Fixed income and equity valuation

Lecture 1

Why study this course?

1. To know the tools and techniques for equity valuation and business valuation.

2. Need for understanding equity.

The above skills are required for the analyst position.

1. Skills for managing individual finances.

Gold-based approach - whatever we study has to have an objective - either be analyst, private
banker, financial and wealth management services to high and ultra high network individuals,
portfolio manager or be in financial advisory services where we may be in the process of
disseminating the research reports.

Job market for analyst is not huge. It is lucrative and competitive.

Research team comprises of primarily 10-15 members while the rest of the people would be
involved in client servicing,client acquisition or relationship management.

Equity as an asset class has generated amongst the highest returns not only in 2-3 decades but
across 200 years of history.

Analysis in basic terms means tracking the stock prices.

There are two types of analysis, technical and fundamental.

Difference between technical and financial analysis:

 Technical analysis is not an analysis in true form

(Cash flow is a difference between revenues and expenses including operating expenses and
other expenses on a cash basis.

You cannot forecast the future cash flows of the company without understanding the business
of the company, market size, market share, at what rate the industry would grow, what is the
margin structure of the company, how much capex is the company planning to do, how
would you forecast the expenses, earnings and cash flows

Difference between investment and speculation:

When you buy a stock of the company, you are called as an investor and this is investing.

When you buy a stock of the company as a speculator then this is speculation.
Father of value investing - Benjamin Graham - Guru of Warren Buffet - Intelligent investors
and margin of safety books.

Whether you have done proper analysis of the company and then invest in the company

If yes, then investment

If no, then speculation. Speculators most of the time is short term investor.

When you roll a die, you speculate that the number 2 will come on no basis. So event is
random and if you forecast that random event them it’s known as forecasting.

When there is a reasonable basis by following some laid down principles of analysis, then it’s
known as investment.

Distinguish between value and price and how are they determined?

In the context of any financial asset, for example equity, the difference between price and
value is given below:

Basically,

 Price is what we pay

 Value is what we get

Say, Price of 1 share of reliance industry is 2300, it means that at this instance, there is a
transaction that has happened in which someone has sold a share of reliance and someone has
bought the share of reliance at 2300. So this keeps on changing continuously because buyers
and sellers are trading at different prices at different times.

Market price means the last traded value or the price where the last transaction has taken
place is known as the price.

Price is that monetary value in which buyers and the sellers agree for transactions.

Price changes, like sensex has increased, reliance industry has increased happens because:

 Price changes because of changes in expectations of value.

 Price is determined by demand and supply

There is an electronic market base and there are people who are biding to buy the shares and
there are people who are offering the price in which they want to sell the share. When the
matching happens between the buyer and seller happens then that price becomes at that point
of time.

Say, in china crc coil price and hrc coil price is coming down. It means, that pricing per ton
for steel is coming down. It means, that the price per ton for the steel manufacturers would
come down. If the realisation would come down and people who are expecting higher
expectations, would want to sell the shares of steel industry. People might think that the price
of steel might increase and lock the shares.

Price is a function of demand and supply. Demand here is quantity of shares.

While we are buying and selling the shares like in intraday, then how much of interest is there
in the stock is evaluated. The other name for it is delivery percentage. Out of the total volume
that has happened, what percentage has been delivered and what percentage has been covered
up in intra day.

Demand and supply determines the price and price and price keeps of changing because of
several things.

Price is observable because at any point of time we can go to the stock market and we can
observe the latest price. Latest price is the price at which last trade has happened.

There has to be divergence in opinion and expectations. If there is no divergence, then there
will be a no buyer and the seller.

Value - How is value related to price?

If there is cash outflow. You are expected to cash flows. You find the irr. Similarly, you pay a
price for stock and expect a cash flow from them which is the dividend or the stock price at
which you are going to sell it.

Cash flow you are getting is the function of cash flow which the company is making.

If the company makes more earnings, the company generates more cash flow, then it makes
more dividends, then the stock price will increase, then you can sell at higher price.

