Liquid secondary market makes the task easier of raising funds in primary market.</li></ul>TYPES <br /><ul><li>Order driven (NYSE) – </li></ul> Brokers match buying and selling orders <br /><ul><li>Quote Driven (NASDAQ) – </li></ul>Dealers provide bid-ask quote and dealer markets bring together buyers and sellers to transact at efficient prices<br />
Types Of Capital Markets<br /><ul><li>3rd market:
Trade in exchange listed securities on an OTC basis(save commission)
All bids, asks are declared and then one price is set at which all </li></ul> trades occur<br /><ul><li>Small exchanges adopt this kind of structure
This method is generally used for setting opening price or setting </li></ul> prices after halting the trade <br /><ul><li>Continuous Markets
Trade occur at any time till the market is open
The price is set either by auction process (Order Driven) or by </li></ul> dealer bid-ask quotes(Quote Driven) <br />
Functions Of Underwriters<br />Origination: <br /><ul><li>Bring to bear their knowledge and understanding of the current market needs so as </li></ul> to create and optimally priced issue<br /><ul><li>Planning and registration of the issue</li></ul>Risk Bearing:<br /><ul><li>The underwriter takes on the risk that the public may not be willing to take up at the </li></ul> time of IPOs<br /><ul><li>Ensures and Guarantees the price </li></ul>Distribution:<br />sales network that can identify buyers for the securities either through private placement or for the general public<br />
Types of Exchange Membership<br /><ul><li>The Specialist
Controls the limit order book. Use the information to </li></ul> stabilize the markets.<br /><ul><li> Posts bid and ask prices and trades on their own account to </li></ul> maintain liquidity in the market.<br /><ul><li> Provides bridge the liquidity to market. Helps to improve </li></ul> Bid-Ask spread. Known as Market Making. <br /><ul><li>The Commission broker - Executes clients’ trades
Floor Brokers – Work as a broker for other commission broker
Registered Traders – Trade for their own account</li></li></ul><li>Types of Orders<br /><ul><li>Market order:
Best possible price when the order reaches the trading floor
Sale of borrowed shares; requires margin to insure adverse movement in prices;
Borrower needs to pay the dividends to the owner during the short period;
Uptick Rule is scrapped by SEC from June,2007.</li></li></ul><li>Margin Transactions<br />Buying securities on borrowed money, brokers lend money against clients securities<br />In US, Margin lending limit is fixed by US Fed reserve board.<br />Due to leveraged position, investor enjoys magnification of profits as well as bears the high risk.<br /><ul><li>Initial Margin-
It is the minimum amount investor should provide as equity at inception
Current requirement – 50%</li></ul>Types Of Margin<br />
Margin balance falls below margin requirement, investor receives margin call, either he has to liquidate the position or bring the margin amount to minimum requirement. </li></ul> Trigger Price for margin call = Initial Price 1 – Initial Margin<br /> 1 – maintenance Margin<br />Formula <br />
Stock Market Index<br /><ul><li>Measure of average performance of a group of stocks
Functions include:</li></ul>Enable indexed portfolio creation<br />Works as a Benchmark for investment managers<br />Proxy for market portfolio to measure beta and systematic risk<br />Facilitate comparisons across international markets<br />Aiding market technicians for investment decisions<br />
Key considerations in index analysis<br /><ul><li>Composition of index </li></ul> Securities to be included for index construction<br /><ul><li>Mathematics behind the index
Market Return can be matched by proportionate market value investments
Good benchmark since institutional investors invest more into higher market cap stocks
Examples include: S&P, NASDAQ, Wilshire 5000, etc.</li></li></ul><li>Un weighted Index<br /><ul><li>Places equal weight on returns of all stocks, no differentiation on price or market cap
Here, all attention is given to returns of each stock
Index may be calculated on arithmetic or geometric basis.
