Introduction to Security Analysis Industry Analysis Unit 1

Introduction to Security Analysis & Industry Analysis Unit 1

What is Security Analysis? Security Analysis • Security analysis is about valuing the assets, debt, warrants, and equity of companies from the perspective of outside investors using publicly available information. • The security analyst must have a detailed understanding of financial statements. • As such, the ability to value equity securities requires cross-disciplinary knowledge in both finance and financial accounting. • There is a fair overlap in the analytical tools used in security analysis and those used in corporate finance, • security analysis tends to take the perspective an external investors, whereas • corporate finance tends to take an inside perspective such as that of a internal corporate finance manager.

What is Investment Analysis? Investment Analysis • Investment analysis is defined as the process of evaluating an investment for profitability and risk. • It ultimately has the purpose of measuring how the given investment is a good fit for a portfolio. • Furthermore, it can range from a single bond in a personal portfolio, to the investment of a startup business, and even large scale corporate projects. • Investment analysis means the process of judging an investment for income, risk, and resale value. • It is important to anyone who is considering an investment, regardless of type. Investment analysis methods generally evaluate 3 factors: risk, cash flows, and resale value.

Factors of Investment Evaluation - Risk • The first factor evaluated in any investment analysis is risk. • The reason for this is simple: if the risk of the investment is too great then loss is quite likely. • In this case, cash flows and resale value generally do not matter because the investment is worth nothing. • To evaluate risk, one simply uses a variation of the following formula: Rate of occurrence x the impact of the event = Risk • Despite this, risk is not a definite factor. • One must evaluate all the factors related to the investment: market, industry, governmental, company, and more. • In this way evaluating risk is as much of an art as a science.

Factors of Investment Evaluation – Cash Flows • The second factor of investment analysis is cash flows. • Cash flows occur in many ways: dividends a stock, interest payments on a bond, or even free cash flow which can be distributed to the investors in a small business. • Cash flows are one of the methods of repayment on an investment. • Thus, investors evaluate if the cash flows compensate for the risk they have taken. • Many methods of evaluating cash flows exist: future value of cash flows and Discounted Cash Flow Analysis. • Others provide each investor with a method of analysis based in the type of investment they are considering. • Regardless, ignoring the analysis of cash flows is a quick path to loss of investment capital.

Factors of Investment Evaluation – Resale Value • The third factor of investment analysis is resale value. • Profit from resale is made through a gain in the market value of the asset. • When the asset is sold to another investor for a value higher than the original purchase price, profit from resale value has occurred. • In the process of investment analysis, an investor will want to measure the expected rate of growth on the asset to make sure that the value of this and any associated cash flows are larger than the loss of investment and the estimated value of the risk of the investment.

• All of these methods of investment analysis are applicable to any investment: stocks on the stock market, treasury bills, the purchase and growth of a business, or even currency trading. Though each has a purpose-built method for investment analysis, each requires this if the investor is to be sure that the risk is worth the reward. • Though investment for real estate decisions will be different than for a stock, the basic concept is the same.

Participants in the Securities Market The Indian securities market comprises of a number of participants as described below: Regulators The key agencies that have a significant regulatory influence, direct or indirect, over the securities market are currently as follows: • The Company Law Board (CLB) which is responsible for the administration of the companies Act 2013. • The Reserve Bank of India (RBI) which is primarily responsible, Inter alia, for the supervision of banks, money market, and government securities market. • The Securities and Exchange Board of India (SEBI) which is responsible for the regulation of the capital market. • The Department of Economic Affairs (DEA) an arm of the government, which, inter alia, is concerned with the orderly functioning of the financial market as a whole. • The Department of Company Affairs, an arm of the government, which is responsible for the administration of corporate bodies.

Participants in the Securities Market Stock Exchanges A stock exchange is an institution where securities that have already been issued are bought and sold. Presently there are 23 stock exchanges in india, the most important ones being the NSE and BSE Depositories A depository is an institution which dematerializes physical certificates and effects transfer of ownership by electronic book entries. Presently there are two depositories in India. The National Securities Depository Limited (NSDL) and the Central Securities Depository Limited (CSDL).

Participants in the Securities Market Brokers are registered members of the stock exchanges through whom investors transact. There about 10000 brokers in India. Foreign Institutional Investors from abroad who are registered with SEBI to operate in the Indian Capital Market are called foreign institutional investors. There about 600 of them and they have emerged as a major force in the Indian Market. Merchant Bankers Firms that specialize in managing the issue of securities are called merchant bankers. They have to be registered with SEBI.

