In this chapter we shall focus on the basic concepts underlying investing, equities, debt and some of the major assumptions underlying research.
Key Terminologies to Be Understood In Equity Markets
For an analyst to be able to give a view on the markets and specific stocks, an in-depth understanding of the concepts underlying the capital markets is a must. Here are some key concepts that analysts must be familiar with.
- Face Value or par value represents the nominal value of a share. Equity capital of the company is a product of the number of shares and its face value. Shares are issued either at par or at a premium to face value. Face values are normally 10 / 5 / 2 / 1.
- Book Value or net worth is normally expressed on a per share basis. It also represents the assets of the company, net of outside liabilities; both long term and short term. This is considered to be a static measure of value.
- Market Value or market capitalization is the stock price multiplied by the total number of shares outstanding. It represents the actual value of the company and wealth creation or wealth depletion is measured based on increases or decreases in market cap.
- Replacement Value is an interesting concept which indicates that if a new company were to set up from scratch then the cost of creating similar capacity and scale will be replacement value. It is often used for cement and steel companies.
- Intrinsic Value involves projecting the cash flows into the future and then discounting the cash flows back to present value based on an appropriate cost of capital. Intrinsic value is the basis of valuation and investments based on fundamentals. Market value above or below intrinsic is used to decide whether stock is undervalued or overvalued.
- Large cap, mid cap and small cap are popular usages in the stock market. This is based on the concept of market capitalization or market value. The market cap corresponding to the latest SEBI definition given to mutual funds is:
- Large caps - market cap above Rs.50,000 crore
- Mid caps - market cap between Rs.10,000 crore and Rs.50,000 crore
- Small caps - market cap below Rrs.10,000 crore, but companies with market cap below Rs.2000 crore are normally dropped
- Enterprise Value is a recent addition to the stock market lexicon and has caught on rapidly among analysts and investors. EV represents the theoretical takeover price of a firm. EV is calculated as (market cap + cash – outstanding debt) and is popular in mergers and acquisitions.
Key Terminologies to Be Understood In Equity Markets
Valuation ratios are less about fundamentals and more about market perception. They are called valuation ratios because they are used to ratify valuations and for peer group benchmarking. Some popular valuation ratios are:
- P/E ratio or the price / earnings ratio is the ratio of the market price of the company to the EPS. It represents how much the stock market is willing to pay for every rupee profit that the company earns.
- P/BV or price to book value ratio is the ratio of the market price of the stock to the book value of the company. This is more static compared to the P/E but P/BV is useful when the company is loss making. Banks are normally benchmarked based on P/BV.
- P/S or the price to sales ratio is again useful when the company is loss making. Normally, companies in long gestation sectors like power, telecom and ecommerce take a long time to breakeven. Here, P/S can be a useful proxy for valuation.
- P/CF or price to cash flow ratio is not so often used. It is an extension of the P/E ratio and focuses on the actual cash that comes into the business. P/E has a shortcoming in that it considers accrued profits. P/CF overcomes this shortcoming.
- EV/EBITDA is the ratio of the enterprise value to the earnings before interest, tax, depreciation and amortization. This measure is useful when the company is not making profits but this ratio used frequently for buying out divisions of a company or acquiring a loss-making company.
- Dividend yield is often used as a proxy for ratifying decision based on P/E or P/BV. Dividend yield is the ratio of the dividend per share to the market price. This ratio works better at an index level than at stock level.
Going Beyond Equity; Here Is What Analysts Must Know About Debt
Just as it is important for analysts to understand basic terminologies of equity, they must also grasp the basic terminologies pertaining to debt.
- Face Value of bond is the value that is mentioned on the bond certificate and is the value on which coupon interest is paid. Face values of bonds are normally in denominations of Rs.100, Rs.1000 or higher. It shows the value of the debt liability.
- Coupon Rate is the interest paid on the bond / debt security and is expressed as a percentage of its face value. An 8.50% bond with a face value of Rs.1000 payable half-yearly will pay Rs.425 at the end of every 6 months.
- Maturity is the tenure of the bond / debt instrument and is also called tenor or tenure of the bond. For example a 2020 bond matures in the year 2020 when the principal mentioned on the bond certificate will be repaid to the investor.
- Principal amount is the total investment made by the lender to the account of the borrower. This is the initial investment. Principal amount is the number of bonds owned multiplied by the face of value of these bonds. This is also the maturity value.
- Redemption of a bond is the repayment of the bond on maturity. The coupon payments are serviced through the tenure and on redemption of the bond, the principal is repaid to the lender along with the last instalment of interest payment.
- Holding Period Returns (HPR) is the return earned on an investment during a specific period when it was bought and held by the investor. Investor can directly purchase the bond from the issuer or from the secondary market.
- Current Yield is a simple approach to calculating return on a debt security. Current yield is the annual coupon amount divided by the current market price of the bond. If bond trades at a discount then the current yield will be more than the coupon rate.
- Yield to Maturity (YTM) is the most important aspect of debt instrument and measures the return based on the market yield available. The coupon receipts and the principal on redemption are discounted to the present value based on the prevailing market yield. When interest rates are cut by the RBI, the market yield comes down and thus the future cash flows are valued at a higher rate. That is the reason bond prices move up when interest rates fall and bond prices fall when interest rates rise.
- Duration is an extremely important concept for bond traders and long term investors. It measures how soon the holder of the bond gets back his principal either in the form of intermediate payments or as redemption. For any coupon bond, the duration is always lower than the term to maturity. Long duration bonds are more vulnerable to movements in interest rates. Similarly, when you have a liability after 10 years, then you match with a bond of duration 10 years and not maturity of 10 years.
Various Types of Bonds on Offer
Bonds may look like a plain vanilla product but there are a plethora of variations. Here are some popular types of bonds.
- Coupon bonds are the most popular bonds that pay interest at regular intervals and redeem the principal amount on maturity. These are the most popular and most G-Secs and corporate bonds belong to this category.
- Zero-Coupon Bond or ZCBs do not pay intermediate coupons. Instead, they issue the bond at a discount and redeem the bond at par. Treasury bills of the government and the Kissan Vikas Patra are examples of ZCBs. They are also called deep discount bonds. These bonds are free of reinvestment risk and duration is equal to maturity period.
- Floating Rate Bonds have a floating interest rate coupon which is reset based on a benchmark like the repo rate or t-bill rate. They are useful when rates are moving up.
- Convertible Bonds are issued as a debt instrument with the option to convert the bond into equity at a later date; either partially or wholly.
- Amortization Bonds are a derivative of coupon bonds where each intermediate payment contains some portion of interest and principal. Typically, home loan EMIs and car loan EMIs belong to this category.
- Callable Bonds and puttable bonds are bonds with options. Callable give an option to the issuer to redeem the bonds if the rates fall. Similarly, puttable bonds give the investor the option to redeem the bonds if the rates rise, so as to deploy elsewhere.
In addition to these, there are complicated structures like principal protected notes (PPN) and inflation adjusted bonds (IABs) issued from time to time.
What Are The Qualities That A Good Investment Must Have?
It has long been debated if investing is an art or science. The truth is that it is a bit of both. A good investment must have the following qualities.
- Adequate returns consistent with the risk assumed
- Focus on safety of principal and capital
- Research driven and not speculative in nature
- Must be constantly monitored and tracked
- In sync with the long term goals of the investor
- Aligned with the risk-appetite and risk capacity of the investor
- Investing is business and must always be business like
- Predicted on the gap between price and value
- Based on fundamental, technical and behavioural analysis of the investment