Index Value </li></ul> (Arithmetic Mean) = ƩXi /n…. Xi is return on each stock<br /> (Geometric Mean) = n√X1 * X2 *…Xn - 1<br /> …..Xi is (1+Holding period Return)<br /><ul><li> Use of geometric mean rather than arithmetic mean will always result lower index value. </li></li></ul><li>Style Index<br /><ul><li>Indexes that reflect investment styles used by portfolio managers or market capitalization or investment classification (Growth/ Value Stocks).
Can be used to measure the relative performance of portfolio managers. </li></li></ul><li>Bond Market Index<br /><ul><li>Relatively new
Difficult in creation of bond index rather than stock index-
Global Bond Indexes </li></li></ul><li>Composite Stock Bond indexes<br />Developed to measure the performance of all the securities in the country.<br />Return generated on this index can be approximately used as market return<br />Example – Merrill Lynch-Wilshire Capital Markets Index <br />
Benefits of Diversification<br />If Securities from different countries and different asset classes are combined together, risk reduces to great extent because correlation between securities from two different countries is definitely much lower than 1<br />
Market Efficiency and Anomalies<br />Limitations to achieve informational efficient prices<br /><ul><li>Processing new information takes time and cost. If prices are fully efficient then it would not able to generate returns for analyst which will halt the fundamental analysis.</li></ul> If prices are adjusting to any new information in few minutes or hours, still it assumed to be efficient prices.<br /><ul><li>Gains made by the trading on new information is lower than the transaction costs.
Many times, arbitrage process, to bring the security to efficient prices through fundamental analysis , is not riskless. Traders do not know that when the gains would be realized. </li></ul>Example : Internet stock bubble <br />
Primary Limitations for arbitragers to correct anomalies<br /><ul><li>No guarantee about the time frame within which mispricing would be corrected.
Existence of risk as it is difficult to find two securities having same risk with mispricing
With limitation of funds, arbitragers can eliminate only significant mispricing
Restriction placed by providers of sources of funds</li></li></ul><li>Risks which justify the mispricing<br /><ul><li>Risk measurement and returns</li></ul>Sometimes, Model used (CAPM) for calculation of normal returns is flawed or beta used may not capture firms’ risk entirely.<br /> Other Factors such as firm size or price-book value tools should be used.<br /><ul><li>Strategy Risk</li></ul>Any strategy designed to exploit anomalous returns has inherent risk that strategy may not work for entire duration of the strategy or due to wide use of the same strategy, it won’t generate abnormal returns.<br />
Bias in abnormal return estimation<br /><ul><li>Data Mining Bias – </li></ul> Many relationships in data resulting purely on chance basis.<br /> Example – Relationship between returns of the stock and environmental changes <br /><ul><li>Survivorship Bias – </li></ul> While taking sample, researcher should not only take surviving companies. <br /> Example – While calculating performance of MF, only surviving <br /> MFs are considered.<br /><ul><li>Small Sample Bias –</li></ul> Inferences drawn from very small sample.<br /> Example – Inferences drawn for an industry from analysis of few <br /> companies <br /><ul><li>Non synchronous Trading</li></li></ul><li>Reasons of existence of Anomaly<br />Lack of theoretical explanation<br />If the reasons behind anomaly are not well understood, <br /> traders and arbitragers don’t try to exploit that.<br />Transaction Costs<br />Costs of the trade are greater than potential return. <br /> Costs of the trade include brokerage, bid-ask spread, <br /> impact of trade on prices etc.<br />Small Profit opportunity<br />Total profit gained by exploitation of mispricing is small – <br /> which unattractive to large funds.<br />
Reasons of existence of Anomaly<br />Trading Restrictions<br />Restrictions on some trading strategy make it impossible to exploit any anomaly. <br /> Example: restriction on Short selling at the opening of IPO<br />Irrational behavior<br />Limits on arbitragers – Previously discussed<br />(Limited capital, strategy risk, restriction by lenders of the funds etc)<br />
Why Anomalies are not profitable<br /><ul><li>Strategies that worked on average are not profitable for longer period of time.
