on which it is based are of poor quality.
Preferred Stock
Preferred stock as an instrument is a hybrid it is similar to bonds in some respects and to

common equity stock in others. The hybrid nature of preferred stock becomes apparent when we
try to classify it in relation to bonds and common equity stock. Like bonds, preferred stock has a
par value and a fixed amount of dividends that must be paid before dividends can be paid on the
common stock. However, if the preferred dividend is not earned, the directors can omit (or pass) it
without throwing the company into bankruptcy. So, although preferred stock has a fixed payment
like bonds, a failure to make this payment will not lead to bankruptcy.
As noted above, a preferred stock entitles its owners to regular, fixed dividend payments. If the
payments last forever, the issue is a perpetuity whose value, Vp, is found as follows:
Dp
Vp
rp
Where
Vp is the value of the preferred stock
Dp is the preferred dividend
rp is the required rate of return.
Suppose Company ABC has preferred stock outstanding that pays a dividend of Rs. 10 per year. If
the required rate of return on this preferred stock is 10 percent, then its value is Rs. 100, found by
solving the above equation.
VALUATION OF FIRMS
Weighted Average Cost of Capital
Before doing the valuation of any company, an analyst should know its weighted average cost of
capital (WACC), i.e., the discounting rate. What needs to be understood is the significance of
WACC.
Generally firms employ several types of capital, called capital components, with equity and
preferred stock, along with debt, being the three most frequently used types. All capital components
have one feature in common: The investors who provided the funds expect to receive a return on
their investment.
The required rate of return on each capital component is called its component cost, and the cost of
capital used to analyze capital budgeting decisions should be a weighted average of the various
components costs. We call this weighted average cost of capital, or WACC.
We can find out the weighted average cost of capital by applying the formula:
WACC = Ke*We + Kd*Wd(1-t)+Kpf*Wpf
Where,
Ke = Cost of Equity
We = Weight of Equity
Kd = Cost of Debt
Wd = Weight of Debt
Kpf = Cost of Preferred Stock
Wpf = Weight of Preferred Stock
t = Tax Rate
Cost of Debt Kd(1-t)
Generally the cost of debt is calculated by applying the formula Kd = Interest / Debt
Suppose a company had issued debt in the past, and its bonds are publicly traded. The financial
staff could use the market price of the bonds to find their yield to maturity (or yield to call if the
bonds sell at a premium and are likely to be called). The YTM (or YTC) is the rate of return the
existing bondholders expect to receive, and it is also a good estimate of Kd, the rate of return that
new bondholders would require.
If a company had no publicly traded debt, its staff could look at yields on publicly traded debt of
similar firms. This too should provide a reasonable estimate of Kd.
The required return to debt holders, Kd, is not equal to the companys cost of debt because, since
interest payments are deductible, the government in effect pays part of the total cost. As a result,
the cost of debt to the firm is less than the rate of return required by debt holders. The after-tax
cost of debt, Kd(1-t), is used to calculate the weighted average cost of capital, and it is the interest
rate on debt, Kd, less the tax savings that result because interest is deductible.
After-tax component cost of debt = Interest rate Tax savings

= Kd t*Kd
= Kd(1-t)
Therefore, if a company can borrow at an interest rate of 10 percent, and if it has a

marginal tax rate of 30 percent, then its after-tax cost of debt is 7 percent:
Kd (1-t) = 10 (1-.3) = 7%
Cost of Preferred Stock Kpf
Generally cost of preferred stock is calculated by applying the formula i.e.

Kpf = Dpf / Pn
Where,
Dpf = Dividend on Preferred Stock
Pn = Net issuing price of Preferred Stock which is the price the firm receives after
deducting flotation costs
Suppose that a company has preferred stock that pays Rs.10.00 as dividend per share and
sells for Rs.100 per share. If the company issued new shares of preferred, it would incur a
flotation cost of 5 percent, or Rs.5.00 per share, so it would net Rs. 95.00 per share.
Therefore, cost of preferred stock is 10.52 percent:
Kpf = 10 / 95 = 10.52 %
Cost of Equity Ke
Companies can raise common equity in two ways: (1) directly by issuing new shares and (2)
indirectly by retaining earnings. In both the cases the required rate of return is equivalent to cost of
equity. There are generally three ways to find out the cost of equity. They are as follows:
a) The Capital Asset Pricing Model.

b) The Discounted Cash Flow Method.
c) The Bond-Yield Risk-Premium Approach.
These methods are not mutually exclusive no method dominates the others, and all are subject
to error when used in practice. Therefore, when faced with the task of estimating a companys cost
of equity, we generally use all three methods and then choose among them on the basis of our
confidence in the data used for each in the specific case at hand.
CAPM Approach
To estimate the cost of equity using the Capital Asset Pricing Model (CAPM), we proceed as
follows:
a) Estimate the risk-free rate (Rf)

b) Estimate the current expected market risk premium (Rm Rf)
c) Estimate the stocks beta coefficient and use it as an index of the stocks risk (i)
d) Substitute the preceding values into the CAPM equation to estimate the required
rate of return on the stock in question
Ke = Rf + (Rm Rf) i
Suppose the beta of a company is 1.1. Take the risk-free rate as 10-year Treasury
bill yield rate i.e. 7.43%. The return on market index is 15%. So the return on
companys stock is:
Ke = 7.43 + (15 7.43) 1.1
= 15.757 %
It should be noted that although the CAPM approach appears to yield an accurate, precise estimate
of Ke, it is hard to know the correct estimates of the inputs required to make it operational because
(1) it is hard to estimate the beta that investors expect the company to have in the future, and (2) it
is difficult to estimate the market risk premium. Despite these difficulties, surveys indicate that
CAPM is the preferred choice for the vast majority of companies.
Discounted Cash Flow Approach (DCF)
In the previous chapter Valuation of Stocks, we saw that if dividends are expected to grow at a
constant rate, then the price of a stock is
D1
Po
Ke g
Here Po is the current price of the stock
D1 is the dividend expected to be paid at the end of Year 1
Ke is the required rate of return.
We can solve for Ke to obtain the required rate of return on common equity:
D1
Ke g
P0
Thus, investors expect to receive a dividend yield, D1/Po, plus a capital gain, g, for a total expected
return. In equilibrium this expected return is also equal to the required return, K e. This method of
estimating the cost of equity is called the discounted cash flow, or DCF, method. Three inputs are
required to use the DCF approach: the current stock price, the current dividend, and the expected
growth in dividends. Of these inputs, the growth rate is by far the most difficult to estimate.
We can use these approaches for estimating the growth rate: (1) historical growth rates, (2) the
retention growth model, and (3) analysts forecasts.
Historical Growth Rates If earnings and dividend growth rates have been
relatively stable in the past, and if investors expect these trends to continue, then
the past realized growth rate may be used as an estimate of the expected future
growth rate.
Retention Growth Model Most firms pay out some of their net income as
dividends and reinvest, or retain, the rest. The payout ratio is the percent of net
income that the firm pays out as a dividend, defined as total dividends divided by
net income; the retention ratio is the complement of the payout ratio: Retention
ratio = (1 - Payout ratio). ROE is the return on equity, defined as net income
available for common stockholders divided by common equity. The growth rate of a
firm will depend on the amount of net income that it retains and the rate it earns
on the retentions. Using this logic, we can write the retention growth model:
g = ROE (Retention ratio)

