chapter 3.pdf

CHAPTER 3: INVESTING IN STOCKS LEARNING OBJECTIVES: After studying this chapter, you should understand about: x Equity as an investment opportunity x Types of risk involved in equity investment x Management of risk through diversification...

CHAPTER 3: INVESTING IN STOCKS LEARNING OBJECTIVES: After studying this chapter, you should understand about: x Equity as an investment opportunity x Types of risk involved in equity investment x Management of risk through diversification x The process of equity research and stock selection x Fundamental and Technical analysis of equity investment 3.1 Equity as an investment Securities markets enable investors to invest and disinvest their surplus funds in various securities. These securities are pre-defined for their features, issued under regulatory supervision, and in most cases have ready liquidity. Liquidity refers to the marketability (meaning existence of sellers when one needs to buy; and buyers when one needs to sell). There are two broad types of securities that are issued by seekers of capital from investors: Equity and Debt. Equity securities are issued by companies providing ownership to the investor in their company, and Debt securities are issued by companies providing the rights of a lender to the investor. The features of both these securities differ due to the inherent difference in the claim of the investors on the company. Equity investors also known as shareholders have residual claim 10 in the business. Because they are the owners of the company and not lenders, the company which issues equity securities is not contractually obligated to repay the amount it receives from the shareholders. It is also not contractually obligated to make periodic payments to shareholders for the use of their funds, like interest payments in the case of lenders. Equity investors get voting rights. When equity investor own a sizeable amount of shares in a company, they get an opportunity to participate in the management of the business. Investors who purchase equity shares look for capital appreciation and dividend income. There is no assurance of both by the company to the equity investor. While dividend payment depends on the profitability of the company, capital appreciation depends on the share market conditions and peculiarities. Because all residual benefits of deploying capital in a 10 Claim on the company’s net assets, i.e. the value of assets after all liabilities have been paid. 43 business go to the equity investor, the return to equity investor is likely to be higher than that of the debt investors. Choosing between equity and debt is a trade-off. Investors desiring lower risk, and willing to accept a lower stable return choose debt. However, if they seek a higher return, they may not be able to earn it without taking on the additional risk of the equity investment. Most investors tend to allocate their capital between these two choices, depending on their expected return, their investing time period, their risk appetite and their needs. 3.2 Diversification of risk through equity instruments Equity is inherently riskier compared to bonds and many other asset classes. However, there are ways to mitigate the risks in stocks. The most meaningful way to risk reduction is through diversification – both on cross sectional (i.e. across business sectors and industries) as well as on time series basis (i.e. across various time periods). Empirical research has demonstrated that a significant portion of risk can be reduced through diversification. Conceptually, it is achieved due to the relatively less correlated behaviour of various business sectors which underlie each equity investment. This is what the old adage ‘Don’t put all your eggs in one basket’ means. Cross sectional risk diversification is reducing risk by holding equities in many different kinds of businesses at a point in time and also across various geographies of the world. Reaping the benefits of time diversification requires investing in equities for a long period of time. The belief is that bad times will get cancelled out by good times. This is why “time in the market” is suggested for equity investment as against “timing the market”. Underlying the word ‘diversification’ is the concept of business cycles and counter-cyclical businesses, and the phenomenon of lag and lead between the behaviour of investments returns and countries’ economic performance. In Exhibit 3.1, a business cycle is shown as a dark line. Some businesses may be at peak when the business cycle is in its trough, as shown by the broken line. These products or businesses are called ‘counter-cyclical’ or defensive businesses. Businesses that do better in a recession are called ‘recession-proof’ businesses. Some products, sectors or countries come out of a recession faster than others (these are called as leading sectors); other products, sectors or countries may go into recession later than others (these are called lagging sectors). 44 Exhibit 3.1 Counter-cyclical products Counter Cyclical Products 3.3 Risks of equity investments Equities are often regarded as riskier than other asset classes. The main types of risks discussed in the context of equity investments are discussed below: 3.3.1 Market risk Market risks arise due to the fluctuations in the prices of equity shares due to various market related dynamics. These factors affect all the listed, market traded assets, irrespective of their business sector. The degree of impact may be different. Beta is a proxy measure for market risk. Market risk cannot be diversified away, though it can be hedged. 3.3.2 Sector specific risk Risks due to sector specific factors is part of non-market risks. These risks can be diversified away. Sector specific risk is due to factors that affect the performance of businesses in a particular sector. Businesses belonging to other sectors do not get affected by them. This risk can be diversified away by investing into other shares of businesses in different sectors. 3.3.3 Company specific risk Risks due to sector specific factors are not part of market risks. These risks can be diversified away by investing in different business sectors. Sector specific risks arise due to factors that affect the performance of businesses in a particular sector/industry. Factors affecting certain sectors might not impact certain other sectors. Such risks are also called “idiosyncratic risks”. Say for instance there are restrictions on the movement of international tourists, the airline industry and hospitality industry are going to be affected. But industries and business sectors dependent on domestic customers are not affected by such restrictions. 3.3.4 Liquidity risk Liquidity risk is defined in Chapter 1. It is measured by impact cost. The impact cost is the percentage price movement caused by a particular order size (let’s say an order size of Rs.1 lakh) from the average of the best bid and offer price in the order book snapshot. The impact 45 cost is calculated for both—the buy and the sell side. Less liquid stocks are more thinly traded, and a single large trade can move their prices considerably. Such stocks have high impact costs. A lower market impact implies the stock is more liquid. 3.3.5 Currency Risk Prima facie, it appears that currency risk is not directly related to prices of equity. However, once the financial markets are open to the international investors, currency risk sets in. Currency risk arises due to uncontrollable, unpredictable and volatile exchange rates of various pairs of currencies. When a significant proportion of players in a financial market belong to the international institutional investors groups, then that financial market is bound to be related to exchange rate movements. Many times we hear that stock market reacts to FPIs’ buy and sell pressure, and FPIs move in and move out of a country with changes in their home country interest rates, or due to sudden unfavourable exchange rate movements, like deep depreciations in their host countries or due to any other socio-politico-economic, industry or market shocks. Apart from the above most prominent risks, all other macro-economic factors like inflation, fuel prices, interest rates, economic growth, economic slowdown, do influence stock markets. 3.4 Overview of Equity Market Equity securities represent ownership claims on a company’s net assets. A thorough understanding of equity market is required to make optimal allocation to this asset class. The equity market provides various choices to investors in terms of risk-return-liquidity profile. There are opportunities in listed as well as unlisted equity space available. 