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UNIVERSITY INSTITUTE OF ENGINEERING & TECHNOLOGY
REPORTON
“ TRADING IN STOCK EXCHANGE ”July-Dec 2012(MBA, 9th SEM)
DATED: 3-11-2012
TEACHER CONCERNED: Submitted by: Mr. Rajesh Jhamb ABHAY SOOD (UM8402) NAVPREET SINGH (UM8504) PARUL MITTAL (UM8505) SUMEET KAUR (UM8510)
ACKNOWLEDGEMENT
It is our pleasure to be indebted to various people, who directly or indirectly contributed in the development of this work and who influenced our thinking, behavior, and acts during the course of study. We are thankful to Mr. Rakesh Jhamb for his support, cooperation, and motivation provided to me during the project for constant inspiration, presence and blessings.
We also extend sincere appreciation to Mr. Harmeet Singh, Mr. Manoj Thakur, Mr. Smile Baly who provided their valuable suggestions and precious time in accomplishing this project report.
Lastly, we would like to thank the almighty and our parents for their moral support and our friends with whom we shared our day-to-day experience and received lots of suggestions that improved our quality of work.
CONTENTSCH 1 : BASICS OF INVESTMENTS
1.1 INVESTMENT
1.2 FINANCIAL MARKETS
1.2.1 STRUCTURE OF FINANCIAL MARKET
1.3 STOCK EXCHANGE
1.4 SEBI (Security and Exchange Board of India)
1.4.1 OBJECTIVES
1.4.2 FUNCTIONS
1.5 BSE (Bombay Stock Exchange)
1.5.1 BSE SENSEX
1.5.2 CALCULATION
1.6 NSEI (National Stock Exchange of India)
1.6.1 Market Segments
1.6.2 S&P CNX NIFTY
1.7 MCX (Multi Commodity Exchange)
1.8 NCDEX
1.9 FOREX
1.10 STOCKS BY SIZE AND SECTORS
1.11 MUTUAL FUNDS
1.11.1 CHARACHTERISTICS
1.11.2 RISK RETURN MATRIX
1.11.3 WORKING
1.11.4 TYPES
1.11.5 TYPES OF RETURNS
1.11.6 ADVANTAGES
1.11.7 DISADVANTAGES
1.12 ETFs
1.12.1 WORKING
1.12.2 COMPARISON WITH MUTUAL FUNDS
1.12.3 ADVANTAGES
1.12.4 DISADVANTAGES
Ch-2 Margin trading and Technical Analysis
2.1 Margin Tradinga. Margin account
b. Margin call
2.2 Futures
a. Marging trading vs future
b. how do future markets benefit society
2.3 Options
a. call,put,premium
b. How to start option trading
c. why option trading
2.4 Technical analysis
a. Timeframe
b. equidistant channel
c. support and resistance
d. Trendlines
e. moving averages
Ch-3 Factors affecting market
3.1 factors affecting market
3.1.1 Introduction 3.1.2 Effect on Short- and Long-Term Trends due to above factors
3.2 other factors affecting market
3.2.1 Policies 3.2.2 World market
3.2.2.a recession 3.2.2.b inflation 3.2.2.c deflation
3.2.3 Schemes 3.2.4 Scams
1992 security scandal Satyam scandal
3.2.5 increase in gold prices 3.2.6 increase in crude oil prices 3.2.7 increase in copper prices 3.2.8 seasonal changes in crop prices on MCX 3.2.9 right issue and bonus issue on stock price
Ch-4 FUNDAMENTAL ANALYSIS
4.1 Financial Literacy and its Vital Learning’sa. Seven Cures of Lean Purseb. The Five Laws of Goldc. Cash-flow (LONG TERM INVESTMENT)
4.2 How to Follow Money in Stock Exchange
a. A Basic Understanding of Accountingb. Role of Financial Statementsc. Principal Financial Statements
Balance Sheet Income Statement Cash Flow Statement
4.3 Everything Is Number and Ratio
a. Ratios Galoreb. Management Performance Ratiosc. Debt or Leverage Ratiosd. Liquidity Ratiose. Price Ratios with Earnings and Dividends
BIBLIOGRAPHY
LIST OF FIGURES
1.1 Functions of Financial Markets1.2 Financial Market Structure1.3 Indian Financial Market Structure1.4 SENSEX movement from 1998-20111.5 NIFTY movement from 1998-20111.6 Currency1.7 FOREX Chart1.8 Risk Return Matrix1.9 Mutual Fund Organisation1.10 Types of Mutual Funds1.11 ETF Working
CHAPTER 1: BASICS OF INVESTMENT
1.1 INVESTMENT
Meaning of Investment
An investment involves the choice by an individual or an organization such as a pension fund, after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such as property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the foreign asset denominated in foreign currency, that has certain level of risk and provides the possibility of generating returns over a period of time.
When an asset is bought or a given amount of money is invested in the bank, there is anticipation that some return will be received from the investment in the future.
1.2 Fundamentals of Investment
There are three fundamentals of investment, namely:
SAFETY
LIQUIDITY
RETURN
1.2. 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.
Fig 1.1: Function of Financial Markets
1.2.1 STRUCTURE OF FINANCIAL MARKET
Fig1.2: Financial Market Structure
1.3. STOCK EXCHANGE
A stock exchange is a regulated market which provides services for stock brokers and traders to trade stocks, bonds, and other securities.
The initial offering of stocks and bonds to investors is done in the primary market and subsequent trading is done in the secondary market. Supply and demand in stock markets are driven by various factors that, as in all free markets, affect the price of stocks.
1.4. SEBI (Security and Exchange Board of India)
It was established in 1988 to regulate functions of security market. Initially SEBI was not able to exercise complete control over stock market transactions. As a result it was given legal status in1992 under SEBI Act, 1992 which is having a separate entity and perpetual succession.
SEBI is statutory organization established to protect the interest of investors, development and regulation of security market.
Fig 1.3: Indian Financial Market Structure
1.4.1 Objectives of SEBI
To regulate the activities of security market to promote the orderly function. To protect the rights and interest of investors. To keep a check on malpractices by having balance between self regulation and its statutory
regulation. To regulate and develop the code of conduct and fair practices by intermediaries like brokers,
merchant bankers.
1.4.2 Functions of SEBI
1. REGULATION
a) Registration of brokers and sub-brokers and other players in the market
b) Registration of collective investments schemes and Mutual Funds
c) Regulation of stock exchanges and other Self-Regulatory Organizations (SRO), Merchant banks etc
d) Prohibition of all fraudulent and unfair trade practices
e) Calls for information, undertakes inspection, conducts audits and enquiries of Stock Exchanges.
2. DEVELOPMENT
a) Training of intermediaries
b) Promotion of fair practices and Code of conduct for all S.R.O.s
c) Conducting Research and Publishing information useful to all market participants
3. PROTECTION
a) Investor education by giving press notes and booklets.
b) Controlling Insider Trading and takeover bids and imposing penalties for such practices
c) Safeguards investors by providing booklets for educating them
1.5 BOMBAY STOCK EXCHANGE (BSE)
Bombay Stock Exchange is a stock exchange located on Dalal Street, Mumbai. It is the oldest stock exchange in Asia. The Bombay Stock Exchange was established in 1875. The equity market capitalization of the companies listed on the BSE was US$1 trillion as of December 2011, making it the 6th largest stock exchange in Asia and the 14th largest in the world. The BSE has the largest number of listed companies in the world.
As of March 2012, there are over 5,133 listed Indian companies and over 8,196 on the stock exchange, the Bombay Stock Exchange has a significant trading volume.
1.5.1 BSE SENSEX
The BSE SENSEX (Bombay Stock Exchange Sensitive Index), also called the BSE 30 or simply the SENSEX, is a free-float market capitalization-weighted stock market index of 30 well-established and financially sound companies listed on Bombay Stock Exchange (BSE). The 30 component companies which are some of the largest and most actively traded stocks are representative of various industrial sectors of the Indian economy. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79.
The 30 companies that make up the Sensex are selected and reviewed from time to time by an “index committee”. This “index committee” is made up of academicians, mutual fund managers, finance journalists, independent governing board members and other participants in the financial markets.
Apart from BSE SENSEX, which is the most popular stock index in India, BSE uses other stock indices as well like BSE 500, BSE 100, BSE 200, BSE PSU, BSE MIDCAP,BSE SMLCAP,BSE BANKEX, BSE Teck, BSE Auto, BSE Pharma, BSE Fast Moving Consumer Goods (FMCG), BSE Metal etc.
1.5.2 Calculation
Sensex is calculated as per free float capitalization methodology. According to this methodology, the level of index at any point of time reflects the free float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is multiplied by a free float factor to determine the free float market capitalization. Free float factor is also referred as adjustment factor. Free float factor represents the percentage of shares that are readily available for trading.
The calculation of SENSEX involves dividing the free float market capitalization of 30 companies in the index by a number called index divisor. The divisor is the only link to original base period value of the SENSEX. It keeps the index comparable over time and is the adjustment point for all index adjustments arising out of corporate actions, replacement of scrips, etc.
Fig 1.4: SENSEX Movement from 1998-2011
1.6 NATIONAL STOCK EXCHANGE OF INDIA (NSEI)
The National Stock Exchange (NSE) is stock exchange located at Mumbai, Maharashtra, India. It is in the top 20 largest stock exchanges in the world by market capitalization and largest in India by daily turnover and
number of trades, for both equities and derivative trading. NSE has a market capitalization of around US$1 trillion and over 1,652 listings as of July 2012. The NSE's key index is the S&P CNX Nifty, known as the NSE NIFTY (National Stock Exchange Fifty), an index of fifty major stocks weighted by market capitalization.
NSE is mutually owned by a set of leading financial institutions, banks, insurance companies and other financial intermediaries in India but its ownership and management operate as separate entities.
1.6.1 Market segments of NSEI
1. Debt market segment
It provides a trading platform for wide range of fixed income securities such as treasury bills, bonds, zero coupon bonds, Certificate of Deposits (COD), Commercial Paper(CPs), Central Government securities.
2. Capital Market segment:
It provides an efficient and transparent trading in equity, preference shares, debentures as well as government securities.
1.6.2 S&P CNX Nifty
The S&P CNX Nifty, also called the Nifty 50 or simply the Nifty, is a stock market index, and one of several leading indices for large companies which are listed on National Stock Exchange of India. Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL (Credit Rating and Information Services of India Ltd).
The S&P CNX Nifty consists of 50 companies and covers 22 sectors of the Indian economy and offers investment managers exposure to the Indian market in one portfolio. The S&P CNX Nifty stock represents about 65% of the free float market capitalization of the stocks listed at National Stock Exchange (NSE) as on March 30, 2012.
Fig 1.5: Nifty movement from 1998-2011
The S&P CNX Nifty index is a free float market capitalization weighted index. The base period for the S&P CNX Nifty index is November 3, 1995 and the base value of the index has been set at 1000, and a base capital of Rs 2.06 trillion.
1.7 MULTI COMMODITY EXCHANGE (MCX)
Commodity markets are markets where raw or primary products are exchanged.
Multi Commodity Exchange of India Ltd (MCX) is an independent commodity exchange based in India. It was established in 2003 and is based in Mumbai. The turnover of the exchange for the fiscal year 2009 was US$ 1.24 trillion, and in terms of contracts traded, it was in 2009 the world's sixth largest commodity exchange.
MCX offers more than 40 commodities across various segments such as bullion, ferrous and non-ferrous metals, energy, and a number of agri-commodities on its platform.
It is regulated by the Forward Markets Commission.
MCX was the first exchange in India to initiate evening sessions to synchronize with the trading hours of global exchanges in London, New York and other major international markets.
It was the first exchange in India to offer futures trading in steel, crude oil, and almond MCX is India's No. 1 commodity exchange with 83% market share in 2009 Globally, MCX ranks no. 1 in silver, no. 2 in natural gas, no. 3 in crude oil and gold in futures trading. The highest traded item is gold. MCX has several strategic alliances with leading exchanges across the globe As of early 2010, the normal daily turnover of MCX was about US$ 6 to 8 billion MCX now reaches out to about 800 cities and towns in India with the help of about 126,000 trading
terminals
MCX COMDEX is India's first and only composite commodity futures price index
In June 2005, MCX launched MCXCOMDEX, India’s first real time composite commodity futures index, which provides our members with valuable information regarding market movements in the key commodities, as determined by physical market size in India, which are actively traded on our Exchange.
There are other indexes like MCXAgri (agricultural commodities index), MCXEnergy (energy commodities index) and MCXMetal (metal commodities index).
There are three rain indices, namely RAINDEXMUM (Mumbai), RAINDEXIDR (Indore), and RAINDEXJAI (Jaipur) which track the progress of monsoon rains in their respective geographic locations. In December 2009, EFP transactions were launched for the first time in India, which enables parties with futures positions to swap their positions in the physical markets and vice versa.
1.8 NATIONAL COMMODITY AND DERIVATIVES EXCHANGE (NCDEX)
National Commodity & Derivatives Exchange Limited (NCDEX) is an online multi commodity exchange based in India. It was incorporated as a private limited company incorporated on 23 April 2003 under the Companies Act, 1956. It has commenced its operations on 15 December 2003. NCDEX is a closely held private
company which is promoted by national level institutions and has an independent Board of Directors and professionals not having vested interest in commodity markets. NCDEX is regulated by Forward Market Commission (FMC) in respect of futures trading in commodities. 57 commodities are traded on this exchange.
1.9 FOREIGN EXCHANGE MARKET (FOREX)
The foreign exchange market (FOREX or currency market) is a form of exchange for the global decentralized trading of international currencies. The foreign exchange market determines the relative values of different currencies.
The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.
FOREX, unlike other financial markets, is not tied to an actual stock exchange. Forex is an over-the-counter (OTC) or off-exchange market. It’s a 24 hour market. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
Fig 1.6: Currency
1.9.1 Purpose
The foreign exchange market is the mechanism by which currencies are valued relative to one another, and exchanged. An individual or institution buys one currency and sells another in a simultaneous transaction. Currency trading always occurs in pairs where one currency is sold for another and is represented in the following notation: EUR/USD or CHF/YEN. The exchange rate is determined through the interaction of market forces dealing with supply and demand.
Foreign Exchange Traders generate profits, or losses, by speculating whether a currency will rise or fall in value in comparison to another currency. A trader would buy the currency which is anticipated to gain in value, or sell the currency which is anticipated to lose value against another currency. The value of a currency, in the simplest explanation, is a reflection of the condition of that country's economy with respect to other major economies. Reactive trading is the buying or selling of currencies in response to economic or political events, while speculative trading is based on a trader anticipating events.
1.9.2 Operation
The 8 Major Currencies
Whereas there are thousands of securities on the stock market, in the FOREX market most trading takes place in only a few currencies; the U.S. Dollar ($), European Currency Unit (€), Japanese Yen (¥), British Pound Sterling (£), Swiss Franc (Sf), Canadian Dollar (Can$), and to a lesser extent, the Australian and New Zealand Dollars. These major currencies are most often traded because they represent countries with esteemed central banks, stable governments, and relatively low inflation rates.
Currencies are also always traded in pairs (i.e. USD/JPY or Dollar/Yen) at floating exchange rates.
The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors.
1.9.3 How to Read a FOREX Chart
Fig 1.7: FOREX Chart
The current exchange rate is shown as a brown line with the pair’s price in a brown box. In the above chart, the current rate (120.93) for the USD/JPY pair means 1 Dollar is exchanged for 120.93 Yen. Forex notation is a little awkward as the rate is equivalent to how much of the counter currency (second in the pair) is required to exchange for 1 unit of the base currency (first in the pair). Therefore, the notation is upside down from the normal logic of using a fraction. When the value of the base currency, here the Dollar, is rising, the rate will be moving upwards If the rate changes from 120.93 to 121.50, it will take more Yen to buy the same amount of Dollars. When the situation is reversed, the Japanese currency is doing better and the pair's price will fall. It will take less Yen to buy the same amount of Dollars.