There are linkages, that the value of the company is the function of the future cash flows that
the company makes. The objective of the company is to generate maximum or higher cash
flows in the future. The value of the equity or the value of the firm is the present value of the
future cash flows that accrues to the equity shareholders. Terms

 present value

 Future cash flows - to the firm or the equity shareholders or to the debt holders.

Value of equity is the present value of future cash flows of the equity holders. These future
cash flows is not certain. Value depends upon investor to investor. For example, for some
person, the value of reliance share may be of 3000 rupees, for some it may be 1500 rupees.
Why the value may differ? Value may differ because the expectation of future cash flows
may differ. If the expectations of future cash flows differ then the value may also differ. And
only if the value differs only then there will be seller and buyer.

Discounted cashflow perspective of value: DCF

Value of equity is the present value or the sum of the present value of the expected future
cash flow and the expectations of the future cash flows is the function of the expected future
earnings, future capital expenditure, future working capital. These 3 factors may vary from
analyst to analyst. Hence the intrinsic value may vary from analyst to analyst. And hence to
some analysts, the value of equity at any point may be more than the market price and they
might want to buy and vice versa.

Price is not only determined by future cash flows but also some other factors while value is
only determined by future cash flows. Price changes if our expectations for future cash flow
changes. Whenever their is a new news, it may bring in some change in value. The same
news may have different impacts on the value.

When the cost of production increases, the company can do two things. Pass on the burden to
customers and maintain their profit margins or reduce their margins. If the margins reduces,
then the earnings will reduce resulting in a decreased cash flow and the intrinsic value. If the
margins doesn’t reduce, then the earnings will remain the same.

Another factor, sometimes no news comes in the market. Value doesn’t change very
frequently. So Price is not only a function of expectations of value, it is also a function of
more than that. Those factors are:

Inflation in metals or raw materials - Chemical prices have increased, steel prices have
increased, and almost all raw material costs have increased. So the increased in the raw
material cost is more than the decrease in the administration expenses. So effectively profit
are not increases to that extent.

 Liquidity - as the purchasing power changes, we tend to buy those expensive things
which we thought earlier that is of no use.

 Interest rates

 44

 worldwide their is a more rise of equity. Because the said rates i.e federal reserves of
USA, decreased it’s interest rates to 0%. So if interest rates are very low in USA, the
flow of liquidity has increased and the money is flowing in from the developed
markets to emerging markets. Driving force is primarily liquidity of FII and DIIs.

 In last 1-1.5 years, the interest rates are at the bottom, inflation is high, so the real rate
of return is at bottom or negative in any asset class. If the real rate of return is
negative we would look at other asset classes like equity.

 Global surplus or slush of liquidity

 Low interest rates in india

 Company specific factors - A lot of companies have paid their debts. Interest cost will
reduce in future quarters which will lead to increase in earnings which in turn lead to
increased cash flows. So people will want to buy at higher prices. So some changes in
value is even happening. So bulk of goods is driven by liquidity and bulk of it is
driven by lower interest rates.
2 types of industries broadly:

 Cyclical industry - Those particular industries move in cycles. If the cycle is 4-5 years
then they will have higher revenue, higher profits. Then there will be capacity
expansions and demand will come down. Higher fixed costs will there so there will be
loses. These industries goes through massive changes in revenue, margins and cost.
For example, tata steel will make losses, but suddenly they will make huge profits that
will cover up their loses.

 Non cyclical industry - when a company goes through a lower cycle or a depressed
cycle

Valuation parameter: sometimes in good times we are ready to pay more for something and
sometimes we are ready to pay less for the same thing.

During tough times, eps is low or negative. So the valuation is also very low. So price is very
low. Suddenly there is a change, the world is opening up and demand starts increasing, so
earnings starts increasing. So price earning ratio and eps moves up. Hence, price will
manifold increase.

When both earnings growth and valuation growth happens then price can increase much more
than earnings growth.

In a relative valuation framework, we say that the price can be written as P=p/e*eps