11 Investments in listed companies is relatively more liquid than investment in unlisted companies. Listed companies have to abide by the listing norms, making this investment space more regulated with better disclosures. In addition to equity shares, companies may also issue preference shares. Preference Shares rank above equity shares with respect to the payment of dividends and distribution of company’s net assets in case of liquidation. However, preference shares do not generally have voting rights like equity shares, unless stated otherwise. Preference shares share some characteristics with debt securities like fixed dividend payment. Similar to equity shares, preference shares can be perpetual. Dividends on preference shares can be cumulative, non- cumulative, participating, non-participating or some combination thereof (i.e. cumulative 11Listing is a process through which the companies fulfilling the eligibility criteria prescribed by the Exchange(s) are admitted for trading on the Exchange. 46 participating, cumulative non-participating, non-cumulative participating, non-cumulative non-participating). In case preference stock is cumulative, the unpaid dividends would accumulate to be paid in full at a later time, whereas in non-cumulative stocks the unpaid or omitted dividend does not get paid. A non-participating preference share is one in which a dividend is paid, usually at a fixed rate, and not determined by a company’s earnings. Participating preference share gives the holder the right to receive specified dividends plus an additional dividend based on some pre-specified conditions. Participating preference shares can also have liquidation preferences upon a liquidation event. Preference shares can also be convertible. Convertible preference shares entitle shareholders to convert their preference shares into a specified number of equity shares. Since preference shares carry some characteristics of equity share and at the same time some of the debt securities, they are referred to as hybrid or blended securities. The chief characteristic of equity shares is shareholders’ participation in the governance of the company through voting rights. Generally companies issue only one kind of common shares, on the principle of ‘one share, one vote’. Some companies, however issue share with differential voting rights (DVRs). Shares with DVRs can either have superior voting rights (i.e. multiple votes on one share) or inferior voting rights (i.e. a fraction of the voting right on one equity share) or differential rights as to dividend. Shares with DVRs are very popular in the western world for many decades. They have not really gained momentum in India. Though way back in 2000, the Companies Act, 1956, was amended to permit issuance of shares with DVRs, not many companies have issued shares with DVRs. Tata Motors was one of the first companies in India to issue DVRs in 2008. These DVRs carried 1/10 voting rights and 5% higher dividend than ordinary shares. Since then, Pantaloon Retails (currently Future Enterprises Ltd.), Gujarat NRE Coke Ltd., Jain Irrigation Systems Ltd. have issued DVRs. Companies issuing equity shares can be classified on the basis of size—measured by way of their market capitalization as ultra large cap, large cap, mid-cap, small cap, micro-cap etc., each group represents a particular risk-return-liquidity profile. For example large cap companies as a group have lower variability in return than small cap companies. Technological advancements and integration of global markets have expanded the investment opportunity set for the investors. They can invest in global equities within the restrictions placed by the RBI. 47 3.5 Equity research and stock selection As there are thousands of opportunities available to investors in equity market, equity research and stock selection process plays a very important role in identifying stocks which suits the risk-return-liquidity requirements of the investors. Equity research involves thorough analysis and research of the companies and its environment. Equity research primarily means analysing the company’s financials and non-financial information, study the dynamics of the sector the company belongs to, competitors of the company, economic conditions etc.. The idea behind equity research is to come up with intrinsic value of the stock to compare with market price and then decide whether to buy or hold or sell the stock. There are many frameworks/methodologies available for stock selection. Analysts use fundamental analysis - top-down approach or bottom-up approach - quantitative screens, technical indicators etc., to select stocks. 3.5.1. Fundamental Analysis Fundamental analysis is the process of determining intrinsic value for the stock. These values depend on underlying economic factors such as future earnings or cash flows, interest rates, and risk variables. By examining these factors, intrinsic value of the stock is determined. Investor should buy the stock if its market price is below intrinsic value and do not buy, or sell, if the market price is above the intrinsic value, after taking into consideration the transaction cost. In other words, the difference between intrinsic value and market price should be enough to cover the transaction costs. Investors who are engaged in fundamental analysis believe that, intrinsic value may differ from the market price but eventually market price will merge with the intrinsic value. An investor or portfolio manager who can do a superior job of estimating intrinsic value will generate above-average returns by acquiring undervalued securities. Fundamental analysis involves economy analysis, industry analysis, company analysis. Top Down approach versus Bottom up Approach Analysts follow two broad approaches to fundamental analysis—top down and bottom up. The factors to consider are economic (E), industry (I) and company (C) factors. Beginning at company-specific factors and moving up to the macro factors that impact the performance of the company is called the bottom-up approach. Scanning the macro economic scenario and then identifying industries to choose from and zeroing in on companies, is the top-down approach. 48 EIC framework is the commonly used approach to understanding fundamental factors impacting the earnings of a company, scanning both micro and macro data and information. Buy side research versus Sell Side Research Though both Sell-side and Buy-side researchers and analysts take up similar works, they differ in terms of: for whom they work, how accurate they need to be, and for what are they paid. Sell-side Analysts work for firms that provide investment banking, broking, advisory services for clients. They typically publish research reports on the securities of companies or industries with specific recommendation to buy, hold, or sell the subject security. These recommendations include the analyst’s expectations of the earnings of the company and future price performance of the security (“price target”). In essence, the sell-side analysts are paid for providing useful information to be acted upon. In this regard, the expectations from the sell-side research is a broad guidance on multiple sectors, rather than accurate price predictions. Buy-side Analysts work for fund managers like those of mutual funds, hedge funds, pension funds, or portfolio managers that purchase and sell securities for their own investment accounts or on behalf of their clients. These analysts generate investment recommendations for their internal consumption viz. use by the fund managers within organization. Research reports of these analysts are generally circulated among the top management/investment managers of the employer firms as these reports contain recommendations about which securities to buy, hold or sell. Therefore the buy-side researchers need to be more accurate and they are paid for their investment recommendations. 3.5.2. Stock Analysis Process The value of an investment is determined by its expected cash flows and the investor’s/analyst’s required rate of return (i.e. its discount rate). The expected cashflows as well as required rate of return are influenced by the economic environment. The analyst needs to have good understanding of important economic variables and economic series. The macroeconomic analysis provides a framework for developing insights into sector and company analysis. The objective of stock analysis is to make the critical risk-return decision at the market- industry-company stock level. The stock analysis process involves three steps. It requires analysis of the economy and market. Another crucial step in the process is examination of various sectors. The process culminates with the analysis of stocks. 