1.9.4 Fluctuations in exchange rates
A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean
people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).
Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.
Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to sell their currency to keep it stable. When that happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit.
1.10 STOCKS BY SIZE AND SECTOR
There are thousands of stocks to choose from, so investors usually like to put stocks into different categories: size, style and sector.
1.10.1By size
A company's size refers to its market capitalization, which is the current share price times the total number of shares outstanding. It's how much investors think the whole company is worth.
XYZ Corp., for example, may have 2 billion shares outstanding, and a stock price of $10. So the company's total market capitalization is $20 billion. A thumb rule
Mega-cap: Over $200 billion Large-cap: Over $10 billion Mid-cap: $2 billion–$10 billion Small-cap: $250 million–$2 billion Micro-cap: Below $250 million Nano-cap: Below $50 million
Large-cap companies tend to be established and stable, but because of their size, they have lower growth potential than small caps. Over the long run, small-cap stocks have tended to rise at a faster pace. It's much easier to expand revenues and earnings quickly when you start at, say, $10 million than $10 billion. When profitability rises, stock prices follow.
1.10.2By sector
Market is basically classified into 11 different sectors. Investors consider two of these sectors “defensive” and the remaining nine “cyclical.”
Defensive
Defensive stocks include utilities like water, electric, gas and consumer staples like beverages, cosmetics, foods, medical products, tobacco etc. These companies usually don’t suffer as much in a market downturn because people don’t stop using energy or eating. They provide a balance to portfolios and offer protection in a falling market.
However, for all their safety, defensive stocks usually fail to climb with a rising market for the opposite reasons they provide protection in a falling market: people don’t use significantly more energy or eat more food.
Cyclical stocks
Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down, however when one sector is going up another may be going down.
Here is a list of the nine sectors considered cyclical:
1. Basic materials – aluminium, steel, gold mining, metals, paper, containers, lumbar2. Capital goods – aerospace, engineering, construction, machinery, manufacturing , electrical
equipment3. Communications – communication equipment, mobile phone, broadband4. Consumer cyclical – automobiles, building materials, leisure time, retail, restaurants, textiles, home
building5. Energy – gas, oil6. Financial – banks, insurance, loans, brokerages7. Health care – pharmecuticals, private hospitals8. Technology – computer software, electronics, photography, office equipment9. Transportation – delivery services, logistics
Investors call them cyclical because they tend to move up and down in relation to businesses cycles or other influences.
1.11 MUTUAL FUNDSMutual funds refer to the funds that are raised and invested mutually, i.e. on behalf of everyone participating in the scheme. Hence it can be said that mutual fund is just the connecting bridge or a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. If you and your friend both pool your money and invest it jointly, you have created your own mutual fund.
1.11.1Characteristics:
A mutual fund actually belongs to the investors who have pooled their funds.
A mutual fund is managed by investment professionals and other service providers, who earn a fee for their services, from the fund.
The pool of funds is invested in a portfolio of marketable investments. The value of the portfolio is
updated every day.
The investor’s share in the fund is denominated by ‘units’. The value of the units changes with change in the portfolio’s value, every day.
1.11.2 Risk Return Matrix
The risk return trade-off indicates that if investor is willing to take higher risk then correspondingly he can expect higher returns and vice versa if he pertains to lower risk instruments, which would be satisfied by lower returns. For example, if an investors opt for bank FD, which provide moderate return with minimal risk. But Mutual funds are less risky and provide more returns. This is because the money that is pooled in are not invested only in debts funds which are less riskier but are also invested in the stock markets which involves a higher risk but can expect higher returns. Hedge fund involves a very high risk since it is mostly traded in the derivatives market which is considered very volatile.
Fig 1.8: Risk Return Matrix
1.11.3 Working of Mutual funds
To protect the interest of the investors, SEBI formulates policies and regulates the mutual funds. It notified regulations in 1993 (fully revised in 1996) and issues guidelines from time to time. MF either promoted by public or by private sector entities including one promoted by foreign entities is governed by these Regulations.
SEBI approved Asset Management Company (AMC) manages the funds by making investments in various types of securities. Custodian, registered with SEBI, holds the securities of various schemes of the fund in its custody.
According to SEBI Regulations, two thirds of the directors of Trustee Company or board of trustees must be independent.
The Association of Mutual Funds in India (AMFI) reassures the investors in units of mutual funds that the mutual funds function within the strict regulatory framework. Its objective is to increase public awareness of the mutual fund industry.
Fig 1.9: Mutual Fund Organization
AMFI also is engaged in upgrading professional standards and in promoting best industry practices in diverse areas such as valuation, disclosure, transparency etc.
1.11.4 Types of MUTUAL FUNDS
Fig 1.10: Types of MUTUAL FUNDS
On basis of STRUCTURE
1. Open - Ended Schemes: An open-end fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV") related prices. The key feature of open-end schemes is liquidity.
2. Close - Ended Schemes:A Close-Ended fund is open for subscription only during a specified period, generally at the time of initial public issue. The Close-Ended fund scheme is listed on the some stock exchanges where an investor can buy or sell the units of this type of scheme. 3. Interval Schemes:Interval Schemes are that scheme, which combines the features of open-ended and close-ended schemes. The units may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV related prices.
On basis of NATURE
1. Equity fund: These funds invest a maximum part of their corpus into equities holdings. The structure of the fund may vary different for different schemes and the fund manager’s outlook on different stocks. The Equity Funds are sub-classified depending upon their investment objective, as follows:
Diversified Equity Funds Mid-Cap Funds Sector Specific Funds Tax Savings Funds (ELSS)
Equity investments are meant for a longer time horizon, thus Equity funds rank high on the risk-return matrix.2. Debt funds:The objective of these Funds is to invest in debt papers. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Debt funds are further classified as:
Gilt Funds: Invest their corpus in securities issued by Government, popularly known as Government of India debt papers. These Funds carry zero Default risk but are associated with Interest Rate risk. These schemes are safer as they invest in papers backed by Government.
Income Funds: Invest a major portion into various debt instruments such as bonds, corporate debentures and Government securities.
MIPs: Invests maximum of their total corpus in debt instruments while they take minimum exposure in equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the risk-return matrix when compared with other debt schemes.
Short Term Plans (STPs): Meant for investment horizon for three to six months. These funds primarily
invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate debentures.
Liquid Funds: Also known as Money Market Schemes, These funds provides easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter-bank call money market, CPs and CDs. These funds are meant for short-term cash management of corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds.
3. Balanced funds:As the name suggest they, are a mix of both equity and debt funds. They invest in both equities and fixed income securities, which are in line with pre-defined investment objective of the scheme. Equity part provides growth and the debt part provides stability in returns.
Other schemes
Tax Saving Schemes:Under Sec.88 of the Income Tax Act 1961, contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.
Index Schemes:Index schemes attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE 50. The portfolio of these schemes will consist of only those stocks that constitute the index. And hence, the returns from such schemes would be more or less equivalent to those of the Index.
Sector Specific Schemes:These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. The returns in these funds are dependent on the performance of the respective sectors/industries. These are most risky ones.
1.11.5 Types of returnsThere are three ways, where the total returns provided by mutual funds can be enjoyed by investors:
Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in the form of a distribution.
If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
1.11.6 Advantages of Investing Mutual Funds1. Professional Management - The basic advantage of funds is that, they are professional managed, by well qualified professional. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio. 2. Diversification - The idea behind diversification is to
invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. 3. Economies of Scale - Mutual fund buy and sell large amounts of securities at a time, thus help to reducing transaction costs, and help to bring down the average cost of the unit for their investors.4. Liquidity - Just like an individual stock, mutual fund also allows investors to liquidate their holdings as and when they want.5. Simplicity - Investments in mutual fund is considered to be easy, compare to other available instruments in the market, and the minimum investment is small. Most AMC also have automatic purchase plans whereby as little as Rs. 2000, where SIP start with just Rs.50 per month basis.
1.11.7 Disadvantages of Investing Mutual Funds1. Professional Management- Some funds do not perform in neither the market as their management is not dynamic enough to explore the available opportunity in the market, thus many investors debate over whether or not the so-called professionals are any better than mutual fund or investor himself, for picking up stocks. 2. Costs – The biggest source of AMC income is generally from the entry & exit load which they charge from an investor at the time of purchase. The mutual fund industries are thus charging extra cost under layers of jargon.3. Dilution - Because funds have small holdings across different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.4. Taxes - when making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gain tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.
1.11.8 How do the funds raise money?
The asset management companies (AMCs) that manage the mutual funds define avenues where they think profitable opportunities exist. For example, currently many AMCs believe that small and medium cap stocks will yield significant return over the medium to long term. Hence, they launch a 'fund' (called a new fund offer: NFO) which seeks to bring all those investors together who believe similarly.
The AMC releases a prospectus wherein it details the objective of the fund, the credentials of the company and the fund manager and the avenues where the money will be invested. Based on this information, the investor needs to decide whether this fund meets his objective or not. If the investor (or his advisor) believes that the new fund fits his required risk-return profile, the investor invests in the fund.
1.12 EXCHANGE TRADED FUNDS
An ETF is an investment company whose shares are traded intraday on stock exchanges at market-determined prices. Investors may buy or sell ETF shares through a broker or in a brokerage account just as they would the shares of any publicly traded company. Most ETFs are structured as open-end investment companies (open-end funds) or unit investment trusts, but other structures also exist—primarily for ETFs that
invest in commodities, currencies, and futures.
An exchange-traded fund, or ETF, is an investment product representing a basket of securities that track an index such as the Standard & Poor's 500 Index, BSE Sensex, Nifty etc . ETFs, which are available to individual investors only through brokers and advisers, trade like stocks on an exchange. The returns one can expect from ETFs will be equal to the rise in the index.
ETFs are a mix of a stock and a MF in the sense that
Like mutual funds they comprise a set of specified stocks e.g. an index like Nifty/Sensex or a commodity e.g. gold; and
Like equity shares they are traded on the stock exchange on real-time basis.
1.12.1 How does an ETF work?In a normal fund we buy/sell units directly from/to the AMC. First the money is collected from the investors to form the corpus. The fund manager then uses this corpus to build and manage the appropriate portfolio. When you want to redeem your units, a part of the portfolio is sold and you get paid for your units. The units in a conventional MF are, therefore, called in-cash units.
But in ETF, we have something called the authorized participants (appointed by the AMC). They will first deposit all the shares that comprise the index (or the gold in case of Gold ETF) with the AMC and receive what is called the creation units from the AMC. Since these units are created by depositing underlying shares/gold, they are called in-kind units.
Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase Creation Units are frequently institutions. These creation units are a large block, which are then split into small units and accordingly bought/sold in the open market on the stock exchange by these authorized participants.
Working of ETF
Fig 1.11: ETF working
1.12.2 Comparison with conventional MFs
1. Since all ETFs require certain specific shares to be deposited for units to be created, they all are usually index-specific like Nifty, Sensex, Bankex etc. As against this, a conventional MF can have any portfolio (though as per the pre-defined objective). Of course index funds will also mimic the index and hence to that extent ETFs & index funds are same
2. Because ETFs are index-specific, the portfolio remains more or less constant, whereas portfolio of an actively managed conventional MF will change on day-to-day basis. Hence, while portfolio of ETF is known beforehand, the portfolio of a conventional MF can be known only at the time of month-end disclosures.
3. ETFs are bought/sold on the stock exchange and need a demat account. Conventional MFs are bought/ sold from/to the AMC.
4. ETFs can be traded like a stock at any time of the day and at real-time prices, while the market is open. Whereas, one can buy MFs only at the NAV based on the closing prices.
5. The unit capital of close-ended funds (and even shares) will not change with trading. But unit capital of ETF can change with trading and hence to that extent they behave like open-ended funds
6. There are some close-ended funds listed on the exchange. But because they are structurally different from an ETF, they can trade at substantial discount (or premium) to the NAV. This will not be the case with ETFs.
7. Like conventional MFs, they offer the benefits of diversification 8. As financial instruments per se, ETFs are as safe as conventional MFs. But, of course, the market risk
remains. 9. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures 10. Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to meet
the redemptions the normal buying & selling of units amongst the investors will take care of day-to-day redemptions. To that extent, ETFs are somewhat protected
11. In ETF each investor pays his share of costs, unlike conventional MFs where costs are deducted from the NAV on an average basis. As such the long-term investors suffer, while short-term investors end-up paying lesser costs in conventional MFs.
1.12.3 Benefits of investing in ETFs
Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices)
One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs
ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs
Not dependent on the fund manager Like an index fund, they are very transparent
1.12.4 Disadvantages of investing in ETFs
SIP in ETF is not convenient as you have to place a fresh order every month Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay
brokerage every time you buy & sell
Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs.
You can’t automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load
Comparatively lower liquidity as the market has still not caught up on the concept
It may, therefore, be concluded that if an investor is looking for a long-term and defensive investment strategy in equities by backing the index rather than looking at active management, ETF offers an alternative to index-based funds. It offers trading convenience & probably lower costs than index funds. A case-to-case comparison is, however, important as some index-funds may be cheaper. Also for SIPs, index-funds may prove better than ETFs.
However, in the absence of conventional MFs like in Gold, ETFs is but a natural and better choice than buying/selling physical gold.
Ch -2 MARGIN TRADING AND TECCHNICAL ANALYSIS
2.1 MARGIN TRADINGPractice of buying stock with money borrowed from the broker. In this arrangement, the investor makes a cash down payment (called the margin) with the broker and can purchase stocks worth about twice the cash amount. The broker charges interest on this loan (in addition to the commission on each buy/sell trade) and the investor has to keep the entire stockholding with the broker as collateral. Also, the investor has to put up additional cash in case the value of the stockholding falls below a certain amount. Margin trading is a double-edged sword - it cuts both ways. If the stock price rises, the investor makes twice as much profit as with his own cash only. Similarly, if the stock price falls, the investor loses twice the amount. In slang, this practice is called 'investing on steroids.'
Imagine this: you're sitting at the blackjack table and the dealer throws you an ace. You'd love to increase your bet, but you're a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn't it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you'll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.
Investing on margin isn't necessarily gambling. But you can draw some parallels between margin trading and the casino. Margin is a high-risk strategy that can yield a huge profit if executed correctly. The dark side of margin is that you can lose your shirt and any other assets you're wearing. One of the only things riskier than investing on margin is investing on margin without understanding what you're doing.
2.1a) Margin account
A brokerage account that allows investors to buy securities by borrowing a portion of the purchase price. Margin accounts are governed by the National Association of Securities Dealers (NASD), the
New York Stock Exchange (NYSE) and the lending brokerage firm.
There are two ways to purchase stocks:
a) The buyer can pay the purchase price in full
b) Using a margin account. In a margin account purchase, the buyer pays a portion of the purchase price and the broker lends the difference. The buyer in turn pays interest on the broker’s loan in addition to the usual commission fees. For collateral, the broker holds onto the stocks. Dividends earned from the stocks are used to help offset the interest payments.
Margin is determined by the following equation:
M is the margin, V is the market value of the securities, and L is the broker’s loan.
2.1b) The margin call
Once the trader buys a future or stocks in the margin account, the client gets the profit/loss since his purchase in his account.
In both futures market and margin trading, if the value of the share falls below the purchase price, the broker will make margin calls, asking the client to deposit additional margin.In a normal market, these margin calls are not a problem as clients can deposit the additional amount easily.When clients are not able to meet the margin requirement, the broker sells the security so that he does not have to bear the risk in case the stock falls further.This typically become a problem when the markets fall far more than expected and traders are not liquid enough to meet the margin calls. And when a lot of traders can't meet margin calls, the situation snowballs.
