sapm - equity

FinancialMarkets –EQUITY

Viswajyothi School ofManagement Studies

NJ Jaissy

Objective: (Module 3)Understand Share valuation , factors affecting shareprice movementsLearn of the various Valuation models: Cash flow &Price : Earnings modelsIntroduction to Fundamental Analysis (versusTechnical analysis)

EconomyIndustryCompany

References: SAPM texts byPunithavathy PandianPrassana Chandra

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What is a share?Represents a Form of ‘ownership’ in the

companyA means of the company raising funds fromthe public ( versus loans or debt’Investors have a varied rate of return – basedon how the company does ( unlike bondswhich give fixed returns)Higher returns associated with higher risk – ifthe earnings are good - higher payouts!Share owners have last recourse tocompany’s assets in the event of bankruptcy

Discussion: What factors would affect a company’s share price?

SHARE VALUATION

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Share ValuationEssentially computing the value of a share. Twomodels:

Using the discounted Cash flow methodHere we find the ‘present’ value of all future returns (dividends) & price gains – similar to how we would pricea bondModels vary depending on the growth rates of dividendsat various stages

Using the Multiplier (P/E)ratio methodPrice : Earnings ratio gives a method to compare onecompany / stock with anotherUseful since prices of different companies varyUseful in evaluating companies that don’t pay dividend

SHARE VALUATION

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Holding period returnThis is the total returns during a particularperiod ( say 1 year)

Return = Price change + Cash dividendPurchase Price

SHARE VALUATION

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Holding period returnMaruti Suzuki’s share price on 1 April 2011was 1271.1 and the price on 9 March 2012was Rs 1341.9. The dividend received wasRs 7.5. What is the holding period rage ofreturn? What is the dividend yield andcapital yield?

SHARE VALUATION

R = (P2-P1)+ Dividend R = (1341.9-1271.1)+ 7.5 = 0.0616P1 1271 = 6.16%

Dividend yield = 7.5/1271 *100 = 0.59%Capital gain yield = (1341.9 – 1271.1)/1271.1 *100 = 5.57%NJ Jaissy

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QuestionA stock is now selling in the stockexchange at $ 24. It pays a dividend of $2p.a. You plan to sell it after 3 years. In 3years the price is expected to go up to Rs25. Discount rate is 11%. What is the valueof the stock?

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Expected Return/Anticipatedreturn

Here we have probabilities of each of therates of return.The expected rate of return is theweighted rate of return where weights =probabilities

SHARE VALUATION

Return ( %) - R Probability (P) R*P ( Expected)10 0.1 111 0.2 2.112 0.4 4.8

Expected rate of return % = 7.9 NJ Jaissy

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1.Dividend Discount model:Single Period

There are single period & multi-periodmodelsEssentially we discount the future cashflows ( similar to how we value a bond)Single period:

Po = D1 + P1(1+r) (1+r)

SHARE VALUATION

P1 = Selling price at the end of 1 yrD1 = Dividend received in the 1 yrR = Investor required rate of return

Po = Present selling price (currentvalue)

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1.Dividend Discount model:Multi Period

Investor may hold the shares for severalyearsThere are several models: constantgrowth, Two stage growth, three phasemodelPo = D1 + D2 +D3 +….. Pn

(1+r) (1+r)^2 (1+r)^3 (1+r)^n

SHARE VALUATION

Pn = Selling price at the end of n yearsD1 /2/3 = Dividend received in yr 1/2/3R = Investor required rate of return NJ Jaissy

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a) Constant growth model(Gordon Model)

Dividends are assumed to grow each year at aconstant growth. ( Growth rate = g)

Po = D(1+g) + D(1+g)^2 + D(1+g)^+.. D(1+g)^n(1+r) (1+r)^2 (1+r)^3 (1+r)^n

When the period approaches infinity the equationbecomes: ( assuming company will grow & paydividends consistently)Po = D1

( r – g)

Dividend discount model

Where D1 = next year dividendg= rate of growthr = required rate of returnNJ Jaissy

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Theoretical or Intrinsic value vsMarket value

Theoretical value = intrinsic value =computed value

If intrinsic price > market price… stock isundervalued….. BUYIf intrinsic price < market price… stock isover valued….. SELLIf intrinsic price = market price… stock isfairly valued….. HOLD

SHARE VALUATION

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Question: 1A company’s next year dividend per share is expected to

be Rs 3.50/ The dividends in subsequent years areexpected to grow at a rate of 10% p.a. IF the requiredrate of return is 15%. What should be the price?

If the market price = Rs 75, what would your advice be tothis investor?


