Terminology in Equity and Debt Markets

1Equity versus debt, and the meaning of value

Equity is available for as long as the business needs it, earns no fixed return, gives ownership and a say in management, and takes the residual profit. Debt must be repaid, earns fixed interest, gives no ownership, and its claim is limited to interest and principal. Equity is riskier, long-term and growth-oriented; debt is lower-risk and income-oriented.

Example A firm borrows at 12% and earns 14% on the assets. Lenders get 12%; the extra 2% goes to shareholders. If the assets earn less than 12%, shareholders absorb the shortfall.

• Face value (FV): the nominal value of a share. Share capital = shares × FV (1 lakh shares × ₹10 = ₹10 lakh). Shares may be issued at par, a premium or a discount. FV changes only on a split (falls) or consolidation (rises): one ₹10 share split into five becomes five ₹2 shares. Dividends declared as a percentage are on face value: 30% on ₹10 FV = ₹3; 30% on ₹2 FV = ₹0.60.
• Book value: the company's net worth; book value per share = net worth ÷ shares outstanding, roughly what each share would get on winding up if assets realised their book value (cost less depreciation).
• Market value: the share's market price; market price × shares = market cap.
• Replacement value: what it would cost today to recreate the company's assets.
• Intrinsic value: the present value of expected future free cash flows; Warren Buffett called it the discounted value of cash that can be taken out of a business over its remaining life. The discount rate (the investor's required return, adjusted for risk) is key.

If intrinsic value is above market price, the share is undervalued; below, overvalued. Judging this consistently is hard because the future is unknown, which makes equity investing an art as well as a science, shaped by human behaviour.

Remember

• Dividend % is on face value.
• Intrinsic > market = undervalued.

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2Market capitalisation and enterprise value

Market cap = market price × shares outstanding (1 lakh × ₹20 = ₹20 lakh). Rough categories: the top 50 to 100 stocks are large cap (liquid, often blue chips with long, stable records), the next 200 to 500 mid cap, the rest small cap (less liquid). The cut-offs vary by market and regulation. Market cap to GDP shows the size of a country's stock market.

Enterprise value (EV) is the value of the capital employed in the business.

Formula Standalone EV = market value of equity + preferred capital + debt − (cash, cash equivalents and non-operating financial investments)

On a consolidated basis, add non-controlling interest and the subsidiary's preferred capital and debt, and deduct the subsidiary's cash and non-operating investments too. Use market values where possible; for unlisted securities and bank debt, book values can be a proxy.

Example 10 lakh shares at ₹340 → market cap ₹34 crore. Preferred capital ₹8.5 crore, debt ₹6.4 crore, cash ₹2.5 crore, financial investments ₹1.4 crore. EV = 34 + 8.5 + 6.4 − 2.5 − 1.4 = ₹45 crore.

Example Market cap ₹10 lakh, debt ₹3 lakh, cash ₹4 lakh → EV = 10 + 3 − 4 = ₹9 lakh.

Remember

• EV = equity + debt (+ preference) − cash and non-operating investments.

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3Earnings, EPS, DPS and the P/E ratio

Earnings exist at several levels: net profit (for shareholders), EBIT (for lenders, government and owners) and EBITDA (before recovering investment in assets). Historical earnings are past years'; trailing earnings cover the latest period on a rolling basis, such as the trailing twelve months (TTM) or trailing four quarters; forward earnings are projections.

Formula EPS = Net profit ÷ Shares outstanding (strictly, the weighted average number of shares)

Example Net profit ₹10 lakh, 2 lakh shares → EPS = ₹5.

Dividend per share (DPS): 40% on ₹10 FV = ₹4; or total dividend ÷ shares. Dividend payout ratio = DPS ÷ EPS.

Formula P/E ratio = Market price per share ÷ EPS

A P/E of 12x means the share trades at 12 times earnings. Because prices anticipate the future, the forward (prospective) P/E matters more than the historical one: a share at 20x this year's earnings but 15x next year's is expected to grow EPS fast. Index P/E helps judge whether the market is expensive: it rises when prices run ahead of earnings and falls when uncertainty rises. Value investors like low P/Es. Large, stable companies often get higher P/Es than small, risky ones, but fast-growing small firms can command higher multiples.

Remember

• Payout ratio = DPS ÷ EPS.
• Expected growth → higher P/E; current P/E above forward P/E.

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4P/S, P/BV and DVR shares

Formula P/S = Price ÷ Sales per share = Market cap ÷ Annual net sales

Example Sales ₹1 crore, 10 lakh shares, price ₹40 → sales per share ₹10; P/S = 4.