This is what happened in the past few days when traders, who were over-leveraged could not meet the margin calls, and their securities kept being sold.
Futures
A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If
you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features:
Buyer Seller Price Expiry
Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.
No delivery right now
Futures are for different kinds of requirements. For instance you may not have the money right now to buy, but you believe the price will go up. You just buy a forward contract for a later date, and on that date you buy and IMMEDIATELY sell, so that you will simply pocket the difference (or lose the difference if the stock has lost money).
Short selling
Secondly, futures can be used to "short sell". If you want to sell something you should own it first, no? But futures are different - since they are for a later date, you can sell something without owning it, and then buy it later! So if you believe the price of an item is going down, you can SELL a forward contract. Since you don't have to deliver it right now, the buyer does not care if you already have it or not. On the later date, just buy from the market and give it to the buyer, pocketing (or losing) the difference.
2.2a)Margin trading vs futures
Most investors buy the futures, but there are times when margin trading makes mores sense. If a stock is not in the futures list, the client can go for margin funding.
Since futures are generally not available beyond one or two months, if the client has a longer view, then margin trading is better. Also, some brokers offer lower interest rates on margin trading than the prevalent rates in the futures market.
2.2b)How Do Futures Markets Benefit Society?
The futures markets can help manage the risks that are part of doing business. This can mean lower costs to you as a consumer, because a well-run business is usually able to bring its goods and services to market more efficiently — at a lower cost. The fewer risks a business has to take, the lower the end
price it needs to make a profit. That’s really the free enterprise system at its best, and futures markets play a vital role in this process.Also, firms that manage their risks tend to be more dependable employers. If you work for a company that deals with overseas customers or suppliers, for example, you have an interest in how well your company copes with foreign exchange rates and how well it manages the risk of fluctuating interest rates to protect its profits. Hedging with futures can assist with this aspect of your employer’s operations.Naturally, if you work for a futures exchange or a firm involved in trading, futures markets are particularly important to you. Futures markets are a part of the business scene in this country. Used knowledgeably and appropriately, futures and options markets can be a valuable asset in the business of doing business, which affects each of us.
2.3a)Options
An option is the right, not the obligation, to buy or sell a futures contract at a designated strike price. For trading purposes, you buy options to bet on the price of a futures contract to go higher or lower. There are two main types of options - calls and puts.
Calls – You would buy a call option if you believe the underlying futures price will move higher. For example, if you expect corn futures to move higher, you will want to buy a corn call option.
Puts – You would buy a put option if you believe the underlying futures price will move lower. For example, if you expect soybean futures to move lower, you will want to buy a soybean put option.
Premium – You are obviously going to have to pay some kind of price when you buy an option. The term used for the price of an option is premium. You can think of the pricing of options as a bet. The bigger the long shot, the less expensive they will be. Oppositely, the more sure the bet is, the more expensive it will be.
Fig2.3.1
Contract Months (Time)
Options have an expiration date, which means they only last for a certain period of time. When you buy an option, you cannot hold it forever. For example, a December corn call expires in late November. You will need to close the position before expiration. Generally, the more time you have on an option, the more expensive it will be.
Strike Price
This is the price at which you could buy or sell the underlying futures contract. For example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the option expires. Most traders do not convert options, they just close the option position and take the profits.
2.3b)How To Start Options Trading?
The easiest way to start options trading is by opening an online options trading account with a broker
which offers online options trading and then practise buying call options for stocks which you think will go up and buying put optionsfor stocks that you think will go down. After you are completely familar with trading call options and put options, you can then move on to the more complex option strategies. Make sure you follow the essential Steps in Trading Options. There are currently (Dec 2010) seven exchanges in the United States that list standardized stock options for options trading -- The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) and NYSE Arca in New York City, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE), Nasdaq Options Market (NASDAQOMX) and Boston Options Exchange (BOX) are electronic marketplaces. Anyone can trade options in any of these options trading exchanges through any options trading brokers.
2.3c)Why Options Trading?
Successful Investors like Robert Kiyosaki and Robert G Allen have popularised options trading through the use ofoptions strategies as part of an overall strategy to financial freedom. They preach that options trading is the investment of the rich.
So what makes it so powerful?
Options Trading Grants Unprecedented LEVERAGE!
Yes, options trading is LEVERAGE! Trading options allows you to potentially make over 10 times more profit on the same move in the underlying stock than if you bought the stock itself! The leverage power of options trading is perhaps the main reason why traders with small funds choose to trade options. Even though options was initially designed to be a hedging tool instead of a leverage tool, options trading is still a great way to profit while risking only very little money. The Leverage effect of option trading also allows investors to participate in the move of high priced stocks using only a small capital outlay.
Options Trading Grants Unprecedented PROTECTION!
Options trading not only grants you leverage, but it also grants you PROTECTION! When a stock moves AGAINST you, an options trader could potentially make a lesser loss than the stock trader. Why? Because your maximum loss is limited to the price you paid for the option which could be just 10% of the price of the stock, or lesser! Taking our Apple example from above, the stock trader's maximum risk is $9365 while the option trader's maximum risk is $170 for controlling the same number of Apple stocks! Indeed, options trading need not be risky!
Options Trading Grants Unprecedented FLEXIBILITY!
Options Trading allows you to profit from every possible move in the underlying asset! Up, Down or Stagnant, there is an option strategy that allows you to profit from that exact move. In Options trading, an options trader can easily participate in a downwards move on a stock through buying a put option without having to risk margin calls by going short the underlying stock or futures.
Yes, there are even times when stock trading is riskier than option trading! Read about How Stocks Can Be Riskier Than Options. This is also why I wrote this options trading tutorials site to teach the world about this wonderful trading instrument.
Fig 2.3c.1
# Futures
Entry type: BuyDirection: UpTrade type: LongEntry type: SellDirection: DownTrade type: Short
# Options
Entry type: Call Direction: Up Trade type: Long Entry type: Put Direction: Down Trade type: Long
2.4Technical analysisIt is research of market dynamics that is done mainly with the help of charts and with the purpose of forecasting future price development. Technical analysis comprises several approaches to the study of price movement which are interconnected in the framework of one harmonious theory. This type of analysis studies the price movement on the market by means of analyzing three market factors: price, volumes, and, in case of study of futures contracts’ market, of an open interest (number of open positions). Of these three factors the primary one for technical analysis is the prices, while the alterations in other factors are studies mainly in order to confirm the correctness of the identified price trend. This technical theory, just like any theory, has its core postulates.
Technical analysts base their research on the following three axioms:
1) Market movement considers everything
This is the most important postulate of technical analysis. It is crucial to understand it in order to grasp rightly the procedures of analysis. The gist of it is that any factor that influences the price of securities, whether economic, political, or psychological, has already been taken into account and reflected in the price chart. In other words, every price change is accompanied by a change in external factors. The main inference of this premise is the necessity to follow closely the price movements and analyze them. By means of analyzing price charts and multiple other indicators, a technical analyst comes to the point that the market itself shows to her/him the trend it will most likely follow.This premise is in conflict with fundamental analysis where the attention is primarily paid to the study of factors, and later on, after the analysis of the factors, to conclusions as to the market trends are made. Thus, if the demand is higher than the supply, a fundamental analyst will come to the conclusion that the price will grow. Technical analyst, however, makes her/his conclusions in the opposite sequence: since the price has grown, it means the demand is higher than the supply.
2) Price moves with the trend
This assumption is the basis for all methods of technical analysis, as a market that moves in accordance with trends can be analyzed, unlike a chaotic market. The postulate that the price movement is a result of a trend has two effects. The first one implies that the current trend will most likely continue and will not reverse itself, thus, excluding disorderly chaotic movement of the market.
The second one implies that the current trend will go on until the opposite trend sets in.
3) History repeats itself
Technical analysis and studies of market dynamics are closely related to the studies of human psychology. Thus, the graphical price models identified and classified within the last hundred years depict core characteristics of the psychological state of the market. First of all, they show the moods currently pre vailing in the market, whether bullish or bearish. Since these models worked in the past, we have reasons to suppose that they will work in the future, for they are based on human psychology which remains almost unchanged over years. We can reword the last postulate — the story repeats itself — in a slightly different .
2.4a)Timeframes
Regardless of the "timeframes" of the data in your charts (i.e., hourly, daily, weekly, monthly, etc.), the basic principles of technical analysis endure. Opportunities exist in any time frame. But customized settings of the technical analysis tools are needed for each time period.
On the weekly chart, the scale interval on the time axis is one week. On the monthly chart, correspondingly, every bar shows price behavior for one complete month. It is obvious that in order to cover a longer period of time and to be able to analyze long-term trends, one has to compress the price behavior. A weekly chart, for example, can cover a period of five years and more, the monthly chart can cover twenty years or more. This is how the analyst manages to see far ahead of her-/himself and that is how s/he can assess the market in terms of the long-termopportunities, which are really valuable while conducting the technical analysis.
It is wise to start by analyzing long-term charts and then move slowly to short-term charts. There is less "noise" on the long periods, that is why graphic models, basic trend lines and different levels of support or resistance are seen more clearly. This accounts for the type of work with data time periods. If we start studying short-term market, later on, as the volume of analyzed data expands, we will have to reconsider the conclusions several times at least. In the long run, short-term results may even change completely after long-term charts have been studied. If we start analyzing longer periods first, we can establish where the market is in terms of a long-term perspective. After that, we could then turn to chart studies which cover shorter periods of time. That is how an analyst goes from "macro" to "micro" analysis. At the final stage of the analysis, we determine the point of "entry into the market", i.e., the point of opening a position. The shorter the last analysis stage is, the more precisely one can determine this entrance point.
2.4b)Equidistant Channel
Equidistant Channel represents two parallel trend lines connecting extreme maximum and minimum close prices. Market price jumps, draws peaks and troughs forming the channel in the trend direction. Early identification of the channel can give a valuable information including that about changes in the trend direction what allows to estimate possible profits and losses. It is necessary to give the direction
of the channel and its width to build the instrument.
Fig 2.4b.1
2.4c)Support and Resistance
Think of prices for financial instruments as a result of a head-to-head battle between a bull (the buyer) and a bear (the seller). Bulls push prices higher, and bears lower them. The direction prices actually move shows who wins the battle.
Support is a level at which bulls (i.e., buyers) take control over the prices and prevent them from falling lower.
Resistance, on the other hand, is the point at which sellers (bears) take control of prices and prevent them from rising higher. The price at which a trade takes place is the price at which a bull and bear agree to do business. It represents the consensus of their expectations.
Support levels indicate the price where the most of investors believe that prices will move higher. Resistance levels indicate the price at which the most of investors feel prices will move lower.
But investor expectations change with the time, and they often do so abruptly. The development of support and resistance levels is probably the most noticeable and reoccurring event on price charts. The breaking through support/resistance levels can be triggered by fundamental changes that are above or below investor's expectations (e.g., changes in earnings, management, competition, etc.) or by self-fulfilling prophecy (investors buy as they see prices rise). The cause is not so significant as the effect: new expectations lead to new price levels. There are support/resistance levels, which are more emotional.
Fig2.4c.1 2.4
Resistance becomes support
When a resistance level is successfully broken through, that level becomes a support level. Similarly, when a support level is successfully broken through, that level becomes a resistance level.
The reason for it is that a new "generation" of bulls appears, who refused to buy when prices were low. Now they are anxious to buy at any time the prices return to the previous level. Similarly, when prices drop below a support level, that level often becomes a resistance level that prices have a difficult time breaking through. When prices approach the previous support level, investors seek to limit their losses by selling.
2.4d)Trendlines
Trendlines are widely used in technical analysis. But it should be noted that there is not consensus of opinions about methods of their building and interpreting. So nobody is surprised at the fact that different analysts using identical data of the same time period draw absolutely different trendlines.
A trendline is a straight line that connects two important minimum or maximum points in the chart. Any amount of secondary and small trends can be found within the main trend. their lengths can vary within a rather wide range. It should be noted that a trendline should not intersect other prices between these two points. A trendline represents a resistance or support pass-through where price changes within the range of the pass-through.
The trendlines can be categorized as follows:
1) Downtrend is characterized through sequential decreasing of maximum prices. It can also be considered as descending resistance level: Bears set the pace as they push prices down.
2) Uptrend is characterized through sequential increasing of minimum prices. It can also be considered as ascending support level: Bulls set the pace as they push prices up.
3) Sideways Trend - price does not practically move at all.
Fig2.4d.1
Trendlines can be categorized by their importance using the five indications below:
1) time scale: the larger is the time scale, the more important is the trendline. The trendline in the weekly chart shows a more important trend than that in the daily chart, and the latter show a more important trend than the trendline in the 1-hour chart.
2) length: the longer is the trendline, the more reliable it is. The short trendline displays the behavior of masses within a short time interval, and a longer trendline displays their behavior within a longer period of time;
3) how many times prices touch the trendline: the more is the count of touches, the more reliable is the trendline. A preliminary trendline is drawn through only two points, sp the third point makes it more reliable and four or five points show that the group prevailing in the market at this moment has a significant potential.
4) slope angle: the angle between the trendline and the horizontal line reflects the intensity of
emotions among the prevailing market crowd. An abrupt trendline means that the prevailing crowd is dynamic, and a relatively flat trendline means that the prevailing crowd is rather inert. A flat trend usually develops longer;
5) volume of transactions: it reflects how serious the players are, as well as the count of participants interested in retaining the existing trend. The increased Volume usually serves as confimation of the preceding trend.
To draw a trendline, it is enough to have two points it to be drawn through, and one more point "to confirm" the trend. The trendline exists until it is broken through due to a price flick up or down. The "dog-legs" in trendlines are relatively rare. If there is no consolidation, the longer it does not happen, the sharper is the subsequent turn.
2.4e)Moving Averages
Moving averages are one of the oldest and most popular technical analysis tools. A moving average is the average price of a financial instrument over a given time. When calculating a moving average, you specify the time span to calculate the average price. For example, it could be 25 days.
Fig2.4e.1
A "simple" moving average is calculated by adding the instrument prices for the most recent "n" time periods and then dividing by "n". For instance, adding the closing prices of an instrument for most recent 25 days and then dividing by 25. The result is the average price of the instrument over the last 25 days. This calculation is done for each period in the chart.
Note that a moving average cannot be calculated until you have "n" time periods of data. For
example, you cannot display a 25-day moving average until the 25th day in a chart.
The moving average represents the consensus of investor’s expectations over the indicated period of time. If the instrument price is above its moving average, it means that investor’s current expectations (i.e., the current price) are higher than their average ones over the last 25 days, and that investors are becoming increasingly bullish on the instrument. Conversely, if today’s price is below its moving average, it shows that current expectations are below the average ones over the last 25 days.
The classic interpretation of a moving average is to use it in observing changes in prices. Investors typically buy when the price of an instrument rises above its moving average and sell when the it falls below its moving average.
Ch-3 Factors affecting market
Trends are what allow traders and investors to capture profits. Whether on a short- or long-term time frame, in an overall trending market or ranging environment, the flow from one price to another is what creates profits and losses. There are four major factors that cause both long-term trends and short-term fluctuations.
1. Governments: Fiscal and monetary policy have a profound effect on the financial marketplace. By altering interest rates and the amount of dollars available on the open market, governments can change how much investment flows into and out of the country.
2. International Transactions: The flow of funds between countries impacts the strength of a country's economy and its currency. Countries that export continually bring money into their countries. This money can then be reinvested and can stimulate the financial markets within those countries.
3. Speculation and Expectation: Consumers, investors and politicians belief where the economy will go in the future impacts how we act today. Expectation of future action is dependent on current acts and shapes both current and future trends. Sentiment indicators are commonly used to gauge how certain groups are feeling about the current economy. Analysis of these indicators as well as other forms of fundamental and technical analysis can create a bias or expectation of future price rates and trend direction.