Participants in the Securities Market Primary Dealers Appointed by the RBI, Primary dealers serve as underwriters in the primary market and as market makers in the secondary market for government securities. Mutual Fund A mutual fund is a vehicle for collective investment. It pools and manages the funds of investors. There about 30 mutual funds in India. Custodians A custodians looks after the investment back office of a mutual fund. It receives and delivers securities, collects income, distributes dividends, and segregates the assets between schemes. Registrars Also known as a transfer agent, a registrar is employed by a company or a mutual fund to handle all in investor-related services. .

Participants in the Securities Market Underwriters An underwriters agrees to subscribe to a given number of shares (or any other securities) in the event the public subscription is inadequate. The underwriter, in essence, stands guarantee for public subscription. Debentures Trustees When debentures are issued by a company, a debentures trustee has to be appointed to ensure that the borrowing firm fulfills its contractual obligations. Venture Capital Funds A venture capital fund is a pool of capital which essentially invested in the equity shares or equity linked instruments of unlisted companies. Credit Rating Agencies A credit rating agency assigns ratings primarily to debt securities.

Financial Markets A financial market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods.

Financial Markets There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one place, thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy such as a gift economy.

Financial Market Functions 1. 2. 3. 4. 5. 6. The raising of capital (in the capital markets) The transfer of risk (in the derivatives market) Price discovery Global transactions with integration of financial markets The transfer of liquidity (in the money markets) International trade (in the currency markets)

Classification of Financial Markets Nature of Claim Maturity of Claim Seasoning of Claim Timing of Delivery Equity Market Money Market Primary Market Cash or Spot Market Debt Market Capital Market Secondary Market Derivatives Market

Equity Markets / Stock Markets A stock market or equity market is a public entity for the trading of company stock (shares) and derivatives at an agreed price; these are securities listed on a stock advantage as well as those only traded privately. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The largest stock market in the United States, by market capitalization, is the new York stock exchange.

Debt Markets Financial instruments that have a fixed income claim and have a maturity of more than one year are traded in the debt market. Debentures or bonds are examples of debt instruments in the capital market. Debt instruments may have several distinguishing features. They can be secured or unsecured debt. A secured debt has assets to fall back on while an unsecured debt is subject to more risk. Since an unsecured debt does not have an asset backing, the repayment risk is more.

Money Markets The money market is a component of the financial markets for assets involved in short -term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves treasury bills, commercial paper, banker’s acceptances, certificates of deposit, federal funds, and short-lived mortgage and asset-backed security. It provides liquidity funding for the global financial system. Money market trades in short-term financial instruments commonly called "paper. " This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

Capital Markets A capital market is a market for securities, where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, The capital market includes the stock market and the bond market (debt). Money markets and capital markets are parts of financial markets. Capital markets may be classified as primary and secondary markets. In primary markets, new stock or bond issues are sold to investors via a mechanism known as underwriting. In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange over-the-counter, or elsewhere.

Difference Between Primary Market vs Secondary Market Stock market refers to a collection of markets and exchanges where the issuing and trading of equities or stocks of publicly held companies, bonds, and other classes of securities take place. This trade is either through formal exchanges or over-thecounter(OTC) marketplaces. The financial market is a world where new securities are issued to the public regularly of varied financial products and services, tailored to the need of every individual from all income brackets. These financial products are bought and sold in the capital market, which is divided into the Primary Market vs Secondary Market. This is both distinct terms. The primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors.

Difference Between Primary Market vs Secondary Market The primary market is where securities are created. It’s in this market that firms float new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market. An IPO occurs when a private company issues stock to the public for the first time. Various types of issues made by the corporation are a Public issue, Offer for Sale, Right Issue, Bonus Issue, Issue of IDR, etc. The company who brings the IPO is known as the issuer, and the process is regarded as a public issue. The process includes many investment banks and underwriters through which the shares, debentures, and bonds can directly be sold to the investors.

Difference Between Primary Market vs Secondary Market The secondary market is commonly referred to as the stock market. The securities are firstly offered in the primary market to the general public for the subscription where a company receives money from the investors and the investors get the securities; thereafter they are listed on the stock exchange for the purpose of trading. The defining characteristic of the secondary market is that investors trade among themselves. In this market existing shares, debentures, bonds, options, commercial papers, treasury bills, etc. of the corporate are traded amongst investors. The secondary market can either be an auction market where trading of securities is done through the stock exchange or a dealer market, popularly known as Over The Counter where trading is done without using the platform of the stock exchange.