A lower P/S than peers may mean undervaluation, but profit potential and risks matter. P/S is useful when a company is loss-making, so P/E is meaningless.

Formula P/BV = Market price ÷ Book value per share (book value per share = net worth ÷ shares)

Example Equity capital ₹10 lakh + reserves ₹50 lakh = net worth ₹60 lakh; 6 lakh shares → BV ₹10. Price ₹20 → P/BV = 2x.

P/BV below 1 means the share trades below book value, but ask why: past poor investments may need writing down, so not every low-P/BV stock is a bargain. Book value is based on historical cost. P/BV works well for banks and financial institutions, whose assets are mostly monetary and close to market value, and when earnings are negative; it is less relevant for asset-light service firms.

Differential voting rights (DVR) shares carry fewer than one vote per share. Issuers raise capital without diluting control; investors who care only about dividends and gains accept them, usually at a discount to ordinary shares. Under the Companies Act, 2013, the issuer needs to have paid dividends of at least 10% over the past 3 years, and DVRs cannot exceed 25% of post-issue paid-up capital. Examples: Tata Motors, Pantaloons.

Remember

• P/S for loss-makers; P/BV for banks.
• DVR: fewer votes, usually cheaper.

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5Debt basics: face value, coupon, maturity, price and redemption

A company can borrow from banks or issue debt securities to many investors, each of whose exposure is limited to their investment. A debt security's features are principal, coupon, maturity, coupon frequency and collateral. Secured debt gives a claim on specific assets on default; unsecured does not. Publicly issued debt must be listed; unlisted debt is held to maturity or traded OTC.

• Face (par) value: the amount borrowed per security and the legal liability; the coupon is a percentage of it, and only it is repaid at maturity whatever price investors paid.
• Coupon rate: the fixed payment as a percentage of face value. (Avoid calling it the interest rate, which means the market rate.)

Example 8.24GS2018 (8.24% G-sec maturing 2018), face value ₹1,000: ₹82.40 a year, paid semi-annually as ₹41.20 every six months, with the last coupon and principal at maturity.

• Maturity (tenor): the single biggest driver of bond price changes and market risk. T-bills run 91, 182 and 364 days; G-secs up to 30 years or more; some bonds are perpetual.
• Market price: set by market interest rates, inflation and default risk. A bond's value is the present value of its cash flows, so prices and interest rates move inversely: when rates rise, prices fall.
• Redemption: at maturity the issuer repays principal with the last coupon and the bond ceases to exist.

Exam trap A 10% bond issued at ₹100 will trade below face value if market rates rise above 10%.

Remember

• Bond prices fall when interest rates rise.
• G-secs pay coupons half-yearly.

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6Measuring bond returns: HPR, current yield, YTM and realised yield

Holding period return (HPR): total return over the period held, combining coupons, interest on reinvested coupons and capital gain or loss, as a percentage of cost. It ignores compounding, so do not compare it with annualised returns.

Example Buy at ₹104, receive ₹8 coupon reinvested at 7%, sell at ₹110 after a year. HPR = [8 + 0.56 + (110 − 104)] ÷ 104 = 14.0%.

Current yield = annual coupon ÷ market price; simple but ignores future cash flows (like a dividend yield).

Example 8.24% bond at ₹104 → 8.24 ÷ 104 = 7.92%.

Yield to maturity (YTM): the discount rate that equates the present value of all future cash flows (coupons, reinvestment income, redemption value) to the market price; the bond's IRR, found by trial and error or Excel's XIRR. Drawbacks: it assumes the bond is held to maturity and coupons are reinvested at the same YTM, implying a flat, static yield curve. Still, it is quick and widely used.

Realised yield: the annualised return when the bond is sold before maturity, allowing for compounding at the actual reinvestment rate.

Formula Realised yield = [(accumulated reinvested coupons + sale proceeds) ÷ purchase price]^(1 ÷ holding period) − 1

Example Buy at ₹1,000, 12% annual coupon reinvested at 14% for 5 years, sell at ₹1,050. Coupons grow to 120 × [(1.14⁵ − 1) ÷ 0.14] ≈ ₹793. (793 + 1,050) ÷ 1,000 = 1.843; 1.843^(1/5) − 1 ≈ 13%.

Remember

• YTM assumes hold to maturity and reinvestment at YTM.
• HPR is not annualised; realised yield is.

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7Duration

Macaulay duration is the weighted average time to receive a bond's cash flows, weighted by their present values; it is usually less than maturity (equal for a zero-coupon bond).

