chapter 2 (2).pdf

LEVEL 2 UNIT ONE (CHAPTER 2) Fundamental analysis, which is a way to assess the value of a company's stock by looking at its financial health and other factors that affect its business. In simpler terms, instead of just focusing on...

LEVEL 2 UNIT ONE (CHAPTER 2) Fundamental analysis, which is a way to assess the value of a company's stock by looking at its financial health and other factors that affect its business. In simpler terms, instead of just focusing on the current price of a stock, fundamental analysis considers various aspects of the company itself to figure out if the stock is worth what it's being priced at. Here's a breakdown of the image for easier understanding:  Company Information: This includes the company's history, its financial performance (past and present), and its prospects. Financial performance includes things like a company's earnings, how much debt it has, and how much it pays out in dividends to its shareholders.  Industry Conditions: This refers to the economic conditions that affect the company's business. For example, if a company sells beach equipment, its sales would likely be higher during the summer months. By considering all this information, investors can make a more informed decision about buying a particular stock. The text in the image says that fundamental analysis is based on the idea that every share of stock has a certain intrinsic value, which is a fancy way of saying its true or fair value. This intrinsic value can change over time, depending on what’s going on with the company and the economy in general. The theory of fundamental analysis is that investors should buy stocks when they are trading for less than their intrinsic value and sell them when they are trading for more than their intrinsic value. When the market price of a share is below its intrinsic value, it’s considered undervalued. On the other hand, if the market value of a share is above its intrinsic value, it’s considered overvalued. People who do fundamental analysis are called fundamental analysts. They’re trying to buy stocks that are undervalued and sell stocks that are overvalued. They believe that even though the market price of a stock may go up and down in the short term, in the long term, the market price will eventually go up to match the stock’s intrinsic value. INTRINSIC VALUE: Intrinsic value is a term used in finance to refer to the estimated value of an investment. In the case of a stock, it's the idea of what a company's share is truly worth based on its fundamentals, like its earnings, assets, and future growth potential. It's important to note that intrinsic value is different from the market price, which is the price at which a stock is currently trading on the stock market. The text mentions that fundamental analysis is a way to determine the intrinsic value of a stock. Fundamental analysts consider a variety of factors when trying to assess a company's intrinsic value, including:  Financial performance: This includes things like a company's earnings, revenue, and profitability. Analysts will look at trends in these metrics over time to get a sense of how well the company is doing financially.  Debt: A company's debt level can impact its ability to grow and pay dividends to shareholders.  Management: The quality of a company's management team is an important factor to consider. A strong management team can help a company to grow and succeed.  Industry outlook: The overall health of the industry that a company operates in can also impact its stock price. By considering all these factors, fundamental analysts can come up with an estimate of a company's intrinsic value. They can then compare this intrinsic value to the stock's current market price to see if the stock is overvalued or undervalued. Here's a simplified way to think about it: Intrinsic value is like trying to guess what a house is worth, based on its size, location, and condition. The market price is what someone is willing to pay for that house at a given time.  The example assumes an investor expects a 20% return on their investment every year for 3 years.  The company is also assumed to pay out dividends of 20%, 25%, and 30% on its Rs. 10 shares over the next three years. So, the dividend received on a share would be Rs. 2 in the first year, Rs. 2.50 in the second year, and Rs. 3.00 in the third year.  At the end of the 3 years, the share is also expected to be sold at Rs. 200. The calculation considers all these cash flows (dividends and the expected selling price) and discounts them to their present value based on the expected return of 20%. Why discount cash flows? The idea is that a rupee today is worth more than a rupee you'll receive in the future because you could invest that rupee today and earn a return on it. So, when considering future cash flows, you need to discount them to their present value to get an accurate idea of their current worth. So, what's the intrinsic value? Following the DCF method in the image, the intrinsic value of the share is calculated to be Rs. 120.88. What does this mean? According to this example, if the market price of the share is below Rs. 120.88, then the share is undervalued and could be a good investment opportunity. On the other hand, if the market price is higher than Rs. 120.88, then the share may be overvalued. Important to note:  DCF is just one method for estimating intrinsic value, and it's not perfect. It relies on several assumptions, such as the expected future growth rate of the company and the discount rate.  A share's actual intrinsic value may differ from what this calculation yields. EFFICIENT MARKET THEORY  The EMH theory suggests that all available information about a company is already reflected in its stock price. This means that the current market price is the true or fair value of the stock, and it considers all the positive and negative aspects of the company.  