fundamental Analysys

8/14/2019 fundamental Analysys

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Fundamental Analysis

Financial Statement Analysis

Company AnalysisIndustry Analysis


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Financial statement analysismeans An analysis and interpretation of balance

sheet and Profit and Loss account

Also going through directors report,auditors report and chairmans speech etc.

We take into account last two years auditedbalance sheets, current years estimated andthe next years projected balance sheet.


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Analysis means

To find out various ingredients by way of rearranging &

regrouping of various items

Calculation of various ratios

Interpretation means

To draw conclusions on the basis of analyzedstatements

To form opinion or draw inferences about

the financial health, profitability, efficiency& other aspects of the business enterprise.


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Financial Statement Analysis

Comparison of the Financial Statements overa period of two to five years

Ratio Analysis

Inter Firm Comparison

Trend Analysis


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Financial StatementAnalysis Balance Sheet Analysis

These data would reflect the prima facieposition of the companys operations and thefinancial results of these operations

Profit & Loss Statement Analysis Cash Flow- Funds Flow Statement Analysis


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P & L A/c

Gross Sales

Net Sales Cost of Production Cost of Sales EBIT/Operating Profits Operating Expenses Financial Expenses Net Profit Non Operating Income


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P & L A/c for the yearended--- Sales Net)

Other Income

Less Cost of the Goods Sold

Gross Operating Profits

Less: Operating Expenses(Administrative,selling & distribution expenses)

Net Operating Profit (EBIDT)

Minus Interest, Depreciation & Taxes

Profit After Tax (PAT) =Net Profit


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P & L Account

Financial Expenses like interest & taxes

are deducted from gross profits to arriveat net profits.

Other non-operative income is added &non- operative expenses are deducted

out of operating profit to arrive at PBT. Non operative income arise fromsecondary activities like interest, rent &dividend received by an enterprise whosemain business is not to deal in finance,

property & investment


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P & L A/c

Other expenses arise from incidental

activities. Net provision for income tax is deducted

from EBT to arrive at EAT.

Profit appropriation i.e. dividend, transfer of

a part/full profit to various reserves. Balance remained after the appropriation is

carried to balance sheet


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Balance Sheet-

LiabilitiesCurrent Liabilities

Term Liabilities

Net Worth

AssetsCurrent Assets

Fixed Assets

Intangible Assets


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Balance Sheet as at

Sources of Funds

1. Shareholders funds

(a) Share Capital

(b) Reserves & Surplus

2. Loan Funds

(a) Secured Loans

(b) Unsecured Loans


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Continued

Application of Funds

Fixed AssetsInvestments

Current Assets, Loans & Advances: Inventories Sundry Debtors

Cash & Bank Balances Other Current Assets Loans & Advances

Less: Current Liabilities & Provisions:

(a) Liabilities (b) Provisions

Net Current Assets


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Statement of Changes in FinancialPosition

It measures the changes that have takenplace in the financial position of a firmbetween two balance sheet dates. Itsummarizes the sources & uses of funds

obtained. The changes in the financialposition could be related to differentconcepts of funds.


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Importance of SCFP

What have been the factors responsible for the

difference in owners equity , assets & liabilities of thefirm at two dates of consecutive balance sheet? What have been the premier financing & investment

activities of the firm during this period? Have long term sources been adequate to finance fixed

assets purchases?

Does the firm possess adequate WC? Why did the firm not pay dividends inspite of adequate

profits? How much funds have been generated from

operations? Has the liquidity position of the firm improved?


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Cash Flow Statement

Operating Activities Investing Activities

Financing Activities

A cash flow statement is concerned only with

cash & cash equivalents. This includes cash onhand, cash in the bank & any cash invested inshort term, highly liquid financial instruments.Accepted cash equivalents include treasury bills,commercial paper & money market funds.


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Cash Flow from OperatingActivities

The amount of cash flow arising fromoperating activities is a key indicator of theextent to which the operations of theenterprises have generated sufficient cash

flows to maintain the operating capability ofthe enterprise , pay dividends, repay loans &make new investments without recourse tothe external sources of financing.


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Cash Flow from OperatingActivities

Any cash transaction related to the companys on

going business, that is the business activitiesthat are responsible for most of the profits.Operating activities usually involve producing &delivering goods & providing services. Cash fromoperations will show the extent to which day-to

day operating activities have generated morecash than has been used.

Funds from operating activities can be broadlyclassified into two sections-how much dooperating profits contribute to funds generated

by the company & secondly how much doesworking capital drain away from these profits. ForEx:-If a company generates Rs 50 crores of fundsfrom operating profits & ploughs back Rs 70crores into WC, it is unlikely to be cash richdespite being profitable.


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Investing Activities

Investing activities are the changes to the cashposition owing to the buying & selling of non-current assets.