Formula Macaulay duration = [Σ (CFₜ ÷ (1 + y)ᵗ) × t] ÷ Price; Modified duration = Macaulay duration ÷ (1 + y)

Modified duration measures price sensitivity to interest rates: the higher it is, the more the price rises when rates fall and falls when rates rise. Duration (and interest rate risk) is higher when:

• maturity is longer;
• coupon is lower;
• yield is lower.

Duration falls as the bond approaches maturity.

Remember

• Longer maturity, lower coupon, lower yield → higher duration and risk.

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8Zero-coupon and floating-rate bonds

Bonds vary in principal, maturity and coupon, and by issuer and credit quality.

Zero-coupon bonds pay no coupon: issued at a discount, redeemed at par; the return is the difference. They have higher duration (more interest rate risk) than coupon bonds of the same maturity, and help issuers conserve cash until a single bullet repayment. T-bills, commercial paper and certificates of deposit are short-term zeros, money market instruments under a year. Very long zeros issued at steep discounts are deep discount bonds (IDBI's bonds; Kisan Vikas Patra).

Example An Essar group company issued zero-coupon bonds in October 2009 at ₹85.80 and ₹82.55 for ₹100 at maturity in 2011, implying yields of about 9.15% and 9.25%.

Floating-rate bonds reset their coupon periodically (often every six months) against a benchmark (an inflation index, inter-bank or call rates). They carry lower interest rate (price) risk and suit rising rate periods. A cap sets a maximum and a floor a minimum coupon. Inverse floaters move opposite to the benchmark.

Remember

• Zeros: discount issue, par redemption, high duration.
• Floaters: low price risk; good when rates rise.

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9Convertible bonds, principal-protected notes and inflation-indexed bonds

Convertible bonds let holders convert into equity on stated terms (date, ratio, price, usually at a discount, and proportion). They can be compulsorily or optionally convertible, and fully or partly convertible. Conversion removes debt and adds equity, diluting EPS and existing holdings. Issuers pay a lower coupon and may avoid repayment; investors get income early and equity upside later.

Principal-protected notes (PPNs): part of the money goes into debt that grows back to the principal at maturity; the rest goes into equity, derivatives or commodities for upside. A synthetic debt-plus-derivative product. Principal protection does not remove the issuer's credit risk. NBFCs have issued them as equity-linked or commodity-linked bonds.

Inflation-indexed bonds (IIBs): fixed-income returns can turn negative in real terms when inflation rises (nominal rate = real rate + inflation). RBI's IIBs pay a fixed real coupon on a principal adjusted by an index ratio (reference index on settlement date ÷ reference index on issue date), using WPI; at maturity the higher of face value and adjusted principal is paid. RBI's Inflation Indexed National Savings Securities – Cumulative 2013 (10 years, for retail investors) paid 1.5% fixed plus CPI inflation, compounded half-yearly and paid at maturity, with the fixed rate as a floor even in deflation.

Remember

• Conversion dilutes EPS.
• PPNs still carry credit risk.

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10Foreign currency, external and perpetual bonds

• Foreign currency bonds: issued in a currency other than the issuer's home currency (for example a 2020 dollar bond by Delhi International Airport). Lower interest rates, but currency risk for the issuer; hedging it can wipe out the rate advantage.
• External (euro) bonds: in a currency different from that of the country of issue. Masala bonds are rupee-denominated bonds issued abroad (first by the IFC in 2014), which shift currency risk to the investor.
• Perpetual bonds: no maturity; the issuer need not redeem but may call them if callable. Indian banks issue AT1 perpetual bonds under Basel III, which are riskier than ordinary bonds: no fixed maturity; subordinate to deposits, other bank loans and all other bonds; coupons paid only from distributable profits and non-cumulative; and they can be converted into equity on a pre-set trigger event.

Remember

• AT1 bonds: perpetual, subordinated, non-cumulative coupons, convertible on a trigger.

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11Commodity market terms

• Spot price: the current price for immediate delivery, set by supply and demand. Exchanges publish it daily and use it for the final settlement price (FSP), important for cash settlement and delivery defaults.
• Basis = spot price − futures price.
• Contango: futures above spot; spot may be expected to rise.
• Backwardation: futures below spot; spot may be expected to fall.
• Cost of carry: storage, insurance, transport, financing and other costs of holding the commodity until delivery.

Example Gold spot ₹1,02,000 per 10 g, carry cost 8% a year. Three-month fair futures price = 1,02,000 + 1,02,000 × 8% × 3/12 = ₹1,04,040.

• Delivery: commodity futures are generally deliverable, settled by physical delivery at expiry.

Remember

• Basis = spot − futures. Contango: futures > spot.

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