Investing in Stocks

1Equity as an investment

Companies raise money in two ways. Equity makes the investor an owner. Debt makes the investor a lender.

• Shareholders hold a residual claim: they get whatever is left of the net assets after all liabilities are paid.
• The company has no contractual duty to repay equity capital or to make periodic payments, unlike interest on debt.
• Shareholders get voting rights. A large holding can give a say in management.
• Returns come from dividends (which depend on profits) and capital appreciation (which depends on the market). Neither is assured.
• Because equity carries the residual risk, investors expect a higher return from it than from debt.

Choosing between equity and debt is a risk–return trade-off. Most investors split their money between the two according to their return expectations, time horizon, risk appetite and needs.

Remember

• Equity = ownership, residual claim, voting rights, no promised return.

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2Diversification: cross-sectional and time series

Equity is riskier than bonds, and diversification is the main way to reduce that risk. It works because different businesses do not move in step: their returns are less than perfectly correlated.

• Cross-sectional diversification: holding many kinds of businesses (sectors, industries and geographies) at the same point in time.
• Time diversification: staying invested over long periods, so bad years are offset by good ones. This is the idea behind "time in the market, not timing the market."

The idea rests on business cycles:

• Counter-cyclical (defensive) businesses can peak while the economy is in a trough.
• Recession-proof businesses do better in a downturn.
• Leading sectors or countries come out of a recession earlier.
• Lagging sectors or countries enter a recession later.

Remember

• Cross-sectional = across businesses at one time; time series = across periods.

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3Risks of equity investing

Impact cost is the percentage price move that a given order size (say ₹1 lakh) causes, measured from the average of the best bid and best offer. It is calculated for both the buy side and the sell side. Thinly traded stocks have high impact cost; a lower impact cost means a more liquid stock.

Wider macro factors, such as inflation, fuel prices, interest rates and growth or slowdown, also move stock markets.

Exam trap Sector and company risks (unsystematic) can be diversified away. Market risk (systematic) cannot; it can only be hedged.

Remember

• Beta proxies market risk; impact cost measures liquidity.

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4Overview of the equity market

Equity represents an ownership claim on a company's net assets. The market offers both listed and unlisted opportunities with different risk, return and liquidity profiles.

• Listed shares are more liquid.
• Listed companies must follow listing norms, so they are more regulated and disclose more.

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5Buy-side vs sell-side research

Equity research studies a company's financial and non-financial information, its sector, its competitors and the economy. The aim is to estimate intrinsic value, compare it with the market price, and decide whether to buy, hold or sell.

Remember

• Sell-side publishes for clients; buy-side advises its own fund managers.

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6Fundamental analysis: top-down and bottom-up

Fundamental analysis estimates intrinsic value from the drivers of value: future earnings or cash flows, interest rates and risk.

• Buy if the market price is below intrinsic value.
• Avoid or sell if it is above, after allowing for transaction costs.

Fundamental analysts believe the market price eventually converges to intrinsic value, so whoever estimates value better can earn above-average returns.

It uses the EIC framework (Economy → Industry → Company):

• Top-down: start with the economy, pick industries, then companies.
• Bottom-up: start with company-specific factors and work up to the macro picture.

Remember

• EIC = Economy, Industry, Company. Top-down starts at E; bottom-up starts at C.

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7The stock analysis process: economy, industry, company

The value of a stock depends on its expected cash flows and the required rate of return (the discount rate). The economic environment shapes both.

Economy analysis

• Fiscal policy: tax cuts encourage spending; removing subsidies or adding taxes discourages it.
• Monetary policy: tighter money supply hurts expansion plans and working capital.
• A macro forecast covers GDP, inflation, interest rates and unemployment. Analysts track releases such as WPI, CPI, IIP and GDP growth.
• Banks and financial stocks are among the most interest-rate-sensitive; pharma is among the least.
• The stock market is a leading indicator: prices reflect expectations of future activity, so they tend to turn before the economy does. Sentiment and fund flows can still push the market ahead of, or behind, the economy.

Industry analysis

• Cyclical sectors, such as cars, consumer durables and tractors, are attractive early in a recovery. Their high operating leverage (and high financial leverage) magnifies gains as sales rise.
• Banks and financials tend to do well towards the end of a recession.
• At the peak, inflation rises. Firms that can pass on costs cope; producers of basic materials such as oil and metals benefit.
• In a recession, defensive sectors (pharma, FMCG) outperform because people still buy necessities.

Industry life cycle

Company analysis is the last step of top-down analysis.

• Financial statement analysis: P&L, balance sheet, cash flow and ratios, compared with industry trends and the company's history.
• SWOT: strengths and weaknesses are internal; opportunities and threats are external (for example, a tax change, new regulation, a large competitor or new technology).
• Competitive strategy:
  • Defensive: position the firm to deflect competitive forces.
  • Offensive: use the firm's strengths to change those forces.

Exam trap A good company is not automatically a good investment. If the share already trades well above intrinsic value, it may be a poor buy.

Remember

• Maturity is the longest life-cycle stage.
• The market leads the economy.

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8Estimating intrinsic value: DCF and asset-based methods

Price is a fact; value is an opinion. Valuation inputs are uncertain, so the result is an educated estimate, which is why valuation is called both an art and a science. Its purpose is to judge whether a stock is fairly priced, over-priced or under-priced.

Discounted cash flow (DCF) is the most appropriate method when three things are known:

1. the stream of future cash flows;
2. their timing;
3. the investor's required return (the discount rate).

The value is the present value of those cash flows. Accounting profit includes accrual adjustments that involve no cash, so analysts derive cash flows from profits rather than discounting profits directly.