Proponents of EMH believe that it's difficult to outperform the market by picking individual stocks because any publicly available information has already been factored into the price. Fundamental analysis vs. EMH  Fundamental analysts, on the other hand, believe that by studying a company's financial health, prospects, and other factors, they can determine a stock's intrinsic value, which is different from the market price.  The image says that EMH argues that this approach might not be effective because the market price already reflects all this information. So, according to EMH, it would be difficult to find stocks that are undervalued or overpriced. Here's an analogy to understand the difference: Imagine you're buying a used car. You research different models online and visit dealerships to understand the going market price for the vehicle you want. This is like how EMH views the stock market. The market price reflects all the available information about the car (its mileage, condition, etc.). Fundamental analysis is like taking the car to a mechanic to get a professional opinion on its value, considering its specific condition. This additional information might reveal that a particular car is overpriced for its condition, even though its price seems in line with the general market value for that car model. So, who's right? The efficiency of the market is a complex and debated topic. Some experts believe that the market is mostly efficient, while others believe there might be opportunities to outperform it through fundamental analysis or other strategies. APPROACHES TO EQUITY VALUATION Top-down approach:  This approach starts with looking at big-picture economic factors, like Gross Domestic Product (GDP) growth rate, interest rates, inflation, and overall market valuations.  Investors who use this approach believe that the overall health of the economy plays a big role in how stocks perform. So, they will first try to identify sectors that are likely to do well in the current economic climate.  For example, if an investor using the top-down approach believes interest rates are going down, they might focus on sectors that benefit from lower interest rates, such as real estate or auto.  Then, they would look for promising individual stocks within those sectors. Bottom-up approach:  This approach focuses on the details of a particular company, rather than economic trends.  Bottom-up investors look at factors specific to the company, like its financial performance (past and present), its competitive advantage, and its future growth potential.  They would analyze things like a company's sales, earnings, debt levels, and price-to- earnings ratio to determine if the company is undervalued by the market. Top-Down vs. Bottom-Up Investing  Top-Down Approach: This approach looks at big economic factors first, like interest rates, inflation, and overall economic growth. Investors who use this approach believe these factors affect how stocks perform overall. So, they pick industries that are likely to do well in the current economic climate. Then, they look for individual stocks within those industries.  Bottom-Up Approach: This approach focuses on the details of a particular company, rather than economic trends. Investors who use this approach look at a company’s financial performance, competitive advantage, and future growth potential. They  analyze things like a company’s sales, earnings, debt levels, and price-to-earnings ratio to determine if the company is a good investment. ECONOMICS ANALYSIS: Economic indicators are statistics that provide information about the health of the economy. Investors use these indicators to try to predict how the stock market will perform. The image lists some examples of leading economic indicators and what they tell us:  Unemployment Rate: A low unemployment rate indicates a strong economy, which can lead to higher corporate profits and stock prices.  Gross Domestic Product (GDP): GDP is the total value of goods and services produced in a country. A rising GDP suggests economic growth, which can be a positive sign for the stock market.  Consumer Confidence: High consumer confidence suggests that people are feeling optimistic about the economy and are more likely to spend money. This can lead to increased sales for companies and higher stock prices. The text also mentions that economic indicators are not always perfectly accurate, and other factors can also affect the stock market. However, they can still be a valuable tool for investors. ECONOMIC INDICATORS: Economic indicators are statistics that provide information about the health of the economy. Investors use these indicators to try to predict how the stock market will perform. The text in the image says that there are three different types of economic indicators, depending on how they relate to the current state of the economy:  Leading indicators: These indicators tend to change before the economy does. For example, the stock market itself can be a leading indicator. A rising stock market may signal that investors are optimistic about the future economy, which can lead to an actual improvement in the economy.  Coincident indicators: These indicators change along with the economy. For instance, unemployment rates tend to rise during economic downturns and fall during economic expansions. EG GDP.  