49 Economy Analysis Macro-economic environment influences all industries and companies within the industry. Monetary and fiscal policy influences the business environment of the industries and companies. Fiscal policy initiatives such as tax reduction encourages spending while removal of subsidies or additional tax on income discourages spending. Similarly, monetary policy may reduce the money supply in the economy affecting the expansionary plans and working capital requirements of all the businesses. Hence a thorough macro-economic forecast is required to value a sector/firm/equity. Any macro-economic forecast should include estimates of all of the important economic numbers, including gross domestic product, inflation rates, interest rates unemployment etc. The most important thing an analyst does is to watch for releases of various economic statistics by the government, central bank and private sources. Especially, they keep a keen eye on the Index of economic indicators like the WPI, CPI, monthly inflation indices, Index of Industrial Production, GDP growth rate etc. Analysts assess the economic and security market outlooks before proceeding to consider the best sector or company. Interest rate volatility affect different industries differently. Financial institution or bank stocks are typically placed among the most interest-sensitive of all stocks. Sectors such as pharmaceuticals are less affected by interest rate change. The economy and the stock market have a strong and consistent relationship. The stock market is known as a leading economic indicator. A leading economic indicator is a measure of economic recovery that shows improvement before the actual economy does because stock price decisions reflect expectations for future economic activity, not past or current activity. Industry/Sector Analysis Industry analysis is an integral part of the three steps of top-down stock analysis. Rates of return and risk measures vary over time in different industries. Industry analysis helps identify both unprofitable and profitable opportunities. Industry analysis involves conducting a macro analysis of the industry to determine how different industry relates to the business cycle. Performance of industries is related to the stage of the business cycle. Different industries perform differently in different stages of the business cycle. On the basis of the relationship different sectors share with the business cycles, they are classified as cyclical and noncyclical sectors. For example, banking and financial sector perform well towards the end of a recession. During the phase of recovery, consumer durable sectors such as producers of cars, personal computers, refrigerators, tractors etc. become attractive investments. Cyclical industries are attractive investments during the early stages of an economic recovery. These sectors employ high degree of operating costs. They benefit greatly during an economic 50 expansion due to increasing sales, as they reap the benefits of economies of scale. Similarly, sectors employing high financial leverage also benefit during this phase, as debt is good in good times. At the peak of business cycle, inflation increases as demand overtakes supply. Inflation impacts different industries differently. There are industries, which are able to pass on the increase in the costs of products to their consumers by increasing prices. Their revenue and profits may remain unaffected by inflation. Industries producing basic materials such as oil and metals benefits the situation. Rising inflation doesn’t impact the cost of extracting these products. These industries can increase prices and experience higher profit margins. However, there are industries that are not able to charge the increased costs of production to their consumers. Their profitability suffers due to inflation. During a recession phase also, some industries do better than others. Defensive industries such as consumer staples, pharmaceuticals, FMCG, outperform other sectors. In such times, even though the spending power of consumer may decrease, people still spend money on necessities. Analyst also see the stage the industry is in its life cycle. The number of stages in the life cycle of the industry are depicted in Exhibit 3.2. Exhibit 3.2: Industry Life Cycle Introduction: During this stage, industry experiences modest sale and very small or negative profit. The market of the products of the industry is small and the firms in the industry may have high development costs. Growth: During this stage, market develops for the products or services of the industry. Number of firms in the industry is less during this phase and hence they may have little competition. Profit margins at this stage are generally high. This stage is followed by mature industry growth. The rapid growth of the earlier phase attracts competitors contributing profits margins go to normal levels. 51 Maturity: This is generally the longest phase in the life cycle of the industry. During this stage, growth rate in the industry normally matches with the economy’s growth rate. Firms in the industry differ from one another given their cost structure and ability to control costs. Competition is high during this stage reducing the profit margin to normal levels. Deceleration of growth and decline: This stage observes decline in sales due to shift in demand. Profits margins are under pressure and some firms may even witness negative profits. Similar to life cycle analysis, competitive structure of the industry is to be analysed by the analysts. It is a key factor affecting the profitability of the firms in the industry. Competition influences the rate of return on invested capital. If the rate is "competitive" it will encourage investment. Porter looked at forces influencing competition in an industry and the elements of industry structure. He described these forces as industry’s micro- environment. Porters model is presented in Exhibit 2.3. Exhibit 2.3 Porter’s Model Potential Entrants Threat of new Bargaining power of entrants suppliers Industry Competitors Suppliers Buyers Rivarly among Existing firms Threat of substitute Substitutes Bargaining power of products or services buyers Michael Porter suggests that five competitive forces determine the intensity of competition in the industry, that in turn affects the profitability of the firms in the industry. The impact of these factors can be different for different industries. The first factor is rivalry among the existing competitors. Every industry is analyzed to determine the level of rivalry amongst its firms. Rivalry increases when the industry has many 52 firms of the same size. And hence firms may compete very hard to sell at full capacity. The second factor is threat of new entrants. The entry barriers influence the entry of new player to the industry. The analysts examine them, as they influence the future competitive structure of the industry and in turn profitability of existing firms. The third factor is threat of substitute products. Substitute products influence the prices firms can charge for their products. Greater the substitutability of the product, lower the profit margins. The fourth factor is bargaining power of the buyers, which influences the profitability. Buyers can influence the profitability of an industry when they are in position to demand lower prices or higher quality by showing a susceptibility to switch among competitors. The fifth factor is bargaining power of the supplier. Suppliers are more powerful if they are few and large in size. They can influence future industry returns if they increase prices or reduce the quality of the product. Company Analysis Company analysis is the final step in the top-down approach to stock analysis. Macroeconomic analysis prepares us to understand the impact of forecasted macro- economic environment on different asset classes. It enables us to decide how much exposure to be made to equity. Industry analysis helps us in understanding the dynamics of different industries in the forecasted environment. It enables us to identify industries that will offer above-average risk-adjusted performance over the investment horizon. If trends are favourable for an industry, the company analysis focusses on firms in that industry that are positioned to benefit from the economic trends. The final