4. Supply and Demand: Supply and demand for products, currencies and other investments creates a push-pull dynamic in prices. Prices and rates change as supply or demand changes. If something is in demand and supply begins to shrink, prices will rise. If supply increases beyond current demand, prices will fall. If supply is relatively stable, prices can fluctuate higher and lower as demand increases or decreases.
Effect on Short- and Long-Term Trends due to above factors:
1. Government: Government news releases, such as proposed changes in spending or tax policy, as well as Federal Reserve decisions to change or maintain interest rates can have a dramatic effect on long term trends. Lower interest rates and taxes encourage spending and economic growth. This has a tendency to push market prices higher, but the market does not always respond in this way because other factors are also at play. Higher interest rates and taxes, for example, deter spending and result in contraction or a long-term fall in market prices. In the short term, these news releases can cause large price swings as traders and investors buy and sell in response to the information. Increased action around these announcements can create short-term trends, while longer term trends develop as investors fully grasp and absorb what the impact of the information means for the markets.
2. The International Effect: International transactions, balance of payments between countries and economic strength are harder to gauge on a daily basis, but they play a major role in longer-term trends in many markets. The currency markets are a gauge of how well one country's currency and economy is doing relative to others. A high demand for a currency means that currency will rise relative to other currencies. The value of a country's currency also plays a role in how other markets will do within that country. If a
country's currency is weak, this will deter investment into that country, as potential profits will be eroded by the weak currency.
3. The Participant Effect: The analysis and resultant positions taken by traders and investors based on the information they receive about government policy and international transactions create speculation as to where prices will move. When enough people agree on direction, the market enters into a trend that could sustain itself for many years. Trends are also perpetuated by market participants who were wrong in their analysis; being forced to exit their losing trades pushes prices further in the current direction. As more investors climb aboard to profit from a trend, the market becomes saturated and the trend reverses, at least temporarily.
4. The S & D Effect: This is where supply and demand enters the picture. Supply and demand affects individuals, companies and the financial markets as a whole. In some markets, such as the commodity markets, supply is determined by a physical product. Supply and demand for oil is constantly changing, adjusting the price a market participant is willing to pay for oil today and in the future. As supply dwindles or demand increases, a long-term rise in oil prices can occur as market participants outbid one another to attain a seemingly finite supply of the commodity. Suppliers want a higher price for what they have, and a higher demand pushes the price that buyers are willing to pay higher. All markets have a similar dynamic. Stocks fluctuate on a short and long-term scale, creating trends. The threat of supply drying up at current prices forces buyers to buy at higher and higher prices, creating large price increases. If a large group of sellers were to enter the market, this would increase the supply of stock available and would likely push prices lower. This occurs on all time frames.
Other factors affecting markets:
1. Policies:
Foreign direct investment (FDI) is direct investment into production in a country by a company in another country, either by buying a company in the target country or by expanding operations of an existing business in that country. Foreign direct investment is done for many reasons including to take advantage of cheaper wages, special investment privileges such as tax exemptions offered by the country as an incentive to gain tariff-free access to the markets of the country or the region.
in regard to the national income equation Y=C+I+G+(X-M), I is investment plus foreign investment, FDI refers to the net inflows of investment(inflow minus outflow) to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, other long-term capital, and short-term capital as shown the balance of payments. It usually involves participation in management, joint-venture, transfer of technology and expertise. There are two types of FDI: inward and outward, resulting in a net FDI inflow (positive or negative) and "stock of foreign direct investment", which is the cumulative number for a given period.
Global overview of foreign direct investment
The United Nations Conference on Trade and Development said that there was no significant growth of global FDI in 2010. In 2010 was $1,122 billion and in 2009 was $1,114 billion. The figure was 25 percent below the pre-crisis average between 2005 and 2007
Foreign direct investment in India
Starting from a baseline of less than $1 billion in 1990, a recent UNCTAD survey projected India as the second most important FDI destination (after China) for transnational corporations during 2010–2012. As per the data, the sectors that attracted higher inflows were services, telecommunication, construction activities and computer software and hardware. Mauritius, Singapore, US and UK were among the leading sources of FDI. According to Ernst & Young, FDI in India in 2010 was $44.8 billion and in 2011 experienced an increase of 13% to $50.8 billion. India has seen an eightfold increase in its FDI in March 2012. India disallowed overseas corporate bodies (OCB) to invest in India.
2012 FDI reforms
On 14 September 2012, Government of India allowed FDI in aviation up to 49%, in the broadcast sector up to 74%, in multi-brand retail up to 51% and in single-brand retail up to 100%.The choice of allowing FDI in multi-brand retail upto 51% has been left to each state.
In its supply chain sector, the government of India had already approved 100% FDI for developing cold chain. This allows non-Indians to now invest with full ownership in India's burgeoning demand for efficient food supply systems. The need to reduce waste in fresh food and to feed the aspiring demand of India's fast developing population has made the cold supply chain a very exciting investment proposition. Foreign investment is announced by the government of India as FEMA (Foreign Exchange Management Act).
SWOT Analysis of FDI in Retail
STRENGTHS
• Retail is a $450bn Industry in India.• Young and dynamic manpower• Highest shop density in the world• High growth rate in retail & Whole-sale trade• Presence of big industrial houses with deep pock.
WEAKNESSES
• High capital investment required in the retail sector (real estate)• Lack of trained and educated work force• Higher prices as compared to local shops• Will mainly cater to high-end consumers placed in metros
OPPORTUNITIES
• High employment generation inthe future• Will enhance financial condition offarmers• Encourage foreign capital inflows• Result in increasing supply-chainefficiency• Improve Logistics & Infrastructure
THREATS:
• Effect on the small retailers - localKirana stores (mom-pop stores)• Long gestation period - ForeignRetailers will take a while to adaptto India and generate profits• States not buying in soefficiencies expected may not beachieved.
Fdi review from Indian perspective:
1. There is clearly an opportunity for the Domestic Giants, Kirana Stores and the Foreign Retailers to co-exist in India
2. The Wal-Mart model, offers every-day low pricing, but are typically in far-off locations, have a homogenous selection of products across their stores, typically need 150,000 sq feet of space and require a car to get to. India is years away from when majority of its population will have the ability to only shop at the Wal-Marts of the world. People will still shop there for proximity, comfort of relationship and easy credit.
3. Foreigners will bring to India their expertise and efficiency in retailing, they will invest capital in improving logistics and infrastructure in India (for example: Cold Storage Logistics is still almost non-existent in India) and share technology and know-how with their local Indian Partners, but will also be able to become profitable over a period of time as their brands and presence increase across the country.
4. On the whole, if India has to grow it needs capital, training and innovation. Yes the short-term effects of the announced reforms will be painful, but in the long-term if they will help make Retail a more organized industry in India, provide better quality goods at cheaper prices at convenient locations, improve infrastructure and the supply chain mechanism throughout the country, provide employment and retail sector specific training to a large population it will be a huge boon to the nation.
World market:
1. Global recession:A recession is a decline in a country's Gross Domestic Product (GDP) growth for two or more consecutive quarters of a year. A recession normally takes place when consumers lose confidence in the growth of the economy and spend less. This leads to a decreased demand for goods and services, which in turn leads to a decrease in production, lay-offs and a sharp rise in unemployment. Investors spend less as they fear stocks values will fall and thus stock markets fall on negative sentiment.According to the U.S. National Bureau of Economic Research (the official arbiter of U.S. recessions) the recession began in December 2007 and ended in June 2009.[12][13] US mortgage-backed securities, which had risks that were hard to assess, were marketed around the world. The emergence of sub-prime loan losses in 2007 began the crisis and exposed other risky loans and over-inflated asset prices. With loan losses mounting and the fall of Lehman Brothers on September 15, 2008, a major panic broke out on the inter-bank loan market. As share and housing prices declined, many large and well established investment and commercial banks in the United States and Europe suffered huge losses and even faced bankruptcy, resulting in massive public financial assistance.A global recession has resulted in a sharp drop in international trade, rising unemployment and slumping commodity prices. In December 2008, the National Bureau of Economic Research (NBER) declared that the United States had been in recession since December 2007.[16] Several economists predicted that recovery might not appear until 2011 and that the recession would be the worst since the Great Depression of the 1930s.
Causes:The origin has been focused on the respective parts played by the public monetary policy (in the US notably) and by the practices of private financial institutions. In the U.S., mortgage funding was unusually decentralized, opaque, and competitive, and it is believed that competition between lenders for revenue and market share contributed to declining underwriting standards and risky lending.Some economists have claimed that the ultimate point of origin of the financial crisis of 2007–2010 can be traced back to an extremely indebted US economy. High private debt levels also impact growth by making recessions deeper and the following recovery weaker.Impact:Indian stock market crashed from the high of 20000 to a low of around 8000 points during the year 2008-2009. Corporate performance of most of the companies remained subdued, and the impact of moderation in demand was visible in the substantial deceleration during the said years. Corporate profitability also exhibited negative growth, which has led to the bearish trend in the stock market. Recession has effected the investments made by Foreign Institutional Investors (FIIs) in the Indian Stock Market as FIIs started disinvesting to meet their commitments abroad. This is putting lot of pressure on domestic financial system, which has led to liquidity crunch in all major sectors of the country. 2008 was a bad year for the markets as the Sensex reported some of its major falls during that year. This owed to the global recession of 2008. Some of the biggest falls of sensex are:
•18th May, 2006 – Massive sell off by FIIs, retail investors and an overall weak global sentiment led to a 826 point fall in the Sensex, which closed at 11,391 points.
r• 21 January, 2008 — This day marked the highest fall in the history of Sensex as it declined 1,408 points on the back of investors selling owing to fears about fears that the US may be headed for a recession.
• 22 January, 2008 – Sensex declined by 875 points to close at 16,729 points. Trading was suspended for an hour at the BSE as crashed by 10 percent.
•11th Feb, 2008 – Sensex declined by 833 points to close at 16,630.9 points.
• 3 March, 2008 — Major sell off by funds, budget related concerns and fears about the US heading for a recession led to a 900 points in Sensex to 16,677 points.
•13th Mar, 2008 – The BSE Sensex declined by 770 points to close at 15,357 points.
• 17 March, 2008 — The Sensex crashed 951 points to close at 14,809 points on concerns about global markets
•10th Oct, 2008 – Sensex closed at 10,527.85 points, lower by 800 points.
• 24 October, 2008 — Markets declined 1070 points to close at 8701 points as the RBI left key interest rates unchanged and lower the GDP target to 7-5 percent for 2008-09.
2. Inflation:Inflation is a state in the economy of a country, when there is a price rise of goods as well as services. To meet the required price rise, individuals have to shell out more than is presumed. Ranging from unemployment, interest rates, exchange rates, investment, stock markets, there is an aftermath of inflation in every sector. Inflation and stock market have a very close association. If there is inflation, stock markets are the worst affected.
Prices of stocks are determined by the net earnings of a company. It depends on how much profit, the company is likely to make in the long run or the near future. If it is reckoned that a company is likely to do well in the years to come, the stock prices of the company will escalate. On the other hand, if it is observed from trends that the company may not do well in the long run, the stock prices will not be high. In other words, the prices of stocks are directly proportional to the performance of the company. In the event when inflation increases, the company earnings (worth) will also subside. This will adversely affect the stock prices and eventually the returns. Effect of inflation on stock market is also evident from the fact that it increases the rates if interest. If the inflation rate is high, the interest rate is also high. In the wake of both (inflation and interest rates) being high, the creditor will have a tendency to compensate for the rise in interest rates. Therefore, the debtor has to avail of a loan at a higher rate. This plays a significant role in prohibiting funds from being invested in stock markets.When the government has enough funds to circulate in the market, the cost of goods, services usually go up. This leads to the decrease in the purchasing power of individuals. The value of money also decreases. In a nut shell, for the economy to flourish, inflation and stock market ought to be more conforming and predictable.
Inflation and its Effects on InvestmentsExample - Our grandfather is to say that in one rupee he was doing shopping for whole month and now days you require minimum RS 10000 for your entire month. This rising prices year after year is called effect of Inflation. And this is reason the earning of common man has also increased from Rs 50 to 100 in older days to Rs 5000 to 10000.In other words inflation reduces the price of money, the movie ticket which was available for 50 paisa in olden days now have become RS 50.Every week on Friday government declares rate of Inflation. (In current policy they have changed it to every month)Suppose if price of one kg sugar is Rs.100 this year and next year the price becomes approximately Rs.106 then the rate of inflation is 6%.
What is rate of return?The rate of return is nothing but how much you earn on your investment. For example - If you invest Rs.500 in stock market and after one year you make profit of RS 100 then your rate of return is 20%. So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation.
What is the Conclusion?If you invest Rs.100 in the market today and you make money at a 5% "rate of return" in one year then you will have Rs.105. But if the rate of inflation remains at 7%, then an item costing today for Rs.100 will cost Rs.107 a year from now.
So what you can buy with today’s Rs.100 will be available for Rs.107 a year from now but your earning is Rs 106. So the conclusion is you are losing the money.
So what to conclude from this Inflation
1) If you are seeking good wealthy future then it is not advisable to keep your money in safe locker but do safe investing because if you just keep putting your money in locker then it will loose its value as year passes. For example if you keep Rs.5000 in your locker today and you keep it there for 15 years or 20 years then there are quit possibilities that your RS 5000 could become worth Rs. 500.
2) If it is getting difficult for you to decide where to invest then you can put in at least in bank and let it grow by earning interest year after year.
3) When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation though inflation control is not in your hand.
3. Deflation:Deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels).Deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time. While deflation sounds like it should be welcomed by investors, it actually causes a drop in the stock market because investors perceive deflation as the result of a weak economy. Economists generally believe that deflation is a problem in a modern economy because they believe it may lead to a deflationary spiral.
Historically not all episodes of deflation correspond with periods of poor economic growth. Deflation occurred in the U.S. during most the 19th century (the most important exception was during the Civil War). This deflation was caused by technological progress that created significant economic growth
The effects of deflation are:1. Decreasing nominal prices for goods and services2. Increasing buying power of cash money and all assets denominated in cash terms3. May decrease investment and lending if cash holdings are seen as preferable (aka hoarding)4. Benefits recipients of fixed incomes
III) Schemes:Rajiv Gandhi equity saving scheme:Rajiv Gandhi Equity Saving scheme was introduced in the budget (2012-13) this year by the Finance Minister. This is first of its kind scheme in India which allows the retail investor to invest upto Rs.50000 directly into equity shares and avail tax benefit on 50% percent of investment made directly into equity shares. Some of the conditions put under the scheme to avail tax benefits are:1) The investor should have income of less than Rs. 10 lakhs in a year,2) The benefit under the scheme will be given to the first time investors into equity market only.3) Investments will be subjected to lock-in period of three years and
4) If the assessee has claimed and has been allowed a deduction under this section for any assessment year in respect of any amount, he shall not be allowed any deduction under this section for any subsequent assessment year. This is as per Section 80CCG.5) The RGESS would cover stocks listed under BSE 100, CNX 100 and Navratna, Maharatna and Miniratna public sector firms.
The scheme, which was announced in the Union Budget, is supposed to help bring back retail investors into the stock market, and more importantly make stock investment more attractive from gold purchases which results in higher forex outflow. Unlike the previous finance minister’s realm, which was opposed to allowing mutual funds in the scheme, RGESS has been extended to mutual funds as well.