Lagging indicators: These indicators change after the economy does. An example is the unemployment rate, which tends to rise a few quarters after the economy starts to decline. The image you sent is about cyclic economic indicators. These are indicators that move in the same direction as the economy. So, if the economy is doing well, the indicator will also be positive. And if the economy is weak, the indicator will also be negative. Here’s a breakdown of the image to make it easier to understand:  Procyclic indicator: This type of indicator increases when the economy improves and goes down when the economy weakens. An example of this is the Gross Domestic Product (GDP). GDP basically measures the total value of goods and services produced in a country. So, if the economy is doing well, there’s usually more production, which leads to a higher GDP.  Countercyclical indicator: This is the opposite of a procyclical indicator. It moves in the opposite direction of the economy. So, it increases when the economy weakens and goes down when the economy improves. An example of this is the unemployment rate. Typically, the unemployment rate rises when the economy is weak and falls as the economy improves.  Acyclic indicator: This type of indicator doesn’t really have a connection to how the economy is doing. It might go up and down for its own reasons, independent of the economic climate. An example of this could be the number of tomatoes harvested in a year. POLITICAL ANALYSIS: In simpler terms, it's about how the government (political system) and the economy (financial system) influence each other. The text says that no business or person can operate completely independently of the government and the economic system they're a part of. Here's a breakdown of the key points in the image:  Businesses are affected by government regulations and economic conditions. For example, a government might set environmental regulations that a company needs to follow, or the overall health of the economy can affect how many people buy a company's products.  The government can also be affected by businesses. For instance, a company might create a lot of jobs in a community, which could influence how people vote in elections. So, political economy looks at this two-way relationship between governments and economies. FOREIGN EXCHANGE RESERVES: The image you sent is about foreign exchange reserves, which are a country's stash of foreign currency. Countries use these reserves for a few reasons, according to the text in the image:   To pay for imports: A country needs foreign currency to buy things from other countries. For instance, if India wants to buy oil from Saudi Arabia, it needs to pay in U.S. dollars (the currency Saudi Arabia uses for oil sales).  To service foreign debt: If a country borrows money from another country, it usually must pay back the loan (plus interest) in foreign currency. So, foreign exchange reserves help ensure a country can make these payments.  To intervene in the currency market: Sometimes a country's own currency might be getting too weak or too strong. Foreign exchange reserves allow the government to buy or sell its own currency to try to influence its exchange rate. Why are foreign exchange reserves important?s The text says that having enough foreign exchange reserves is important for a country's economic health. If a country doesn't have enough reserves, it might not be able to afford to import essential goods, which could hurt its economy. The image lists three main indicators for reserve adequacy:  Import cover: This refers to how many months of imports a country can afford to cover with its reserves. For instance, if a country has enough reserves to pay for six months of imports, that might be considered a good level of import cover.  Debt adequacy: This looks at how well a country’s reserves can cover its external debts, especially short-term debts.  Monetary adequacy: This indicator is about how prepared a country is for capital flight, which is when a lot of money suddenly leaves the country.   India expresses its foreign exchange reserves in US dollars. This is the international standard for holding foreign exchange reserves.   These reserves are held in various currencies, but their value is measured in US dollars. The main component is foreign currency assets (FCAs) which include currencies like Euros, Yen, and Pound Sterling.   The central bank can use these reserves to intervene in the foreign exchange market. This means they can buy or sell Indian rupees to influence the exchange rate.   The goal of intervening in the market would be to control the exchange rate. By buying rupees, the central bank can increase its value. By selling rupees, they can decrease its value.   Countries hold foreign exchange reserves for some reasons. These include paying for imports, servicing foreign debt, and intervening in the foreign exchange market, as mentioned above. CRUDE OIL:  Crude oil is a major source of energy for many countries. This means it's a key input cost for many businesses and industries.  When crude oil prices go up, it can lead to higher costs for businesses and consumers. This can have a ripple effect throughout the economy, potentially leading to inflation. For example, if the price of oil goes up, transportation costs can increase, which can raise the price of goods that need to be shipped.  Higher oil prices can also lead to a transfer of wealth from oil-importing countries to oil-exporting countries. This is because oil-importing countries will have to spend more money on oil, which can hurt their economies.  The impact of oil price changes can vary depending on the country. Countries that rely heavily on oil imports are generally more vulnerable to rising oil prices.  Oil prices are affected by several factors, including supply and demand, geopolitical events, and economic conditions. This means that oil prices can be volatile and can fluctuate significantly over time. CREDIT POLICIES:  The Reserve Bank of India (RBI) is responsible for formulating and implementing monetary policy in India. This means they take steps to influence the money supply and credit conditions in the economy.  