Analysts Forecasts Analysts publish growth rate estimates for most of the larger
publicly owned companies. For example, Value Line provides such forecasts on
more than 1000 companies. Further, several companies compile analysts forecasts
on a regular basis and provide summary information such as the median and
range of forecasts on widely followed companies. However, these forecasts often
involve non-constant growth.
Suppose a company stock sells for Rs.35; its next expected dividend is Rs.3.00;
and its expected growth rate is 7 percent. The expected and required rate of return,
hence its cost of common stock, would then be 15.57 percent:
Ke = 3.00/35.00 +7 = 15.57 %
Bond-Yield-plus-Risk-Premium Approach
Here Analysts use the formula i.e. Ke = Bond Yield + Risk Premium
Suppose the 10-year bond yield in the market is 7.43% and risk premium is 3%.
Ke = 7.43% + 3%
= 10.43%
Because the 3 percent risk premium is a judgmental estimate, the estimated value
of Ke is also judgmental.
Weighted Average Cost of Capital (WACC)
Suppose the capital structure of the company is as follows:

Common Equity: 200000 Rs.
Preferred Stock: 100000 Rs.
Debt: 200000 Rs.
Cost of Equity = 10%
Cost of Preferred Stock = 20%
Cost of Debt = 15%
Tax Rate = 30%
We = 200000/500000 = 0.4
Wpf = 100000/500000 = 0.2
Wd = 200000/500000 = 0.4
WACC = 0.4 * 10% + 0.2 * 20% + 0.4 * 15% (1-0.3)

= 12.2 %
Discounted Cash Flow Corporate Valuation Model
The corporate valuation model is the present value of expected future free cash flows, discounted at
the weighted average cost of capital. In a sense, the corporate valuation model is the culmination of
all the material covered so far like analysis of financial statements, cash flows, financial
projections, time value of money, risk & return, and the cost of capital.
Corporate assets are of two types: operating and non-operating. Operating assets, in turn, take two
forms: assets-in-place and growth options. Assets-in-place include such tangible assets as land,
buildings, machines, and inventory, plus intangible assets such as patents, customer lists,
reputation, and general know-how. Growth options refer to opportunities the firm has to increase
sales. They include opportunities arising from R&D expenditures, customer relationships, and the
like.
Most companies also own some non-operating assets. Financial, or non-operating, assets are
distinguished from operating assets and include items such as investments in marketable
securities and non-controlling interests in the stock of other companies. For most companies
operating assets are far more important than non-operating assets. Moreover, companies can
influence the values of their operating assets but the values of non-operating assets are largely out
of their direct control.
There are five steps in estimating the value of a firm under the discounted cash flow model. They
are as follows:
1. Estimating the free cash flow for the explicit forecast period.
2. Estimating the growth in earnings.
3. Computing the weighted average cost of capital.
4. Computing the terminal or continuing value.
5. Determination of value of the firm.
We have already discussed about how to compute WACC and growth in earnings. Now we will
discuss the remaining processes.
Estimating the Value of Operations
Free cash flow (FCF) is the cash from operations that is actually available for distribution to
investors, including stockholders, bondholders, and preferred stockholders. It represents the cash
that a company is able to generate after laying out the money required to maintain or expand its
asset base. It is important because it allows a company to pursue opportunities that enhance
shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay
dividends and reduce debt. FCF is calculated as:
If you carefully observe the first three lines of the above mentioned equation, you will find that it is
actually the cash flow from operating activities. So it measures the financial performance of the
company which is calculated as operating cash flow minus capital expenditures.
The value of operations is the present value of all the future free cash flows expected from
operations when discounted at the weighted average cost of capital:
Value of operations = Vop = PV of expected future free cash flow
FCF1 FCF2 FCF

.......
(1 WACC ) (1 WACC )
1 2
(1 WACC )

FCFt

t 1 (1 WACC )t
To find the value of operations as a going concern, we use an approach similar to the non-constant
dividend growth model, proceeding as follows:
a) Assume that the firm will experience non-constant growth for N years, after which it will
grow at some constant rate.
b) Calculate the expected free cash flow for each of the N non-constant growth years.
c) Recognize that after Year N growth will be constant, so we can use the constant growth
formula to find the firms value at Year N. This is the sum of the PVs for year N +1 and all
subsequent years, discounted back to Year N.
d) Find the PV of the free cash flows for each of the N non-constant growth years. Also find
the PV of the firms value at Year N.
e) Now sum all the PVs, those of the annual free cash flows during the non-constant period
plus the PV of the Year N value, to find the firms value of operations.
The terminal or horizon value is the value of operations at the end of the explicit forecast period. It
is also called the continuing value, and it is equal to the present value of all free cash flows beyond
the forecast period, discounted back to the end of the forecast period at the weighted average cost
of capital:
Terminal Value = Vop (at time N)
FCFN 1 FCFN (1 g )

WACC g WACC g
Suppose the weighted cost of capital is 20% with FCF at the end of period 1 = 200, FCF at
the end of period 2 = 500, FCF at the end of period 3 = 400. After that FCF is growing at a
constant growth rate of 5% each year up to infinity. The valuation of operation is as follows:
5% Growth up
Time: 0 1 2 3 4 to infinity
20%
PV =? 200 500 400 400 * 1.05

First we need to find out the terminal value at the end of period 3 by using the above
mentioned formula i.e.
TV3 = 400 (1+0.05) / (20% - 5%) = 2800 Rs.
Now our time line has been reduced to:
Time: 0 20% 1 2 3
PV =? 200 500 400 + 2800