One of the prime concerns of mutual fund houses was that under the Direct Taxes Code, equity-linked savings schemes (ELSS) are expected to go out of Section 80C. Therefore, there are no incentives for the investor to put in money into equity schemes. The introduction of RGESS will partly offset the adverse impact. But ELSS, for some time now, has been doing quite badly. In the last four calendar years, net collections from these schemes have been falling consistently – from Rs 5,642 crore in 2008 to Rs 813 crore in 2011. In 2012, the net flows stand at Rs -132 crore, implying outflows. The scheme, itself, has very few benefits. Investors whose annual income is less than Rs 10 lakh can invest up to Rs 50,000 and get a deduction of 50 per cent of the investment. So, if you invest Rs 50,000, you can claim a tax deduction of Rs 25,000 (50 per cent of Rs 50,000). By capping it for investors whose incomes are less than Rs 10 lakh, a person in the 20 per cent tax bracket can get this benefit. And the maximum benefit will be Rs 5,000 (20 per cent of Rs 25,000). On the other hand, under ELSS, the entire amount (up to the limit Rs 1 lakh) was tax deductible. Two, ELSS gives benefits to investors of all income levels. By restricting the income level, the government is actually not giving benefits to the high income bracket – people who are more comfortable with equities as an investment. But, I guess, the tax benefit is not enough to attract them anyway. Allowing mutual funds in the scheme is important because no one wants retail investors to get influenced by tips and lose money. This will drive, not only them but their friends from the market, for a long time. RGESS, along with Sebi’s recent guidelines for mutual funds which allows for a higher expense ratio if money is collected from centres beyond the top 15 cities, will help develop equities. But, a better option perhaps would be to allow NPS or EPF to invest in market more aggressively (not just 50 per cent in ETFs as has been mandated in the NPS).
IV) Various scams:a) Harshad Mehta scam:
Harshad Shantilal Mehta was a convicted stockbroker of his time. Mehta was convicted by Bombay High Court and Supreme Court of India for ripping higher profits from stock market and trading, and for his infamous financial scandal, worth of 5,000 crore (US$945 million) in Bombay Stock Exchange (BSE), of 1992. He was tried for 9 years, until he died in the late 2001.
1992 security scam
On April 23, 1992, journalist Sucheta Dalal exposed Mehta's illegal methods in a column in The Times of India. Mehta was dipping illegally into the banking system to finance his buying. The authors explain:
“The crucial mechanism through which the scam was affected was the ready forward (RF) another. Crudely put, the bank lends against government securities just as a pawnbroker lends against jeweller. The borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan,
typically at a slightly higher price.”
It was this ready forward deal that Mehta and his accomplices used with great success to channel money from the banking system.
Making of 1992 security scam
A typical ready forward deal involved two banks brought together by a broker in lieu of a commission. The broker handles neither the cash nor the securities, though that wasn’t the case in the lead-up to the scam. In this settlement process, deliveries of securities and payments were made through the broker. That is, the seller handed over the securities to the broker, who passed them to the buyer, while the buyer gave the cheque to the broker, who then made the payment to the seller. In this settlement process, the buyer and the seller might not even know whom they had traded with, either being known only to the broker. This the brokers could manage primarily because by now they had become market makers and had started trading on their account. To keep up a semblance of legality, they pretended to be undertaking the transactions on behalf of a bank.
Another instrument used was the Bank receipt (BR). In a ready forward deal, securities were not moved back and forth in actuality. Instead, the borrower, i.e., the seller of securities, gave the buyer of the securities a BR. As the authors write, a BR “confirms the sale of securities. It acts as a receipt for the money received by the selling bank. Hence the name - bank receipt. It promises to deliver the securities to the buyer. It also states that in the mean time, the seller holds the securities in trust of the buyer.”
Having figured out his scheme, Mehta needed banks which issued fake BRs (Not backed by any government securities). “Two small and little known banks - the Bank of Karad (BOK) and the Metropolitan Co-operative Bank (MCB) - came in handy for this purpose. These banks were willing to issue BRs as and when required, for a fee,” the authors point out. Once these fake BRs were issued, they were passed on to other banks and the banks in turn gave money to Mehta, assuming that they were lending against government securities when this was not really the case. This money was used to drive up the prices of stocks in the stock market. When time came to return the money, the shares were sold for a profit and the BR was retired. The money due to the bank was returned.
This went on as long as the stock prices kept going up, and no one had a clue about Mehta’s operations. Once the scam was exposed, though, a lot of banks were left holding BRs which did not have any value - the banking system had been swindled of a whopping 4,000 crore (US$756 million). When the scam was revealed, the Chairman of the Vijaya Bank committed suicide by jumping from the office roof. He knew that he would be accused if people came to know about his involvement in issuing checks to Mehta.
Impact of scam: Index fell from 4500 to 2500 and lead to loss of Rs.1,00000 crore in market. All the banks and financial institution start demanding to return the funds. Shares were tainted. Genuine investors fell like robbed, chaotic condition in the stock market. Government Liberalization policies on hold. SEBI postponed sanctioning of private sector mutual fund
Direct effect on FDI ,as entry of foreign pension funds and mutual funds becomes rare. The Euro-issues planned by several Indian companies were delayed. Adversely affect 15 major commercial banks of India, foreign banks and NHB(national housing bank) When the scam was revealed, the Chairman of the Vijaya Bank committed suicide by jumping from the office
roof, because of his active involvement in issuing cheques to Mehta.
b) Satyam scam: The Satyam Computer Services scandal was a corporate scandal that occurred in India in 2009 where Chairman Ramalinga Raju confessed that the company's accounts had been falsified.On 10 January 2009, the Company Law Board decided to bar the current board of Satyam from functioning and appoint 10 nominal directors. ICAI issued show-cause notice to Satyam's auditor PricewaterhouseCoopers (PwC) on the accounts fudging.
On the same day, the Crime Investigation Department (CID) team picked up Vadlamani Srinivas, Satyam's then-CFO, for questioning. He was arrested later and kept in judicial custody.
On 11 January 2009, the government nominated noted banker Deepak Parekh, former NASSCOM chief Kiran Karnik and former SEBI member C Achuthan to Satyam's board.
Analysts in India have termed the Satyam scandal India's own Enron scandal. Some social commentators see it more as a part of a broader problem relating to India's caste-based, family-owned corporate environment.
On 14 January 2009, Price Waterhouse, the Indian division of PricewaterhouseCoopers, announced that its reliance on potentially false information provided by the management of Satyam may have rendered its audit reports "inaccurate and unreliable". Such reply was disappointment for the general public at large as The Chartered Accountants Act, 1949clearly states that an auditor is responsible towards the information provided to him by the management and shall be grossly negligent on affairs.
On 22 January 2009, CID told in court that the actual number of employees is only 40,000 and not 53,000 as reported earlier and that Mr. Raju had been allegedly withdrawing 20 crore (US$4 million) every month for paying these 13,000 non-existent employees.
Impact of scam:
1. Merrill Lynch (now a part of Bank of America) and State Farm Insurance terminated its engagement with the company.
2. .Credit Suisse suspended its coverage of Satyam.3. It was also reported that Satyam's auditing firm PricewaterhouseCoopers will be scrutinized for complicity
in this scandal. SEBI, the stock market regulator, also said that, if found guilty, its license to work in India may be revoked.
4. Satyam was the 2008 winner of the coveted Golden Peacock Award for Corporate Governance under Risk Management and Compliance Issues which was stripped from them in the aftermath of the scandal.
5. The New York Stock Exchange has halted trading in Satyam stock as of 7 January 2009.6. India's National Stock Exchange had announced that it will remove Satyam from its S&P CNX Nifty 50-
share index on 12 January. 7. The founder of Satyam was arrested two days after he admitted to falsifying the firm's accounts.
8. Satyam's shares fell to 11.50 rupees on 10 January 2009, their lowest level since March 1998, compared to a high of 544 rupees in 2008.
9. In New York Stock Exchange Satyam shares peaked in 2008 at US$ 29.10; by March 2009 they were trading around US $1.80.
10. The Indian Government has stated that it may provide temporary direct or indirect liquidity support to the company. However, whether employment will continue at pre-crisis levels, particularly for new recruits, is questionable.
Increase in gold prices:
Investors generally buy gold as a hedge or harbour against economic, political, or social fiat currency crises (including investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest). The gold market is subject to speculation as are other markets, especially through the use of futures contracts and derivatives. The history of the gold standard, the role of gold reserves in central banking, gold's low correlation with other commodity prices, and its pricing in relation to fiat currencies during the 2007–2012 global financial crisis, suggest that gold behaves more like a currency than a commodity.
On August 22, 2011 gold reached a new record high of $1908.00 at the London Gold Fixing.On 13 June 2012, Gold prices breached Rs 30,000 mark due to global financial uncertainty and touched the record high of Rs 30420 per 10 gms. On 19 June 2012, gold zoomed further to Rs. 30,750 per 10 gm in the New Delhi, breaking its previous record of all time high. Gold price on November 1, 2012 surged to a fresh high of Rs 30,550 in the Capital, tracking global prices which have shot up due to the volatility in the eurozone and rush by investors to embrace the yellow metal. Gold rose Rs 130, surpassing its previous record of Rs 30,420 per 10 grams in Delhi. Experts say the global economic turmoil is likely to spur uncertainty in gold prices, which has already made it a risky asset for investors. "It really depends on how the Greece elections span out. There is a lot of uncertainty, but it looks like the trend will continue and gold
might touch Rs 31,000 mark in the near future. Investment demand will return only when there is some clarity.
Investors are bidding up the price of gold because currencies are being devalued. Governments around the world are printing more money to service their debt. That makes their currencies less valuable, relative to tangible commodities. Investors expect this trend to continue, so they are investing in gold and other commodities, rather than bonds, which will fall in value as the currencies in which they are denominated are debased
Crude oil prices:
Increase in the price of the crude oil has a direct impact on the stock market. Though it is hard to imagine but it is fact that a rise in the oil price has negative effect on the stock prices at the stock exchanges all over the world. The main reason behind this is the fear of the investors that the profit margin of the companies will decrease because of the increase in the oil price. As an increase in the oil price directly increases the operational cost, fuel cost, transportation cost of the companies, it is quite natural that the profit margin of these companies will decrease. This is the reason that the buyers become susceptible about the future of the companies that are hugely dependent on oil. This uncertainty restricts the buyers to invest in these companies and as a result the price of the stocks falls that ultimately has a negative effect on the overall market scenario. But this phase is temporary as the companies adjust in the price level to make up for the increased price in the oil and maintain the profit margin. In practice the effect of the price increase in the profit margin of the
companies takes time. Before that could actually happen the companies take adequate measure to avoid the loss. Therefore, the influence of the rise in the price of crude oil on the stock market is basically triggered of the panic of investors rather than actual impact.
Oil Price Impact on the Stock Market:
The consensus view as iterated on a near daily basis in the mainstream press and on the internet is that rising oil prices are generally bearish for the stock market, and falling oil prices are generally bullish. However, the below graph of the Dow and Crude Oil price illustrates that most of the time the oil price and the stock market (Dow Jones index) can be expected to trend in the same direction. This clearly implies that most of the time a rising oil price is associated with economic growth and thus rising future prospects for corporate earnings are discounted by rising stock prices. Whereas a falling oil price is associated with weaker future economic activity and thus implies lower future corporate earnings which is again discounted in the present.
The rising oil prices are part of an inflationary mega-trend, which means that as higher oil prices trend higher, the associated costs can be expected to be passed into consumers in an orderly manner, thus the peak oil mega-trend is bullish for nominal stock prices.
The only fly in the ointment is that as illustrated by the oil price trend during the first half of 2008, when there was a serious divergence between the stock market and the oil price as mania gripped the market that sent inflation soaring, and thus as the oil price soared the stock market entered into a severe bear market. However this divergence did not persist as oil price bubble burst sending the oil price literally crashing
lower, playing catch up to the stocks bear market into the March 2009 low.
Conclusion: A rising trend for oil prices is bullish for the stock market as long as it does not involve a parabolic mania driven spike that is likely to kill future economic demand and is thus discounted in the present by the stock market trending lower, with the oil prices soon catching up to the stock price decline as occurred during the second half of 2008.The current situation with oil prices hovering just above $100, is not bearish for the stock market as long as the oil price does nothing more than just trend higher rather than enter into a mania driven spike for instance to say $150 by mid summer, therefore a gradual uptrend is unlikely to impact negatively on the stock market .Inversely a weak oil price is likely to be bearish for the stock market. However the current outlook is at worst suggestive of oil prices consolidating before trending higher and therefore continue to support a bullish outlook for stock prices.
VII) Copper prices:
The world price of copper both reflects and drives the hopes and fears of economic recovery and disaster. Roughly 50 pounds (22.7 kg) of copper is used in producing an automobile and 400 (181.4 kg) in constructing a house. The metal is also used in many electrical applications, shipbuilding, piping, roofing and household consumer products, especially in numerous alloys including brass and bronze. So it is not without reason that copper is considered the leading indicator of industrial activity not just in the US (where nearly half of all copper consumption is in building construction) but worldwide as well. Chinese buying was the main propulsion behind the price rises in copper and other base metals up until late 2008, when copper fell to $1.25 near the end of the year. Chinese industry then decreased production and consumed existing supplies. After that process, in early 2009, base metals prices jumped back on renewed Chinese buying. China was in fact expected to provide close to half of growth in global demand for industrial metals in 2009. However, poor demand in economic sectors ranging from construction to the automotive industry led to declines largely across the board.
Because of copper's significance for industrial activity, stock markets watch the world price. Higher prices are taken to mean higher demand, which is in turn taken to mean increased economic activity in the future. Especially today, in the new financial environment of increased share-price volatility around the world, stock markets also sometimes overreact to the swings in world copper prices. Macroeconomic fundamentals offer little support for copper or other base metals. Steel companies helped lead the recent Chinese stock market advance but copper imports and therefore prices are at potential risk if demand from other countries does not increase to pick up the slack. India's consumption will be an important driver of global prices over the longer term, and Indian companies such as Hindalco and Sterlite are significant producers in their own right. The degree to which that is so, however, depends in part upon further electrification of the Indian countryside, to which there remain numerous bureaucratic obstacles.
Seasonal effect on crop prices in MCX:
Factors that Affects Rice/Wheat/Maize Prices1. Role of weather in crop production is immense. Temperature, rainfall and soil moisture are the important parameters that determine the crop condition. 2. Further, natural calamities like typhoon, floods, droughts and earthquake can also affect crops. Markets keep watch of these developments.3. Changes in the minimum support prices (MSP) by the government also have immense impact on the prices of the commodity.
4. Availability of substitute products at cheaper rate may lead to weakness in demand. This situation happens especially when the main products price tends to become higher. For e.g., jowar/ bajra may be preferred by poultry feed manufacturers instead of maize, if its prices are high.5. Seasonal cycles are present in agriculture crops, particularly in short duration annual crops. Price tends to be lower as harvesting progresses and produce starts coming into the market. At the time of sowing and before harvesting price tends to rise in view of tight supply situation.6. Breakthrough in the technology may increase the productivity and would lead to more supply. This may bring some softness in the price.
IX) Right issue , bonus issue effect on stock price:
Right issue:In order to raise extra capital, rather than taking on additional debt, a rights issue involves a company giving existing shareholders the right for a specified period and at a specified (usually discounted) price to subscribe to newly issued shares in proportion to their existing holdings.In the ‘good old times’, the money raised was used for corporate expansion, such as a large takeover. More recently, however, many fundraisings are used to ‘strengthen the balance sheet’ in order to trade trough the credit crunch or even worse to save a company from going bust. Some sort of corporate activity or explanation will always accompany a rights issue.A rights issue dilutes the earnings per share and the equity per share of the outstanding stock in general and therefore has a negative influence on the market price of the shares outstanding.
What happens if a company launches a ‘rights issue’?
The best way to explain this is by way of an example.