Difference Between Primary Market vs Secondary Market Primary Market Secondary Market IPO Trading in listed stocks One time Multiple Times Company issues shares to investors Investors trade amongst themselves Usually fixed price Brokers are intermediaries Underwriters are intermediaries Dynamic Price

Spot Market The spot market or cash market is a public financial market, in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market in which delivery is due at a later date. A spot market can be: 1. An organized market, an exchange or 2. Over-the-counter (OTC) Spot markets can operate wherever the infrastructure exists to conduct the transaction. The spot market for most instruments exists primarily on the internet.

Derivatives Market The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over -the -counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

Indian Equity Markets

Indian Equity Markets

Global Equity Markets

Indian Equity Markets – Top Companies Market Capitalization o It is basically number of outstanding shares * market price of a security o Outstanding shares means shares which can be traded. Shared held by promotors are not part of it as those shares are not traded.

Indian Equity Markets

Indian Equity Markets

Risk and Return Concepts INTRODUCTION Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns. The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return.

Risk and Return Concepts Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk. Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk.

Risk and Return Concepts – Types of Risks There are numerous forces that contribute to variations in return— price or dividend (interest). These forces are termed as elements of risk. Some factors are external to the firm and cannot be controlled. These factors affect large numbers of securities. In investments, those forces that are uncontrollable, external, and broad in their effect are called sources of systematic risk. Other forces are internal to the firm and are controllable to a large degree. The controllable, internal factors Somewhat peculiar to industries and/or firms are referred to as sources of unsystematic risk.

Risk and Return Concepts – Types of Risks Systematic Risk Unsystematic Risk Market Risk Business Risk • Regulation • Execution Risk Economic Risk Financial Risk • Interest Rates • Inflation • Default Risk

Systematic Risks – Market Risk Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The risks will impact the entire market, and all securities in the markets. It could be because of events, or certain political and regulatory decisions. The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investors’ attitudes towards equities in general, or toward certain types or groups of securities in particular. The reaction of investors to tangible as well as intangible events causes market risk.

Systematic Risks – Economic Risks Interest Rate Risk - Interest rates are constantly moving. When interest rates go up, the market value of bonds issued in the past with lower interest rates, will go down. Similarly, stock prices will get impacted negatively with rising interest rates, since cost of capital will rise Inflation Risk - The risk that unexpected changes in consumer prices will penalize an investor's real return from holding an investment. Because investments from gold to bonds and stock are priced to include expected inflation rates, it is the unexpected changes that produce this risk.

Unsystematic Risks – Business Risks The portion of total risk that is unique or peculiar to a firm or an industry, above and beyond those affecting securities markets in general is called unsystematic risk. Factors such as management capability, consumer preferences, and labour strikes can cause Unsystematic variability of returns for a company’s stock. Business risks are of a diverse nature and arise due to innumerable factors. These risks may be broadly classified into two types, depending upon their place of origin. Internal Risks are those risks which arise from the events taking place within the business enterprise. Such risks arise during the ordinary course of a business. These risks can be forecasted and the probability of their occurrence can be determined. External risks are those risks which arise due to the events occurring outside the business organization

Unsystematic Risks – Financial Risks emanate from mismanagement or incorrect decisions on the financial conditions of the firm. Default Risk could be one such risk, where the company is unable to pay the money it has borrowed. Liquidity Risk is the risk that the company has run out of cash when it needs that money.

Return Concepts Return = (Any Cash Flows + Price Now – Price when Purchased) --------------------------------Price when Purchased

Return Concepts Jindal Steels share’s price on June 10, 2018 is Rs. 900 and the price on June 9, 2019 is Rs. 950. Dividend received is Rs. 76. Determine the rate of return. Solution: Return = (Any Cash Flows + Price Now – Price when Purchased) -------------------------------------Price when Purchased (950 – 900) + 76 r = -------------------- x 100 900 = 126 / 900 x 100 = 14%

Risk vs Return Analysis Present Value Calculations • NPV – What is the net present value of the cash flows that you receive against what you have paid • IRR – Whether the project gives a return more than the cost of capital Payback Period • How quickly can you get your money back Maximum Potential Loss • What is the maximum amount one can lose by investing in the project

Risk vs Return Analysis Increasing Expected Return Cash Risk Free Bonds / Government Bonds Fixed Deposits Corporate Bonds Equities – Large Cap Equities Mid and Small Cap Increasing Risk Unlisted Companies

Short Cases Case 1 Find out the following returns 1. Fixed Deposit Rates of Any Large Private Bank 2. Indian Government 10 year government bond yield (return) 3. Indian Equity Markets – Nifty Index annualized Return from 2004 to 2018 Case 2 Find out the standard deviation of daily returns for the BSE Sensex and BSE Midcap over the last 3 years.