This includes selling & replacing equipment thatwears out or acquiring a new land or building so

that company grows. Purchase or sale of stock , bonds. Lending money& receiving payments are also consideredinvesting activities.

the cash flow from investing activities representthe extent to which expenditures have been madefor resources intended to generate future income& cash flows. This gives details of new additionsto Fixed Assets & Investments effected by thecompany


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Financing Activities

Borrowing money

Repaying money,

Issuing stock

Paying dividends.

The cash flow arising from financing activities isuseful in predicting claims on future cash flowsby providers of funds to the enterprise. Thissection provides details of Funds raised frombanks, institutions & capital markets during the

year. Repayment of loans & buyback of sharesare also shown as applications.


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Cash & Cash Equivalents

It consists of Cash on Hand & balances with

banks & investments in money marketinstruments.


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Ratio Analysis

Liquidity Ratio

Solvency Ratio

Profitability Ratio

Efficiency Ratio

Valuation Ratio


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Liquidity Ratios

The Liquidity Ratios measure the ability ofthe firm to meet its short term obligationsand reflect the short term financialstrength/solvency of a firm. Following ratiosindicate the liquidity of a firm:-

Net Working Capital Current Ratios Acid Test/Quick Ratios Turnover Ratios


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Liquidity Ratios

Current assetsCurrent ratio =

Current liabilities

Current assets InventoriesQuick ratio =

Current liabilities

Cash + Marketable securities

Cash ratio = Current liabilities


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Current Ratio

The higher the current ratio,the larger the amount of rupeesavailable per rupee of current liability,the more is the firms ability to meetcurrent obligations & the greater isthe safety of funds of short termcreditors.


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Liquidity Ratios

Net Working Capital is the excess of Current

Assets over Current Liabilities. Turnover or activity ratios measure the

firms efficiency in utilizing its assets.

Cost of goods sold or net salesInventory turnober

Average (or closing) inventoryNumber of days in the year (say, 360)

of inventory holdingInventory turnover

Credit sales or net saDebtors turnover

Days

les

Average (or closing) debtors

Number of days in the year (say, 360)period

Debtors turnoverCollection


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Liquidity Ratio

Creditors Turnover Ratio & Credit Collection

Period

Creditors Turnover Ratio= Net Credit Purchases/Average

Creditors

Net Credit Purchases= Gross Credit Purchasesless returns to suppliers Average Creditors=Average creditors outstanding

at the beginning & at the end of the year Low turnover ratio indicates liberal credit terms

granted by the suppliers while a high ratioindicates that the accounts are to be settledrapidly.

Credit Collection Period= No. of Days/Months in ayear/Creditors Turnover Ratio

L /C it l St t


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Leverage/Capital StructureRatios measure the dependence of a firm on

borrowed funds.

DebtDebt-equity ratio

Equity (Net Worth)

Debtratio

Debt Equity employed

Earnings before interest and taxcoverage

Interest

DebtDebt

Capital

Interest

L /C it l St t


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Leverage/Capital StructureRatios Debt to Capital ratio=Long Term

Debt/Permanent Capital Debt to Total Assets Ratio=Total Debts/Total

Assets

Total Assets= Long Term Debt+

Shareholder's Equity+ Current Liabilities Permanent Capital= Shareholders Equity +

Long Term Debt

Dividend Coverage Ratio

Debt Service Coverage Ratio


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DSCR

Debt Service Coverage Ratio

EBDIT/Interest+Debt Repayment per annum

OR

PAT+Depreciation+Interest/Interest+DebtRepayment

In the second formula,Debt Repayment willbe grossed up for tax impact.

This ratio is useful in predicting sickness.If

DSCR is inadequate, the probability of thecompany turning sick is very high.


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Dividend Coverage Ratio

This ratio measures the ability of the firm to

pay dividend on preference shares, whichcarry a stated rate of return

Earnings After Tax/Preference Dividend

This reveals the margin of safety available to

the preference shareholders. The higher thecoverage, the better it is from their point ofview.


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Profitability Ratios

Profitability ratios measure a firms overallefficiency and effectiveness in generatingprofit.

before interest and tax (PBIT)Margin

Net salesafter tax (PAT)

marginNet sales

PBITreturn on investment

Net assetsProfit after tax

on equityEquity (net worth)

Profit

ProfitNet

Before tax

Return

P fit bilit R ti R l t d t


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Profitability Ratios Related toSales These ratios consist of:-

1.Profit Margin

2.Expenses Ratios


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Profitability Ratios

Related to Sales( Operating Margin Vs NetProfit Margin)

Related to Investments (ROCE Vs RONW)


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Profit Margin

Gross Profit Margin=(GP/Sales) * 100

Gross Profit Margin=(Sales-Cost of the GoodsSold)/ Sales *100

Net Profit Margin

Operating Profit Ratio= EBIT/Sales

Net Profit Ratio = EAT/Sales


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Expenses Ratio

The Term expenses includes:-

Cost of the Goods Sold

Administrative Expenses

Selling & Distribution Expenses

Exclusive of financial expenses like interest,taxes, dividends & extraordinary losses dueto theft of goods, goods destroyed by fireetc.