Prior to the announcement of the rights issue, Example Plc has 45 million ordinary shares at £1, which are valued at £3 on the stock market. The company’s market capitalisation therefore amounts to £135 million (multiply 45m times £3).
At some stage, Example Plc announces that it wants to raise £33 million to complete an acquisition based on the following terms:
it is to issue 15 million new £1 Ordinary Shares to existing shareholders for £2.20 cash per share, on the basis of a “1 for 3” rights issue
A "one for three" rights issue means that an existing investor can buy one extra share for every three currently held.
The price of the newly issued shares is fixed, and is always set below the prevailing market price -in our example £2.20. The main reason is to make the offer relatively attractive to shareholders and encourage them either to take up their rights or sell them so the share issue is "fully subscribed".
How does this effect me?
Suppose you own 3000 shares in Example Plc. You would then be entitled to subscribe for 1000 new shares
at £2.20 each, involving a cash payment of £2,200 to the company.
The value of your shareholding before the rights issue is:
3000 shares at £3 = £9,000
If you decide to take up the rights you will have to purchase 1000 new shares at a price of £2.20:
1000 shares at £2.20 = £2,200
As the name implies, the issue gives shareholders the right to buy the additional shares, but not the obligation. The rights can be sold on to others who wish to take advantage of the offer, and hence each right has a value. A shareholder can take up all, some or none of the rights on offer.
If you decide that you do not wish to invest more cash in Example Plc you could sell your rights in the market. The buyer of the rights would then subscribe the required £2.20 per share in order to obtain the new shares.
If I want to sell my rights what would they be worth?
Lets return to our example.
Prior to the announcement of the rights issue, three shares at £3 are worth £9. Following the completion of the rights issue (1 for 3 rights issue at £2.20 per share) four shares should be worth £11.20 (£9 plus £2.20).
Theoretically, the rights per share are therefore worth £0.20 which also equals the £0.80 ‘discount’ (£3 minus £2.20) divided by four shares.
What happens to the share price after the rights issue?
After the shares goes ex-rights (meaning that anyone buying these shares no longer has the right to buy the new shares) the share price, known as the (theoretical) ex-rights share price, can be computed as follows:
divide the total value of your investment by total number of shares held
(£9,000 + £2,200)/(3000 + 1000) = £2.80
All things being equal, that’s very much the theory.
As mentioned before, a rights issue is accompanied by corporate news including the reasons why new cash is being raised. The stock market will take a view regarding the reasoning and usefulness of the rights issue that will influence the actual ex-rights share price. The then prevailing general market conditions may also influence the share price.
If the new money is to be put to good use, then the share price may rise above the theoretical ex-rights share, even though the extra shares will have a dilutive effect. Often the share price will settle above the issue price, in this example £2.20
When not to take part in a rights issue?
If the share price has fallen below the subscription price (in our example £2.20) it would be cheaper to buy the shares on the stock market than to participate in the rights issue.
Bonus shares are issued in a certain proportion to the existing holders. A 2 for 1 bonus would mean you get two additional shares — free of cost — for the one share you hold in the company.If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you.
Bonus issue:
Bonus shares are issued in a certain proportion to the existing holders. A 2 for 1 bonus would mean you get two additional shares — free of cost — for the one share you hold in the company.If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you.
WHO BEARS THE COST IF IT’S FREE? There are no free lunches. Bonus shares are issued by cashing in on the free reserves of the company. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital. So you do not pay; and the company’s profits are not impacted.WHAT ARE THE EFFECTS OF A BONUS ISSUE?Bonus shares do not directly affect a company’s performance. Bonus issue has following major effects.1. Share capital gets increased according to the bonus issue ratio.2. Liquidity in the stock increases.3. Effective Earnings per share, Book Value and other per share values stand reduced.4. Markets take the action usually as a favorable act.5. Accumulated profits get reduced.6. A bonus issue is taken as a sign of the good health of the company.
WILL THE SHARE PRICE CHANGE AFTER BONUS ISSUE?A bonus issue adds to the total number of shares in the market. Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares. This is referred to as a dilution in equity. Now the earnings of the company will have to be divided by that many more shares.(Earnings Per Share = Net Profit/ Number of Shares)Since the profits remain the same but the number of shares has increased, the EPS will decline. Theoretically, When EPS declines, the stock price should also decrease proportionately. But, in reality, it may not happen.That’s because:i. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.ii. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits
and distribute dividends on all these shares in the future.
Conclusion: Declaring Bonus shares is a sign that companies are increasing their profitability. If you look back, many companies have announced issues of bonus shares to their shareholders by capitalizing their free reserves . Shareholders have benefited tremendously, even after accounting the inevitable reduction in share prices post-bonus, since the floating stock of shares increases. So keep an eye on bonus history it may be a good indicator that the company is healthy.
Chapter – 4
FUNDAMENTAL ANALYSIS
4.1 FINANCIAL LITERACY AND ITS VITAL LEARNINGS
Financial literacy is a must for everyone as it teaches you how to spend, saves, investment of your hard earned money in an intelligent manner. It takes away the illusion from your eyes that money can be multiplied in a short term.
Today you are going to learn about two things
Seven Cures For a Lean Purse
1. Start your purse to fatteningDo you think that your purse is always lean? It gets empty faster than it takes to fill it. Then today
you are going to learn a method to make it fat. Just answer this question: What will happen if you put 10 eggs in a basket and take out 9 eggs
every day? Will the basket overflow or gets empty after some days? If your answer is OVERFLOW, then learn this lesson that putting 10 coins in your purse and taking out 9 coins will make your purse fat in few days.
2. Control your expendituresIf you think that your expenses exceed more than your earnings and how can you make savings to
make your purse fat then think how a person makes his living who’s earning 60-70% of what you earn. Remember one thing “Rich buys luxury items at the end where as poor or mediocre buys luxury first.”
"This, then, is the second cure for a lean purse. Budget your expenses that you have coins to pay for your necessities, to pay for your enjoyments and to gratify your worthwhile desires without spending more than seventh-tenths of your earnings."
3. Make your gold multiplyNext, we will consider means to put your treasure (savings) to labor and to increase. Gold in a
purse is gratifying to own and satisfied a miserly soul but earns nothing. The gold we may retain from our earnings is but the start. The earnings it will make shall build our fortunes. "I tell you, my friends, a man's wealth is not in the coins he carries in his purse; it is the income he builds, the golden stream that continually flows into his purse and keeps it always bulging. That is what every man desires. That is what you, each one of you desires; an income that continues to come whether thou work or travel.
Put your income from investment back in investment, this way you will begot a hoard of golden slaves, each laboring and earning more gold. As they labored for you, so their children also labored and their children's children until great was the income from their combined efforts.
"This is the third cure for a lean purse: to put each coin to laboring that it may reproduce its kind even as the flocks of the field and help bring to you income, a stream of wealth that shall flow constantly into your purse."
4. Guard your treasures from loss "Misfortune loves a shining mark. Gold in a man's purse must be guarded with firmness, else it be
lost. Thus it is wise that we must first secure small amounts and learn to protect them before the Gods entrust us with larger."
Make no investments, which you find most lucrative as these are highly risky investments which can even result in loss of your principal amount too. Study carefully the investment, if you don’t understand it, don’t invest in it on your relatives, friends opinions as your motive is to make your investment safe not to make your friends, relatives happy. “LISTEN TO EVERYONE OPINIONS BUT MAKE YOUR DECISION ON YOUR UNDERSTANDING.”
e.g. “Never give your savings to textile merchant to invest in gold because goldsmith is the right person in this context to make your savings grow.” Think it this way; doctor can cure your disease but not engineer (he can cure machine diseases not humans).
"This is the fourth cure for a lean purse and of great importance if it prevent thy purse from being emptied once it has become well filled. Guard your treasure from loss by investing only where your principal is safe, where it may be reclaimed if desirable, and where you will not fail to collect a fair rental. Consult with wise men. Secure the advice of those experienced in the profitable handling of gold. Let their wisdom protect your treasure from unsafe investments."
5. Make of your dwelling a profitable investmentIf you are living at seventh-tenths of your income as expenditure, and enjoying your life to the
fullest, then think if you can save more money by paying no rents for your accommodation and own your accommodation which will gives you more privacy, more fun and more savings to grow your gold faster.
"Thus come many blessings to the man who owns his own house. And greatly will it reduce his cost of living, making available more of his earnings for pleasures and the gratification of his desires. This is the fifth cure for a lean purse: Own your own home"
6. Insure a future incomeIf you have started working on above five cures, then this is the sixth cure. Insure a future income.
Invest your money in long term investment so that if something happens to you after few years of following the above cures your family as certain assets in form of shares, real estates, insurance, F.D.,
mutual funds etc. to survive even without you. This cure also helps you if you have a really long life by god’s grace and not enough strength to earn more due to old age, then these cash-flows will help you to live a king’s life.
Provide in advance for the needs of thy growing age and the protection of thy family.
7. Increase your ability to earn Many a times, people lack only one or two skills which can help them increase their income to
large extent. E.g. you are a good gardener and earning around $10 a month. You invest your savings in a CLASS to know about various herbs and their uses and their market value. After gaining the new skills, you start planting these herbs in people’s garden where you are working to make their gardens beautiful and sell these plants in market in offseason to increase your income considerably to large amounts.
"Thus the seventh and last remedy for a lean purse is to cultivate your own powers, to study and become wiser, to become more skillful, to so act as to respect yourself. Thereby shall you acquire confidence in yourself to achieve your carefully considered desires?”
THE FIVE LAWS OF GOLD
I. Gold comes gladly and in increasing quantity to any man who will put by not less than one-tenth of his earnings to create an estate for his future and that of his family.
II. Gold labors diligently and contentedly for the wise owner who finds for it profitable employment, multiplying even as the flocks of the field.
III. Gold clings to the protection of the cautious owner who invests it under the advice of men wise in its handling.
IV. Gold slips away from the man who invests it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep.
V. Gold flees the man who would force it to impossible earnings or who follows the alluring advice of tricksters and schemers or who trusts it to his own inexperience and romantic desires in investment.
CASHFLOW (LONG TERM INVESTMENT)
Cash-flow mainly comes from below sources as
1. Equity (Dividend)2. Real Estate (Rent)3. Fixed Deposits (Interest)4. Mutual Funds (Loan)
To have cash-flow from equity investment in terms of dividend, we have to go for fundamental analysis (understanding accounting principles and financial statements).
4.2 HOW TO FOLLOW MONEY IN STOCK EXCHANGE
A Basic Understanding of Accounting
There are two reasons why it is important to have at least a basic understanding of accounting principles and financial statements when using valuation formulas.
The first reason is that the inputs of the formulas are made up of data taken directly or indirectly from the financial statements. Direct data includes items such as sales, net profit, assets, and liabilities. Indirect items that are often required can be calculated from entries in the financial statements and include ratios such as return on equity and dividend payout ratio. Hence it is important to know where to look for these items—which financial statements and their whereabouts in these statements.
The second reason that accounting knowledge is important is that it lets you apply levels of confidence to any forecast that you are required to make in the formulas. For example, suppose the income statements of two companies look essentially the same. Based on this, you may make similar forecasts for their earnings over the next year. Or, if you are going to use forecasts made by analysts, you may find that two analysts make similar forecasts. However, suppose a closer reading of the balance sheet shows that the first company has considerably more debt than the second one. This may cause you to have less confidence in the forecasts for the first company, leading you to require a higher safety margin.
Role of Financial Statements
Financial statements give us a window into the operations of a company. As outsiders we cannot really know the level of creativity and strategic thinking of management or how thoroughly they weigh their options before making decisions. We can know little of the management style or the morale within a company. Nevertheless, in the end what we are after is confidence in any measurements or forecasts that need to be made regarding the assets or profits of the company in order to perform intrinsic value calculations. An understanding of the key features of the financial statements is important for achieving this goal.
The primary goal of financial reporting is the dissemination of financial statements that accurately measure a company’s profitability and financial condition.
The opposing view of financial statements is that those preparing the statements have an underlying agenda, namely to present the company in the best possible light. The proponents of this view argue that there is sufficient flexibility in what is required to be included and in the way it is presented that a misleading impression of the profitability and success of the company may be evoked. From this perspective it is important to be vigilant and skeptical, much like lawyers in a court case. Both sides are required to be honest, but this does not stop them from doing all they can to play up the positive side of the results and downplay the negative side.
Principal Financial Statements We will look at the four principal financial statements prepared by publicly traded companies. They
are:1. Balance sheet. Also referred to as the statement of financial position or condition, it gives a
snapshot of a company’s assets, liabilities, and net equity at the end of the reporting period.2. Income statement. Also referred to as the profit and loss statement (or P&L), it covers the
revenues or sales and expenses over the reporting period.3. Cash flow statement. Also referred to as the statement of cash flows, it covers the cash flows of a
company in the areas of operating, investing, and financing activities.4. Equity statement. Also referred to as the statement of changes in shareholders’ (or stockholders’)
equity, it covers all the items that change the equity of a company over the reporting period.
Follow the MoneyWhether you just flip through them or read them in detail, it is easier to make sense of financial
statements if you have a number of questions in your mind while you go through them. One set of questions relates to following the money. These questions fall into three categories:
1. How much money came in over the reporting period and where did it come from? What were its sources in terms of sectors of the business and national and international regions? How does it compare with previous periods?2. What was it used for? How much money did the company spend or distribute? On what? How does it compare with previous periods?3. How much money did the company manage to keep? What do they intend doing with it? What did they do with the money they kept from previous years? Another set of questions relates to financial ratios. 1. Balance Sheet
The balance sheet, also called the statement of financial position, provides a summary of the equity of the company provided by its shareholders, what the company owns in terms of assets, and what it owes to its lenders as liabilities.
The core relationship is: Assets = Liabilities + Shareholders EquityAn asset is a resource that has the potential to generate future cash inflows or to reduce future
cash outflows. The assets can be broken down into monetary assets, fixed assets, inventory, and intangible assets. Conversely, liabilities are expected to lead to a future cash outflow or the loss of a future cash inflow. The balance sheet is an example of accrual accounting, which means that revenue and expenses are recognized in the periods in which they are earned or incurred, irrespective of whether any cash was involved. For example, if a sale is completed with payment to be made in 30 days, this is called a receivable and appears as an asset on the balance sheet. In the opposite direction, if an agreement is made to pay for an item in 30 days, this is called a payable and appears as a liability on the balance sheet. A typical arrangement is called end of month plus 30: If purchases are made within a particular month, they would be payable within 30 days from the end of that month.
The balance sheet or statement of financial position gives a snapshot of the assets and liabilities of a business at a single point in time.
Assets Liabilities and Shareholders’
Equity Current assets Current Liabilities
Cash and cash equivalents1
2.5 Accounts payable 2
Accounts receivable2
.5 Short-term borrowing 1
Inventories2
0 Other current liabilities 1.5
Other current assets3
.5 Total current liabilities [A] 4.5
Total current assets [A]3
8.5 Long-term debt 30Non-Current Assets Other long-term liabilities 14
Investments1
50 Total liabilities [B] 44Plant, property and equipment 2 Shareholders’ equity
(fixed assets) 35
Intangible assets7
5 Share Capital of Rs. 1 each 100
Total non-current assets [B]4
60 Reserved & Surplus 350
TOTAL ASSETS [A+B]4
98.5 Total Equity [C] 450
TOTAL LIABILITIES + EQUITY
[A+B+C] 498.5
a. The first section of the balance sheet consists of the assets of a business. Those assets that would be turned into cash within 12 months under normal operating conditions are called current assets. They are listed from the most liquid to the least liquid, typically in the order of cash, cash equivalents, accounts receivable, inventory, the portion of prepaid accounts which will be used within a year, and short-term investments.
Cash equivalents are highly liquid short-term assets that can be readily turned into cash.