=3200
166.67
347.22
1851.85
2365.74
In this way we can find out the value of operations. The value of non-operating assets is usually
close to the figure reported on the balance sheet. The corporate valuation model can be used to
calculate the total value of a company by finding the value of operations plus the value of non-
operating assets.
Relative Corporate Valuation Model
Comparable Company Approach
The objective in the discounted cash flow approach to valuation is to value the assets based on
their cash flows, growth and risk characteristics whereas the objective in the comparable company
approach is to value assets based on how similar assets are priced in the market place. It is also
termed as relative valuation.
Basis of Relative Valuation
The relative valuation or the comparable company approach to valuation is based on the principle
of substitution which states that "one will pay no more for an item than the cost of acquiring an
equally desirable substitute". In this approach, the value of a firm is derived from the value of
comparable firms, based on a set of common variables like earnings, sales, cash flows, book value
etc.
Advantages of Relative Valuation
I. Valuation based on multiples and comparable firms can be done with fewer assumptions and
at a faster rate than the discounted cash flow valuation.
II. The relative valuation is simple and easy to understand and present to clients than the
discoursed cash flow valuation.
III. The relative valuation measures the relative value of the asset rather than the intrinsic value
and hence it reflects the current atmosphere of the market.
Process of Relative Valuation
i) Analysis of the Firm
The valuer should analyze the profitability position of the firm by scrutinizing
Return on capital employed,
Return on Net worth,
Operating profit, and
Net profit.
He should also analyze the liquidity and solvency position of the firm by looking at the current &
quick ratio and interest coverage ratio & debt service coverage ratio. He can also check the
efficiency of business by analyzing the different turnover ratio like Asset turnover ratio, inventory
turnover ratio etc. The working capital requirements and capital structure of the firm should also
be analyzed. He may conduct the sensitivity analysis.
The qualitative analysis includes assessing the position of the firm in the industry, market share,
competitive advantage, managerial evaluation, the ownership pattern, & technological performance
etc.
ii) Identification of Comparable Firms
A comparable firm is one with cash flows, growth potential and risk similar to the firm being
valued. The valuer has to carefully assess the general profile of the industry, competitive structure,
demand-supply position, installed capacities, pricing system, availability of inputs, government
policies and regulatory framework, etc.
The parameters for identification of comparable firms include product profile, scale of operations,
markets served, cost structures, geographical location, & technology, etc.
iii) Comparison and Analysis
The historical financial statements (balance sheet, profit & loss account and cash flow/funds flow
statement) of the firm being valued and the comparable firms are to be analyzed, so as to identify
the dissimilarities between them. The dissimilarities essentially arise due to variations in
accounting policies. Some of the common areas of dissimilarities are method of inventory valuation,
depreciation policies, valuation of intangible assets, treatment of off balance sheet items, etc. Once
such dissimilarities are identified appropriate adjustments are to be made to make the firms
comparable.
iv) Selection of Valuation Multiples
The price of a stock is a function of both the value of the equity in a company and the number of
shares outstanding in the firm. Since stock prices are determined by the number of units of equity
in a firm, they cannot be compared across different firms. To compare the values of "similar" firms
in the market, you need to standardize the values in some way. Values can be standardized relative
to the earnings firms generate, to the book value or replacement value of the firms, to the revenues
that firms generate or to measures that are specific to firms in a sector. Different Valuation
Multiples are as follows:
1. Earnings Multiples
One of the more intuitive ways to think of the value of any asset is as a multiple of the earnings
that assets generate. When buying a stock, it is common to look at the price paid as a multiple of
the earnings per share generated by the company. This price/earnings ratio can be estimated using
current earnings per share, which is called a trailing PE, or an expected earnings per share in the
next year, called a forward PE. When buying a business, as opposed to just the equity in the
business, it is common to examine the value of the firm as a multiple of the operating income or the
earnings before interest, taxes, depreciation and amortization (EBITDA).As a buyer of the equity or
the firm, a lower multiple is better than a higher one, these multiples will be affected by the growth
potential and risk of the business being acquired.
2. Book Value or Replacement Value Multiples
While markets provide one estimate of the value of a business, accountants often provide a very
different estimate of the same business. The accounting estimate of book value is determined by
accounting rules and is heavily influenced by the original price paid for assets and any accounting
adjustments (such as depreciation) made since. Investors often look at the relationship between the
price they pay for a stock and the book value of equity (or net worth) as a measure of how over- or
under-valued a stock is; the price/book value ratio that emerges can vary widely across industries,
depending again upon the growth potential and the quality of the investments in each. When
valuing businesses, you estimate this ratio using the value of the firm and the book value of all
assets (rather than just the equity). For those who believe that book value is not a good measure of
the true value of the assets, an alternative is to use the replacement cost of the assets; the ratio of
the value of the firm to replacement cost is called Tobins Q.
3. Revenue Multiples
Both earnings and book value are accounting measures and are determined by accounting rules
and principles. An alternative approach, which is far less affected by accounting choices, is to use
the ratio of the value of an asset to the revenue it generates. For equity investors, this ratio is the
price/sales ratio (PS), where the market value per share is divided by the revenues generated per
share. For firm value, this ratio can be modified as the value/sales ratio (VS), where the numerator
becomes the total value of the firm. This ratio, again, varies widely across sectors, largely as a
function of the profit margins in each. The advantage of using revenue multiples, however, is that it
becomes far easier to compare firms in different markets, with different accounting systems at
work, than it is to compare earnings or book value multiples.
4. Sector-Specific Multiples
While earnings, book value and revenue multiples can be computed for firms in any sector and
across the entire market, there are some multiples that are specific to a particular sector. While
there are certain conditions under which sector-specific multiples can be justified, they are
dangerous for two reasons. First, since they cannot be computed for other sectors or for the entire
market, sector-specific multiples can result in persistent over- or under-valuations of sectors
relative to the rest of the market. Second, it is more difficult to relate sector specific multiples to
fundamentals, which is an essential ingredient to using multiples well. The result will not only vary
from company to company, but will also be difficult to estimate.
The measurement of sector specific multiples varies from sector to sector though they share some
general characteristics. They have a few similar characteristics. The numerator is usually
enterprise value - the market values of both debt and equity netted out against cash and
marketable securities. The denominator is defined in terms of the operating units that generate
revenues and profits for the firm.
For manufacturing firms that produce a homogeneous product (in terms of quality and units), the
market value can be standardized by dividing by the number of units of the product that the firm
produces or has the capacity to produce.
Value per unit product = (Market value of equity + Market value of debt)/ Number of units
produced
For subscription-based firms such as cable companies, internet service providers and information
providers, revenues come from the number of subscribers to the base service provided. Here, the
value of a Firm can be stated in terms of the number of subscribers.
Value per subscriber = (Market value of equity + Market value of debt)/

Number of subscribers
v) Valuation of the Firm
The final step involves valuing the firm in relation to the comparable firm. This requires applying
the multiples identified to the firm being valued. This is a highly subjective process. This process
may provide several different values depending on the multiple applied. In such possibility, average
value may be computed based on the values depending on the multiple applied. In case the valuer
believes that a particular multiple(s) is/are more important, weighted arithmetic average may be
used by assigning appropriate weight ages that reflect the comparative importance of each multiple.
Despite the fact that the use of multiples is simple, there are four steps that must be followed for
optimal output. First, the multiple consistently is defined and uniformly measured across the firms
being compared. Second, there should be a sense of how the multiple varies across firms in the
market. In other words, a high value, a low value and a typical value of the multiple in question
should be identified. Third, the fundamental variables that determine each multiple and how
changes in these fundamentals affect the value of the multiple is identified. Finally, the actual
comparable firms are found out and adjusted for differences between the firms on fundamental
characteristics.
Example
Compute the value of ABC Ltd. with the help of the relative valuation approach using the following
information:
Sales Rs. 200 Cr

Profit after tax Rs. 30 Cr
Book value Rs. 120 Cr
The valuer feels that 50% weight age should be given to earnings in the valuation process. Sales
and book value may be given equal weight ages. The valuer has identified three firms which are
comparable to the operations of ABC Ltd.
(Rs. In Crore)
Particulars XYZ Ltd. ITC Ltd. ABB Ltd.
Sales 160 240 300
Profit After Tax 24 36 50
Book Value 80 180 200
Market Value 240 300 480
Solution
The Valuation multiples of the comparable firms are as follows:
Particulars XYZ Ltd. ITC Ltd. ABB Ltd. Average