Asset-based valuation suits asset-heavy businesses whose assets are close to fair value, such as financial institutions, real estate, and gold, gems and jewellery.

• Firm value = adjusted current market value of net tangible, intangible, financial and net current assets.
• Equity value = firm value − all outside liabilities.
• Drawback: it ignores future profits, cash flows and value from innovation.

Remember

• DCF needs cash flows, timing and a discount rate.
• Asset-based valuation ignores future earning power.

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9Relative valuation multiples

Relative valuation compares a company with similar entities using multiples of earnings, cash flow, book value or sales. Comparisons can be against peers, the industry average or the market index.

P/E ratio = market price ÷ EPS. Use 12 months of EPS, not one quarter.

• Trailing P/E: uses the last four quarters' EPS.
• Forward P/E: uses the expected EPS for the next four quarters.
• Current P/E: uses the latest annual EPS.
• A P/E of 10 means investors pay ₹10 for every ₹1 of earnings.
• Limitations: forward estimates may be wrong; P/E is meaningless when EPS is negative; it changes with every move in price or estimates; and average market P/Es swing with economic conditions.

Example A stock at ₹100 with EPS ₹5 has a P/E of 20. If the company's P/E is 18 against an industry average of 22, it looks undervalued relative to peers.

Price-to-book (P/BV) = price per share ÷ book value per share.

• Book value per share = shareholders' equity ÷ number of shares. Exclude miscellaneous assets not yet written off, because equity has already been eroded by that amount.
• Price below book means either the market is undervaluing the stock (a buying opportunity) or the books contain worthless assets or inflated reserves.
• Limitation: assets are at historical cost less depreciation, and intangibles such as intellectual property are hard to value.
• Widely used for banks and financial services, where assets are close to market value.

Price-to-sales (P/S) = market capitalisation ÷ last 12 months' sales. Sales are harder to manipulate than earnings. The ratio is useful for loss-making firms and high-volume, low-margin businesses.

PEG ratio = P/E ÷ expected annual EPS growth rate (growth in %, usually over 5 years).

• PEG = 1: the price is in line with expected growth.
• PEG < 1: possibly undervalued.
• PEG > 1: possibly overvalued.
• The result is only as good as the growth estimate.

Formula PEG = (Price ÷ EPS) ÷ EPS growth rate. A P/E of 30 with 15% expected growth gives a PEG of 2, which suggests the price runs ahead of growth.

EVA and MVA

• EVA (economic profit) = net operating profit after tax − (invested capital × cost of capital). It shows the value created over a period.
• MVA = current market value of the firm − capital contributed by investors. Positive means value added; negative means value destroyed. The value added must beat investors' opportunity cost.

Enterprise value multiples

• EV = market cap of equity + market value of debt − excess cash and cash equivalents. Excess cash is deducted because no acquirer pays cash to buy cash.
• EV relates to earnings available to all providers of funds (equity and debt), so it is paired with EBIT or EBITDA.
• EV/EBITDA is useful for capital-intensive firms that make losses at the PAT or EBIT level but generate surplus EBITDA. EBITDA strips out depreciation and amortisation to get closer to cash.
• EV/Sales is more comprehensive than P/S because it accounts for debt as well as equity.

Yields

• Dividend yield = DPS ÷ market price × 100. For example, ₹2 ÷ ₹40 = 5%.
• Earnings yield = EPS ÷ market price × 100. For example, ₹2.5 ÷ ₹25 = 10%. It is the inverse of P/E.

Sector-specific choice of method

Remember

• EV deducts excess cash.
• Earnings yield = 1 ÷ P/E.
• PEG below 1 suggests undervaluation.

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10Combining relative valuation with DCF

• DCF gives intrinsic value. It depends on (1) the growth rate of cash flows and (2) the discount rate.
• Multiples compare a stock with similar entities.

Multiples are really a simplified form of DCF: both rest on the same value drivers. A P/E, for example, is ultimately justified by the present value of future earnings.

11Technical analysis

Technical analysts assume that all information is already reflected in price, so they ignore fundamentals. Instead, chartists study past price and volume to forecast the direction and size of future price moves.

Three elements matter:

• past prices, which show the trend and its direction;
• volume, which shows the strength of the trend;
• the time span of the observations.

Assumptions

• Prices are set by supply and demand.
• Supply and demand are driven by both rational and irrational factors.
• Prices adjust gradually and move in trends.
• Trends persist for appreciable periods.
• Trends change when supply and demand shift.
• Those shifts can be detected from market action itself.

Technical vs fundamental: technical analysis ignores whether the price is fair. It suits short-term trading, not long-term investing. A common saying is "pick the stock with fundamentals, time it with technicals." Investors are still encouraged to invest for the long term rather than time the market.

Claimed advantages: it does not depend on financial statements, which miss psychological and non-financial factors, and it needs far less data gathering.

Common tools

• Trend lines: rising, flat and declining channels; peaks and troughs.
• Moving averages (commonly 5, 10, 30, 50, 100 and 200 days): buy when the price is well below the average; sell when it is well above it.
• Bollinger bands: use standard deviations around the moving average. Two SD above suggests the stock is overbought; two SD below suggests it is oversold.

Fixed income: the same techniques apply to bonds wherever price and volume data exist; the rationale is the same.

Remember

• Bollinger: +2 SD overbought, −2 SD oversold.
• Technical analysis works for bonds too.

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12Qualitative evaluation

Qualitative factors are as important as the numbers, sometimes more so. Corporate governance is the cornerstone. Frauds, accounting scandals and excessive pay have driven some companies into bankruptcy.