Monday, June 28, 2010

An introduction to Forward Contracts

Consider a scenario in which an Indian software major is expecting a 100 million USD payment from one of its biggest US clients on the 1st of August. Even if the payment is assured, the software firm faces foreign exchange risk (also called forex risk or exchange rate risk or currency risk) i.e. the risk that USD may depreciate vis-a-vis the INR and the 100 m USD which is worth 4.6 billion INR (since 1 USD =46INR at the time of writing) today may reduce in value to say, 4.3billon INR (or even lower) by the date of receipt of the USD payment. The company can eliminate its risk if it enters a forward contract to sell 100 m USD on August 1 at a fixed price. This fixed price at which the company can sell the USD at the forward date will typically be close to price of the USD at the day when the contract is made. This is due to arbitrage (we will look at arbitrage a little later in this post). Let’s say the price at which the contract in question is made is 46.5 .The counterparty (i.e. in this case the party which agrees to buy the pre-specified amount of USDs at the pre-decided rate on the contract settlement/expiry date) may have entered the contract for one of the following 3 different reasons-
1) It wants to shield itself from the currency risk it faces, for instance it expects an INR payment in the month of July, which it wants to convert to 100 million USD to import expensive machinery from the US. It like the software major is concerned with the exchange rate it will face when it needs to convert the rupees to USD.
2) It expects the USD to trade higher than 46.5 INR at the day of the contract settlement (i.e. contract expiry) so that it can immediately sell the dollars bought at 46.5 for a profit on the day of expiry.
3) In order to profit from arbitrage.
The party which has agreed to buy the asset (here USD) is said to be holding a “long” position on the asset whereas the party which has agreed to sell the asset is said to be holding a “short” position on the asset. If the party has entered the contract to insulate itself from the asset (here USD) price risk it faces, it said to be “hedging” against the risk. Thus while the software firm is engaging in “short hedging” the counterparty is engaging in either “long hedging”(if it has entered the contract for reason 1) or speculation(i.e if it has entered the contract for reason 2). If the party enters the contract to profit from difference between the price agreed upon in the contact and the price of the asset on the day of the expiry, there is a probability that it suffers a loss, if the asset price moves in the direction adverse to which the party expected it to move (i.e. if in the present example the dollar rather depreciating, appreciates versus rupee to a value of say say 42.5 per USD).

A company like Indigo which is doing exceedingly well on operational parameters, will surely not like to make a loss just because it had to purchase Air Turbine Fuel (ATF) at a very high price due to the spiralling oil prices. It in this case it will probably enter a series of long contracts on the ATF (depending upon its future fuel requirements), whereas and oil refiners like RIL may choose to enter the contract on ATF on the short side thereby securing the right to sell the produce at a fixed price.

Contract Settlement
There are two major ways in which a forward contract may be settled on the expiry date
1) Delivery- The short delivers the pre-specified quantity of the asset to the long for the pre-agreed payment on the contract settlement date.
2) Cash settlement – This is the most commonly way to settle the contract if both the parties to the contract are speculating. In this type of settlement the disadvantaged party simply makes a cash payment to the gaining party on the contract settlement date i.e neither of the parties is actually interested in buying/selling the asset but simply want to gain from correctly predicting the direction of the price movement. Suppose two parties enter a contract to buy/sell 100kgs of rice at Rs 35 per kg on a future date. If the price of 1kg of rice on the settlement date is Rs 38, the long party’s right to buy the rice at Rs 35, confers a positive value to the party and an equal negative value to the short. If the long buys rice at Rs 35 and sells them at Rs 38 in the market , it will gain Rs (38-35)*100=300 and the short loses an equal amount , having to buy rice at rs 38 to eventually sell them at Rs 35.i.e short party’s loss is Rs(35-38)*100 =-300. So the parties instead of buying/selling the asset can simply exchange a sum of Rs 300 to settle the contract.
Contract Offsetting –Assume that a party assumes a long position in a forward contract to buy 1000kgs of a particular variety of wheat on the 15th Sept at the rate of Rs 10 per kg (the market rate of the wheat being Rs 9.8/kg). Subsequent to the entry in the contract the asset price starts falling, and the speculator looking at market conditions and other factors decides that the price should fall further by the expiry of the contract. To limit their losses the party can enter an offsetting contract.