One of the main tools the RBI uses for monetary policy is credit policy. Credit policy refers to the guidelines set by the RBI to influence how much banks lend and at what interest rates.  The RBI can tighten credit policy by raising interest rates or increasing the reserve requirement for banks. This makes it more expensive for banks to borrow money from the RBI, which can discourage them from lending money to businesses and consumers.  The RBI can loosen credit policy by lowering interest rates or reducing the reserve requirement for banks. This makes it cheaper for banks to borrow money from the RBI, which can encourage them to lend more money.  The goal of credit policy is to promote price stability and economic growth. By tightening or loosening credit, the RBI can try to control inflation and influence the level of economic activity. FOREIGN INVESTMENT: The document you sent talks about foreign investment in India. The document says that foreign investment is generally allowed in all sectors of the Indian economy except for the following:  Agriculture (excluding floriculture, horticulture, development of seeds, animal husbandry, pisciculture & cultivation of vegetables, mushrooms, etc. under controlled conditions and services related to agro & allied sectors)   Plantations (other than tea plantations)  Atomic energy  Gas pipelines  Courier services  Trading  Lottery and gambling The document also says that for most sectors, foreign investors can invest through an Automatic Route, which means they don't need any approval from the Indian government. They just need to inform the Reserve Bank of India (RBI) about the investment. Here are some key points about foreign investment in India, based on the document:  The Indian government allows foreign investment in most sectors of the economy.  There are some exceptions, such as agriculture and gambling.  For most sectors, foreign investors can invest through an automatic route without government approval.  Investors need to keep the RBI informed about their investments. FDI FDI stands for Foreign Direct Investment. It happens when a company or individual from one country invests in a business in another country, with the intention of having a significant level of ownership and control over that business.  Ownership and Control: Unlike buying stocks in a foreign company (which is a portfolio investment), FDI involves acquiring a substantial ownership stake. This allows the investor to have a say in how the company is run.  Long-Term Perspective: FDI is typically a long-term investment. Investors are looking to establish a lasting presence in a new market, rather than just making a quick profit.  Benefits for Both Sides: FDI can be beneficial for both the investor's country and the host country (the country receiving the investment). The investor gains access to new markets and resources, while the host country can benefit from job creation, technology transfer, and economic growth. There are several ways to categorize FDI (Foreign Direct Investment), but two main types are generally recognized: 1. Greenfield Investment: This involves a foreign company establishing a new business venture in a host country from the ground up. This could involve building a new factory, office, retail store, or any other type of operational facility.  Advantages for Host Country: o Creates new jobs and production capacity. o Introduces new technologies and expertise.  o Boosts economic growth.  Disadvantages for Host Country: o Can put a strain on local resources (e.g., land, water, labour). o Profits may be repatriated back to the foreign company's home country. 2. Mergers and Acquisitions (M&A): This occurs when a foreign company acquires a controlling interest or merges with an existing company in the host country. This allows the foreign company to gain a foothold in the new market quickly and leverage the existing assets and resources of the acquired company.  Advantages for Host Country: o May bring new technologies and management practices. o Can lead to increased efficiency and productivity.  Disadvantages for Host Country: o Doesn't necessarily create new jobs or production capacity. o Local ownership and control over the company diminishes. FII FII stands for Foreign Institutional Investor. It refers to an institutional investor, such as a mutual fund, pension fund, hedge fund, or investment bank, that invests in a country's financial markets from outside that country. Here's a breakdown to make it easier to understand:  Imagine a giant investment pool based in the US, made up of money from many different investors. This pool decides to invest in stocks and bonds of Indian companies. This investment pool would be considered an FII in India. Here are some key characteristics of FIIs:  Institutional Investors: FIIs are not individual investors. They are investment firms or organizations that pool money from multiple investors and invest it in various assets.  Foreign Investors: FIIs invest in a country's financial markets from outside that country. They are not residents of the country they are investing in.  Focus on Financial Markets: FIIs typically invest in stocks, bonds, and other financial instruments traded on a country's stock exchanges or bond markets. They are not directly involved in running companies. Why do FIIs invest in foreign countries? There are a few reasons why FIIs might invest in foreign countries:  Diversification: By investing in different countries, FIIs can spread out their risk and potentially improve their overall returns.   Growth Potential: FIIs may be attracted to emerging markets like India that offer higher potential returns than developed markets.  