Price/Sales Ratio 1.50 1.25 1.60 1.45
Price/Earnings Ratio 10.00 8.33 9.60 9.31
Price/Book Value Ratio 3.00 1.67 2.40 2.36
The Value of ABC Ltd. is as follows:
Particulars Multiple Parameters Value

Price/Sales Ratio 1.45 200.00 290.00
Price/Earnings Ratio 9.31 30.00 279.33
Price/Book Value Ratio 2.36 120.00 282.67
The weights assigned to P/S ratio, P/E Ratio and the P/BV ratio are 1, 2 and 1 respectively, thus
the weighted average value will be:
=[(290*1)+(279.33*2)+(282.67*1)] / 4
= 282.83 (Approx) Crores
DISADVANTAGES OF RELATIVE VALUATION
Though relative valuation has its own strengths compared to the discounted cash flow valuation,
these strengths might sometimes prove to be weaknesses:
I. Relative valuation sometimes leads to inconsistent estimates of value because key variables
like risk, growth, and cash flows are ignored.
II. 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.
III. The lack of transparency regarding the underlying assumptions in relative valuation makes
them particularly vulnerable to manipulation.
Relative and Discounted Cash Flow Valuations
Discounted cash flow valuation and relative valuation generally yield different estimates of value for
the same firm. Even within relative valuation, different estimates of value are obtained depending
upon which multiple is used and on what firms the valuation is based on.
The reason for the differences in value between discounted cash flow valuation and relative
valuation is the different views of market efficiency, or in particular, market inefficiency. In
discounted cash flow valuation, it is assumed that the markets make mistakes and that these
mistakes are corrected over time. These mistakes can often occur across entire sectors or even the
entire market. In relative valuation, it is assumed that while markets make mistakes on individual
stocks, they are corrected on average. Thus, a stock may be over-valued on a discounted cash flow
basis but under-valued on a relative basis, if the firms used in the relative valuation are all
overpriced by the market. The reverse would occur, if an entire sector or market were under-priced.
CHAPTER 5
PORTFOLIO MANAGEMENT
WHAT IS PORTFOLIO MANAGEMENT
An investor considering investment in securities is faced with the problem of choosing from among
a large number of securities. His choice depends upon the risk-return characteristics of individual
securities. He would attempt to choose the most desirable securities and like to allocate his funds
over this group of securities. Again, he is faced with the problem of deciding which securities to
hold and how much to invest in each. The investor faces an infinite number of possible portfolios or
groups of securities. The risk and return characteristics of portfolios differ from those of individual
securities combining to form a portfolio. The investor tries to choose the optimal portfolio taking
into consideration the risk return characteristics of all possible portfolios. As the economic and
financial environment keeps changing, the risk return characteristics of individual securities as
well as portfolios also change. This calls for periodic review and revision of investment portfolios of
investors.
An investor invests his funds in a portfolio expecting to get a good return consistent with the risk
that he has to bear. The return realized from the portfolio has to be measured and the performance
of the portfolio has to be evaluated.
It is evident that rational investment activity involves the creation of an investment portfolio.
Portfolio Management comprises all the processes involved in the creation and maintenance of an
investment portfolio. It deals specifically with security analysis, portfolio analysis, portfolio
selection, portfolio revision, and portfolio evaluation. Portfolio management makes use of analytical
techniques of analysis and conceptual theories regarding rational allocation of funds. Portfolio
Management is a complex process which tries to make investment activity more rewarding and less
risky.
ELEMENTS OF PORTFOLIO MANAGEMENT
Although specifying objectives and constraints and evaluating relevant economic and market
conditions represent the beginning of the process, these decisions are also linked to the
measurement, monitoring, and evaluation steps of the process. The integrative nature of portfolio
management involves numerous feedback loops and allows managers to be as rigid or flexible (or as
quantitative or qualitative) as they desire. This is a continuing process with evaluation of
performance as an indicator of a need for rebalancing. The following represents the elements of the
Portfolio Management process.
Evaluating investor and market characteristics - The first step is to determine the objectives and
constraints of the investor. Objectives are related to the risk and return expectations of the
investor. Constraints are those factors that limit or restrict certain decisions or investment choices.
The second step is to evaluate the economic environment. The factors relevant to an economic
evaluation are mostly macro issues dealing with the overall state of the economy (growth prospects,
inflation expectations, unemployment, and other considerations). An economic evaluation can also
work down to micro issues, such as those related to sector-, industry-, and security-specific
considerations.
Developing an investment policy statement - This next portion of the investment management
process formalizes objectives and constraints into an investment policy statement (IPS), which will
guide investment decisions and formalize the investment strategy (e.g., whether the portfolio will be
actively managed or follow a more passive approach). Capital market expectations that take into
account the economic evaluation conducted previously are also formalized in this step.
Determining an asset allocation strategy - After the formal documentation of the IPS is
completed, decisions on how and where funds will be invested are completed, and a strategic asset
allocation is created. Securities are evaluated as to how they might fit into a portfolio that meets the
objectives and constraints of the investor. Portfolio decisions are implemented and then executed in
a timely fashion so that the investor's funds can be put to use in attaining goals and objectives.
Measuring and evaluating performance - After a stated time period, which will be described in the
IPS, portfolio performance will be measured, and an evaluation as to whether the portfolio attained
investor objectives or followed the IPS will be prepared. Portfolio rebalancing may be indicated by
the evaluation activity and, at the very least, connecting the evaluation step to the beginning of the
process must occur to insure portfolio decisions parallel investor needs and desires.
Monitoring dynamic investor objectives and capital market conditions - Continuous

monitoring of both investor and marketplace characteristics takes place throughout the entire
process. Multiple feedback mechanisms throughout the entire portfolio management process
indicate where significant changes in either investor factors or marketplace prospects require
adjustments to the portfolio. Remember, this is a dynamic, ongoing process. There are no end
points, only continuous connections between objectives and constraints to portfolio monitoring and
evaluation.
Steps in the Portfolio Management Process
The ongoing portfolio management process can be detailed within the integrative steps described by
planning, execution, and feedback. Each general step contains numerous components. The
planning phase consists of analyzing objectives and constraints, developing an IPS, determining the
appropriate investment strategy, and selecting an appropriate asset allocation.
INVESTMENT OBJECTIVES
Investment objectives relate to what the investor wants to accomplish with the portfolio. Objectives
are mainly concerned with risk and return considerations.
Risk objectives are those factors associated with an investor's willingness and ability to take risk.
Combining willingness and ability to accept risk is termed risk tolerance. Risk aversion indicates an
investor's inability and unwillingness to take risk.
For an individual, willingness and ability to take risk may be determined by behavioral or
psychological factors, whereas for an institution, these factors are determined primarily by portfolio
constraints. Some specific factors that affect ability to accept risk are as follows:
Required spending needs - How much variation in portfolio value can the investor tolerate
before she is inconvenienced in the short term?
Long-term wealth target - How much variation in portfolio value can the investor tolerate
before it jeopardizes meeting long-term wealth goals?
Financial strength - Can the investor increase savings if the portfolio is insufficient to meet
his spending needs?
Liabilities - Is the investor legally obligated to make future payments to beneficiaries, or
does the investor have certain spending requirements in retirement?
If the investor's portfolio is large relative to spending and obligations, a greater ability to take risk is
apparent. Appropriately connecting willingness to ability may require educating the client in risk-
return principles, as shown in Figure 1.
Figure 1: Willingness vs. Ability to Take Risk
Ability to Take Risk