Po = 3.5 / ( 15% = 10%) = Rs 70 which is < Rs 75. Thestock is over valued – Do NOT buy!

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Question 2The earnings of Ramesh Engg Lts isexpected to grow at the rate of 6% p.a.The dividend expected on Ramesh’equity share a year hence is Rs 2. This toowill grow at 6%. What price will you put onit if the required rare of return for this shareis 14%?


Po = D1 (R-G) = 2/(14% - 6%) = Rs 25

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b) Two Stage growth modelThis model assumes very high ( or low) growth for acertain period and then constant growth

(Question: Which industry is currently going through thisphase?)Po = Do(1+g1) + Do(1+g1)^2+..Dn(1+g1)^n+ Dn+1 * 1

(1+r) (1+r)^2 (1+r)^n (r-g2) (1+r)^n

= Sum from 1 to N Do(1+g1)^n + Dn+1 * 1(1+r)^n (r – g2) (1+r)^n


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Question 3The current dividend on an equity share of Vertigo ltd is Rs2. Vertigo is expected to enjoy an above normal growthrate of 20% for a period o 6 years. Thereafter the growthrate will fall and stabilize at 10%. Equity investors require areturn of 15%. What is the intrinsic value of the share?

Two Stage growth model

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c) Three phase modelThree phases of dividend growth:

Dividend grows at rate of ‘ga’ for ‘A’ yearsAfter phase A, dividend declines linearlyAfterwards there is constant growth ‘gb’

Po= Do ( 1+G) + Dt-1(1+Gb) + Gb (1+Gb)(1+r) (1+r) r – g( 1+r)t bt - 1

A

t=A + 1

B

Three phase growth model

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Three phase model

Phase 1 (A)

Phase 2 (B)

Phase 3

Ga

Gb

Time

Growth

Three phase growth model

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2) Valuation - P : E RatioUsed to compare prices of stocks which havedifferent earnings per shareUsed to evaluate companies that don’t paydividend but have earningsUse to find the relative positions of differentstocks – but don’t indicate which price is‘correct’P/E ratio a function of payout ratio, growthrate.. ( higher payout ratio , growth rate –higher P/E ratio)

P = dr - g

P/E = d/er - g

d/e = payout ratio

P: E model

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FUNDAMENTAL ANALYSISAnalysis of fundamental variables thataffect the stock market:

Economic AnalysisIndustry AnalysisCompany Analysis

E I C

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Economic Analysis (E of EIC

Economic Factors

Economic factors affect corporate profits, investorattitudes and share prices.When economy booms, stock prices go up ascompanies do well and vice versaThe economic factors analyzed include:

1. GDP( GDP = consumption + investment + Exports –

Imports)Higher GDP, better economic growth – betternews for stock market

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Economic Analysis2. Inflation

Too much money chasing too few goods.Indicates an increase in prices – brings downthe ‘real’ rate of growthHigher inflation means higher prices of rawmaterials for production – bringing downcompany profits. Bad for stock market

Economic Factors

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Economic AnalysisThe economic factors analyzed include:3. Savings & Investment

Higher savings translates into higher investment –which means more productions, better demand &supply, higher company growth . Good for stockmarket

4. Interest rateBase rate affects cost of borrowing. So if interestrates decrease, cost of debt decreases forcompany making it more profitable. Good for stockmarketMore money available to brokers who will invest

with borrowed money. Might see increase in shareprice due to speculation too.

Economic Factors

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Economic Analysis5. Budget / Fiscal Deficit

Budget states Govt’s revenue & expenditure. Balancedbudget is good for stock market( ie expense = revenue)Fiscal deficit = Govt’s Total expenditure (Capitalexpenditure ( capex) + other Revenue expenses) lessRevenue receipts.If capex is high – this means more investment& moreeconomic growth - in which case high fiscal deficit isgood for stock marketIf total expenditure is high on account of other expense (Govt borrowings , subsidies, admin expenses etc) – a highfiscal deficit is not stimulating growth and is not good forstock marketRevenue defecit = Govt revenue expenditure less revenuereceiptIdeally Govt wants to eliminate revenue defecit and limitfiscal defecit ( ~3% to GDP)

Economic Factors

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6. TaxTax exemptions for the stock marketinvestments attract retail investors.Currently no tax on equity capital gain madeon sale of shares if held for > 1 yearAll dividends are taxed. Bond capital gains arenon taxable if held for > 3yrsAll stock transactions attract servicetransaction tax (STT) – currently at 0.1%

Economic Analysis

Economic Factors

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7. FDI / FII’sFDI = foreign direct investment – money inflows fromforeign companies : Includes equity capital,investments, reinvested earnings of foreigncompanies etcIncreases investment in economy, creates growthand jobs, higher FDI good for the stock marketFII = foreign Institutional investor. Lot of inflows andoutflows in the stock market happen by FII’s. FII’sare one of the main drivers in the stock market.Recent Policies of the government have beengeared towards encouraging FII’s investments andFDI into India.