Currency Exposure: FIIs can gain exposure to different currencies through foreign investments. Impact of FIIs: The presence of FIIs can have both positive and negative impacts on a country's economy:  Positive Impacts: FIIs can provide a source of capital for companies, which can help them grow and create jobs. They can also bring in new investment ideas and expertise.  Negative Impacts: If FIIs suddenly pull their money out of a country (capital flight), it can cause stock market volatility and currency depreciation. Here's a point to remember:  The term FII is most used in some countries, like India, to distinguish them from domestic institutional investors. In other countries, the term "foreign portfolio investor" might be used instead. INFLATION Inflation, as you know, refers to the sustained increase in the general price level of goods and services in an economy over time. This means a unit of currency, like a dollar or rupee, buys you less and less over time. Here's a deeper dive into inflation and its significance: Significance of Inflation:  Moderate Inflation: A low and stable level of inflation (around 2-3%) is generally considered healthy for an economy. It encourages borrowing and investment, which can lead to economic growth. It also provides a buffer against deflation (falling prices), which can be harmful.  High Inflation: When inflation gets too high (above 5%), it can have several negative consequences: o Reduced Purchasing Power: As prices rise, consumers can afford less with the same amount of money, lowering their standard of living. o Uncertainty and Risk: High inflation creates uncertainty for businesses and consumers, making it difficult to plan. This can discourage investment and economic growth. o Income Inequality: High inflation can disproportionately hurt low-income earners whose wages might not keep pace with rising prices. o Erosion of Savings: The real value of savings is eroded by inflation, as the money loses its purchasing power over time. Central Bank's Role:   Monetary Policy: Central banks, like the Reserve Bank of India (RBI), are responsible for maintaining price stability and controlling inflation. They use various tools of monetary policy to achieve this, including: o Interest Rate Adjustments: Raising interest rates can slow down inflation by making borrowing more expensive and encouraging saving. Conversely, lowering interest rates can stimulate the economy and potentially lead to higher inflation. o Open Market Operations: The central bank can buy or sell government bonds to influence the money supply. Buying bonds injects money into the economy, which can lead to inflation. Selling bonds removes money from circulation, which can help to control inflation. In conclusion, understanding inflation and its causes is crucial for navigating economic conditions. While a moderate level of inflation can be beneficial, high inflation can have a significant negative impact on individuals, businesses, and the overall economy. Central banks play a critical role in maintaining price stability through monetary policy tools. FOREIGN EXCHANGE RISK Foreign exchange risk, also known as FX risk, currency risk, or exchange rate risk, refers to the potential financial loss that can occur due to fluctuations in exchange rates between currencies. Here's a breakdown to make it easier to understand:  Imagine you're an Indian company that exports furniture to the United States. You agree to sell furniture for USD 10,000 (US Dollars). If the exchange rate between the rupee (INR) and USD weakens before you receive the payment, you might get fewer rupees for your USD 10,000, resulting in a financial loss. Who is exposed to Foreign Exchange Risk?  Businesses involved in international trade: This includes companies that import or export goods and services. Fluctuations in exchange rates can affect the profitability of their international transactions.  Investors with foreign assets: If you invest in stocks, bonds, or real estate denominated in a foreign currency, the value of your investment can be affected by exchange rate movements.  Individuals traveling abroad: When you exchange your home currency for a foreign currency, the exchange rate you get determines how much purchasing power you have in the foreign country. EXCHANGE RATE: Exchange Rates:  Definition: The exchange rate between two currencies specifies how much one currency is worth in terms of the other. Example: Rs.70 to the Dollar means Rs.70 is equal to $1.   Also Known As: Foreign exchange rate. Exchange Rate Policy in Recent Years:  Guiding Principles:  Careful monitoring and management of exchange rates with flexibility.  Avoids fixed target or pre-announced band.  Ability to intervene when necessary.  India's Approach:  Manages foreign exchange reserves by considering the balance of payments.  Reflects liquidity risks different types of flows and other requirements.  Market Levels: Set exchange rates for most major currencies vary over time. Market-Based Exchange Rate:  Fluctuations: Changes with the values of the two currencies.  Currency Value:  Increases when demand is greater than supply.  Decreases when demand is less than supply.  Investor Decisions:  Buying currency if interest rate (return) is high enough.  Higher interest rates in a country increase demand for that currency. Impact of Exchange Rate Policies:  Stability of Trade Policy:  First Impact: Direct effect on trade flows and trade policy through modification of flows, tariffs, and subsidies.  Second Impact: Direct impact on balance of payments.  Third Impact: Indirect effects on domestic growth and inflation. Specific Impacts:  Debt:  Fall in rate leads to a rise in nominal value of debt (especially if borrowed in foreign currency).  Imports:  Fall in rate leads to imported inflation.