investment decision to be made is with regard to which are the best companies in the desirable industries? And are they attractive investments in terms of risk-adjusted returns. Company analysis is to be differentiated from stock valuation. Company analysis is conducted to understand its strength, weaknesses, opportunities and threats. These inputs are used to determine the fundamental intrinsic value of the company’s stock. Then this value is compared with the market price of the stock. If the intrinsic value is higher than the market price, the stock is bought and vice versa. It is very important to note that stocks of good companies need not make good investment opportunities. The stock of a good company with superior management and strong performance measured by current and future sales and earnings growth can be trading at a price much higher to its intrinsic value. It may not make a good investment choice and it should not be acquired. Company analysis is needed to determine the value of the stock. There are many components to company analysis. Financial statement analysis of the company is often the starting point 53 in analysing company. Analysing the profit and loss account, balance sheet and the cash flow statement of the company is imperative. The financial performance numbers of a company, as presented in the financial statements, can be used to calculate ratios that gives a snapshot view of the company’s performance. The ratios of a company have to be seen in conjunction with industry trends and historical averages. Another important component of company analysis is SWOT Analysis. SWOT analysis involves examination of a firm’s, strengths, weaknesses, opportunities, and threats. Strengths and weaknesses deal with company’s internal ability, like company’s competitive advantage or disadvantages. Opportunities and threats deal with external situations and factors the company is exposed to. Opportunities include a favourable tax environment. An example of threat is stringent government regulation. Company analysis also involves analysing its competitive strategies. A firm may follow a defensive strategy. A defensive strategy is one where the firm positions itself in such a way that its capabilities provide the best means to deflect the effect of competitive forces in the industry. Alternatively, a firm may be following an aggressive strategy in which the firm attempts to use its strengths to affect the competitive forces in the industry. Michael Porter suggests two major strategies: Cost Leadership and Differentiation. Cost Leadership: Under this strategy the firm seeks to be the low-cost producer, and hence the cost leader in its industry. Cost advantages vary from industry to industry. Differentiation Strategy: Under this strategy, the firm positions itself as unique in the industry. Again the possibilities of differentiation differ from industry to industry. Another very important component of company analysis is understanding the business model of the company. As part of it, the following questions need to be asked. x What does the company do and how does it do? x Who are the customers and why do customers buy those products and services? x How does the company serve these customers? Almost all successful investors and fund managers repeat this thought that one must invest only in such firms where one understands the business. In the checklist for research, this is one of the most prominent questions – ‘Do I understand the business?’ No analyst should move to the next question if he/she can’t address what a company does in a line with preciseness and clarity. There are over 6000 companies listed on Indian exchanges. It is not possible to track and understand all of them. Investors should consider buying shares of few companies they understand rather than invest in a number of companies they don’t understand. 54 Further, each sector has its own unique parameters for evaluation. For the retail sector, footfalls and same store sales (SSS) are important parameters, whereas for banking it is Net Interest Income (NII)/ Net Interest Margin (NIM). For telecom, it is Average Revenue Per User (ARPU) and for hotels, it is average room tariffs etc.. Analysts must possess an in-depth knowledge of the sectors while researching companies. Further, each company will have its unique way of doing business. The efficiency with which products and services are produced and delivered to the customers may vary from one business to another and will significantly impact its earnings. Therefore, it becomes imperative for analysts to understand the entire business model of companies. 3.5.3. Estimation of intrinsic value Once the analysis of economy, industry and company is completed, the analyst can go ahead with estimating intrinsic value of the firm’s stock. Price and value are two different concepts in investing. While price is available from the stock market and known to all, value is based on the evaluation and analysis of the entity that is undertaking the valuation of the stock at a point in time. It may be noted that Price is a Fact but Value is an Opinion. There are various approaches to valuation. They are explained in the subsequent paragraphs. There are uncertainties associated with the inputs that go into these valuation approaches. As a result, with due diligence, the final output can at best be considered an educated estimate. That is the reason, valuation is often considered an art as well as a science. It requires the combination of knowledge, experience, and professional judgment in arriving at a fair valuation of any asset. The purpose of valuation is to relate market price of the stock to its intrinsic value and judge whether it is fairly priced, over-priced, or under-priced. Discounted Cash Flow Model Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate approach for valuations when three things are known: x Stream of future cash flows x Timings of these cash flows, and x Expected rate of return of the investors (called discount rate). Once these three pieces of information are available, it is simple mathematics to find the present value of these cash flows which a potential investor would be willing to pay today to receive the expected cash flow stream over a period of time. Typically, any investment involves the outflow of cash. Later the investor expects, cash inflows during the investment horizon. Finally, at the time of disinvestment, the investor expects a large cash inflow - preferably larger than the original investment - representing the return of original investment with some appreciation. The same framework can be applied to valuing businesses. Popularly, profits are compared to the regular inflows from traditional 55 investments. However, it should be appreciated that profits are accounting estimates rather than facts. Because accounting standards and tax authorities permit accrual accounting, there can be many valid adjustments to the figure of profit without any involvement of cashflows. Therefore profits in business and returns in the form of cashflows in financial investments are not comparable. This gave birth to the philosophy of estimating cashflows in business from the profit figures. Business valuation professionals applied the philosophy of discounting to valuation of business entities, drawing from the postulates of time value of money and the fundamental framework, that “the intrinsic value of any asset, should be equal to the present value of future benefits that accrue from owning it”. For instance, when one holds a real asset, like land and buildings, its value should logically depend on the future rental income and resale value that could be generated from it, measured in present value terms. In case of a Bond, the intrinsic value of a bond should depend on the future coupons and the redemption value, measured in present value terms. In both the cases, the entity that estimated the intrinsic value, uses a particular discounting rate, which includes, the minimum risk free rate, the compensation for the term period of the investment, the premia for the asset specific risks, the transaction costs, and the taxes. The aggregate of all these components are referred to as required rate of return. However, in common parlance the transaction costs and taxes are taken as given, so they are ignored. Extending the logic to business valuation or equity valuation, the investor should logically discount the future benefits accruing to the business or by being an equity investor. In case of a business that has not taken any debt in its capital structure, the