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Expenses Ratio

There are different variants of expenses

ratios. They are:-Cost of the goods sold ratio

Operating Expenses Ratio

Administrative Expenses Ratio

Selling Expenses RatioOperating Ratio

Financial Expenses Ratio


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OPM Vs NPM & ROCE VS RONW

Operating Profit Margin is a Business levelratio whereas Net Profit Margin is ownerlevel ratio.

OPM reflects business level (Marketing &

Operations) efficiency whereas NPM reflectsfinancial

Similarly, Return on Capital Employed(ROCE)is gross level OR Business level ratiowhereas Return on Net Worth is owner level

ratio.


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ROCE Vs RONW

ROCE = PBIT/CE

CE= Net Worth + Debt ie total moneyinvested in the business.

RONW = PAT/NW= Profit after Tax/Net Worth

NW= Capital + Reserves

Profitability Ratios Related to


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Profitability Ratios Related toInvestments

Return on Assets

Return on Capital Employed Return on Shareholders Equity

Earnings per Share

Dividends per Share

Dividend Pay-out Ratio

Earnings Yield

Dividend Yield

Price Earning Multiple


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Valuation Ratios

Equity-related ratios measure theshareholders return and value.

Profit after taxEPS

Number of ordinary shares

DPSNumber of ordinary shares

DPSratio

EPS Pr after tax

DPSyieldMarket value per share

Dividends

DividendsPayout

ofit

Dividend


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Valuation Ratios

EPSEarnings yield

value per share

value per shareP / E ratio =

EPS

Net worth

value per share Number of ordinary shares

value per shareM Bvalue

Book value per share

Mar'

Market

Market

Book

Market

Tobin s q

ket value of assetsEconomic value of assets

Other Important Ratios (Valuation


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Other Important Ratios (ValuationRatios)

PEG Model Price to Cash Profit Multiple= MPS/CEPS

Cash Earning Per Share= PAT + Depreciation_____________________

No. of Shares

Enterprise Value to EBIDTA MultipleEnterprise Value= Market Capitalization of

Equity + Book Value of Debt CashEquivalents

P/E Multiple Vs Enterprise Value /EBIDTA

MultipleWealth Creation Ratio=Market to Book

Value Ratio.


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EV/EBIDTA

Enterprise Value by EBIDTA.This ratio tells

what the market is willing to pay for everyoperating rupee earned. This brings into playthe markets perception, which would placevalue on intangibles, future potential, qualityof management amongst other factors


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DU Pont Analysis

This analysis developed by DO Pont of the USbelieves that the company should strive toincrease its Return on Net Worth (Returns toShareholders). This analysis attempts tobreak down this return on Net Worth into

three basic components. RONW= PAT/NW. This is broken down into:- RONW=PAT/Sales *Sales/CE * CE/NW The first leg indicates Profitability The second leg indicates Efficiency The third leg indicates Solvency/Gearing


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Utility of Ratio Analysis

Assessment of the firms financial conditions

and capabilities. Diagnosis of the firms problems, weaknesses

and strengths. Credit analysis Security analysis Comparative analysis Time series analysis


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Shareholder Value Creation

Economic Value Added

Market Value Added

Corporates are implementing strategiesdesigned to improve EVA.

Recent rankings of the companies are basedon their market capitalisations rather thansales & assets which used to be the basessome years ago


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EVA

EVA = Net Operating Profit AfterTaxes(NOPAT)-Cost of CapitalEmployed(COCE)

NOPAT = Profits after depreciation & taxesbut before interest costs. NOPAT thusrepresents the total pool of profits availableon an ungeared basis to provide a return tolenders & shareholders.

COCE = Weighted Average Cost of Capital(WACC) * Total Capital Employed

Weighted Average Cost of


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Weighted Average Cost ofCapital Cost of capital includes Cost of Debt Capital,

Cost of Equity Capital & Cost of PreferenceShare Capital. WACC is worked out on posttax basis.

The mix of Debt & Equity Capital has a vitalrole in determining the cost of capital. EquityCapital is generally more costly than DebtCapital.

While liberal use of debt capital reduces thecost of capital, it increases the risk element

in the company & indirectly increases thecost of equity.Debt Equity mix should alwaysbe aimed at considering the trade-off inbetween risk & return.


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WACC

The following steps are involved for calculatingthe firms WACC: Calculate the cost of specific sources of funds Multiply the cost of each source by its

proportion in the capital structure. Add the weighted component costs to get the

WACC


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What does EVA Show?