Willingness to Take Risk Below Average Above Average
Below Average Lower risk tolerance Education/ resolution required
Above Average Education/ resolution required Higher risk tolerance
There are two categories of risk objective measurements: absolute and relative risk objectives.
Standard deviation of total return represents an example of an absolute risk objective, whereas
deviations from an underlying index, or tracking risk, represent an example of a relative risk
objective. Relative risk measures are often easier to quantify from an individual investor's
perspective, but absolute risk objectives are also referred to, even if only stated in qualitative forms.
Individuals often state their willingness to assume risk in broad terms; for example, "I have a
moderate level of risk tolerance." Although institutions may state specific quantitative risk
measures, such as, "the level of portfolio volatility not to exceed 25% in any given year," their risk
objectives can also be ranked along a qualitative risk objective spectrum. It is important to
incorporate whatever level of specificity is mentioned when analyzing the risk objective.
Return objectives can be classified as either a desired or a required return. A desired return is
that level of return stated by the client, indicating how much the investor wishes to receive from the
portfolio. A required return represents some level of return that must be achieved by the portfolio,
at least on an average basis to meet the target financial obligations. As such, required returns serve
as a much stricter benchmark than desired returns.
In either case, the level of return needs to be consistent with the risk objective. Desired or required
returns might be unrealistic given prevailing market conditions or risk objectives. Educating the
investor as to disconnections between return and risk may be required. Some additional
considerations in calculating return levels are differentiating between real and nominal returns,
and distinguishing pre-tax and after-tax returns.
Whatever the return level generated, one factor to remember is that the return objective should be
considered from a total return perspective. Even if a substantial income (or spending) component is
required from the portfolio, the return objective should be evaluated by the total return (e.g., return
from income and capital gains) and the characteristics of the portfolio
THE INVESTMENT POLICY STATEMENT
The IPS is a formal document that governs investment decision making, taking into account
objectives and constraints. The main role of the IPS is to:
Be readily implemented by current or future investment advisers (i.e., it is easily

transportable).
Promote long-term discipline for portfolio decisions.
Help protect against short-term shifts in strategy when either market environments or
portfolio performance cause panic or overconfidence.
Of the numerous elements in an IPS, some of the notable ones are:
A client description that provides enough background so any competent investment adviser
can gain a common understanding of the client's situation.
The purpose of the IPS with respect to policies, objectives, goals, restrictions, and portfolio
limitations.
Identification of duties and responsibilities of parties involved.
The formal statement of objectives and constraints.
A calendar schedule for both portfolio performance and IPS review.
Asset allocation ranges and statements regarding flexibility and rigidity when formulating
or modifying the strategic asset allocation.
Guidelines for portfolio adjustments and rebalancing.
PHASES OF PORTFOLIO MANAGEMENT
Portfolio management is a process encompassing many activities aimed at optimizing the