The quantity and quality of the asset and the date of expiry of the contract will be the same in both the offsetting and the original contract. The difference being that the party assumes a reverse position (i.e. short position in this case) in the offsetting contract and the offsetting contract confers a right upon the parties to buy/sell the asset albeit at a different price than specified in the original contract. Let’s suppose the contract is to buy/sell a kg of wheat at Rs 8(when the prevailing price is Rs 7.9/kg). Now the party has a short position in the offsetting contract and long position in the original contract. This way the party has locked in a loss of Rs 2 per kg. Let’s see how. At expiry if the price of a kg of wheat is Rs 20, the right to buy wheat at the rate of Rs 10 per kg has a value of (20-10)*1000=10000 and the right to sell wheat at Rs 8 has a value of Rs(8-20)*1000=-12000, thus in totality both the rights have a value equal to -2000 .i.e a loss of 2 rupees per kg, this is true for irrespective of the spot price of wheat at the time of expiry. Another way to look at this is to consider that the party has a right to buy 1000kg of rice for Rs10000 and is required to sell those 1000kgs at Rs8000, thus incurring a loss of Rs 2000.

Hedging( whether long or short ) is of course not without its costs, a company like the software major above , is required by the contract terms to sell the dollars at a pre-agreed price, even if the prevailing price is much higher than this pre-agreed price. A long hedger on the other hand has an obligation to buy the asset at the predetermined price even if the asset is trading at a much lower price in the market at the time of contract settlement.
Default Risk
An unscrupulous party may however choose not to perform as per the terms of the contract, for instance a the party holding the long position (sometimes simply called the “long”) may choose not to perform if the free market price of the asset is lesser than the price it has agreed to buy upon as per the contract. Similarly, the short may breach the contract if it can sell the asset at a price higher than stipulated in the contact. The risk a party faces due to possible non performance of a disadvantaged counterparty is termed as the default risk. The most commonly appointed measure to reduce (if not totally eliminate) the default risk is to sign up a trusty third party dealer. When the two parties sign up the contract the parties deposit some amount of money with the dealer as a guarantee of performance.

Arbitrage
Apart from speculation and hedging there is a third reason as to why a company many choose to enter a forward contract. Suppose that the current exchange rate of the USD is 46 rupees. The price at which at asset can be currently bought or sold is called the spot price of the asset. The price at which the asset can be bought or sold in the future is called the future price. Suppose the Future price of USD for August 1 delivery is 47 INR. A party wanting to profit from arbitrage will buy the USDs now and sell them at the contract price on the contract settlement date (i.e buy at 46 now and sell at 47 on the contract settlement date). Such arbitrage opportunities and the consequent buying support for the USD will tend to increase the demand for USDs and hence will tend to increase the USD price to the point where spot prices and the future price become equal and the arbitrage opportunities are effectively eliminated. There are two potential barriers to arbitrage
1) The transaction costs may be so high that they effectively nullify the possibility of profiting from the price difference.
Before we discuss the 2nd factor that makes arbitrage ineffective let’s discuss what is the Risk Free Rate. In order to meet their financial obligations governments around the world issue bonds. Buying (or investing in) such a bond is considered akin to lending money to the government, i.e. the government’s promise to pay a fixed rate of interest to the bond holders (“the borrowers”) and the principal upon bond expiry/maturity. Now it is very unlikely that the government will default on its obligation to pay the bond holders the promised interest and principal payments. Therefore these bonds which can be issued for various durations and carry different rate of interest depending upon the duration for which they are issued are regarded to be free of default risk. While this assumption may be true in normal circumstances, the bonds issued by an economy in a bad shape like that of Greece (where Debt/GDP ratio is greater than 1) is regarded to be carrying a good degree of default risk. The debt issued by various companies is generally considered less safe than government issued debt and is thought to be having various degrees of default risk. How much risk the company’s debt obligations carry is determined by its business position, ability and credibility of its management, past payment record etc. Determination of the degree of risk is a task best left to the credit rating agencies like Moody and Fitch in the US and ICRA and CRISIL in India. The greater the default risk of the bond the greater is the interest rate required by the investors to invest in such a bond.
So much for the Risk free rate (RFR), let’s come to second hurdle against arbitrage. As discussed above forward contracts carry default risk. So if the returns from arbitrage are less than the returns on the government bonds (i.e. the RFR), the sane investors instead of attempting to profit from arbitrage will invest at the RFR in the government bonds. It is therefore true that greater the time to expiration of the contract, greater is the potential price difference between the future price and the spot price.
There are other derivative instruments available in the market apart from forwards. In one of the subsequent posts we will cover two such instruments namely futures and options .Happy Reading!