entire profits belong to the owners. However when the company engages borrowed capital in the business, then the lenders also have a claim in the assets and profits of the business. If booked profits are considered to be the future benefits, then Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) are the profits left for both the lenders and owners to share along with government for tax. Earnings After Tax (EAT or PAT) are the profits left for only the owners of the business, as other stakeholders (lender, and government) have taken away their dues. As discussed earlier, the inherent weaknesses with the EBITDA and EAT figures, valuation experts preferred cashflow versions of the two accounting figures mentioned above. FCFF represents the cashflow left for both the lenders and owners, out of which lenders can take their interest and principal repayments, and the owners can take their dividends. FCFE represents the cashflow left only for the owners of the business. Therefore depending on the purpose of valuation, i.e. to value a firm or equity, either FCFF or FCFE is used, respectively. FCFF for a future year is calculated as = Expected EBIT (1-Tax Rate) + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm –Expected Increase in Working Capital 56 FCFE for a future year is calculate as = [(Expected EBIT – INTEREST EXPENSE) * (1 – Tax Rate)] + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm – Expected Increase in Working Capital – Expected Debt Repayments + Expected Fresh Borrowings OR FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + (Expected Fresh Borrowings – Expected Debt Repayments) OR FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + Expected Net Debt Issues OR when the company has preference shares also in the capital, it is calculated as FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) – Expected Preference Dividend + Expected Net Debt Issues + Expected Net Preference Share Issues Apart from depreciation, other non-cash charges include amortization of intangible assets and loss on sale of assets, which are added back. Unrealised Gains on assets are deducted from the FCFF and FCFE calculations. The FCFF and FCFE figures are known as “free” because all the other stakeholders, leaving the financiers of the business, are paid their dues before arriving at the figures. Further, the business is also treated as a stakeholder, and the funds required for its growth and sustenance are also provided in the form of CAPEX, and working capital. Therefore what is left is for the financiers’ to claim free of all encumbrances. Rarely, FCFF may be negative, but there are reasonable chances that FCFE may be negative. In such cases the FCFF may be used for valuing the firm, and then the value of equity can be calculated by deducting the value of debt from it. Valuation requires forecasting cashflows into the future. This can be done by applying historical growth rate exhibited by company or a rate estimated by the analysts based on their information and analysis. A firm may show a period of high growth in revenues, profitability, capex and other performance parameters, and then stabilize to a steady growth. It may be noted that growth rate in one parameter like sales, should not be considered as growth in assets, similarly the growth in assets cannot be considered as growth in profits or cashflows. However a good proxy that is used in the valuation industry for growth in profits is the product of retention ratio and return on equity as follows: Growth in profits in a dividend paying firm = Retention Ratio * Return on Equity OR (1 – DPR) * ROE 57 Since equity is for perpetuity and it is not possible to forecast the cashflows forever, the practice is to calculate a terminal value of the firm. This terminal value is calculated as at the end of the year, till which time one could comfortably forecast the cash flows with all the available information. The terminal value may be calculated using the formula of a perpetually growing annuity. In this case cash flows are expected to grow, forever, at a steady though modest rate. The average long term GDP growth rate or inflation rate is a good proxy for this growth rate. The terminal value is calculated by multiplying the cash flow for the last year of forecasted period, by (1+ Normal Growth rate) and dividing the resultant value by (Discounting rate- Growth rate). The terminal value is added as an additional independent component, to the stream of cash flows projected during the growth period or the projection period, and then aggregate of all these cashflows are discounted to today (the day of valuation). Say for instance one could confidently forecast cashflows for the next 5 years. Then 5 th year is the last year of the confident forecast, and from the 6 th year onwards the cashflows are expected to grow constantly at a particular rate as described above. The terminal value is calculated as at the end of 5th year and finally this value is discounted to today, when the valuation exercise is undertaken. The other method to calculate the terminal value is by applying a multiple to either a financial or non-financial metric of performance of the firm, such as the EBITDA, at the end of the confident forecasted year. Meaning in the 5th year as discussed in the previous paragraph. The multiple of a comparable firm is used for the purpose. The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and also the expectations of the investors. In most of the valuation exercises, cost of debt is taken as the prevailing interest rates in the economy for borrowers with comparable credit quality. And, cost of equity is the rate of return on investment that is required by the company's common shareholders. Capital Asset Pricing Model - CAPM, which establishes the relationship between risk and expected return forms the basis for cost of equity. As per Capital Asset Pricing Model (CAPM) ,the cost of equity is computed as follows: Ke = Rf + β * (Rm – Rf) where: x Rf : Risk Free Rate (usually the ongoing 10 years government bond yield) x (Rm – Rf): Market risk premium (MRP) (which is a historical average value for a particular market or country) x β = Beta (it is the sensitivity of a security’s return to an index’s return, which is chosen as a proxy for market portfolio) 58 The Weighted Average Cost of Capital of the firm (WACC) is then calculated as under: WACC = [Ke * (Equity / (Equity+ Debt))] + [Kd * (1-Tax)* (Debt / (Equity+ Debt))] OR WACC = [Ke * We] + [Kd * (1-Tx)*Wd] where: x Ke : Cost of Equity, x Kd : Cost of Debt, x Wd: Weight of Debt x We: Weight of Equity To calculate the value of the firm, its FCFF is discounted by the weighted average cost of capital (WACC). To calculate the value of equity, its FCFE is discounted using the cost of equity. ௡ ‫ܨܨܥܨ‬௜ ܸܶ ܸ݈ܽ‫ ݉ݎ݅ܨ݂݋݁ݑ‬ൌ  ෍ ௜ ൅  ሺͳ ൅ ܹ‫ܥܥܣ‬ሻ ሺͳ ൅ ܹ‫ܥܥܣ‬ሻ௜ ଵୀଵ  Where, i = the period for which confident projects of cashflows are done, starting from 1 to n number of years in future n = the last year for which the cashflows are projected year wise ‘FCFF’ and ‘wacc’ are as explained above ‫ܨܨܥܨ‬௡ାଵ ܶ݁‫ ݁ݑ݈ܸ݈ܽܽ݊݅݉ݎ‬ൌ  ܹ‫ ܥܥܣ‬െ ݃ Where ‘g’ = is the constant growth rate of the FCFF in future. The same equations are used to calculate the value of equity of the firm. The only changes are ‘FCFF’ is replaced with ‘FCFE’; ‘wacc’ is replaced with ‘ke’; ‘g’ is the constant growth rate of ‘FCFE’ Asset Based Valuation Asset Based valuation methodology is used in some businesses where the business is asset heavy, and the assets are usually reflected in the financial statements at fair market value, like financial Institutions, firms in real estate and gold, gems and jewellery. Under this method, the value of the firm is equal to the “adjusted current market values of Net Tangible, 59 Intangible, Financial, and Net Current Assets”. Value of equity is “value of firm less value of all outsider liabilities”. Significantly the issue with this approach is that it does not recognise the value of future profits and cashflows of the firm, and all future possible value creation the firm can do due to its research and innovation. Relative Valuation (Multiple Based) When the entity that is undertaking the valuation, neither has adequate information to undertake an elaborate valuation exercise like the discounted cashflow approach, nor does it believe in the financial statement values of the assets and liabilities of a firm, it adopts Relative or Multiple based valuation. Relative valuation arrives at the value of a firm or equity, by multiplying either a financial metric or a non-financial metric of