CHAPTER 2: SECURITIES: TYPES, FEATURES AND CONCEPTS

TYPES OF SECURITIES

EQUITY DEBT

1. Have to be returned after specific

1. Available for the company
to use as long as it is needed
2. No any fixed return or
return of principal
3. Investors are the owners of
the business
4. Investors participate in the
management
5. High risk and high returns
time
2. Earn a fixed rate of interest or
return of principal at maturity
3. Investors are lenders to the
business
4. Investors do not participate in the
management
5. Relatively low- risk and income-
oriented investment
 NATURE

INSIDE AND
DENOMINATIO OUTSIDE
N SHAREHOLDE
RS

FEATURE
S OF
VARIABLE
PART
EQUITY RETURN AND
OWNERSHI CAPITAL RESIDUAL
P CLAIM

MANAGEME
NT AND NET WORTH
CONTROL
 INSTRUMENT
TYPES
FLOATING
CONVERSIO RATE OF
N INTEREST

FEATURE
S OF
DEBT CREDIT
CONTROL CAPITAL RATING

SECURITY PRIORITY
Factors to be considered before choosing between equity and debt financing
A. Ability to pay periodic interest:
• If a business generates stable profit, such that it can pay interest on a regular basis then in such cases, the
businesses can consider raising debt capital.
• Business that does not generate steady and regular profits may choose equity over debt capital.
B. Willingness to dilute ownership in the company:
• Equity capital represents ownership and confers voting rights to holders.
• If existing equity holders do not want a reduced stake in the business, then they may consider raising
debt capital to equity capital.
C. Ability to give collateral as security:
• Lenders or debt financers prefer secured borrowings.
• If a business is services‐based and not asset‐based then equity financing is preferred to debt financing.
D. Time period for which capital is required:
• If capital is required to tide over short‐term capital requirements, a firm may choose debt capital.
• If there is a long‐term need and if debt investors are unwilling to take the risk, a firm issues equity
capital.
 Intrinsic value is the estimated
value per equity share, based
on the future earning potential
of the company
INVESTING IN EQUITY PRICE AND VALUE

Market price is the price at

which the share trades in the
stock market
EQUITY INVESTING PROCESS

SECURITY
SELECTION

MARKET
TIMING

SECTOR
AND
SEGMENT
WEIGHTIN
G
 • Done by broking houses, who
engage specialists to track
SELL-SIDE
RESEARCH sectors and stocks.
• They also interact with
management, peers, client,
suppliers and customers.
• They may also arrange
management meetings and
EQUITY create event-based reports and
RESEARCH analysis.

• Done by institutional investors.

• Objective is to generate active
returns higher than
benchmarks. BUY-SIDE
• They are tend to be generalists RESEARCH
rather than specialists.
EQUITY ANALYSIS AND VALUATION

There are two parts to evaluating a stock for investment:

• Equity analysis to establish the fundamental reasons for investing in a particular stock.
• Equity valuation and assessment of market price, to determine whether to buy or sell a stock at a given
price.

There are two approaches to such evaluation:

a. Fundamental analysis is a study of the financial statements and information pertaining to a stock, to
estimate the future potential.
b. Technical analysis involves studying the price and volume patterns to understand how buyers and sellers
are acting on existing price information
Equity analysis involves studying a range of variables, factors and numbers and their implications for the
future potential of a stock.
It is done in two principal ways:
• Top-down approach begins at macro factors and identifies sectors and stocks based on the identification
of macro trends.
• Bottom -up approach begins at stock selection based on the business potential and its ratification by
examining industry and macro indicators.
Information for equity analysis is gathered from the following sources:
• Audited financial statements
• Analyst meetings, plant visits and interactions with the management
• Industry reports, analytics and representations
• Government and regulatory publications
Valuation of equity shares involves using extensive information that enables estimating future cash flows, modeling these
variables into a logical valuation framework, and understanding the sources of risk to the estimates of valuation

There are two broad approaches to valuation:

1. DISCOUNTED CASH FLOW MODELS 2. RELATIVE VALUATION MODELS

• Theoretical constructs that are based on the understanding
that value can be estimated by looking into information
about the business itself, its earnings, growth and
dividends.
• Rigorous models requiring clearly specified assumptions
and a focus on the core factors that drive the valuation of a
stock.
• One set of assumption is about the cash flow estimates; the
others are about the discounting rate, the proxy for risk.
• There can be differences in DCF valuation estimates
depending on the above two factors, which tend to vary
quite significantly across analysts who value stocks.
• This model tends to try and find the pricing of something
similar to the asset being valued.
• Using the peer group averages, sector averages of and
other such commonalities that enable one to compare an
equity with another, or a group.
• Help in identifying both undervalued and overvalued
stocks since it include market variables, more importantly
the price of a stock.
• Easier to understand and tweak.
• The use of relative valuation model is widespread, some
of the assumptions regarding comparable stocks, peer
groups or averages may be generalized and prone to error.
 COMMONLY USED TERMS IN EQUITY INVESTING
1. PRICE EARNING MULTIPLE
The price‐earnings ratio or the PE multiple is a valuation measure that indicates how much the
market values per rupee of earning of a company.