Accounts receivable is the outstanding balance owed to the business on credit sales. This must be reported at its net realizable value, meaning the net amount owing less an allowance for doubtful accounts. This allowance is an estimate made by the company based on past experience of management, the company’s collection policies, customer quality, and perhaps even the state of the economy. If a loss actually occurs, it must be written off and adjustments made to the level of allowances for doubtful accounts.
Inventory is a company’s raw materials and finished and unfinished products which have not yet been sold. If the inventory will be sold within 12 months, it is included as part of the current assets. Otherwise it is included as noncurrent assets.
Short-term investments are investments made by the company in such items as Treasury bills and various short-term debt instruments that have a maturity of less than 12 months. Typically they are used as a safe place to park money but are still reasonably accessible with minimum cost.
After the current assets come the noncurrent or long-term assets. Typically these are fixed assets such as plant, property and equipment, and long-term investments. They may also include inventory that is not likely to be sold within the next 12 months. Fixed assets are displayed as their actual cost less depreciation. Obviously some assets such as land can appreciate in value.
b. The next section of the balance sheet is concerned with the liabilities of a company. As with assets, it is in two halves; the first half lists the current liabilities while the second half lists the remaining liabilities.
The current liabilities are listed from the most liquid to the least liquid with typical items being payables and short-term loans.
Payables are money owing to suppliers and other creditors, typically for inventory or services. If the time frame is less than 12 months, they are included as current liabilities.
The same applies for short-term loans—their period needs to be less than 12 months.
The remaining liabilities are usually made up of long-term debt. They can also include deferred federal income tax liabilities and pension and lease obligations.
c. One of the most contentious issues for balance sheet entries is the treatment of intangible assets, the nonmonetary assets that cannot be seen, touched or physically measured. For example, if a business is started it may develop a strong brand name. This brand name has value for the business but it will not appear on the balance sheet of the original company. However, if the business was sold for an amount that exceeded its equity, the difference would appear on the balance sheet of the purchasing company as goodwill.
Some of the forms of intangible assets include trade secrets, copyrights, patents, trademarks, and goodwill. These are called legal intangibles since it is possible to have right of ownership over them; they can be sold to other companies and their ownership can be defended in court.
There are also competitive intangible assets associated with the human capital of a business. As the name suggests, they help give a company a competitive advantage even though they cannot be bought or sold in the same way as legal intangibles. They are more difficult to define and usually arise through experience. Examples are general know-how and reputation. Some intangible assets such as trademarks and goodwill are taken to have an indefinite life. In such cases they have to be examined each year for any loss in value.
If this occurs, the amount of the impairment will be entered in the income statement as a loss. Other intangible assets such as copyrights and patents are described as having a specified useful life and are amortized over this life by specified schedules.
The main balance sheet is prepared at the end of each financial year with three further balance sheets at the ends of the intervening quarters. Each is a snapshot of the company at those positions in time. In the annual report and 10-K report, the balance sheet always shows the company’s position for the last day of the financial year as well as its position on the last day of the preceding financial year. It is important, when looking at a balance sheet, to get into the habit of also looking at the figures for the preceding year as a point of reference.
d. The final section in the balance sheet is called stockholders’ equity or shareholders’ equity. This is simply the assets minus the liabilities and represents the ownership of the company. The owners are the ones with the greatest risk should the company run into difficulties because they will be the last to be paid. Conversely, should the company be successful (and these are the type of companies we are looking for), then the owners or shareholders will benefit through an increased share price or higher dividends. Furthermore, these benefits to shareholders are open-ended whereas, in most cases, the company only has fixed-interest or fixed-amount obligations to the creditors listed earlier in the balance sheet. When equity is divided by the number of shares outstanding, it is called book value.
The total shareholders’ equity is typically broken into four parts:Preferred stock, common stock, additional paid-in capital, and retained earnings.
o Preferred stock is a hybrid between common stock and a bond; for example, it typically pays a guaranteed dividend whereas dividends paid to holders of common stock are at the discretion of the board.
o Common stock is a theoretical value calculated by multiplying the par or stated value of the stock by the number of common stock shares outstanding. The par value is the minimum price that the shares can be initially sold for and has no relationship with the actual market price.
o Additional paid-in capital represents the amount by which the original sale of shares exceeded their par value.
Combining the first two items gives the total amount of money received by the company by direct sale of its shares. Once the shares have been sold by the company, further transactions are between investors and are carried out independently of the company. Hence they do not appear in any of the financial statements.
o The fourth item, retained earnings (or deficit), is the total amount of earnings received by the company over its life minus payments to shareholders as dividends or cash. Also referred to as accumulated earnings (or deficit), it is money that the company has decided to reinvest in the business rather than pay out to its shareholders. It is not cash sitting in the business (although some of it may be).
o There may be a fifth item in the section on total shareholders’ equity called treasury stock. This item is related to a company buying back its own stock. When a company does this, there are two possibilities: Cancel the shares or hold on to them. When the shares are held by the company, they are called treasury stock. At first it may be thought that treasury stock should be listed as an asset in the same way that other stock purchases by the company would be included on the balance sheet. This is not done, however, since treasury stock has a number of distinguishing restrictions, such as not paying dividends and not giving the company as its owner any voting rights. It also does not give the company the right to receive any assets in the case of its liquidation. The result is that treasury stock is listed as an offset.
e. Off-Balance-Sheet ItemsAs the name implies, off-balance-sheet activities or arrangements are rights and obligations of a
company which are sufficiently at arm’s length that they are not included on the balance sheet as assets or liabilities. In particular, they occur when the company does not have direct control over the activities or arrangements but because of certain guarantees they may be a source of potential risk to the company even though they are not recorded as liabilities. Some of the names and acronyms used to describe them include structured investment vehicle (SIV), special purpose entity (SPE), and collateralized debt obligation (CDO). They are used to transfer the risk from the parent company and its shareholders to others who are willing to take on the risk. Nevertheless, the parent company is always left with some commitments or obligations even if there is only a remote chance that it will be called upon to meet them. Problems occur when extraordinary circumstances come about, triggering
these commitments to be fulfilled, resulting in the items being brought onto the balance sheet of the parent company.
2. Income StatementThe income statement or profit and loss statement (P&L) gives rise to two commonly used
terms: the top line and the bottom line. The top line of a business refers to the total sales or revenue coming into the business.
This is usually from the sale of goods and services to customers. Companies may also receive revenue from interest, dividends, or royalties paid to them by other companies. In the income statement the revenue is placed on the first line, giving rise to it being referred to as the top line of a business. From this amount the company pays for the purchase of raw materials and for manufacturing finished products. This is referred to as the cost of sales.
The company also pays operating and selling expenses plus general and administrative expenses. Finally, the company pays interest on any loans it may have and makes provision for income taxes. After paying all the expenses and costs, what is left is called net income or earnings. Because of its position in the income statement, it is often referred to as the bottom line.
As explained, the typical income statement starts with revenues and makes adjustments for the cost of goods sold, including depreciation on the assets used to produce the revenues, and any selling, general, and administrative (SG&A) expenses. The result from this first set of calculations is called the operating profit or simply earnings before interest and taxes (EBIT). The next step is to subtract interest expenses, giving the taxable income. Removing the taxes leads to the net income or earnings. Finally, this is adjusted for discontinued operations, extraordinary items, and changes caused by accounting changes. The final figure is divided by the number of shares outstanding.
Usually two figures are presented, corresponding to basic shares outstanding and diluted shares outstanding. When options are awarded to management and staff as bonuses, even though they are not yet publicly traded shares, they are included as part of the diluted shares outstanding. Also items such as the conversion of convertible bonds and preferred shares need to be included in this number. The final results are called basic earnings per share and diluted earnings per share. It is prudent to run your eye over the lines describing the share numbers to compare the differences between the basic and diluted numbers, and to see if there have been any trends in total numbers over the past financial years.
If the company pays dividends, there is another line called dividends declared per common share. The ratio of dividends to earnings is called the payout ratio. The remainders of the earnings are kept back in the company and used for expansion and investment purposes. The proportion that is retained is called the earnings retention ratio.
Revenues 100– Cost of goods sold -20Gross Profit 80– Selling expenses -16– Administration expenses -16– R&D -20Operating profit or EBIT 28– Interest expenses -4Earnings before taxes 24– Taxes (30%) -7.2Gain for the year 16.8
Gains (losses) from discontinued operations -2.2extraordinary Gains (losses) 1.6Net income after extraordinary items 16.2Basic net income per share 0.162Dividends declared per common share (30%) 0.0486
Intangible assets are an increasingly significant economic component of companies. It used to be that goodwill and other intangible assets were amortized in a standardized manner over time. New regulations now talk about impairment, which must be measured at least annually and entered into the income statement
On some financial web sites you might see a reference to normalized earnings or normalized income. These are the net income of a company, adjusted for nonrecurring or unusual items. They are an attempt to provide information that is more representative of the performance of the company rather than include items that are likely to be one-off.
3. Statement of Cash FlowsThe statement of cash flows is like a giant checkbook that summarizes all the cash
transactions of the business for the period of the financial statements. The annual statement of cash flows summarizes the cash transactions for the previous financial year, while the quarterly statements of cash flows do the same for the quarters. The key difference between the statement of cash flows and the previous two financial statements is that the statement of cash flows deals with cash while the other two use accrual accounting and contain noncash items such as receivables and payables (found in the balance sheet) and depreciation (found in the income statement).
In this way the statement of cash flows completes the cycle of the financial statements by linking together the results in the balance sheet and the income statement by adjusting them for or netting out their noncash components.
There are many examples of companies of all different sizes and industry types that have healthy net profit but struggle to have the money to pay for day-to-day expenses such as employee wages and supplier bills. A careful analysis of the statement of cash flows could reveal this. Sometimes it is painfully clear.
The statement of cash flows is in three parts: operating activities, investing activities, and financing activities.
The operating activities section mainly concerns that part of the business associated with the sale of goods or revenue for services and payments for inventories and operating expenses such as salaries. It represents the cash generated by the business internally.
The second two sections describe the cash generated by the business from external sources. The investing activities section focuses on transactions associated with assets such as
property, plant, and equipment, and debt or equity securities (except those that are treated as cash equivalents).
The third section, financing activities, includes:1. Transactions with creditors such as the proceeds from and repayments of borrowings.2. Proceeds from issuing the company’s own shares and the repurchase of these shares.3. Payment of dividends.We will just look briefly at some of the items in the cash flow from operating activities and
how they can be derived from the income statement and balance sheet. This procedure is called the indirect method. Starting with the bottom line of the income statement, the net profit is adjusted to arrive at the cash collected from customers. If there has been an increase in accounts receivable over
the past year, then the amount of the increase is subtracted from the net profit since more profit was recognized than was received in cash. In the opposite direction, if there was a decrease in receivables, the amount of this decrease is added to the net profit.
CASH FLOW FROM OPERATING ACTIVITIES Income from continuing operations 16.8Adjustments from continuing operations Depreciation 9other operating activities 3Changes in certain assets and liabilities Decrease (Increase) in accounts receivables -8Decrease (Increase) in inventories 5Increase (Decrease) in accounts payable 8Increase (Decrease) in accrued liabilities -6Net cash provided by operating activities (A) 27.8 CASH FLOW FROM INVESTING ACTIVITIES Purchase of fixed assets -11Proceeds from sale of fixed assets 7.5Investment in subsidiaries -3Interest Received 1.5Dividend Received 1Other investing activities -6Net cash provided by investing activities (B) -10 CASH FLOW FROM FINANCING ACTIVITIES Increase (Decrease) in short term borrowings -3Payment of long term debt -8Dividends Paid -4.86Purchase of company stock 0Payment of capital lease obligations -3.5Proceeds from issuance of long term debt 3.5Net cash provided by financing activities [C] -15.86 NET INCREASE (DECREASE IN CASH) [A+B+C] 1.94CASH AT BEGINNING OF YEAR 10CASH AT END OF YEAR 11.94
Similarly, if there has been an increase in accounts payable over the past year, then the amount of the increase is added to the net profit since the company was able to increase the amount of deferred payments to its suppliers for the purchase of inventory or services. In the opposite direction, if there was a decrease in payables, the amount of this decrease is subtracted.
The next step is to adjust the cash position for any changes in inventory: If there is an increase in inventory, the difference is subtracted because more cash was required in the purchase of inventory than was included in the net profit. Explaining it differently, extra cash has been used to purchase inventory that has not yet been sold. In the opposite direction, if there was a decrease in inventory, the amount of the decrease is added to the net profit. The result of these adjustments is the cash paid to suppliers.
Examine Net Cash Flow from Operating ActivitiesA key warning sign from the statement of cash flows is that the net income substantially
exceeds the net cash flow from operating activities. If this happens it may mean that the earnings of the company are of doubtful quality. This is even more serious if the net cash flow from operating activities is negative while the net profit is positive.
Positive and Negative Cash SignsTwo signs of a cash-healthy company that you can keep a lookout for in the statement of cash
flows are:1. Cash provided by operations is positive and trending upwards. After all, this represents the
core activities of the business.2. Cash flows from operating activities are more than sufficient to cover cash used for
investing. In the opposite direction, a positive cash flow due to financing activities and not operations
may mean trouble. It could be that the company is taking on a lot of debt.
4.3 Everything Is Number and Ratio
A financial ratio is not a valuation method in the sense that intrinsic value is. Just the same, such ratios are useful in helping to determine whether an investment is likely to be successful.
Consider a company that had a return on equity (ROE) of 20 percent for a number of years with all the signs indicating that this level will continue into the future. Assume that it pays no dividends. As a general approximation, its earnings per share (EPS) will grow by around 20 percent per year. If the price-to-earnings (P/E) ratio stayed fairly constant, this would represent an average annual return of 20 percent per year. This means that its price will double in less than four years and will triple in around six years. In 10 years the price will have grown by over 600 percent. Even if the P/E ratio halves over the next 10 years, it would still return around 12 percent per year, a profitable investment by most people’s standards.3 In contrast, if a company’s return on equity is only 5 percent and seems likely to remain level in the future, it is unlikely to be a successful investment. Put another way, money cannot come from nowhere. Therefore, the ability of management—as measured by ratios such as return on equity—is a crucial indicator of whether to invest in a particular company.
Another role of financial ratios is to compare companies of different sizes. One company may have net profit of $10 billion, another only $10 million. It makes no sense to compare directly the financial statements of these two companies, whereas financial ratios provide useful comparisons. For example, the first company might have produced its profit using equity of $100 billion and the second company with $50 million. By dividing earnings by equity we see that the return on equity for the two companies is 10 percent and 20 percent. This provides us with a means of comparing the two companies: The second company is getting twice the return on equity of the first company, something to be welcomed by investors looking for value.
Ratios GaloreThe first issue to face is that there are virtually an unlimited number of financial ratios. No
matter how big your list of ratios, it seems it is always possible to find one more. Also, most of the standard ratios have alternative definitions. To help overcome this difficulty, I have chosen a core selection of financial ratios based on common use and my experience. They are in the areas of management performance, debt, and liquidity. For some of the ratios I will indicate what levels we should look for as pointers toward potentially valuable investments.
In evaluating a company for an investment portfolio, we can use financial ratios in three ways:1. Examine the company’s financial ratios as a guide to its strengths and weaknesses.2. Compare the financial ratios in step 1 with the ratios of other companies and with the
average ratios for the sector and the overall market.3. Review the history of the financial ratios of the company for signs of favorable or
unfavorable trends.Financial ratios also act in a support role for the valuation methods described. For example,
healthy financial ratios such as a low debt-to-equity ratio make it more likely that the price of a seemingly undervalued company (that is, via some valuation method) will rise to the company’s intrinsic value.