Arbitragers have already exploited the opportunity and hence it is not profitable
Factors that caused the mispricing in prior periods are non-existent </li></li></ul><li>Introduction to Security Analysis<br />
Relative Valuation Techniques<br /><ul><li>Relative Valuation techniques based on current equity valuations in the market.
Multiples of firm can be compared with its peers of the industry.
By comparing with other firms in the industry, one can easily find under or over valued stocks.</li></li></ul><li>Present Value Technique<br />At the most fundamental level, we fall back on our Time value of money concept<br />PV = CF1/(1+r) + CF2/(1+r)^2 + ……<br />For matured dividend paying firms, dividends need to be discounted at cost of equity; <br />For high growing, non dividend paying firms, operating cash flows after tax need to discounted at WACC.<br />
Problems in Equity Valuation by PV<br /><ul><li>Uncertain Time Horizon</li></ul> No definite maturity date for stocks; indefinite investment horizon<br /><ul><li>Unknown Discount Rate</li></ul> Discount rates are not easily determinable or available; based on market interest rates and risk due to unpredictability of future cash flows<br /> Requires Analysts Judgment<br /><ul><li>Uncertain Cash flows</li></ul> Dividends not based on contract unlike coupons for bonds<br />Requires Analysts Forcast<br />
Dividend Discount Model<br />These issues are addressed through simplification of the model<br />
One Year Holding DDM<br /><ul><li>Price = Div(1)/[1+k] + Year ending price/[1+k]
Where k is required return on common equity </li></ul> k = RFR + β(Rm – RFR)<br /><ul><li>Price = Div(1)/[1+k] + Div(1)/[1+k] +Year 2 ending </li></ul> price/[1+k]<br /><ul><li>Where k is required return on common equity </li></ul> k = RFR + β(Rm – RFR)<br />Multi Year Holding DDM<br />
Required rate of return is greater than growth in dividends
Valid for mature firms which regularly pay hefty dividends
As per dividend discount model, </li></ul> Current price = Div1/(1+k) + Div1*(1+g)/(1+k)^2 + ……<br /> The equation reduces to – <br /> Current Price = Div(1)/[k– g]<br />
Growth Rate of the Company<br />Earnings would rise on funds invested back in the business. ROE would be generated on those retained funds.<br />Growth rate is firms’ earnings plough back times its ROE<br /> g = Retention Ratio * ROE<br />
Constant Growth (Gordon) Model<br />IMPACT ON STOCK PRICE<br />
Constant Growth (Gordon) Model<br /><ul><li>If we try to shuffle the formula for current price, we get the formula for k – required rate of return for investor</li></ul>k = Div (1) / current price + g(div)<br /><ul><li>Required rate of return consists of two parts– </li></ul>Div (1) / current price ---Dividend Yield<br />g(div) ---Growth in dividends<br />
Value of common stock experiencing super normal growth :<br /><ul><li> It is possible that firm may grow at higher rate than it’s required rate of return. This might be corrected in few years after which company matures and enjoys constant growth.
As assumption of Infinite DDM does not hold true here, so Gordon formula cannot be used.
At the most fundamental level, we fall back on our Time value of money concept</li></li></ul><li>Value of common stock experiencing super normal growth :<br /><ul><li>For calculating Current Price, we need to discount dividend at required rate of return till super normal growth phase and after maturation of the company, Gordon’s formula can be used.
As per dividend discount model, </li></ul> Current price = Div1/(1+r) + Div2/(1+r)^2 + ……+ <br />Div.n/(1+r)^n + Pn/ (1+r)^n<br /><ul><li>Here, Pn is computed using Gordon Model as </li></ul> Dn+1/ r – g(Div)<br />
Factors affecting Required rate of Return<br />
Factors affecting Required rate of Return<br /><ul><li>k = [(1+rfr) x (1+inflation) x (1+r(erp)] – 1 </li></ul> = (1+rf) x (1+r(erp) – 1<br /><ul><li>Required Rate of return can be approximated by taking the sum of risk free rate, inflation premium and risk premium.</li></li></ul><li>Estimating Required rate of return of Foreign Securities<br /><ul><li>Apart from risk free rate, inflation premium and risk premium, we have to add country risk premium in order to achieve the required rate of return for Foreign Securities.