EVA is residual income after charging thecompany for the cost of capital provided bylenders & shareholders. It represents thevalue added to the shareholders bygenerating operating profits in excess of thecost of capital employed in the business.


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When will EVA Increase?

EVA will increase if:

a Operating profits can be made to growwithout employing more capital i.e greater

efficiency.b. Additional Capital is invested in projectsthat return more than the cost of obtainingnew capital i.e profitable growth.

C. Capital is curtailed in activities that do

not cover the cost of capital.

k l dd d( )


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Market Value Added(MVA)

MVA is determinant of the premium the

market is willing to place on the companysvalue in recognition of its earnings potential.

MVA of a company depends upon its past,present & future performance

MVA= Current Market Value of Debt & Equity Economic Book Value

Economic Book Value= Share Capital+FreeReserves+Debts

k l dd d


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Market Value Added

MVA is the definitive measure of wealth

creation because it captures the marketsassessment of the effectiveness with which acompanys managers have used the scarceresources under their control.

It also reflects how well management haspositioned the company for longterm,because market value incorporates thepresent value of the expected long run netcash flows/outflows

C f C i l


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Cost of Capital

The Cost of Capital is the minimum required

rate of return expected by the providers offunds.

Cannot be calculated with precision.

C t f C it l


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Cost of Capital

Concept

Cost of Equity(Dividend Discount &CAPMModel)

Cost of Debt

Cost of Preference Capital

Weighted Average Cost of Capital

Significance of the Cost of


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Significanceof the Cost ofCapital

Evaluating investment decisions,

Designing a firms debt policy, and

Appraising the financial performance of topmanagement.

W i ht


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Weights

Book Value Reported Value in Books ofAccounts.

Market Value--- Market Capitalization Valueof each source of Finance

Those sources of Finance which are notquoted, Book Value is used.

Why would you use Market Value? Book Value is historical in nature & hence not

relevant

Market Value captures expectations of theproviders of funds.

C t f E it C it l


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Cost of Equity Capital

Is Equity Capital Free of Cost? No, it has an opportunitycost.

Cost of Internal Equity: The DividendGrowth Model

Normal growth

Supernormal growth

Zero-growth

C t f E it C it l


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It is the return expected by shareholders who

choose to invest in a particular companysequity. Equity Capital & accumulatedreserves & surpluses which are free to equityshareholders carry the same cost becausethe reserves & surplus are created out of the

appropriation of profit, that is, by retentionof profit attributable to equity shareholders.

It is important to understand the concept ofBeta, for calculating the Cost of Equity

Capital

B t


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Beta

Beta is a relative measure of volatility that is

determined by comparing the return on ashare to the return on the stock market as awhole.

In simple terms, the greater the volatility,the more risky the share & the higher thebeta.

If a company is affected by themacroeconomic factors in the same way asthe market, then the company is likely to

have a beta of one & will be expected togenerate returns equal to the market.

B t


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Beta

A company having a beta of 1.3 implies that

if stock market increases by 10 %, thecompanys share price will increase by 13 %& if stock market decreases by 10 %, thecompanys share price will decrease by 13%



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Cost of External Equity: The DividendGrowthModel

EarningsPrice Ratio and the Cost of Equity

The Capital Asset Pricing Model(CAPM)


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(CAPM)

As per the CAPM, the required rate of return onequity is given by the following relationship:

Equation requires the following three parametersto estimate a firms cost of equity:

The risk-free rate (Rf)

The market risk premium (Rm Rf)The beta of the firms share ()

Limitations of CAPM


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It is based on unrealistic assumptions

It is difficult to test the validity of CAPM Betas do not remain stable over time.

It is very difficult to find a risk free security.

It is unlikely that the Govt. will default, butinflation causes uncertainty about the realrate of return.Further, investors might nothold well diversified portfolios or the marketindices may not be well diversified.

Beta Estimation


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Beta Estimation

The ratio of covariance between marketreturn and the securitys return to themarket return variance:

2

Covar=

Cor = = Cor

j, m

jm

j m j, m j

j, m

m m m

Beta Estimation


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Beta Estimation

The Market ModelIn the market model, we

regress returns on a security against returnsof the market index.

Security Market Line


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Security Market Line

For a given amount of systematic risk Beta,SML

shows the required rate of return. A securitysbeta of 1 indicates systematic risk equal to theaggregate market risk & the required rate on thesecurity will be equal to the market rate ofreturn.

If the securitys beta is greater than 1, then itssystematic risk is greater than the aggregatemarket.This implies that the securitys returnsfluctuate more than the market returns.

A security of Beta less than 1means that the

securitys risk is lower than the aggregate marketrisk. This implies that the securitys returns areless sensitive to the changes in the marketreturns.