investment of one's funds. Five phases can be identified in this process:
1. Security analysis.
2. Portfolio analysis.
3. Portfolio selection.
4. Portfolio revision.
5. Portfolio evaluation.
Each phase is an integral part of the whole process and the success of portfolio management
depends upon the efficiency in carrying out each of these phases.
Security Analysis
The securities available to an investor for investment are numerous and of various types.
Traditionally, the securities were classified into ownership securities such as equity shares and
preference shares and creditor ship securities such as debentures and bonds. Recently a number of
new securities with innovative features are being issued by companies to raise funds for their
projects. Convertible Debentures, Deep Discount Bonds, Zero Coupon Bonds, Floating Rate Bonds,
Global Depository Receipts. Euro-currency Bonds, etc. are some of these new securities. From this
vast group of securities the investor has to choose those securities which he considers worthwhile
to be included in his investment portfolio. This calls for a detailed analysis of the available
securities.
Security analysis is the initial phase of the portfolio management process. This step consists of
examining the risk-return characteristics of individual securities. A basic strategy in securities
investment is to buy underpriced securities and sell overpriced securities. However, it is vital to
know how to differentiate underpriced and overpriced securities, or in other words, 'mispriced'
securities. This is what security analysis is all about.
There are two alternative approaches to security analysis, namely, fundamental analysis and
technical analysis. They are based on different premises and follow different techniques.
Fundamental analysis, the older of the two approaches, concentrates on the fundamental factors
affecting the company such as the EPS of the company, the dividend pay-out ratio, the competition
faced by the company, the market share, quality of management, etc. The fundamental analyst
studies not only the economy fundamentals but also the fundamental factors affecting the company
but also the fundamental factors affecting the industry to which the company belongs.
According to this approach, the share price of a company is determined by these fundamental
factors. The fundamental analyst works out the true worth or intrinsic value of a security based on
its fundamentals; then compares this intrinsic value with the current market price. If the current
market price is higher than the intrinsic value, the share is said to be overpriced and vice versa.
The mispricing of securities provides an opportunity to the investor to acquire the share or dispose
of the share profitably. An investor would buy those securities which are underpriced and sell those
securities which are overpriced. It is believed that notable cases of mispricing will be corrected by
the market in future. Prices of undervalued shares will increase and those of overvalued shares will
decline. Fundamental analysis helps to identify fundamentally strong companies whose shares are
worthy to be included in the investor's portfolio.
The alternative approach to security analysis is technical analysis. As mentioned earlier in the
module, the technical analyst believes that share price movements are systematic and exhibit
certain consistent patterns. He therefore studies past movements in the prices of shares to identify
trends and patterns. He then tries to predict the future price movements. The current market price
is compared with the future predicted price to determine the extent of mispricing. Technical
analysis is an approach which concentrates on price movements and ignores the fundamentals of
the shares.
A more recent approach to security analysis is the efficient market hypothesis. According to this
school of thought, the financial market is efficient in pricing securities. The efficient market
hypothesis holds that market prices instantaneously and fully reflect all relevant available
information. It means that the market prices of securities will always equal its intrinsic value. As a
result, fundamental analysis which tries to identify undervalued or overvalued securities is deemed
to be a futile exercise.
The efficient market hypothesis further holds that share price movements are random and not
systematic. Consequently, technical analysis which tries to study price movements and identify
patterns in them is of little use.
Efficient market hypothesis is a direct repudiation of both fundamental analysis and technical
analysis. An investor cannot consistently earn abnormal returns by undertaking fundamental
analysis or technical analysis. According to efficient market hypothesis it is possible for an investor
to earn normal returns by randomly choosing securities of a given risk level.
We have already covered Security Analysis through the way of fundamental method in detail in
Module 1 (Company Valuation and Modeling).
Portfolio Analysis
A portfolio is a group of securities held together as investment. Investors invest their funds in a
portfolio of securities rather than in a single security because they are risk averse. By constructing
a portfolio, investors attempt to spread risk by not putting all their eggs into one basket. Thus
diversification of ones holdings is intended to reduce risk in investment.
Security analysis provides the investor with a set of worthwhile or desirable securities. From this
set of securities an indefinitely large number of portfolios can be constructed by choosing different
sets of securities and also by varying the proportion of investment in each security. Each individual
security has its own set of risk return characteristics which can be measured and expressed
quantitatively. Each portfolio constructed by combining the individual securities has its own
specific risk and return characteristics which are not just the aggregates of the individual security
characteristics. The return and risk of each portfolio has to be calculated mathematically and
expressed quantitatively.
Portfolio analysis phase of portfolio management consists of identifying the range of possible
portfolios that can be constituted from a given set of securities and calculating their return and risk
for further analysis.
Portfolio Selection
Portfolio analysis provides the input for the next phase in portfolio management which is portfolio
selection. The proper goal of portfolio construction is to generate a portfolio that provides the
highest returns at a given level of risk. A portfolio having this characteristic is known as an efficient
portfolio. The inputs from portfolio analysis can be used to identify the set of efficient portfolios.
From this set of efficient portfolios, the optimal portfolio has to be selected for investment. Harry
Markowitz's portfolio theory provides both the conceptual framework and the analytical tools for
determining the optimal portfolio in a disciplined and objective way.
Portfolio Revision
Having constructed the optimal portfolio, the investor has to constantly monitor the portfolio to
ensure that it continues to be optimal. As the economy and financial markets are dynamic, changes
take place almost daily. As time passes, securities which were once attractive may cease to be so.
New securities with promises of high returns and low risk may emerge. The investor now has to
revise his portfolio in the light of the developments in the market. This revision leads to purchase of
some new securities and sale of some of the existing securities from the portfolio. The mix of
securities and their proportion in the portfolio changes as a result of the revision.
Portfolio revision may also be necessitated by some investor-related changes such as availability of
additional funds, change in risk attitude, need of cash for other alternative use, etc.
Whatever be the reason for portfolio revision, it has to be done scientifically and objectively so as to
ensure the optimality of the revised portfolio. Portfolio revision is not a casual process to be carried
out without much care. In fact, in the overall process of portfolio management, portfolio revision is
as important as portfolio analysis and selection.
Portfolio Evaluation
The objective of constructing a portfolio and revising it periodically is to earn maximum returns
with minimum risk. Portfolio evaluation is the process which is concerned with assessing the
performance of the portfolio over a selected period of time in terms of return and risk. This involves
quantitative measurement of actual return realized and the risk borne by the portfolio over the
period of investment. These have to be compared with objective norms to assess the relative
performance of the portfolio. Alternative measures of performance evaluation have been developed
for use by investors and portfolio managers.
Portfolio evaluation is useful in yet another way. It provides a mechanism for identifying
weaknesses in the investment process and for improving these deficient areas. It provides a
feedback mechanism for improving the entire portfolio management process.
The portfolio management process is an ongoing process. It starts with security analysis, proceeds
to portfolio construction, and continues with portfolio revision and evaluation. The evaluation
provides the necessary feedback for a better designing of portfolio the next time around. Superior
performance is achieved through continual refinement of portfolio management skills.
ROLE OF PORTFOLIO MANAGEMENT
There was a time when portfolio management was an exotic term and an elite practice beyond the
reach of ordinary people in India. Over the years, this scenario has changed radically. Portfolio
management is now a familiar term and is widely practiced, the theories and concepts relating to
portfolio management now find their way to the front pages of financial news papers and the cover
pages of investment journals in India.
In the beginning of the nineties India embarked on a program of economic liberalization and
globalization. This reform process has made the Indian capital markets active. The Indian stock
markets are steadily moving towards higher efficiency, with rapid computerization, increasing
market transparency, better infrastructure, better customer service, closer integration and higher
volumes. The markets are dominated by large institutional investors with their diversified
portfolios. A large number of mutual funds have been set up in the country since 1987. With this
development, investment in securities has gained considerable momentum.
Along with the spread of securities investment among ordinary investors, the acceptance of
quantitative techniques by the investment community changed the investment scenario in India.
Professional portfolio management, backed by competent research, began to be practiced by mutual
funds, investment consultants and big brokers. The Securities and Exchange Board of India (SEBI),
the stock market regulatory body in India, is supervising the whole process with a view to making
portfolio management a responsible professional service to be rendered by experts in the field.
With the advent of computers the whole process of portfolio management has become quite easy.
The computer can absorb large volumes of data, perform the computations accurately and quickly
give out the results in any desired form. Moreover, simulation, modeling etc. provide means of
testing alternative solutions.
The trend towards liberalization and globalization of the economy has promoted free flow of capital
across international borders. Portfolios now include not only domestic securities but also foreign
securities. Diversification has become international. In this context, financial investments cannot
be conceived of without portfolio management.
Another significant development in the field of investment management is the introduction of

derivative securities such as options and futures. The trading in derivative securities and their
valuation has broadened the scope of investment management.
Investment is no longer a simple process. It requires scientific knowledge, a systematic approach

and also professional expertise. Portfolio management which combines all these elements is the
method of achieving efficiency in investment.
PORTFOLIO RISK & CALCULATION
Mean-Variance Analysis
Mean-variance analysis refers to the use of expected returns, variances, and covariances of
individual investments to analyze the risk-return tradeoff of combinations (i.e., portfolios) of these
assets.
Over a half century has passed since Professor Harry Markowitz established the tenets of mean-
variance analysis, or capital market theory, the focal point of which is the so-called efficient
frontier. Several assumptions underlie mean-variance analysis. The assumptions establish a
uniformity of investors, which greatly simplifies the analysis.
The main assumptions of mean-variance analysis can be summarized as follows:
All investors are risk-averse. Investors minimize risk for any given level of expected return,
or, stated differently, investors demand additional compensation in exchange for additional
risk. Investors may differ in their degree of risk aversion, but the key is that all investors
are assumed to be risk averse to some degree.
Expected returns, variances, and covariances are known for all assets. Investors are aware
of the future values of these parameters.
Investors create optimal portfolios by relying solely on expected returns, variances, and
covariances. No other distributional parameter is used. For example, returns are often
assumed to follow a normal distribution in which skewness and kurtosis can be ignored.
Investors face no taxes or transaction costs. Therefore, there is no difference between
before-tax gross returns and after-tax net returns, placing all investors on an equal footing.
Mean-variance analysis is used to identify optimal or efficient portfolios. Before we can discuss the
implications of efficient portfolios, however, we must first be able to understand and calculate
portfolio expected returns and standard deviations.
Expected Return and Standard Deviation for a Two-asset Portfolio
The expected return on a portfolio is a weighted average of the expected returns on the individual
assets that are included in the portfolio. For example, for a two-asset portfolio:
The weights (w1 and w2) must sum to 100% for a two-asset portfolio.
The variance of a two-asset portfolio equals:
The covariance, Cov1, 2 measures the strength of the relationship between the returns earned on
assets 1 and 2. The covariance is unbounded (ranges from negative infinity to positive infinity),
and, therefore, is not a very useful measure of the strength of the relationship between two asset's
returns. Instead, we often scale the covariance by the standard deviations of the two assets to
derive the correlation, 1, 2.
From the previous equation, notice that the covariance equals 1, 212 where 1, 2 is the correlation
of returns between the two assets. Therefore, the variance of the two-asset portfolio can be written:
Example: Expected return and variance for a two-asset portfolio
Using the information in the following figure, calculate the expected return and standard deviation
of the two-asset portfolio.
Characteristics for a Two-Stock Portfolio
Tata Steel ACC
Amount Invested 40000 60000
Expected Return 11% 25%
Standard Deviation 15% 20%