Saturday, June 19, 2010

The PE Ratio: Calculation and Interpretation

Price to Earnings (PE) is ratio often considered to be the most important ratio in the fundamental analysis of stocks. While looking at PE ratio alone may not be sufficient, it is unlikely that a dyed-in-the-wool analyst to will ignore it. Price to earnings ratio links the operational efficiency of a business to the market price of its shares. In this piece we will first see how this simple ratio is calculated and then look at possible ways to interpret it .The price in the PE (or P/E) refers to the market price of the shares of the company for which the ratio is to be calculated. The Earnings “E” in the ratio refers to the annual earnings (read profits) of the company on a per share basis. Suppose a company has issued 100 crore shares, with each share currently trading at Rs52, the
and the company earned a profit of Rs 278 crores in the Financial Year 10(FY10 i.e. April 1st 09 to March 31st 10).The earnings per share (EPS) as you might have guessed are 278/100=Rs 2.78(Since profits are in rupee units and the no of shares do not have units). Since this EPS is calculated on the basis of past (known) profits it is called “trailing” EPS. Another popular version of EPS called the forward EPS which utilizes future earnings for the next four quarter is called the “forward” EPS. Since the future earnings of a business are not known but have to be estimated, it goes without saying that correctness of these earnings estimates is heavily dependent upon the ability of the analyst and different analysts will arrive at their of estimates of earnings.

Now if you own 1000 shares of the company your share of company profits is Rs (278 crores/100 crores)*1000(=Rs 2780), which is quite simply the Earning per share times the No of shares held. The company management may decide to do any of the three things with the Rs 278 crore profits earned.

1) It can give away all the profits to the owners (i.e shareholders) in the form of dividends. In this case since you hold 1000 shares you will get Rs 2780 and an investor who holds 1 lac shares will get EPS* No of shares held i.e. Rs 2.78 lacs.
2) Companies in their growth phase are usually cash hungry and they need a large amount of cash for activities such as setting up a new plant, setting up business in new geographies, setting up R & D facilities so on and so forth. If this is the case with the company at hand, it may not choose to distribute dividends to its owners but reinvest the profits earned to fund to the growth of the business.
3) The third approach a company can use is the mixture of the two approaches above, that is the company may distribute the fraction of its profits and choose to reinvest the rest into the business. Suppose the company above chooses to distribute 115 crores as dividends. Then the dividend per share (DPS) is 115crores/100 crores(=Rs 1.15 ) and the Dividend payout ratio is DPS/EPS or alternatively Total Dividends/Total profits=115/278=0.413

Having seen what the earnings are and what are the ways a company deals with the earnings, let’s come to the P/E ratio. PE ratio is simply the division of the current market price of the company shares with the earnings per share. So in the case of the company above if the shares are trading at a price of Rs 52, the PE ratio of the company would be Rs 52/Rs 2.78 = (18.7). If the company stock price goes to Rs 50 a day later the PE would change to 18. PE ratio can be expressed in multiple forms. Lets look some of the ways an analyst may state the PE ratio of the above company.