Economic Analysis

Economic Factors

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8. International Economic factorsInternational economic factors affect the

Indian stock market – eg: Is the Greek crisisand the China Bubble burst an indicator of aglobal economic crisisEconomic depression in the west will have aripple down effect in India with MNC’s cuttingjobs to save costs.

Economic Analysis

Economic Factors

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8. Monsoon & AgricultureGood monsoon affects agriculture which isdirectly / indirectly connected to manyindustries.Eg: production of raw materials which form theinputs to many manufacturing plants,pesticides, fertilizers, farm equipment dependon success of agricultural sectionBetter monsoon leads to a bumper crop &more disposable income in rural areas –leading to more spending & higher sales.So a good monsoon is a boon for the stockmarket.

Economic Analysis

Economic Factors

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Economic ForecastingAnalysts try to predict themacroeconomic trends that would affectthe industry they are investing in.Analyst use many forecasting techniquesand make use of indicators ( NSE, BSE)Analysts sometimes build modelscorrelating the stock price movementwith economic factors. These are calledeconometric models

Economic Analysis

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Industry Analysis ( I of EIC)Analysis of the performance & problems of anindustry is known as Industry analysis.Risk and return levels of industries vary– socompanies ( and therefore stock) in differingindustries will fare differently.The performance of an industry will affect allcompanies in it ( e.g: IT downturn affected allIT companies in 2002-2003).Industry – collection of companies that havea similar technological structure forproduction & that produce similar goods.

Industry Analysis

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Examples of Industries:Food products & beveragesTextilesClothing apparel, dressingPaper and paper productsPublishing, printingChemicals and chemical productsMotor vehiclesMedical and precision & optical instruments

All of them use similar technology / methods of production andproduced similar types of goods / services

Industry Analysis

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The business cycle

Boom Boom

Recession

Recovery

Depression

BOOM:•High growth•Record turnover & profit•Expansion planned•Stock market attractive

RECESSION•Earnings targets not met•Profits drop•Stock market falls pricesdrop

RecessionRecovery

RECOVERY:•Entrepreneurs invest•Economy recovers•Investors start to be optimisticabout Stock market

Depression

Industry Analysis

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Types of Industries - 1Industries can be classified on the basis of

how they respond to the business cycles:

1. Growth2. Cyclical3. Defensive4. Cyclical Growth

Industry Analysis

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Types of Industries - 11. Growth

High rate of earnings & growth in expansionirrespective of external economic factors (will boom even in recession) – eg Pharmaindustry in India continues to boom evenwhen other stock goes down

Industry Analysis

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Types of Industries - 22. Cyclical

Move along with business cycle – do wellin a boom time and struggle in arecessionWhite goods – washing machine, fridgeetc ( people are more careful withspending during a recession)

Industry Analysis

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Types of Industries - 33. Defensive

Functions independent of the businesscycleFood & shelter industry – people need toeat even in a recession so there is alwaysbusiness for companies in this space. (only essential requirements)Good stock to hold ( will always earnincome!)

Industry Analysis

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Types of Industries - 44. Cyclical Defensive

Cyclical yet growingInnovation & changes in technology helpthis industry grow even while it movesalong with the industry boom ( eg: ITES,automobile, IT industry – TCS, Cognizantetc)

Industry Analysis

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Industry Life cycle Stages1. Pioneering Stage

Demand is growing & competition is highDifficult to select companies forinvestment as survival rate is not knownVC firms typically invest in this phase (eg:today’s online business’ – flipkart, quickretc).

1. Declining stage

Industry Analysis

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Industry Life cycle Stages2. Rapid Growth stage

Firms that survived earlier stage nowimprove their market share and financialperformance.The companies have stable growth rateand they declare dividend.Worth investing in these companies(eg:Indigo which recently launched an IPOthat was over subscribed, is in this stage)

Industry Analysis

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Industry Life cycle Stages3. Maturity & Stabilization stage

Growth tends to moderate and be at parwith industry levels.Technological innovations need to beintroduced to keep up with the marketEg: Infosys’ new head V. Sikka is looking tointroduce new focus areas for business totake Infosys to the next level. IT telecomcompanies like Airtel are in this stage.