a firm with some number. This number is called a “multiple”. The multiple is created as a “ratio” by relating historical market values of either the firm, or its equity, to any chosen financial or non-financial metric. The multiple is calculated for the comparable firms, and then the average value of the same is chosen to value the target company. The value of the target firm is calculated as “the product of the target firm’s financial or non-financial metric TIMES the comparable firm’s multiple” While choosing the multiple, the relative approach believes that the value of a firm should very closely relate to the value of other firms in the same business sector. Such other firms are comparable on the basis of asset size, revenue size, business model, revenue model, and product line offering etc. The assumption of this approach is that “a company into confectionary products would not be worth more than any other similar confectionary company currently traded and operating in the market”. The numerator of the multiple in most of the cases is either the Price of the equity share of a comparable firm or its Enterprise Value. Enterprise Value is the sum of “Market value of Equity and Market Value of Debt LESS the value of excess Cash in the business”. The denominator in the multiples are either various versions of Profits or Revenue or Cashflows or Book Value of Equity. Off late, the increasing start-up culture and their long gestations to experience profits in a growing firm, industry analysts have also started relating the value to non-financial metrics. The chosen metric is believed by the analyst to be a significant value driver of the firm, in that business sector. This belief may appear to be like a subjective judgement call, however there are some fundamental relationships underlying the non-financial metric and the profits or revenues. For instance “Average Revenue per Mega Byte” “Average Revenue per User” in the case of Telecom companies, “Plant Load Factor” in the case of Power companies, “Occupancy Rates” in the case of Lodging Hotels, “Footfall” in the case of Retail sector, etc., 60 The following are some of the popular multiples used in the valuation of equity and firm. P/E Ratio The most common stock valuation measure used by analysts is the price to earnings ratio, or P/E. For computing this ratio, the stock price is divided by the EPS figure. For example, if the stock is trading at Rs. 100 and the EPS is Rs. 5, the P/E is 20 times. Historical or trailing P/Es are computed by dividing the current market price of the equity share by the sum of the last four quarters’ EPS. Forward or leading P/Es are computed by dividing the current mark price of the equity share by the sum of the expected next four quarters of EPS. Current P/E Ratio is current market price of the equity share divided by the current or the immediate recent annual EPS of a company. For example, consider a company whose fiscal year ends in March every year. In order to compute the forward P/E for the financial year ending 2019 (technically called FY19), an investor would add together the quarterly EPS estimates for the future quarters ending June 2019, September 2019, December 2019 and March 2020. Then the current market price of equity is divided by this number aggregate number to get a forward P/E Ratio. A stock's P/E tells us how much investor is willing to invest in an equity share, per rupee of earnings. Therefore a P/E ratio of 10 suggests that investors in the stock are willing to invest Rs. 10 for every Re. 1 of earnings that the company generates. For judging whether the target firm is fairly valued, undervalued or overvalued, its PE ratio is compared with the market PE ratio (i.e. of Nifty 50, S&P Sensex, SX40, among others), or the average PE ratio of the industry to which it belongs, or with the PE ratios of peer group companies. For example the PE Ratio of the target company is 18, and that of the industry, market or the comparable firms is 22, then the firm is judged to be undervalued. There are certain limitations to using the PE ratio as a valuation indicator. The projected P/E ratios are calculated based on analyst estimates of future earnings that may not be accurate. PE ratios of companies that are not profitable, and consequently have a negative EPS, are difficult to interpret. P/E ratios change constantly and the ratio needs to be recomputed every time there is a change in the price or earnings estimates. The average P/E ratio in the market and among industries fluctuates significantly depending on economic conditions. As a general guidance one is advised to approach relation valuation in this manner. For example, all things being equal, a Rs.10 stock is enjoying a P/E of 75, then it is should be considered "expensive" than a Rs.100 stock with a P/E of 20. 61 Price to Book Value Ratio Price to Book Value (P/BV) is another relative valuation ratio used by investors. It compares a stock's price per share (market value) to its book value of equity per share. The P/BV ratio is an indication of how the market is valuing the book value of equity or how much more less are the shareholders valuing the equity to be. The market price being above or below the book value is much to do with market players and investor’s expectations of the value currently not recognised in the books. The book value per share is calculated by dividing the reported shareholders' equity by the number of equity shares outstanding. Care should be taken, to exclude any existing miscellaneous assets in the balance sheet from the reported shareholder’s equity value. Because the value equity has already been eroded as per books, to the extent of value of miscellaneous assets. If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities. The first scenario is that the stock is being incorrectly undervalued by investors due to lack of information, and hence the company’s stock represents an attractive buying opportunity. On the other hand, if the company is being correctly valued in the opinion of the investors, then it is due to the existence of some “value less” assets in the books or fictitious profits or reserves in the shareholder’s equity. The use of book value as a valuation parameter also has limitations because a company's assets are recorded at historical cost less depreciation. Depending on the age of these assets and their physical location, the difference between current market value and book value can be substantial. Also, assets like intellectual property are difficult to assess in terms of value. Hence, book value may undervalue these kinds of assets. Though P/B ratio has its shortcomings, is still widely used as a valuation metric especially in valuing financial services and banking stocks where the assets are marked to market. P/S Ratio The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company's total sales or revenue over the past 12 months. The logics applied for identifying the undervalued and overvalued shares are similar in this multiple too. Sometimes concerns are raised regarding the tendency of the firms to manipulate earnings. In such situations, price to sales ratio can be used instead of earning based ratios as sales are less prone to manipulation. Also in case of companies not earning profits yet, or companies in high volume low margin businesses instead of earning based ratios investors can look at the P/S ratio to determine whether the stock is undervalued or overvalued. Typically the forward Price to Sales ratio is given as below 62 P Pt S S t 1 Pt = end of the year stock price for the firm St+1 = expected annual sales per share for the firm for the next year Price Earnings to Growth Ratio Price earnings to growth ratio (PEG Ratio) takes three factors into account—the price, earnings and earnings growth rates. The formula used to compute the PEG ratio is as below: (EPS is calculated as Profit after tax (PAT)/Number of outstanding common shares of the company) This ratio may be interpreted as the price that an investor is willing to pay for a company, as justified by the growth in earnings. The assumption with high P/E stocks is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio is an improvisation of the PE ratio using a companion variable called growth. Using either the industry or the comparable firms’ PEG ratios one can decide whether the target firm’s equity is overvalued or undervalued. The PEG ratio may show that one company, compared to another, may not have the growth rate to justify its higher P/E, and its stock price may appear overvalued. The thumb rule is that if