Country Risk Premium is dependent on following aspects:</li></li></ul><li>Industry Analysis<br /><ul><li>Analyst Should always look out structural changes that affects the industries</li></ul>Demographics<br />Lifestyles<br />Technology<br />Policies and Regulation<br />
1. Demographics<br />Demographic factors Include-<br /><ul><li>Age distribution and population changes
Changes in political climate and government policies can affect industries significantly.
Example: Imposition of Import duties help domestic </li></ul> industries and players<br />4. Policies and Regulation<br />
Company Analysis<br /><ul><li>After analyzing various industries, next step in valuation process is Company analysis for selecting a Stock.
After picking best industries, analyst has to find the best stock. For that, he needs to analyze the fundamentals of the company, its future prospects, its intrinsic value and current price of the stock.
It’s not simple job as analyst has to analyze n number of stocks and it’s valuation is dependent on many assumptions. </li></li></ul><li>Good Stock v/s Good Company<br /><ul><li>At the end of the this step, analyst needs to find the stock which will generate excess risk adjusted returns.
Good company with strong fundamentals, high growth prospects may not turn into good investment option as everything is already priced in its current price.
So, analyst should always look for good stock which will generate high returns rather than good company.
Every time analyst should ask himself a question: Is this company valued correctly</li></li></ul><li>Defensive Company v/s Defensive Stock<br />Defensive company is company whose earnings are insensitive to the downturn in the economy.<br />These stocks have typically low business risk<br />For Example : FMCG , Pharma companies<br /><ul><li>Defensive stock is a stock that will not decline while market declines.
These stocks have low correlation with market have low betas.</li></li></ul><li>Cyclical Company V/s Cyclical Stock<br /><ul><li>Cyclical companies are the companies whose earnings are directly dependent on business cycle.
Cyclical companies generally have high business and financial risk. (High Fixed Costs)</li></ul> Example : Steel, Automobile companies<br /><ul><li>Cyclical stocks, having beta more than 1, its return changes more than the market return. </li></ul> Cyclical stocks are risky in nature. <br />
Speculative Stock v/s Speculative Company<br /><ul><li>Speculative stock is the stock which normally generate low or negative risk adjusted returns. But these stocks own low possibility of generating significantly high risk adjusted returns
Speculative companies are the companies, equipped with risky assets, having potential to earn enormous returns.
Earnings, revenues of these companies are dependent on some uncertain factors.</li></ul> Example : Oil exploration, diamond mining etc <br />
Growth Stock v/s Value Stock<br /><ul><li>Growth stock refers to company enjoying high earnings growth rate
Growth stock enjoys high multiples such as PE ratio and trade at high prices compared to its peers
Value Stock refers to the company, having strong fundamentals, still enjoys low multiples such as PE ratio, PBV multiple etc.
Many times, value stocks outperform growth stocks in long run </li></li></ul><li>Equity Valuation<br />Price Of the Stock<br />
Earnings Multiplier Model and DDM<br />As per Gordon’s Indefinite DDM,<br /> Current Price = Div(1)/[r– g]<br /> P0 = Div(1)/[r– g]<br /> Multiply both sides by forward earnings,<br /> P0/E1 = Div(1) * E1 /[r– g]<br /> PE Ratio = Div(1) * E1 /[r– g]<br />
Stock Valuation through earnings multiplier <br /><ul><li>Valuation is forward looking process. Analyst has to use his judgment and come at Forward earnings per share (EPS) and Forward PE ratio.
