SECURITY ANALYSIS & BUSINESS VALUATION CA AMIT SINGHAL

INVESTMENT An investment is a commitment of funds made in the expectation of a positive rate of return that is commensurate with the risk assumed by the investor.

Investment versus Speculation Time horizon Risk-return characteristics Own funds and borrowed funds (The same security can be purchased as an investment or as a speculation depending on the motivation of purchaser.)

An example A friend calls you to tell you about a biotech company that is currently selling at Rs.247 per share. She says that the company has developed a new drug that would treat a life threatening disease at very low cost. According to her, when this news is confirmed and circulated, the stock will fly to around Rs. 500 per share. The decision to buy would be ____________.

Do we need speculation? Speculators add to liquidity in secondary market. Liquidity in secondary market is essential for primary market to prosper.

Approaches to investment decision making Fundamental approach Psychological approach Academic approach Eclectic approach

Fundamental approach There is an intrinsic value of a security. Intrinsic value can be established by an analysis of fundamental factors relating to company, industry and the economy. At any given point of time, there are some securities for which the prevailing market price will differ from intrinsic value. Superior returns can be earned by buying under valued securities and selling over valued securities.

Psychological approach Stock prices are guided by emotion or psychological mood of investors rather than reason. When greed and euphoria sweep the market, prices rise to dizzy heights. When fear and despair envelop the market, prices fall to abysmally low levels. Use of technical analysis with a view to developing trading rules aimed at profit making.

J.M.Keynes on psychological approach “A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.” J.M.Keynes, The General Theory of Employment, Interest and Money, 1936

Academic approach Stock markets are reasonably efficient in reacting quickly and rationally to the flow of information. Hence, stock prices reflect intrinsic value fairly well. Stock price behaviour corresponds to a random walk. Successive price changes are independent of past price behaviour. There is a positive relationship between risk and return.

Eclectic approach: combination of all three Conduct fundamental analysis to establish certain value anchors Do technical analysis to assess the state of market psychology. However, complicated technical systems should be regarded as a suspect because they often represent figments of imagination rather than tools of proven usefulness.

Eclectic approach contd… Combine fundamental and technical analysis to determine which securities are worth buying, worth holding and worth disposing of. Respect market prices and do not show excessive zeal in ‘beating the market’. Accept the fact that the search for a higher level of return often requires the assumption of a higher level of risk.

Investment avenues Securities Real estate Commodities Art

The Investment Process (in case of securities) Security analysis Portfolio management

Security Analysis Fundamental analysis Technical analysis

Fundamental analysis Computing intrinsic value of a security and making investment decisions. Estimating risk and return of securities E-I-C analysis

Time value of money Present value of a single amount PV=FV n [1/(1+r) n ] Present value of an annuity PVA n =A[1- (1/(1+r)) n ]/r Present value of an uneven series Future value of a single amount FV n =C(1+r) n Future value of an annuity FVA n =A[(1+r) n – 1] / r

Intrinsic value of bonds The value of a bond is equal to the present value of the interest and redemption value to be received in future. Bond values with annual interest Bond values with semi-annual interest Zero coupon bonds Perpetual bonds Relationship between value and the required rate of return.

Intrinsic value of equity shares Dividend discount model Zero growth model Constant growth model Two stage growth model Valuation in case of finite holding period.

Test your understanding Compute the value of shares of the following three companies today and after one year growth rate(%) Low growth firm5 Normal growth firm10 Supernormal growth firm15 The expected earnings per share and dividend per share of the three firms are Rs. 3 and Rs.2 respectively. Investor’s required total return from equity investments is 20%. What if the required rate of return is 14%?

Earnings multiplier approach to equity valuation Value of share = Estimated earning per share (E 1 )* Justified price earning ratio

Determinants of P/E ratio Growth prospects Risk Liquidity Reputation of management

Empirical estimation of P/E Whitbek and Kisor found the following relationship in a study conducted in US: P/E multiple= growth rate in earnings payout ratio – 0.2 variability in earnings.

Obaidullah and Kalyani Ramachandran estimated the following relationship in indian market in 1992: P/E multiple = growth rate in earnings – required rate of return growth rate in funds flowing into the securities market.