the PEG ratio is 1, it means that the market is valuing a stock in accordance with the stock's estimated EPS growth. If the PEG ratio is less than 1, it means that the stock's price is undervalued given its growth rate. On the other hand, stocks with PEG ratios greater than 1 can indicate just the opposite - that the stock is currently overvalued. This is based on an assumption that P/E ratios should approximate the long-term growth rate of a company's earnings. The efficacy of the PEG ratio as a valuation measure will depend upon the accuracy with which the earnings growth numbers are estimated. Overestimation or underestimation of future earnings will lead to erroneous conclusions about the valuation of the share. EVA and MVA There are many ways analysts can estimate the value of a company. EVA and MVA are the most common metrics used to determine a company's value. Economic value added (EVA) attempts to measure the true economic profit produced by a company. It is also referred to as "economic profit". Economic profit can be calculated by 63 taking a company's net after-tax operating profit and subtracting from it the product of the company's invested capital multiplied by its percentage cost of capital. EVA provides a measurement of a company's economic success over a period of time. This measure is useful for investors who wish to determine how well a company has produced value for its investors. Market Value Added (MVA) is the difference between the current market value of a firm and the original capital contributed by investors. If the MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value added needs to be greater than the firm's investors opportunity cost. The opportunity cost is calculated by estimating the return the investors would have got by investment in the market portfolio adjusted for the leverage of the firm. EBIT/EV and EV/EBITDA Ratio Enterprise Value (EV) is an important component of many ratios analysts use to compare companies, such as the EBIT/EV multiple and EV/EBITDA. The EV of a business is: Market capitalization of equity + Market Value of Debt - Excess cash and cash equivalents There can be two ways to understand EV. One is to understand how much capital is actually committed in the enterprise that is revenue generating. The other is when some entity is interested to acquire another firm, how much cash would be required to buy the target firm. The assumption is that no entity would be interested in paying cash to acquire cash. EV can be related to Earnings/Cash from Operations available to the entire fund providers i.e. equity and debt holders. The appropriate financial metric would be Earnings before Interest and Taxes (EBIT). However EBIT is again influenced by the accrual mechanics of the accounting system, and hence to adjust it to make it a cashflow based measure, analysts have coined EBITDA (Earnings Before Interest Tax Depreciation and Amortisation). The EV/EBITDA multiple is extremely useful in valuing firms which are highly capital intensive and they are not yet making book profits at PAT level or at EBIT level, however, at a gross level and in terms of cash available to the fund providers (i.e. EBITDA) it is surplus. If one goes by the P/E ratio, then unless the company is profitable, the P/E ratio would not be meaningful at all for valuation. Though the company is listed and has a good price in the market, the earnings per share is negative, which is not intuitive to analysts and investors. Investors can still be bullish and positive about such companies, because they understand the need to wait till the company breaks-even or till the impact of capital expenditure on the revenues and profits kicks off. EV/EBITDA accommodates this thought process. It can be used to judge 64 whether the firm is overvalued or undervalued by comparing its EV/EBITDA value with that of the industry average, or its relevant decile or quintile. EV/S Ratio Enterprise value-to-sales (EV/sales) compares the enterprise value (EV) of a company to its annual sales. The EV/sales multiple enables investors to value a company based on its sales, while taking account of both the company's equity and debt, and hence, comprehensive than Price to Sales Ratio. This ratio is more meaningful when the firm is highly capital intensive and its sales and profits cannot be ascribed only to equity investments. Industry/sector specific valuation metrices As discussed above, there are different valuation tools. No one method is perfect for all the sectors and companies. Different sectors are valued on different metrices. Non-cyclical sectors like FMCG and Pharma which generate predictable cashflows can be valued using discounted cashflow technique. Replacement cost method is applied for valuing businesses which are capital intensive like cement and steel. Relative valuation tools like P/E Ratio are used as add on metrics across all sectors. It is also popularly used to comment on the valuation of market, comparing it with other markets and also doing comparison over a period of time. Often newspapers and media report the P/E ratio of the market and comment that it is expensive or cheap, compared to other emerging markets. P/B ratio is very popular among banks and financial service sector. Investors/analyst should understand the characteristics and attributes of the sector before they select a particular valuation tool. 3.5.4 Combining relative valuation and discounted cash flow models Discounting models are used to estimate the intrinsic value of the stock. The relative valuation multiples arrive at the likely market value the firm would compare, by comparing it to similar firms or industry at large. Further the multiples can be categorised as transaction multiple or trading multiples, which provide a good handle for the valuation professionals to justify their valuation and also to adjust their intrinsic valuations according to the latest market sentiments. Trading multiples are based on the prices in the markets at which trades have consummated. Transaction multiples are based on the recent corporate acquisitions which depict the motivations and future prospects as seen by strategic acquirers, who are unlike the intraday or technical based traders in the markets. Discounting models are dependent on the (1) the growth rates of whichever variable is chosen in the numerator and (2) the required rate of return as the discount rate. If Dividends are substituted in the DCF models that used FCFF or FCFE as discussed in the previous sections and with an assumption that dividends of a firm are going to be given eternally with a constant 65 growth rate, then the formula for terminal value calculations can be applied to arrive at the intrinsic value of dividends as follows. This ratio is also influenced by the same variables that influence the value under the discounted cash flow techniques. Price is calculated as follow. This is also the famous Dividend Discounting Model. ‫ܦ‬ଵ ܲ ൌ ݇െ݃ ‫ܦ‬ଵ = is the dividend that is expected one year hence. This can be as D0*(1+g) where ‘g’ denote expected growth in dividend, and D0 indicates current dividend. ‘k’ is the discount rate which is the proxy for the required rate of return of the equity investors. A deeper look into the formula that D1 can be expressed as E1 * DPR which is the expected Earnings Per Share a year hence multiplied by Dividend Payout Ratio (DPR). So the formula can be expressed as follows ܲൌሺ‫ܴܲܦכͳܧ‬ሻȀሺ݇െ݃ሻ Now, let us look at the P/E ratio to understand the connection between discounted techniques and relative valuation: Forward P/E Ratio = Price / Expected Earnings Per Share or P / E1 To convert the dividend discounting model depicted above to a P/E ratio, one can divide both the sides of the equation by ࡱ૚ (expected earning during the next time period) to get ܲ ‫ܴܲܦ‬ ൌ ‫ܧ‬ଵ ݇െ݃ Thus P/E Ratio is affected by three variables: 1. Required rate of return of the equity investors (k) 2. Expected growth rate of dividends (g) 3. The dividend payout ratio of the firm. Higher the expected growth rate of dividends, higher would be the P/E ratio. Higher the required rate of return on equity, lower would be the P/E ratio. Higher the dividend payout ratio higher would be the P/E ratio. The above equation is usually known as “Fundamental P/E” of a company, which is derived based on how the firm is performing and the expectations of the equity investors. However this ratio appears to show its dependence on dividend payout ratio, and hence it should be cautiously applied to only companies which are stable dividend paying and then compare with such companies only. This approach cannot be 66 applied to start-ups, irregular dividend paying companies, and companies which are in a growth path and the markets are accounting for such a growth in the price. 