Industry Analysis

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Industry Life cycle Stages4. Declining stage

Demand for the particular productdeclines and the earnings for thecompanies in the industry declineEven in a boom, growth of the industry islow. Eg: Kodak and Nokia are companiesthat were in this phase

Industry Analysis

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Other factors to consider:1. Growth of the industry

How has this industry fare in the past?2. Cost structure & profitability

Higher fixed costs –mean more sales needed tocover fixed investments & less flexibility

3. Nature of the productLook at the related ‘feeder’ & ‘end user’ industriesthat supply into the industry being analyzed.Agriculture affects fruit beverage & fertilizerindustryAre there substitute products coming up? ( digitalcamera vs mobile camera?)

Industry Analysis

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Other factors to consider4. Nature of the competition

Are there local competitors coming atcheaper prices to international brands?What is the market share of the company

5. Government policyAre the government policies placingrestrictions on this industry ( e.g; power,sugar)

Industry Analysis

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Other factors to consider5. Labor

What is the level of unionization in theindustry? ( eg: textiles, manufacturing (maruti) – have had huge labour problems

6. Research and DevelopmentEvaluate the level of R&D done in theindustry / company eg: Pharma & Biotechindustry needs a high level of R&D. Is thecompany being analyzed investing in R&D?

Industry Analysis

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Industry Analysis: ModelsCommonly used models to evaluate anindustry:

1. SWOTStrengths, Weakness, Opportunities, Threats

2. Porters 5 Force modelA model that looks at the competitiveforces that affect an industry

Industry Analysis

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SWOT ModelInvestor to carry out a SWOT analysis for anindustry being evaluatedStrengths: Include market share, brand name,growing market – high demandWeakness: Include: Large no of players,regulations, costs have increased,Opportunities: Include: Government measures toencourage industry, growing population, potentialin rural areasThreats: Includes: Include: High Fake substitutes,High government regulations, Pricing control, Lawsuits

Industry Analysis

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Porter’s 5 force modelThreat of

newentrants

RivalryamongstExisting

firms

Availabilityof

substitutes

Suppliers’bargaining

power

Buyer’sbargaining

powerDegree ofCompetition

Industry Analysis

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1. Threat of new entrantsNew companies entering increasescompetition & reduces profitabilityHigh entry barriers in industries like power,airlines, oil & gas – therefore more difficultfor new companies to enterInitial investment, distribution channels,economies of scale, customer switchingcosts – all for barriers for a new entrant

Porter’s 5 force model

Online market places – low entry barriers! NJ Jaissy

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2. Threat of substitutesIf customer is willing to buy cheapersubstitutes, sales drops. Factors affectingthisPrices of new substitutesCost of switching overDegree of similarity & performance ofsubstitute


Thriving Fake leather handbag industry an example of this!NJ Jaissy

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3. Supplier’s bargaining powerInputs / raw materials needed forproduction and cost of raw materials keycostSuppliers’ bargaining power increases if:Fewer suppliers can drive up pricesIf there are many buyers – suppliers strongSuppliers supply to multiple industriesSuppliers can forward integrate intoindustry


Is the Oil & Gas industry an example of this? NJ Jaissy

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4. Buyer’s bargaining powerThe buyers = the customers who buy theproductStrong buyers will demand a higherquality for the same prices / lower pricesIf the products are similar & standardized,easy to switch from one to anotherIf the number of products are high, theycan also switch easily


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5. Rivalry amongst existingfirms.

Higher competition as all firms try toexpand their market shareDegree of competition depends on:1. Degree of differentiation2. Cost of switching is low3. High exit barriers for company to leave4. Cost structure of industry ( if fixed costs

high, greater tendency to cut prices toget sales & cover fixed costs)


The telecom industry ( mobile charge / airtime) is an exampleNJ Jaissy

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Company Analysis-C of EICAn industry has lots of companies producingsimilar products but with differing level ofefficiencies & profitabilityAn investor needs to select the bestperforming company from within a selectedindustryWithin an industry companies risk – returnprofile variesAnalysis required of the factors that will affectshare price

Company Analysis

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Company AnalysisQualitative Factors(cannot compute!)

Business modelManagementCultureGovernance

Quantitative factors(can compute!)