Correlation 0.30
Answer:
First, determine the weight of each stock relative to the entire portfolio. Since the investments are
40,000 and 60,000, we know the total value of the portfolio is 100,000:
wT = investment/portfolio value = 40,000/100,000 = 0.40
wA = investment/portfolio value = 60,000/100,000 = 0.60
Next, we determine the expected return on the portfolio:
E (RP) = wT E (RT) + wA E (RA)
= 0.40 * 0.11 + 0.60 * 0.25
= 0.1940 = 19.40%
Then, we calculate the variance of the portfolio:
P2 wT2 T2 wA2 A2 2wT wA T A TA
= (0.40)2(0.15)2 + (0.60)2(0.20)2 + 2(0.40)(0.60) (0.15)(0.20) (0.30) = 0.02232
And, finally, the standard deviation of the portfolio:

P P2 = 0.1494 = 14.94%
Correlation and Diversification
Portfolio diversification refers to the strategy of reducing risk by combining many different types of
assets into a portfolio. Portfolio variance falls as more assets are added to the portfolio because not
all asset prices move in the same direction at the same time. Therefore, portfolio diversification is
affected by the:
Correlations between assets: lower correlation means greater diversification benefits.

Number of assets included in the portfolio: More assets mean greater diversification
benefits.
Effect of Correlation on Portfolio Diversification
As the correlation between two assets decreases, the benefits of diversification increase. As the
correlation decreases, there is a lesser tendency for stock returns to move together. The separate
movements of each stock serve to reduce the volatility of a portfolio to a level that is less than the
weighted sum of its individual components (e.g., less than w11 + w22). No diversification is
achieved if the correlation between assets equals +1. The greatest diversification is achieved if the
correlation between assets equals -1.
To illustrate the effects of correlation on diversification, consider the expected return and standard
deviation data derived for domestic stocks, DS, and domestic bonds, DB as shown in Figure 6.
Figure 6: Diversification Example
Expected Return Standard Deviation

Domestic Stocks (DS) 0.20 0.30
Domestic Bonds (DB) 0.10 0.15
The expected return, standard deviation combinations for various portfolio percentage allocations
to domestic stocks and domestic bonds for each of the following correlations +1, 0, and -1 is shown
in Figure 7.
Figure 7: Expected Return/Standard Deviation Combinations for Various Allocations
DS % DB%
Correlation Allocation Allocation E(RP) P
100.00 0.00 0.200 0.300
66.67 33.33 0.167 0.250
+1 50.00 50.00 0.150 0.225
33.33 66.67 0.133 0.200
0.00 100.00 0.100 0.150
100.00 0.00 0.200 0.300
66.67 33.33 0.167 0.206
0 50.00 50.00 0.150 0.168
33.33 66.67 0.133 0.141
0.00 100.00 0.100 0.150
100.00 0.00 0.200 0.300
66.67 33.33 0.167 0.150
-1 50.00 50.00 0.150 0.075
33.33 66.67 0.133 0.000
0.00 100.00 0.100 0.150
The plot of the expected returns and standard deviations for each of the three correlations is
provided in Figure 8.
Figure 8: Effects of Correlation on Portfolio Risk
The lower and upper endpoints of the minimum-variance frontier in Figure 5 denote the risk and
return of assets DB and DS, respectively. Starting at the point representing 100% invested in DB,
as we increase the weight of DS and decrease the weight of DB, the frontier bulges to the left. The
amount of bulge (i.e., the diversification effect) is a function of the correlation between the two
assets.
As indicated in Figure 8, the lower the correlation between the returns of the stocks in the portfolio,
the greater the diversification benefits. If the correlation equals +1, the minimum-variance frontier
is a straight line between the two points (DB and DS), and there is no benefit to diversification. If
the correlation equals -1, the minimum-variance frontier is two straight-line segments, and there
exists a portfolio combination of stocks and bonds with a standard deviation of zero (the allocation
of 66.67% to domestic bonds and 33.33% to domestic stocks).
Capital Allocation Line (CAL) and Capital Market Line (CML)
Recall that the expected return for a portfolio of two assets equals the weighted average of the asset
expected returns. Therefore, the expected return on Investment C that combines the risk-free asset
and risky Portfolio P equals:
Also, recall that the variance of the portfolio of two assets (F and P) equals:
We know that the variance for the risk-free asset equals zero, and the covariance of the risk-free
asset with Portfolio P equals zero. Recall that the covariance between any two assets equals the
product of the correlation and the standard deviations of the two assets. The standard deviation of
the risk-free asset equals zero, and the covariance of the risk-free asset with any risky asset also
equals zero.
Therefore, the variance and standard deviation for the investment combination C can be calculated,
respectively, as:
Capital Allocation Line
Until now, our portfolios have consisted of risky assets only. But, in reality, investors usually
allocate their wealth across both risky and risk-free assets. The following discussion illustrates the
effects of the inclusion of the risk-free asset. A risk-free asset is the security that has a return
known ahead of time, so the variance of the return is zero.
Consider the task of creating portfolios comprising the risk-free asset, F, and a risky portfolio, P. It
is helpful to assume that Portfolio P lies on the efficient frontier. Various combinations of Portfolio P
and the risk-free asset can be created. By adding the risk-free asset to the investment mix, a very
important property emerges:
The shape of the efficient frontier changes from a curve to a line after the inclusion of a risk-
free asset into the portfolio.
The following example illustrates this important property. Assume that the expected return for
Portfolio P equals 12% and that its standard deviation equals 24%. Also, assume that the risk-free
rate equals 6%. To calculate the expected return and standard deviation for an investment
combination of P and F, we use the formulas provided in the Warm-Up:
E (RC) = wFRF + wPE(RP)

C = wPP
The expected returns and standard deviations for various combinations of the risk-free asset and
portfolio are shown in the Figure 11. Notice that a weight less than zero means we have sold the
asset short. For example, suppose we have 100,000 to invest in a portfolio, and we borrow an
additional 25,000 at the risk-free rate. The weight on the risk-free asset is -0.25 (-25,000/100,000)
and the weight on the risky portfolio is 1.25 (125,000/100,000). Notice that the weights still add up
to 1, however.
Figure 11: Combining the Risk-free Asset with a Risky Portfolio
Portfolio Possibility (C) wF wP E (RC) C

