3 - Investmenr and Risk MGT - Equity

Sensitivity: Business Only

Chapter 3: Investment & Risk
Management - Equity
Contents
▪ Role of Equity
▪ Active and Passive Exposures
▪ Sector Exposures
▪ Diversification
▪ Fundamental Analysis
▪ Technical Analysis
▪ Fundamental Valuation Approaches
▪ Investment and Speculation
▪ Leveraging
3
Asset Class
An asset class is a specific category of
assets or investments, such as cash,
fixed interest, property, alternative Derivatives
investments and shares.
Equity Real Estate
Modes of
Alternate
Investments
Commodities Gold
4
Role of Equity
5
Role of Equity
o Equities are growth assets
which plays an important Helps in beating inflation
Assists in Portfolio
Diversification
role to grow investor’s
wealth and protect them
from inflation.
Benefits of
having Equity
o Equities offer return in the in Portfolio
form of dividend and
capital gains. Yield from Excellent Return on
dividend is likely to be Investment in Long Regular Income by way
Term – capital of Dividends
smaller than through yield appreciation
from capital gains.
6
Active and Passive Exposures
Whenever investors invest in equities, they need to decide whether they
would prefer an active exposure or a passive exposure.
7
ACTIVE EXPOSURE PASSIVE EXPOSURE
Seeks to beat a Market i.e. Seeks to obtain return in line
Return Objective
benchmark index with benchmark
Invest in an index (such as
Invest in an actively managed the S&P CNX Nifty) i.e.
Style funds like open-ended equity buying stocks in the same
mutual proportion as an index or
investing in an index fund.
Due to high churning of
Investment Management Comparatively low fund
portfolio, the costs of actively
Fees management cost
managing the funds are high.
Depend on the Investment
Tax Efficiency Generally Tax Efficient
Manager
Only Market risk of
Risk High
benchmark
Emotions & Bias High Low
Fund Manager Dependence High Low
Trading Cost High Low
8
Sector Exposures
Investor adopting active
management looks for sectoral plays
i.e. he wants to go under-weight or
over-weight on specific sectors.
In a top-down portfolio building

approach, the investor takes sectoral
decisions and then decides on the
stocks to buy within each sector.
High exposure to a sector leads to

concentration risk in the portfolio and
can be very risky. Example sector
mutual funds such as:
9
Diversification
Diversification is the process of
allocating capital in a way that
reduces the exposure to any
one particular asset or risk.
A common path
towards diversification is to
reduce risk or volatility by
investing in a variety of
assets.
10
Fundamental Analysis
o Fundamental analysis is based on
a study of the company’s
fundamentals viz. its industry
position, management capability,
business strategy, financial
strength and such other factors.
o Study of the company’s financial

statements is a key aspect of
fundamental analysis.
o Long term investors rely on

fundamental analysis.
11
Fundamental Analysis
o Fundamental analysis provides an analytical framework for rational
investment decision.
o This analysis is used to evaluate the present and future earnings
capacity of shares based on economy, industry and company
fundamentals.
12
Technical Analysis
Technical analysis is a security
analysis methodology for forecasting
the direction of prices through the
study of past market data, primarily
price and volume.
It helps in timing the execution of the

decision.
Short term investors including day-

traders operate based on technical
analysis.
13
Fundamental v/s Technical Analysis
14
Fundamental Valuation Approaches
5/16/2018
Discounted Cash Flow Method
o DCF is a method of valuing a company, typically a going concern by
estimating the cash flows & adjusting it for the time value of money. In
this method, all future cash flows of the company are estimated and
discounted by an appropriate discount rate (to cover riskiness or
expectation) to give their present values (PVs).
o Two alternative approach can be used
1. Measuring the discounted Free Cash Flow to the Firm (FCFF)
2. Measuring the discounted Free Cash Flow to Equity (FCFE)
16
Free Cash Flow to the Firm (FCFF)
• FCFF is the operational cash flow that is available for servicing
debt and equity investors. It is calculated as follows:
• FCFF = PAT + Depreciation & Amortisation + Interest (1 – Tax

Rate) – Normal Working Capital Investment – Normal Fixed
Capital Investment
• Value of the firm is separately determined for an initial period and

subsequent stable period, as in the case of dividend discounting
method. However, the discount factor used is the weighted
average cost of capital.
5/16/2018
Free Cash Flow to Equity (FCFE)
• From FCFF, if the payments towards debt servicing are reduced,
the balance belongs to equity investors.
• This is FCFE. FCFE = FCFF – Interest (1-tax rate) – Loan