EarningsFinancial leverageOperationalleverageProductionefficiency

Company Analysis

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1. Business ModelWhat does the company do, how does itrun operations? - Operating modelHow does the company make money? -- Revenue modelHow is it run ? - Organizational structureWhich are the markets it caters to

Qualitative Factors

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1. Business ModelWhat does the company do, how does itrun operations? - Operating modelHow does the company make money?Which are the markets it caters to -Revenue modelHow is it run ? - Organizational structure

Qualitative Factors

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Company Analysis

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2. Management StructureObjective of management is to achieve thestated goals of the company and create wealthfor share holdersWho is the team running the company & what istheir r track recordPublic listed companies have to publish details oftheir management team – this is usually availableon the companies websiteEvaluation of management: during publicquarterly conference calls between mgmt &analysts, annual reports, does management ‘own’stock?

Qualitative Factors

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Company Analysis

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3. Corporate GovernanceGovernance = process & systems put in placeto ensure transparency, accountability & tosafeguard shareholder interestsHighest governing body in public co: Board ofdirectors - decide % dividend, protect shareholder interestsGovernance ensure process’ in place toensure transparent reporting of financialsCorporate culture plays a role in hiring /attrition & relationships with customers &thereby profitability

Qualitative Factors

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ManagementBusiness modelCultureGovernance



Company Analysis

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1. Earnings of the companyEarnings = profits of the companyDividends paid out of earnings therefore higherearnings means potentially higher dividendsHigher prices – usually goes with higher earnings /potential earningsAnalyze the income – is it from operating incomeor from investments / sale of assetsEvaluate why income /earnings is varying (accounting related / business related)Most popular analysis = Earnings multiplier ( EPS)

Quantitative Factors

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1. Measures of earnings – EPSEvaluate earnings by looking at:a) Earnings per share

EPS = Net income- preferred stock dividendAverage outstanding no. of shares

EPS can be diluted if more shares/convertible areissuedEstimated EPS is a measure of projectedprofitability of company


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Measures of earningsb) Book Value per share= Reserves + paid up equity capital

Average outstanding shares

c) Dividend payout ratio = ammount ofequity earnings paid out as dividend =

= DividendEarnings

Higher book value & higher dividend payout ratio -> better for stock


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2. Measure of Earnings –earnings growth

Higher earnings growth means higherdividends & therefore higher stock priceGrowth depends on earnings retained &reinvestedROE = ( return on Equity) = Earnings / Equity

ROE = Profit after Tax * Sales* Total Assets*Sales Total Assets Equity


Net profitmargin Asset

turnoverEquitymultipier

Higher ROE -> better for stockNJ Jaissy

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CAGR = compound annualgrowth rateEPS / Sales Over 5 years ( 2002…. 2007)

CAGR in sales = Sales in 2007 - 1Sales in 2002

CAGR in EPS = EPS in 2007 - 1EPS in 2002

If CAGR in Sales and EPS is low – this means lowsustainable growth -> not good for stock

1/5

1/5


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3. Price: Earnings MultipleP:E = Market Price per share

Earning per shareMeasure of the price an investor is willingto pay per future earningTypically companies P:E compared withIndustry average P:E factoring in reasonsfor the same.Higher P:E ratio means markets isexpecting higher earnings / growth


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4. Intrinsic valueIntrinsic value= Average P/E ratio over years * Present earnings /

share

From earlier formula: Po = D/ ( r – g)

Hence expected P/E: = D/E D/E = avg. dividendr-g payout ratio

P(intrinsic) = D/E * EPS r = reqd. rate of returnr - g g = growth rate

EPS = current Earnings/share


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Company Analysis

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Financial LeverageThe degree of borrowed money in a firm =leverageCapital structure of company is amountof debt capital( loans, bonds) & equitycapitalHigher debt capital = higher interest =lower profit and EPSDuring a recession, high debt can evenresult in bankruptcy if company sales drop


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Measures of FinancialLeverage

Interest coverage ratio = Earnings (>1)Interest

Asset limit of debt = Fixed Assets ( < 0.5)Debt


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EarningsFinancial leverageOperational leverageProduction efficiency

Company Analysis

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Operational leverageOperational efficiency of the company looksat the sensitivity of the return on equity withsales.If fixed costs are high – first fixed costs need tobe covered before profits can be made soPAT% change low with sales.If fixed costs low, then % changes in PAT highwith % changes in sales.Hence in a recession, firms with higheroperating leverage ( higher fixed costs)affected very badly with decline in sales

Company Analysis

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Financial Analysis of companyAnalysts also do a detailed financial analysisof the companies Balance sheet & Profit &Loss statementsRatios are used to assess the company:

Leverage ratios: Debt : Equity, Debt: AssetsLiquidity ratios: Current ratioTurnover ratios: Inventory turnover, Receivablesturnover, fixed asset turnover ( = Net sales / x)Profitability ratios: Net Margin, Return on equityValuation ratios ( Book value per share)

Company Analysis

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