Management Performance Ratios
It is impossible for outsiders to know much about the abilities of management in running a business in areas such as style, clarity of analysis, creativity, and foresight. What we can do, though, is bypass these questions and go straight to the bottom line for management and ask how well management is using the resources it has available to it. We call these management performance (or simply management) ratios and look at four of them: return on equity (ROE), return on capital (ROC), return on assets (ROA), and net profit margin (NPM).
Buffett and other analysts make it very clear that they consider return on equity and return on capital to be very important. For example, each year in the annual report of Berkshire Hathaway,
Buffett writes that he is “eager to hear from principals or their representatives about businesses earning good returns on equity while employing little or no debt.”
Also, Buffett often talks about return on capital. For example, in the 2007 annual report, he declared that “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” Charles Mizrahi talks about return on equity as his “deserted island” indicator and writes, “If I could only have one piece of information about a company, I would want to know the ROE.” For Pat Dorsey, return on capital is “the best benchmark of a company’s profitability.” A lot of the effectiveness of return on equity comes from the fact that it combines financial data from both the balance sheet and the income statement.
The reason for the importance of ROE as an indicator of a successful investment can be seen in two steps. First, high ROE leads to high growth in earnings (assuming that the company can reinvest its earnings at the same rate). Second, how high growth in earnings leads to high growth in the share price. Putting these two steps together gives the result that high ROE leads, over time, to high growth in price, what we all want as investors.
Return on equity is defined as the net profit over a financial year divided by the common stock equity at the end of the period. It is a key measure of how well a company is performing for its shareholders. If return on equity is and has been low with little sign that it will improve in the future, and then it is unlikely that it will be a satisfactory investment
The second management ratio in the table is return on capital. It is a partner to return on equity and vitally important for measuring the effectiveness of management.
Once again, turning to Buffett: “We believe a more appropriate measure of managerial economic performance to be return on equity capital [rather than simple growth in earnings].” The basic idea is that it measures the profit of the business in terms of the capital employed to create that profit. Within this framework there are even more variations than there were for return on equity. For instance, the numerator can be net profit, net profit plus interest, or net operating profit. Value Line even uses net profit plus half the interest paid. The capital as the denominator starts with equity and adds various amounts related to debt. In some cases only long-term debt is used while in others current debt is also included. The simplest definition of return on capital is the ratio of net income to the sum of total equity plus long-term debt and capital lease obligations. It may also include short-term debt and capital lease obligations
For some companies there is no difference between return on equity and return on capital because there is no debt. A large difference between the two ratios means that the company has fairly high debt. We will see that this is, indeed, the case when we look at debt ratios. Note also that there are variations in the name of the ratio such as return on invested capital and return on equity employed.
Return on assets is similar to return on equity except that equity is replaced by assets. Since equity is assets minus liabilities, except in the case when the company has no liabilities, return on assets is less than return on equity
Net profit margin is the ratio of earnings or net profit divided by sales or revenue. It measures the amount of money coming in from the activities that is actually kept after all the expenses. This ratio varies enormously between industries.
Look for ConsistencyLook for levels of these management ratios that are high and consistent. During most years a
satisfactory level for return on equity and return on capital is 10 percent, but more desirable is 15 percent or above. When Warren Buffett was interim chairman of Salomon Inc. during its time of
problems in 1991, he indicated that 15 percent was the level he looked for. As part of an interview for Forbes he stated, “As long as we can make an annual 15 percent return on equity, I don’t worry about one quarter’s results.”
Warning: Contracting EquityReturn on equity can be high for two reasons: Either the earnings are high or the equity is low.
Make sure return on equity has not been pumped up by a contracting equity through too many write-downs or devaluations. Another way that the equity can drop significantly is through share buybacks. The result is a sudden jump in return on equity.
Debt or Leverage RatiosThe next set of ratios measure different aspects of debt in terms of leverage (the amount of
debt compared to various measures of the assets of the company) and interest coverage (the ability of the company to meet its interest payments). We include four ratios: the debt ratio, debt to equity, financial leverage multiplier, and the interest coverage ratio. Each of these ratios measures a different aspect of debt
Generally speaking, companies are best served if they take on some debt, assuming that they can use it at a higher rate than they pay for it. However, too much debt can make a company vulnerable to any increases in interest rates or claims by its creditors for early repayment of debt. It can also prevent the company from taking advantage of expansion opportunities that require extra capital.
The first ratio is the debt ratio, defined as total liabilities divided by total assets. Since we are talking about total assets, we are going beyond the normal use of the term debt in the sense of specific debt contracts. However, an alternative definition takes this into account and defines the debt ratio as interest-bearing debt divided by total assets. Notice that since the numerator (total liabilities) is included in the denominator (assets), the debt ratio can never exceed 100 percent
The next ratio, debt to equity, measures the ratio between the funds supplied by creditors, which is debt, and the funds supplied by investors, which is equity. In the event of bankruptcy, creditors must be paid before owners and so the debt-to-equity ratio is a measure of risk associated with the business. Usually the debt-to-equity ratio only includes long-term debt. However, because of the ease with which companies can roll over short-term debt, many companies use short term
financing to fund long-term projects. This just means that it pays to be alert when using any of these ratios. As a broad rule of thumb, be particularly careful with companies that have a ratio of debt to equity above 50 percent.
Warning: The Debt Ratio Can Be MisleadingIf a company has a lot of debt, sometimes it will tend to put more attention on the debt ratio
in its reports than on the debt-to-equity ratio. This is because the debt ratio is always below 100 percent and so it looks more benign. The debt-to-equity ratio is a better indicator of the debt level of a company, so use it as a starting point when evaluating the debt position of a company.
Warren Buffett Talking about DebtWarren Buffett has a clear opinion about the dangers of high levels of debt for Berkshire
Hathaway or when considering companies to invest in. Here are few examples taken from annual reports of Berkshire Hathaway. “Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.” (1986) “A small chance of distress or disgrace [because of high debt] cannot, in our view, be offset by a large chance of extra returns.” (1988) “The roads of business are riddled with potholes [because of debt]; a plan that requires dodging them all is a plan for disaster.” (1990) “Debt is a four-letter word around Berkshire.” (2001) “We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet . The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return.” (2008)
The last debt ratio we consider is the financial leverage multiplier , defined as total assets divided by total equity. Since assets are equal to equity plus liabilities, the ratio of assets divided by equity equals 1.0 plus liabilities divided by equity. This means that if the financial leverage multiplier is 1.0, the company has no liabilities; the further it is above 1.0, the greater the liabilities compared to the equity. It is called a multiplier instead of a ratio since it measures the multiplying effect of extra liabilities.
The final ratio in this section is called the interest coverage ratio. It measures the ability of the company to pay its interest bill and is defined as earnings from continuing operations before interest and taxes over a financial year (commonly called EBIT) divided by the interest expense over the same period. The higher the ratio, the bigger the safety margin the company has in being able to pay the interest on its loans. It is also called times interest earned. Anything below 2.0 should be watched carefully, while below 1.0 means that the company is not earning enough to pay its interest bill.
Examine How the Debt Is Being UsedThe level of debt is important, but perhaps more important is what the debt is being used for.
Look for any spikes in the debt-to-equity ratio over past years. If there are any, try to ascertain what the extra debt is being used for. Buying companies that have little relationship with the core business is a warning sign. Alternatively, buying companies that augment the existing business may be a sign that management wants to be more active in growing the business and is not content with internal organic growth. Notice whether the business has taken on extra debt in the past but has managed to reduce it to reasonable levels over the next two or three years. This is a sign of the ability of management to make sensible acquisitions and then integrate them quickly into the overall business.
Warning: Zero Net Debt
Be alert when companies state that they have zero net debt. It does not mean that the company has no debt. Net debt means total debt less cash and other similar liquid assets, so zero net debt simply means that it could, in principle, pay all its debts. However, most companies need reserves in cash and cash equivalents to be able to operate, so it is not feasible to use all of them to pay off debt.
Liquidity RatiosThe third group of ratios describes the liquidity of the business in terms of its ability to meet its
short-term debt and liability obligations.
The current ratio is a measure of how well the company is able to withstand a sudden demand on its current liabilities. Would it be able to pay them relatively easily if they were suddenly all called in? If the current ratio is below 1.0, then the company may have difficulties meeting its short-term obligations. Conversely, if it is too high, then it may be that it is not using its current assets efficiently.
The quick ratio is similar to the current ratio except that the numerator only consists of the assets that can be accessed quickly, namely cash plus receivables. A weakness of the current ratio is that it includes inventory, which may be of doubtful value if the company is required to liquidate it quickly. Therefore, it is recommended that both ratios be considered since the quick ratio does not include inventory. (The quick ratio is also called the acid test.)
Using these average levels as a guideline, broadly speaking, a current ratio or quick ratio that is high could mean that the company has a lazy balance sheet and is not making maximum use of its current assets. For example, it may be that inventory is building up because of slowing sales. So it is not necessarily true that the higher the current ratio and quick ratio, the better. In the opposite direction, if the ratios are low, the company could be in danger of defaulting on payables or loans.
Current Ratio and Quick RatioAs a broad rule of thumb, a high current ratio or quick ratio is not necessarily a positive sign,
but if it is low or trending down it is generally a negative sign.There are times when these simple comparisons with average levels can be misleading since
acceptable levels of the current ratio and quick ratio vary considerably between industries and even between companies within an industry. For example, retail stores, particularly supermarkets, tend to have lower ratios. Most of their revenues are in cash, so they have low receivables and hence low
current assets. At the same time, commonly their agreements with their suppliers give them 30 days or longer to pay, so they have high payables and hence high current liabilities.
Examine Ratio LevelsAs a general rule, a current ratio of 1.25 or above and a quick ratio of 0.75 or above are
satisfactory levels for industrial companies. But make allowances for companies where the standard levels are much lower, such as supermarkets or retail stores. Also, any adverse trends or sudden changes in the levels of the current ratio and the quick ratio are just as important as the actual levels. If the levels are trending downward, this could be a sign that the company is having cash difficulties, forcing it to allow its payables to increase in relation to its receivables.
Although not strictly a liquidity ratio, we also include total asset turnover in this group. Defined as revenue divided by assets, it measures the efficiency of a company in using its assets to generate sales or revenue—the higher the number the better. In general terms, companies with a high total asset turnover have low profit margins, and companies with a low total asset turnover have high profit margins.
Price Ratios with Earnings and Dividends
Prices of equities and related ratios are not strictly part of this part since prices are not in the financial statements but are outcomes of market opinions and actions. Nevertheless, earnings and dividends are found in the financial statements and since the ratio between prices and earnings and between prices and dividends are so important, we will briefly discuss them here. The price-earnings ratio (or price-to-earnings ratio, or P/E ratio) is the ratio of the price divided by earnings per share. Suppose that the price of equity is $30.00 and the EPS is $2.00. Then the P/E ratio is 30/2, or 15. Since $2.00 added to itself 15 times is $30, another way of thinking about the P/E ratio is that it is the number of years (in this case, 15) it would take for the EPS ($2.00) to add up to the price of the equity ($30.00), assuming that the EPS stays constant each year. This makes it clear why sometimes the market is willing to buy equities with very high P/E ratios (say over 25); at the time there is a general consensus that the earnings of the company will grow strongly. Conversely, the belief that the earnings will not grow and may even decrease will result in the stock being traded at low P/E ratios, perhaps 10 or lower.
It is common to see different P/E ratios being simultaneously quoted on different web sites or by different analysts.
There are two reasons for this. The first is that, even though EPS is quoted in the financial statements of publicly traded
companies, different web sites and different stock analysis firms often have different protocols regarding what they include in the final determination of earnings and what they do not. For example, sometimes the company data is modified to remove unusual or nonrecurring events.
The second reason for the variations that can be seen in P/E ratios is that the EPS in the ratio may be calculated over different time frames and may even include consensus analyst forecasts.
Table 5.17 shows the four main variations.
It is common in any list of current prices of publicly traded companies to state the P/E ratio. Generally this is the current price divided by the EPS found over the four most recent quarters in the financial statements of the company. This is the second variation in Table 5.17 and is referred to as the trailing 12 months P/E ratio or sometimes simply the current P/E ratio.
Because of the widespread availability of the P/E ratio, it makes sense to be able to make maximum use of it by understanding its strengths and weaknesses as an investment tool.
In the meantime, one way to get a sense of what is a reasonable level for the P/E ratio is via the earnings yield, the inverse of the P/E ratio.
In other words,Earnings yield = Earnings per share/Share price
If we think of EPS as the money generated by the company on your behalf for each share or unit of stock that you own in it, this terminology makes sense: Earnings yield is the return or yield in terms of earnings on the money outlaid to buy shares in the company. Looking at the earnings yield is a reminder that, unless there is a growth in earnings, the return on investment may be quite modest.
For example, a P/E ratio of 20 represents an earnings yield of 5 percent since 1/20 is equal to 0.05 or 5 percent. A P/E ratio of 10 represents an earnings yield of 10 percent. Table 5.18 gives a range of P/E ratios and the corresponding earnings yields. It is reasonable as a simple rule to think of EPS in this way, namely as money generated by the company on behalf of the owners of each share in the company. As a start, if the company pays out all its earnings as dividends (in other words, if the dividend payout ratio is 100 percent), then this is literally the case. There are even cases where companies routinely have payout ratios above 100 percent. For example, a real estate investment trust (REIT) is required to distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. Because this distribution is calculated before tax, the actual proportion that is paid out as dividends may exceed the earnings, giving it a dividend payout ratio that exceeds 100 percent.
Even if the company pays no dividends, it could be using the money to expand the business or to buy back its shares. In both cases it is anticipated that the EPS will grow, in the first case because the total earnings has grown and in the second case because the number of shares has decreased, cutting the earnings pie into fewer slices.
Hence, in both cases it is anticipated that the growth in EPS will contribute to the value of the holding.
The same type of ratio can be formed with dividends. Dividend yield is defined as the dividends per share over the recent four quarters (or over the most recent financial year) divided by the current price.
In other words,Dividend yield = Dividends per share/Share price
As a final comment, what is important about earnings per share and dividends per share is not their actual values, since this depends on the number of shares that are outstanding. Rather, the main importance is their values relative to the current share price, since this is the yield or return on the money required to buy shares in the company.
Ratios Numerator Value Denominator Value Ratio PercentageGPM Gross Profit (I) 80 Revenue (I) 100 0.8 80Net Profit w.r.t Gross Profit Net Profit (I) 16.8 Gross Profit (I) 80 0.21 21Return on Equity Net Profit (I) 17.8 Equity (B) 100 0.178 17.8Return on Capital Net Profit (I) 18.8 Capital (B) 144 0.130556 13.0555556Return on Assets Net Profit (I) 19.8 Assets (B) 498.5 0.039719 3.97191575Net Profit Margin Net Profit (I) 20.8 Net Sales (I) 100 0.208 20.8Debt Ratio Total Liabilities (B) 48.5 Total Assets (B) 498.5 0.097292 9.72918756Debt to Equity Ratio Total Debt(B) 44 Total Equity (B) 450 0.097778 9.77777778Financial leverage multiplier Total Assets (B) 498.5 Total Equity (B) 450 1.107778 110.777778
Interest Coverage RatioPretax Income + Interest Expense (I) 28
Interest Expense (I) 4 7 700
Current Ratio Current Assets (B) 38.5Current Liabilities (B) 4.5 8.555556 855.555556
Quick Ratio Cash + Receivables (B) 15Current Liabilities (B) 4.5 3.333333 333.333333
Total Asset Turnover Revenue (I) 100 Assets (B) 498.5 0.200602 20.0601805E\P Raio EPS (I) 0.162 Market Price (B) 15 0.0108 1.08B\P Ratio Book price (B) 4.5 Market Price (B) 15 0.3 30
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Clason Warren Buffets – Management Secrets Rich Dad Poor Dad by Robert Kiyosaki