1 1.000 0.000 0.060 0.000
2 0.750 0.250 0.075 0.060
3 0.500 0.500 0.090 0.120
4 0.250 0.750 0.105 0.180
5 0.000 1.000 0.120 0.240
6 -0.250 1.250 0.135 0.300
7 -0.500 1.500 0.150 0.360
Notice that the relationship shown in the example between the investment combination's (C) risk
and return is linear. For example, each time the expected return changes by 1.50%, the risk
changes by 6%.
Figure 12 illustrates the linear relationship between expected return and risk for the investment
combinations of P and F.
This linear relationship is a key result and is instrumental in the investor's asset allocation
decisions. We will use the capital allocation line to answer several important questions. For
example:
Question 1: How should the investor choose a particular risky portfolio among the many possible
risky portfolios to combine with the risk-free asset?
Question 2: Given the investor's risk tolerance (i.e., target standard deviation), what rate of return
should be expected?
Question 3: Given the investor's risk-return objectives, what percentage allocation should be given
to the risk-free asset and the risky portfolio?
All of these questions are answered by employing the linear risk-return relationship that results
from the opportunity to invest in the risk-free asset. The following discussion will highlight the key
role that the capital allocation line plays in determining optimal asset allocations for the investor.
The Capital Market Line
The Capital Market Line (CML) is the capital allocation line in a world in which all investors agree
on the expected returns, standard deviations, and correlations of all assets (also known as the
"homogeneous expectations" assumption). Assuming identical expectations, there will be only one
capital allocation line, and it is called the capital market line.
Under the assumptions of the CML, all investors agree on the exact composition of the optimal
risky portfolio. This universally agreed upon optimal risky portfolio is called the market portfolio, M,
defined as the portfolio of all marketable assets, weighted in proportion to their relative market
values. For instance, if the market value of Asset X is 1 billion, and the market value of all traded
assets is 100 billion, then the weight allocated to Asset X in the market portfolio equals 1%.
The key conclusion of the CML can be summarized as follows:
All investors will make optimal investment decisions by allocating between the risk-free
asset and the market portfolio.
A graph of the CML is provided in Figure 15.
Figure 15: Capital Market Line
The equation for the CML is:
The slope of the CML is often called the market price of risk, and equals the reward-to-risk ratio (or
Sharpe ratio) for the market portfolio.
Because the CML is just a special case of the CAL, the CML also can be used to calculate the
expected return commensurate with the investor's risk tolerance. All prior examples hold for the
CML if we make one simple assumptionthat investors have identical expectations. Under this
assumption, the tangency portfolio discussed earlier for the specific investor (Portfolio T) is the
market Portfolio M.
As illustrated in the previous discussion, the addition of the risk-free asset has profound
implications for the efficient frontier. Most importantly, all investors can maximize their reward-to-
risk ratio by investing in a combination of the risk-free asset and the market portfolio. So, with the
introduction of the risk-free asset, the shape of the efficient frontier changes from a curve (the
Markowitz frontier) to a line (the Capital Market Line). Stated more emphatically, the Capital
Market Line dominates the Markowitz frontier.
For example, all investors would prefer Portfolio A over Portfolio B in Figure 15. Portfolio A has the
same risk but higher expected return than Portfolio B. Moreover, all investors would prefer Portfolio
A over Portfolio C. Portfolio A has the same expected return but lower risk than Portfolio C. Similar
contrasts can be found all along the Capital Market Line and Markowitz frontier. Because optimal
portfolios are now found on the Capital Market Line, the Capital Market Line becomes the new
efficient frontier.
Investors with high risk-aversion will invest a larger percentage in the risk-free asset and a smaller
percentage in the market portfolio (for an investment combination lying on the lower end of the
Capital Market Line). The reverse is true for investors with low risk aversion.
Differences between the CAL and the CML
Although the CAL and CML are generated using exactly the same mean-variance calculations, there
are a few important differences:
There is only one CML, because it is developed assuming all investors agree on the
expected return, standard deviation, and correlations for all assets.
There is an unlimited number of CALs, because each is developed uniquely for each
investor.
The tangency portfolio for the CML is the market portfolio, and there is only one market
portfolio. The market portfolio uses market value weights.
The tangency portfolio for the CAL can differ across investors depending on differences in
investor expectations.
The CML is a special case of the CAL.

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FUNDAMENTAL

2 Chapter 2 : Fundamental Analysis 17

3 Chapter 3 : Value Investing 39

4 Chapter 4 : Valuation of Stocks 59

5 Chapter 5 : Portfolio Management 78

WHY INVEST IN SHARES?

7. With shares you can start small

Whats not so good about shares?

Cash Flows: -1000 ?

Future Value of a Single Deposit

PV = present value, or beginning amount, in your account.

Cash Flows: -1000

To find out the PV, we can rearrange the equation:

In the above case Present value = 1610.51/ (1+0.10)5 = 1000 Rs.

Solving for Interest Rate and Time

Therefore, the interest rate is 10 percent.

Time: 0 10% 1 2 n-2 n-1 n=?

RISK AND RETURN

a. The return that can be expected from holding a security.

rit = Realized Return generated by the ith stock in time period t.

E (r )i = Expected Return on asset i

The arithmetic average, customarily designated by the symbol X (X bar)

The geometric average reflects compound, cumulative returns over time.

TOTAL PROCEEDS INCOME CAPITAL GAIN 2 3

Where n = number of possible stats of the economy.

Xi = the cash flow in the ith state of the economy.

P (Xi) = the probability of ith cash flow

E[R] = the expected return on the stock,

N = the number of states,

pi = the probability of state i, and

Ri = the return on the stock in state i.

Expected Return on Stocks A and B

ERA = .20(5%)+.30(10%)+.30(15%)+.20(20%) = 12.5%

ERB = .20(50%)+.30(30%)+.30(10%)+.20(-10%) = 20%

The formula for Expected (ex-ante) P(n X ) 2

Where n = a possible outcome

X = the expected outcome.

P = the probability (or likelihood) of the difference between n and X occurring.

rit = Realized Return generated by the ith stock in time period t.

ri = Average Return of ith stock.

N = the number of states,

pi = the probability of state i,

Ri = the return on the stock in state i, and

E[R] = the expected return on the stock.

Note: ERA = 12.5% and ERB = 20%

A2 = .20(.05-.125)2 + .30(.10-.125)2+.30(.15-.125)2+.20(.20-.125)2 = .00263

What is Fundamental Analysis?

Fundamentals: Quantitative and Qualitative

Quantitative capable of being measured or expressed in numerical terms.

In our context, quantitative fundamentals are numeric, measurable characteristics about a

The Concept of Intrinsic Value

Criticisms of Fundamental Analysis

TABLE 1: Economic indicators and their impact on the stock market

Gross National Product High growth rate Slow growth rate

What is an economic indicator?

Different Economic Indicators and their impacts

Gross Domestic Product (GDP)

An FII, or Foreign Institutional Investor, is an investor or investment fund that is from or

LIFE CYCLE OF AN INDUSTRY

Let us discuss each stage of a typical industry life cycle:

Note: This is the time to invest in emerging blue chip companies.

Evaluation of an industry should encompass four critical areas:

1. What are the strengths of the industry?