Beta Estimation in Practice


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In practice, the market portfolio is

approximated by a well-diversified shareprice index. We have several price indicesavailable in India.

There is no theoretically determined timeperiod and time intervals for calculatingbeta. The time period and the time intervalmay vary.

The returns may be measured on a daily,weekly or monthly basis. One should have

sufficient number of observations over areasonable length of time.



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The return on a share and market index may

be calculated as total return; that is, dividendyield plus capital gain.

One may calculate the compounded rate ofreturn as shown below:

rj = log[Pt Pt -1] = log[Pt /Pt -1

Summaries of Regression Parameters


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for Company X Vs. Market Returns

Alpha (intercept) 0.0061

Standard error of alpha 0.0038

Beta 0.7479

Standard error of beta 0.1107

Correlation 0.6635Coefficient of determination 0.4402

F-statistic 45.6143

Significance 0.0000Market HLL

Average return0.00046 0.00647

Variance of returns 0.00115 0.00149

Variance 0.00086

Does Beta Remain Stable Over


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Time? Betas may not remain stable for a company

over time even if a company stays in thesame industry. There could be severalreasons for this. Over time, a company maywitness changes in its product mix,technology, competition or market share.

Risk


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Risk

Company Specific Risk

Market Risk Co. specific Risk will include all those risk factors

which would affect one company or set ofcompanies in an industry. Govt. Policy, ExciseDuty Change, Technology

Valuation Models


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Valuation Models

Dividend Discount Model

Free Cash Flow Approach Contemporary Concepts & their Application

Enterprise Value & Earnings

Industry Analysis


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Industry Analysis

Industry Characteristics Importance to the Economy Criticality for Customers Nature of Producers

Cyclicality in Supplier & User Industries

Govt. Policies Regulation Subsidies Export Incentives Customs & Excise Duties

Demand/Supply Dynamics

Competitive Forces


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Competitive Forces

Competition Among Domestic Players

- Number of Players- Relative Market Shares

- Demand-Supply

- Cartelisation & threats therein

- Unorganized Sector Competition

Threats of Imports/Substitutes


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Threats of Imports/Substitutes

Global Demand Supply Dynamics

Relative Cost Structure;International &Domestic

Availability of Substitutes

Economic Feasibility of Substitutes

Entry Barriers


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Entry Barriers

Capital Intensity

Technology Availability Regulatory Issues

Demand & Supply

Existence of strong players

Industry Financials


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Industry Financials

In Industry Analysis, other key factors to be looked intoby the analyst are:-

Past sales & earnings performance Industry Share Prices Relative Earnings per Share Operating Margins Return on Capital Employed

Earnings Growth Analysis of Fixed Costs Industry Peculiarities-seasonality, stocking

requirements, debtors etc. P/E Ratio Trends

Industry Indices

Company Analysis


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Company Analysis

Annual Reports

Chairmans Speech to its investorsThe Managements views on the current

performance of the company

Performance after the year end

The backdrop of the economy & industry in which

the company operatesFuture Plans

Difficulties faced by the company along withmeasures to tackle them

Future Prospects

Directors Report


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Directors Report

The State of the Companys Affairs

The amounts which it proposes to Carry tothe Reserves

The amount which should be paid by way ofDividend

Material Changes & commitments, if any,affecting the financial position of thecompany which have occurred in between

The conservation of energy, technologyabsorption, foreign exchange earnings &

outgo.

Auditors Report


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Auditors Report

This is a statutory report testifying the

correctness of the accounts & giving theircomments on the accounting practices &procedures of the company. The real position ofthe companys operations is known from thefootnotes to the accounts & the comments of theAuditors.

Analysts should examine carefully thesenotes & the Auditors Report to make anycorrect assessment of the valuation of ashare

Why Study Economics?


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Why Study Economics?

Harry S. Truman (33rd President of the UnitedStates) once asked his advisors to find him aone-armed economist. When asked, Why?,

Truman replied, So he cant say, On the onehand and on the other....

What can Economics help us


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understand?

Macro questions How are interest rate and exchange rates determined? What determines national income? How do we measure productivity? What determines the wealth of nations?

Micro questions How are markets organized? How are prices determined?

How do we measure inflation? How do demand and supply operate in product,

financial and labor markets?

Why do we care?


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Why do we care?