Repayment This has to be discounted at the Cost of Equity to
arrive at the Value of Equity of the firm.
• The value is separately determined for an initial period and the

subsequent period of stable growth. The summation of the two is
the value of the equity of the firm.
5/16/2018
Enterprise Value (EV)
• Measure of what the market believes a company's ongoing operations
are worth.
• Enterprise value discusses the aggregate value of a company as an
enterprise rather than just focus on its current market capitalization.
• Enterprise value = Market value of equity (Market capitalization) +
Market value of debt – cash and cash equivalents
Market Cap = Current share price * Total shares Outstanding
Debt = Long Term Debt + Short Term Debt
Net Debt
Market Value
(Total debt – Enterprise
of Equity
Cash & Cash Value (EV)
(Market Cap)
Equivalents)
19
Price to Earnings Ratio (P/E Ratio)
o Price to Earnings Ratio or the P/E Current
Market Price
Ratio measures the price that the (CMP)
market is willing to pay for the P/E
earnings of a company. Ratio
o P/E Ratio = Current Market Price / Earnings per
Share (EPS)
EPS
o To arrive at the intrinsic fair value of
the Company, EPS is projected.
o This is multiplied by the expected
Price to Earnings Ratio to arrive at
the value of the share.
o If the fair value is higher than the
CMP, the stock is undervalued and
investor can buy the stock.
20
Price-to-Book Value Ratio (P/BV)
o Price to Book Value Ratio is one of the most widely used ratio to find
price relative to the value.
o P/BV Ratio = Current Market price (CMP) / Current

Book value per share Market
Price
o P/BV less than 1 indicates the company is (CMP)
trading below its book value, and hence the P/BV
stock is deemed to be undervalued.
o This approach entails projecting the book
Book
Ratio
value of each share of the company. Value
per
o This is multiplied by the expected Price to Share
Book Value Ratio to arrive at the fair value
of the share.
o If the fair value is higher than the CMP, the stock is undervalued and
investor can buy the stock.
21
Dividend Discounting Method
o The price of any stock is equal to the present value of the expected
future dividends it will pay.
o Gordon Growth Model (GGM) assumes that dividends increase at a
constant growt rate indefinitely.
o Value of the share would be the sum of the value for the initial period
and the present value of the terminal value.
22
Investment and Speculation
o Investment is generally
associated with longer time
horizon.
o Shorter term investments are
referred to as speculation.
o Speculators takes more risk than
the investor and thus hopes to be
compensated with higher returns.
Liquidity
Return Safety
Contribution
Risk Characteristics to capital
of Investment formation
23
Investment v/s Speculation
Bases Investment Speculation
1. Risk assumed Low to High Always high
Regular return + capital

2. Objective Capital gain
gain
3. Time period long term Always short term
Use borrowed fund to

4. Funds His own fund
supplement his own fund
5. Nature of return Consistent & Long term Quick & Short term
24
Leveraging
An investment approach where the investor relies on borrowed funds to
support the investment position is called leveraging. This might take
various forms, as follows:
o Investing in a derivative instrument like a future or option.
o Margin trading, where a broker or other financier offers to fund a
percentage of the investor’s position on an ongoing basis.
o Term loan for a fixed period.
25
Leveraging Example-
Investors’ perspective
Capital Requirement Unleveraged Position Leveraged Position
Investment Value (Original) 1000000 1000000
Borrowing Limit 0 60%
Loan (Original) 0 600000
Own Capital (original) 1000000 400000
Market Decline 10% 10%
Loss 100000 100000
Investment Value (Revised) 900000 900000
Borrowing Limit (Revised) 0 540000
Additional Capital Required to
0 60000
continue position
26
Leveraging – Risky Investment Approach
o The primary advantage of leverage is to
increase the profitability of an asset.
o One of the main disadvantages is that if
the asset’s value drops there is a
higher risk of losing your initial
investment. In other words, if things do
not go according to plan, investor can
lose all their own initial capital.
o Leveraging can deliver superior returns
in favourable market conditions; but it
can deliver significant losses in adverse
market conditions. Therefore,
leveraging is a risky approach to
investment.
27
Thank You
28
DISCLAIMER
The following presentation is for educational purpose only. All symbols and investment/ trading ideas
discussed by instructors are for demonstration purposes only and are not recommendations to buy or sell into
any asset class.
This information may demonstrate certain hypothetical trading strategies with the use of software(s). Please
note, hypothetical or simulated performance results have certain inherent limitations and do not represent
actual trading. Simulated trading are generally designed with the benefit of hindsight. No presentation is being
made herein, that any account will or is likely to achieve profits or losses similar to those shown here. This
demonstration is not a recommendation to buy or sell financial instruments, but rather guidelines to interpret
and use specific indicators and features within the software.
We strongly suggest that information and techniques presented should only be used by investors who are
aware of the risk inherent in trading. www.elearnmarkets.com will have no liability for any investment
decisions based on the use of information and/ or techniques shown in this presentation.
29

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Sensitivity: Business Only

Sensitivity: Business Only

Equity Real Estate

In a top-down portfolio building

High exposure to a sector leads to

o Study of the company’s financial

o Long term investors rely on

It helps in timing the execution of the

Short term investors including day-

• FCFF = PAT + Depreciation & Amortisation + Interest (1 – Tax

• Value of the firm is separately determined for an initial period and

• This is FCFE. FCFE = FCFF – Interest (1-tax rate) – Loan

• The value is separately determined for an initial period and the

o P/BV Ratio = Current Market price (CMP) / Current

Regular return + capital

3. Time period long term Always short term

Use borrowed fund to

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