3.6 Technical Analysis Technical analysis is based on the assumption that all information that can affect the performance of a stock, the company fundamentals, the economic factors and market sentiments, are reflected already in its stock prices. Accordingly, technical analysts do not analyse the fundamentals of the business. Instead, the approach is to forecast the direction of prices through the study of patterns in historical market data—price and volume. Technicians (sometimes called chartists) believe that market activity will generate indicators/signals through price trends that can be used to forecast the direction and magnitude of stock price movements in future. There are three essential assumptions in technical analysis about the price and volume behaviour: 1. The history of past prices provides indications of the underlying trend and its direction. 2. The volume of trading that accompanies price movements provides important inputs on the underlying strength of the trend. 3. The time span over which price and volume are observed influences the strength or weakness of the underlying trend. Technical analysis integrates these three elements into price charts, points of support and resistance in charts and price trends. By observing price and volume patterns, technical analysts try to understand if there is adequate buying interest that may take prices up, or vice versa. Technical Analysis is a specialized stream in itself and involves study of various trends- upwards, downwards or sideways, so that traders can benefit by trading in line with the trend. Identifying support and resistance levels, which represent points at which there is a lot of buying and selling interest respectively, and the implications on the price if a support and resistance level is broken, are important conclusions that are drawn from past price movements. For example, if a stock price is moving closer to an established resistance level, a holder of the stock can benefit by booking profits at this stage since the prices are likely to retract once it is close to the resistance level. If a support or resistance is broken, accompanied by strong volumes, it may indicate that the trend has accelerated and supply and demand situation has changed. Trading volumes are important parameters to confirm a trend. An upward or downward trend should be accompanied by strong volumes. If a trend is not supported by volumes or the volumes decrease, it may indicate a weakness in the trend. Technical analysis converts the price and volume data into charts that represent the stock price movements over a period of time. Some of the charts used include line charts, bar 67 charts, candlestick chart. The patterns thrown up by the charts are used to identify trends, reversal of trends and triggers for buying or selling a stock. Typically, chartists use moving average of the price of the stock to reduce the impact of day to day fluctuations in prices that may make it difficult to identify the trend. 3.6.1. Assumptions of technical analysis From the above discussion on what technical analysts do, the following assumption are delineated: 1. The market price is determined by the interaction of supply and demand. 2. Supply and demand are governed by many rational and irrational factors. 3. Price adjustments are not instantaneous and prices move in trends 4. Trends persist for appreciable lengths of time. 5. Trends change in reaction to shifts in supply and demand relationships. 6. These shifts can be detected in the action of the market itself. 3.6.2. Technical versus Fundamental Analysis Fundamental analysis involves determining the intrinsic worth of the stock and comparing it with the prevailing market price to make investment decisions. Fundamental analysts believe that prices will move towards their intrinsic value sooner or later. Technical analysis is not concerned if the stock is trading at a fair price relative to its intrinsic value. It limits itself to the future movements in prices as indicated by the historical data. It is used for short-term trading activities and not necessarily long-term investing. 3.6.3 Advantages of technical Analysis Technicians feel that the major advantage of their method is that it is not heavily dependent on financial accounting statements. They feel that a great deal of information is lacking in financial statements. They also contend that a lot of non-financial information and psychological factors do not appear in the financial statements. Technicians also feel that unlike fundamental analysts, they do not need to collect information to derive the intrinsic value of the stocks. They only need to quickly recognize a movement to a new equilibrium value for whatever reason. Hence they save time in collecting enormous information and data which is a prerequisite for fundamental analysis. 3.6.4 Technical Rules and Indicators There are numerous trading rules and indicators. There are indicators of overall market momentum, used to make aggregate market decisions. There are trading rules and indicators to be applied for individual securities. Some of the popular ones are: 68 x Trend-line analysis x Moving averages x Bollinger-Band Analysis Trend-Line Analysis The graph (Exhibit 3.4) shows a peak and trough, along with a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would ideally want to trade. Exhibit 3.4: Stock price trend line Moving-Average Analysis Moving-Average Analysis is the most popular technical indicator. The moving average of a time series of past prices can provide a nonlinear graphic of price movements. Generally a 5, 10, 30, 50, 100, and 200 days moving averages are calculated. One simple strategy for using the moving-average analysis is to buy when the price is sufficiently below the moving average and sell when the price is sufficiently above the moving average. Bollinger-Band Analysis Bollinger bands use normal distribution to calculate the deviation of the market price from the moving average. For example, when the price goes two standard deviations above the moving average, the stock might be regarded as overbought. If the price goes two standard deviations below the moving average, the stock might be regarded as oversold. 3.6.5 Fixed income securities and Technical analysis The techniques depicted above can also be applied to the fixed income securities as long as price and volume data is available. The theory and rationale for technical analysis of bonds 69 are the same as for stocks, and many of the same trading rules are in fact used by analysts in bond markets. 3.7 Understanding Corporate Governance While analysing companies, the qualitative aspects of the companies are equally important if not more. Corporate governance practices are the cornerstone in evaluating a business. Corporate governance has become a well-discussed topic in business world. Newspapers and media report detailed accounts of corporate fraud, accounting scandals, excessive compensation etc., some leading to even bankruptcy of the companies fraught in such mis governance. Corporate governance includes a wide array of mechanisms and expectations that are of importance to businesses, the economy, and society. World over economies are dominated by companies of different sizes. How these companies are governed affects not only the shareholders of the companies but also thousands of people who work with such companies, buy products of these companies or are affected by them implicitly. Governance aspects are reflected in acts, rules and regulations, contracts, and in important institutions such as stock exchange listing standards and the audit process. The components of corporate governance vary by country, over time, and by company type, size, and ownership. Analysts and investors play a very important role in driving good practices and highlighting companies with poor governance practices. There are some important aspects analysts should look for. For example they should also pay attention to the quality of independent directors in a business. Analysts should focus on the qualifications and experiences of these independent directors, how many meetings they attend and what are their contributions to the business. It may be good practice to interact with some of them to understand them better. Good governance practices can also be used as filters for selecting the investment universe. 70