Maybe we wont be better at prediction but we

will understand the dynamics of the market andhow we can read Expectations

Understanding how and why nations succeed orfail will help us understand their real andfinancial interactions

Markets have undergone major transformationsin recent years, we may be able to anticipatefuture developments

It will be easier to analyze companies,governments and financial institutions if we

understand the dynamics of supply and demandand the structure of the markets in which theyoperate

A look @ the Indian Economy


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A look @ the Indian Economy

Trends in GOI Yield Curve

Trends in Exchange Rate Trends in 6 M Premiums(%)

Monthly Increase in Forex Reserves

Likely Trends in Inflation

Trends in FII Flows Trends in Commodities(Oil Prices, Gold &

Silver)

Equity Classes


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Equity Classes

Growth and value

Active and passive Large and small cap

Cyclical vs defensive stock

Stock selection

- P/E ratio- Dividend yield

Fundamental analysis

Technical analysis

Equity Markets and MutualF d


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Funds Equity stocks can be classified as large cap, mid cap

and small cap

Market cap = Market Price per share X No of sharesoutstanding

Large cap stocks are traded everyday in large volumes;hence highly liquid but these are establishedcompanies offering normal profit potential

Small cap stocks provide higher return potential butare generally not very liquid

Cyclical stocks are those whose performance is closelylinked to macro economic factors; eg. cement stockswhich are linked to infrastructure development in thecountry

The P/E ratio (Market Price Per Share / Earnings PerShare) indicates the price the market is willing to payper rupee of companys earnings (or potentialearnings)

Higher P/E ratio indicates growth stock; value stockshave generally lower P/E ratios



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Funds The investment pattern of a fund is primarily dictated

by the fund objectives

Growth investing is a style which is aggressive and thefund manager is willing to invest in companies whichmay be expensive but have high future profit potentialas well; fund manager focuses on sectors which are

expected to do well in future, and even be willing tobuy them at higher prices

Value Investing is a style where the fund managerprefers investing in companies which are undervalued

today; he will buy only if the price is right; his focus ison companies which have a value proposition that isyet to be recognized by the market



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Funds So, by definition

P/E Ratio is Market Price Per Share / Earnings perShare, and;

Dividend Yield is defined as Dividend Per Share /Market Price Per Share

If market price moves up, P/E ratios are higher

and Dividend Yield is lower If market prices move up, P/E ratios are lower and

dividend yield is higher


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Fundamental Analysis is the analysis of the profit

potential of a company, based on numbersrelating to its products, sales, costs, profits andmanagement of the company

Technical Analysis is the analysis of the marketprices and trading volumes data to identify clues

to market assessment of a stock A fund manager focuses on asset allocation, asecurities dealer buys and sells shares and ananalyst researches and recommends them forbuying and selling


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An active fund manager hopes to do better than

the market by selecting companies which hebelieves will outperform the market

A passive fund manager simply replicates theindex, and hopes to do as well as the index

A passive fund manager tries to keep costs down

and has to rebalance his portfolio if thecomposition of the index changes

Types of Equity Instruments


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yp q y

Ordinary Shares

Preference Shares Equity Warrants

Convertible Debentures

pproac es o or o oManagement & Role of


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gSecurities Research Passive Fund Management: Index Funds

Active Fund Management

Fundamental Analysis

Technical Analysis

Quantitative Analysis

Successful Equity PortfolioManagement


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Management Set realistic target returns based on appropriate

benchmarks Be aware of the level of flexibility available while

managing the portfolio

Decide on an appropriate investment philosophy,I.e whether to capitalize on economic cycles, or to

focus on growth sectors or on finding valuestocks

Develop an investment strategy based on theinvestment objective, the time frame forinvestment & economic expectations over this

span Avoid over-diversification to maintain focus &

facilitate sound tracking

Develop a flexible approach to investing

Fund Selection


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Equity funds: Characteristics

- Fund category Suitability to investor objective

- Investment style

Growth vs Value

- Age of the fund

Experience preferred to new fund- Fund management experience

- Size of the fund

Larger funds have lower costs

- Performance and risk

Equity Funds Selection Style


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q y y

Percentage holding in cash.

Concentration in portfolio. Market capitalisation of the fund.

Portfolio turnover.

Risk Statistics

- Beta

- Ex-Marks

- Gross dividend yield

- Funds with low beta, high ex-marks and high gross

dividend yield is preferable

Equity Price Risks


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q y

Company Specific

Sector Specific Market Level

Company specific risks have to be researched& assessed by the funds analysts & portfolio

managers. Holding a large, say 15/20 shareportfolio generally balances out & diversifiescompany specific risks.

Specific sector funds have more risks. Fundsresearch & track the sectors with good

potential. The more the number of sectors ina portfolio, the less is the portfolios sectorrisk

Market Risk


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Market Risk is not diversifiable as it arises

from broad economic & other factors.Managers try to anticipate bear or bullphases & try to adjust their portfolio assetallocation. If equity index futures & optionsare available, managers try to hedge their

portfolios with these instruments.

Market Cycles


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These are extensively researched & analysed

in the U.S by agencies such as Lipper. In India, independent agencies, brokers &

newspapers are doing some of this analysis.It is important to see how a portfolio or ashare performs over a well defined cycle than

over some arbitrary calender period. Equity investments are basically more

rewarding in the long term.Any equity fundcan be more risky as a short term

investment. Sticking to a good fund helps.