It is computed as: Market price per share/Earnings per share

• Earnings per share are the profit after taxes divided by the number of shares outstanding. It indicates the amount
of profit that company has earned, for every share it has issued.
• It is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE
multiple moves high when prices run ahead of the earnings numbers and the market is willing to pay more and
more per rupee of earnings
• Analysts also compare the PE of one company with another, to check the relative value. The PE multiple at
which a stable, large and well- known company would trade in the market, is likely to be higher than the PE
multiple the market is willing to pay for another smaller, less known, and risky company in the same sector.
2. PRICE TO BOOK VALUE (PBV)
The PBV ratio compares the market price of the stock with its book value.

It is computed as: Market price per share/Book Value per share.

• The book value is the accounting value per share, in the books of the company. It represents the net worth
(capital plus reserves) per share.
• If the market price of the stock were lower than the book value and the PBV is less than one, the stock may
be undervalued. In a bullish market when prices move up rapidly, the PBV would move up, indicating rich
valuation in the market.
3. DIVIDEND YIELD
The dividend declared by a company is a percentage of the face value of its shares. When the dividend
received by an investor is compared to the market price of the share, it is called the dividend yield of the
share.

It is computed as: Dividend per share/Market price per share

• The dividend yield of a share is inversely related to its share price. If the price of equity shares moves up,
the dividend yield comes down, and vice versa.
• Dividend yields are also used as broad indicators of the market cycles. A bull market will be marked by
falling dividend yields, as prices move up. A bear market will have a relatively higher and increasing
dividend yields as prices tend to fall.
RISK AND RETURN FROM INVESTING IN EQUITY

• Investing in equity shares of a company means investing in the future earning capability of a business.
• Return can be two forms :
Dividend
Increase in value
• Returns to investors are always contingent on the company's future residual cash flows.
• The risk that an equity investor faces is that future gains are not guaranteed.
• The price movements in the stock market for equity shares is always noisy
• Stock markets are always subject to bull and bear cycles.
 DEBT INSTRUMENTS
DEBIT CAPTIAL

• It can be created by borrowing from banks and other institutions or by issuing debt securities.
• A debt security is a contract between the issuer (business) and the lender (investor) that lets the issuer to
borrow a certain amount of money under certain conditions.

FEATURES OF DEBT SECURITIES

• Principal : it is the amount borrowed by the issuer

• Coupon : it is the rate of interest paid by the borrower
• Maturity : it is the bond refers to the date on which the contract requires the borrower to repay the
amount
Examples of debt securities are : debentures, bonds ,commercial papers and treasury bills
 TYPES AND STRUCTURES OF DEBT INSTRUMENTS

• plain vanilla bond : it requires interest to be paid at a fixed rate periodically, and principal to be returned
when the bond matures.
• zero coupon bond : it does not pay any coupons during the term of the bond. The bond is issued at a discount
to the face value and redeemed at face value and with a long maturity is issued at bid discounts .
• Floating rate bonds : this instruments where the interest rate is not fixed, but re‐set periodically with
reference to a pre‐decided benchmark rate. This bonds are also known as variable rate bonds and adjustable-
rate bonds and common in housing loan market.
• Callable bonds : it allow the issuer to redeem the bonds prior to their original maturity date. Such bonds
have a call option in the bond contract, which lets the issuer alter the tenor of the security.
• puttable bond : it gives the investor the right to seek redemption from the issuer before the original maturity
date .
• Amortizing bonds : are those in which the principal is not repaid at the end/maturity, but over the life of the
bond. Thus, the periodic payments made by the borrower include both interest and principal. Examples are
Auto loans, consumer loans and home loans, in which each installment paid has both interest and principal
components.
 CLASSIFICATION OF DEBT INSTRUMENTS  
Debt instruments can be classified in two broad ways. 
• By type of borrower:
• By tenor/maturity of the instrument:  

• Government Securities : it is also called treasury bonds, are predominantly issued to fund the fiscal deficit
of the government. G‐secs are issued through an electronic auction system managed by the Reserve Bank of
India. Fixed coupon bonds, commonly referred to as dated securities, are the most common instrument
• Corporate bond markets : this are dominated by short‐term commercial papers and long ‐term bonds.
Banks issue short‐term debt securities called certificates of deposit. The rate at which corporates, banks and
institutions borrow depends upon the credit quality of the borrower.The market for long term corporate debt
is made up of two segments:
a. Bonds issued by public sector units (PSU), including public financial institutions, and
b. Bonds issued by the private corporate sector
 MONEY MARKET SECURITIES

The money market securities include instruments for raising and investing funds for periods ranging from one
day up to one year . The money market securities include instruments for raising and investing funds for
periods ranging from one day up to one year.
Types of money market securities
• Reverse repo
• Collateralized Borrowing and Lending Obligation (CBLO)
• Certificates of Deposits (CDs)
• Treasury Bills :
• Commercial Paper  
 CONCEPTS AND TERMS RELATING TO DEBT SECURITIES

1. Time Value of Money

2. Yield and Price
3. Yield to Maturity (YTM)

BENEFITS AND RISKS OF INVESTING IN DEBT SECURITIES

RISK
BENEFITS
• Inflation/purchasing power
• Fixed Income
• Fixed Tenor risk
• Default/credit risk
• Reinvestment risk
• Call risk
• Liquidity risk
 CHOOSING BETWEEN DEBT AND EQUITY INVESTMENT

The factors that investors in equity or debt capital consider, before making a choice are as
follows:
Need for regular
Risk appetite
income v/s growth

Frequency of
Time horizon
review
 HYBRID INSTRUMENTS

Preference Shares

Convertible Debentures

Foreign Currency Convertible Bonds

(FCCBs)

ADRs, GDRs and IDRs