Forward Earnings</li></ul> Analyst is required to forecast the sales and profit margin.<br /> Estimated EPS = Estimated Sales * Estimated Profit Margin<br /><ul><li>Forward PE ratio (Can be used two methods)</li></ul>Micro-economic analysis of Earnings Multiplier<br /> Forecast Dividend payout ratio, growth rate and required <br /> rate of return and based on that calculate Forward PE ratio<br />Macro-economic Analysis of Earnings Multiplier<br /> Compare Industry and peer average and forcast Forward <br /> PE ratio<br />
Relative Valuation Techniques<br /><ul><li>Relative Valuation techniques based on current equity valuations in the market.
Multiples of firm can be compared with its peers of the industry.
By comparing with other firms in the industry, one can easily find under or over valued stocks.</li></li></ul><li>Price to Earnings Ratio<br /><ul><li>The rationale for using the P/E Ratio is that the earnings capacity per share is one of the primary determinants of the value of investment.
On the basis of the calculation of the earnings (Denominator ) P/E Ratio can be categorized as –</li></ul>Leading P/E Ratio: Next years expected earnings are taken.<br />Trailing P/E Ratio: Earnings of the most recent 12 months are taken<br />
Leading P/E Ratio= Market Price per Share<br /> Forecasted EPS for next 12 months<br />Trailing P/E Ratio= Market Price per Share<br /> EPS over previous 12 months<br />Advantages <br />P/E Ratio is popular in the investment community.<br />Empirical research shows that P/E differences are significantly related to long term stock returns.<br />
Disadvantages<br />Negative earnings can produce useless P/E Ratios.<br />Volatility in the earnings and abnormal income can make interpretation of P/E Ratio difficult.<br />Differences in the Accounting policy can hinder comparison.<br />
Price to Book Value Ratio<br /> P/B Ratio indicate the cost of investment in relation to the book value of net assets available per share as per the balance sheet.<br /> P/B Ratio= Market price per share<br /> Book value per share<br />Book Value= Common Share holders equity<br /> = Total Assets- Total Liabilities - <br /> Preference shares<br />
Advantages<br />The book value is generally positive and so can be used even when negative earnings render P/V Ratio useless.<br />Book value is more stable that EPS<br />P/BV Ratio can be used to value companies that are expected to go out of business<br />Empirical evidences show that P/BV Ratio helps to explain differences in long term average returns<br />
Disadvantages<br />P/BV does not recognize non physical assets like human capital<br />Difference in Accounting policies for valuation of assets can make comparison difficult<br />Inflation and Technological change can cause the book and the market value of the assets to change radically.<br />
Price to Sales Ratio <br /> The P/S Ratio indicates the Cost of the investment of investor in relation to the sales per share<br /> P/S Ratio= Market value per share<br /> Sales per share<br />
Advantages<br />As sales are always positive P/S Ratio can be used even in the case of distressed firms<br />Sales are difficult to manipulate unlike earnings are book value<br />P/S ratios are relatives less volatile<br />
Disadvantages<br />High growth in sales does not necessarily indicate growth in operation profits<br />Difference in revenue recognition practices can distort the forecasts<br />As only sales are considered, differences in the cost structure across companies are not considered.<br />
Price to Cash Flow Ratio <br /> The Price to Cash Flow Ratio indicates the cost of investment per unit of cash flow generated.<br /> For the purpose of the P/CF Ratio any of the following may be considered as the cash flow-<br />Cash Flow= Net income+ Depreciation+ Ammortisations<br />Adjusted CFO= CFO +Net cash interest outflow net of tax<br />Free Cash Flow available to Equity Share Holders<br />EBITDA<br />
P/CF Ratio= Market Price per Share<br /> Cash Flow per share <br />Advantages<br />Cash flows are difficult to manipulate<br />Price to cash flow is more stable than price to earning<br />Reliance on Cash Flow rather than earnings addresses the problem of the difference in the quality of the reported earnings<br />
Disadvantages<br />The definition of the term Cash Flow are not clear eg: EBITDA, FCFE<br />Some items affecting actual cash flow from operation are ignored when EPS plus non cash transaction approach is used example: change in working capital<br />FCFE can be volatile<br />