Risk Measures


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Risk defined as volatility, is measurable by

the statistical concept of StandardDeviation(SD)

SD measures the fluctuations of a fundsreturns around a mean level.Use monthlyresults of an equity fund. Tabulate returns.

Calculate mean returns. Calculate variancesof each months returns from the mean.Square these numbers. Sum up. Divide by theno. of periods of observations. Computeoverall variance or the standard deviation.SDgives an idea of how volatile the earningsare.

Standard Deviation


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SD can be computed for both equity & debt

funds.SDs of different funds can becompared with each other, or with SD of amarket index or even that of anothercategory.

SD is the best measure of risk, though it is

based on past returns.It is broader conceptthan beta. It measures total risk & not justmarket risk.It is an independent number.

Risks of both specialized & diversified funds

& both equity & debt funds are measurablewith SD

Standard Deviation


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Measures the absolute risk of a portfolio byexplaining the dispersion of return around themean

It explains the extent of deviation from the meanreturn of a portfolio

It is the preferred measure of risk in a portfolio

Higher SD implies higher portfolio risk.

Beta Coefficient:


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this measures the extent to which fund returnsare impacted by market factors;

Higher beta means higher impact of marketreturns hence more risky

Lower beta means less risk.

Beta Coefficient


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Beta relates a funds return with a market index& measures the sensitivity of the funds return tochanges in the market index.

A beta of 1 means the fund moves with themarket. A beta of less than 1 means the fund willbe less volatile than the market,typically in caseof conservative portfolios

Higher Beta portfolios give greater returns inrising markets & are riskier in falling markets.It isa good measure of fund risk level

Beta is based on past performance, so it does notnecessarily indicate future performance

Funds with specialized portfolios cannot beassessed by betas based on overall market index

Bogles Ex-marks or R-Squared:


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measures return from a fund and the returnsfrom a market index and measures the extentof correlation in their movement;

R-squared of an index fund would be 1 or ex-marks would be 100%;

lower ex-marks means lower correlation orsympathy with market returns;

a fund's risk can be gauged by its ex-marks incomparison with the market index

Quality of beta depends on ex-marks.

ExMarks or R-Squared


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This is used to help spot questionable betas.

R-squared measures how much of a fundsfluctuations is attributable to movements inthe overall markets from 0 to 100 %

An Index Fund will have ExMarks of nearly100 %.Non-Diversified funds will have lower

ExMarks To be meaningful,the fund being evaluated

should have some correlation with themarket. A low beta fund with very low R-

squared/ExMarks is least risky;but not so ifthe fund is a Gold Fund, with little relation tostock markets

Risk Adjusted Return


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The differential return earned by the fund

manager may be due to difference in theexposure to risk. Hence it is imperative toadjust the return for the risk. There areessentially two major methods of assessingrisk-adjusted performance:

Return per unit of risk Differential Return(Alpha)

Risk Adjusted Return


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Returns must be evaluated on a risk-adjustedbasis

Higher return may be accompanied by higherrisk

Compute return and risk for both for fundand benchmark and find out return per unit

of risk, earned by each of them Eg. benchmark return (12%) and S.D. (9%) Fund return (16%) and risk i.e. SD (11%) Then the benchmark has return per unit of

risk of (12/9)1.33 and the fund has return per

unit of risk of (16/11) 1.45 Hence, on a risk adjusted basis, the fund has

performed better than the benchmark

SHARPE & TREYNOR RATIO


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Sharpe Ratio is a measure of risk-adjustedperformance of a fund by measuring the returnper unit of Standard Deviation

Sharpe Ratio = (R-Rf)/SD

Treynor ratio is a measure of risk-adjusted returnby measuring the return per unit of beta (market

risk) Treynor Ratio = (R-Rf)/b

Sharpe Ratio is useful to understand a singlefunds performance

Treynor ratio is useful for comparison of multiple

funds

Portfolio Turnover


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Portfolio turnover refers to churn

Portfolio turnover is the ratio of amount of salesor purchases (whichever is lesser) / net assets ofthe fund

Higher the portfolio turnover, greater the amountof churning of assets done by fund manager

If portfolio turnover is 200%, it means that on anaverage every investment is held for a period of 6months

Higher turnover rate also means highertransaction costs. This ratio is relevant for

actively managed equity portfolios


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Comparisons are usually done

With a market index With funds from peer group

With similar products in which investors puttheir funds

When comparing fund performance with peer

group, size and composition of the portfoliosmust be comparable

Tracking Error


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In order to obtain the same returns as the

index, an Index Fund invests in all of thestocks included in the index calculation, inthe same proportion as the stocksweightage in the index.

An index funds actual return may, however

be better or worse by the tracking error. The tracking error arises from the practical

difficulties faced by the fund manager intrying to always buy or sell stocks to remainin line with the weightage that the stocksenjoy in the index.

Active Equity Funds


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Selection of appropriate benchmark is

required to compare the returns of an equityfund to the returns on benchmark, usingappropriate market index.

The appropriate index to be used to evaluatea broad based equity fund should be decided

on the basis of the size & composition of thefunds portfolio

If the fund has a large portfolio, a broadermarket index like BSE 100 or 200 or NSE 100may have to be used as the benchmarkrather than S & P CNX Nifty or BSE 30

as s o oos ng anAppropriate PerformanceB h k


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Benchmark 1. The Asset Class it invests in: An equity

fund has to be judged by an appropriatebenchmark from the equity markets, a debtfund performance against a debt marketbenchmark & so on. And

2 The funds stated Investment Objective: If a

fund invests in long term growth stocks, itsperformance ought to be evaluated against abenchmark that captures growth stocksperformance.

Choosing Market Benchmarksin Practice


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in Practice Agencies such as Credence prefer the BSE

200 because of its broad-based nature. For sector funds, the S & P CNX Sectoral

Indices have been preferred

India Index Services Ltd, Index ServicesDivision of BSE or other exchange

Debt Funds


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1. I-SEC : Its I-Bex index is often used bysome analysts as a benchmark to trackgovernment securities performance. Thereare 4 indices- Li-bex that tracks thesecurities with long maturities over 7 years,Mi-Bex tracking maturities between 3 & 7years, Si-Bex tracking short maturities of 1-3

years & a Composite Index that is theaverage of all three maturities.

2. CRISIL: has 8 debt indices,4 primaryindices that track the prices of underlyingsecurities & 4 derived indices based on the

primary indices. Primary indices cover AAA &AA rated securities, and Call Market &Commercial Paper

Derived Indices


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Liquid Funds Index : This tracks the returns

on Call Market & Commercial Paper; Balanced Fund Index: This tracks the returns

on Nifty Index for equity & CRISIL CompositeBond Fund Index for debt. The CBFI in turntracks returns on Call,Govt.Securities, AAA &

AA securities & CP.

Debt Funds


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3. NSE : has designed a Government

Securities Index & a Treasury Bills Index.These indices track either

a. Market price movements( capital gains orlosses) that are a mirror image of yieldmovements,and are called Principal Return

Index; or b. Both interest accruals and capital gains

or losses, the so called Total Return Index

In any case, any benchmark for a debt fund

must have the same portfolio composition &the same maturity profile as the fund itself,to be comparable

Money Market/Liquid Funds


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Liquid Funds have portfolios of short term

instruments.Hence performance is usuallybenchmarked against the governmentsecurities of appropriate maturities. In India,besides NSE, J.P Morgan has also developed aTreasury Bill Index.I-BEX, being a composite

index is not suitable for liquid funds. A better benchmark for MM funds in India is

either the Liquid Fund Index of CRISIL orNSEs G-Sec & T-Bills indices

Criteria for Peer GroupComparisons


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p The investment objectives & risk profiles

Portfolio Composition Credit Quality & Average Maturity

Fund Size

Expenses Ratios

Advance/Decline Issues Ratio (A/DIssues Ratio)


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the advance/decline issues ratio (AD issues ratio)is one of the most widely followed measures of

market breadth; it can also be used as a measureof market strength (market momentum).

The formula for calculating the A/D issues ratio issimple:

A/D Ratio (Issues)=Advancing Issues/Declining

Issues The AD issues ratio is applied as follows: 1. Values higher than 1 show that more issues

are presently advancing than declining; 2. Values between 0 and 1 indicate that more

issues are currently declining in price.

Advance/Decline Issues Ratio (A/DIssues Ratio)


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The A/D ratio has an absolute value that does notvary in function of the number of components

being analyzed it remains constant, regardlessof the number of stocks under consideration. Thisis a big advantage, especially when analyzingentire stock exchanges, where the number oftraded issues changes constantly. The other keyadvantage of using the A/D ratio is that it easily

allows comparisons among different indexes orstock exchanges. For instance, comparing the A/Dratios of the DJI and the NYSE is much easier thanevaluating the A-D lines for the NYSE (which canrange from 0 to over 3.600) and the DJI (it has amuch smaller range: from 0 to 30).

What is put call ratio (PCR)?


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Put call ratio (PCR) can be judged for aparticular stock or index or all the availableoption stocks. In the Indian stock marketcontext investors generally talk more about

the PCR of nifty which can be found by thetotal number of nifty puts divided by totalnumbers of nifty calls (Nifty Puts/ NiftyCalls). The data can be available from theNse site. PCR ratio has not been able to give

clear guidance of the trend of Indian stockmarket.

fundamental Analysys

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