X’s share is trading at 52 and it discounts its trailing 4 quarter earnings by 18.7
X’s share is trading at 18.7x (x stands for times) its trailing 4 quarter earnings
X’ share is trading at a PE (FY10 earnings) ratio of 18.7
X’s share is trading at 52 and at an earnings multiple of 18.7 on a trailing basis.
so on and so forth

The higher the PE the more you are paying for every rupee of earnings the company generates. So seen in this sense higher PE stocks are more expensive then lower PE ones.

Consider a hypothetical scenario of 4 companies, A, B, C, D identical in every respect (Industry, Products, Sales, assets, profits, debt, ownership structures, share price etc). Now suppose company A announces the discovery of a raw material source close its factories, which would significantly lower its transportation costs and hence enhance its profitability. Even if the trailing earnings of all the four companies are equal, the next 4 quarter expected profits of company A are higher than that of other companies. The company A which was identical in all respects till a few moments back, now appears to be likely to outdo the other companies in the current year expected profits. In neutral market conditions the markets will re-rate the stock of company A. By rerating we simply mean that the post the arrival of good news the increased demand for the company shares will cause their market price to surge and hence its PE gets automatically rerated to higher value. This adjustment may be slow or may be fast, according to the Efficient Market Hypothesis, markets react quickly to the arrival of new news (good or bad) and rerating process typically takes a few minutes. Experience sometimes shows that markets are not always efficient and it typically takes some time before the change in supply and demand situation, adjusts the stock price so that it starts hovering around a new equilibrium value post a good or a bad news. After the adjustment it can be said that the market is paying a premium (i.e. assigning a higher PE value) for the shares of company A with respect to its peers (B, C, D). So in this example above while the trailing PE of the stock A is higher than that of its peers(same EPS but higher stock price), the forward PE of the stock A may be higher , lower or equal to its peers( higher forward EPS and higher stock price).

PE ratios generally make more sense when comparing two or more companies in the same industry. Consider an industry, in which the PE for the various stocks ranges between 20-22 .An analyst discovers a stock that is trading at a trailing PE of 12, next the analyst through his analysis of the company (using business model, its ability to generate profits, analysis of the Balance Sheet, Profit and Loss statements so on so forth) estimates that the company is likely to grow as fast in profits as the industry on an average. So, the analyst will start believing that the company is undervalued compared to its peers and will buy the stock for himself or will issue a BUY call. In real practice, the analyst will look at some other ratios (ex Price to Sales, Price to book value) before deciding that the stock is undervalued. The buy call is issued In the hope that slowly and gradually the market participants will turn its attention towards the company and the price of it will soar relative to its peers so that it becomes “fully valued” relative to its industry. There can be several reasons as to why the company may be undervalued relative to its industry. Lets look at three of these reasons

1) There was a company specific bad news around 6 months back, so the markets decided to punish the company by lowering its share price, the bad news did not quite have its expected effect on the company’s financial situation but at the same time the share does not recover from the fall
2) Generally bigger players in any industry trade at a higher PE than the smaller ones. The reasons are not too far to seek, a bigger company is deemed to be “higher up on the learning curve” and generally has better access to resources to manage its financial risks and the business risks. Now suppose an analyst finds that a smaller company has recently executed orders which augur well of its ability to compete with some of the big boys in the industry. The company however is trading at a significant discount to the bigger boys in the industry (let us 9x vs 20x) and is growing a bit faster than the industry average. The analyst may expect the discount to reduce going forward so that the company starts trading at PE of say, 12-13 as compared to the industry’s average of 20.
3) The earnings of the company are unlikely to be sustained in the future or the company is subject to greater risks than the industry as a whole.

Here we reproduce a table from Wikipedia (http://en.wikipedia.org/wiki/P/E_ratio) with some alterations. When looking at PE ratio the following points may come in handy

A company with negative earnings (A loss making company)- By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be determined, mathematically. In these case of these companies forward PE may be used if it is positive or the analyst can look towards other ratios (Price to Book Value, Price to Sales) etc.
PE lower than the industry average- Either the stock is undervalued or the company's earnings are thought to be in decline or of unstable nature. So a low PE does not always mean a good BUY
PE more or less equals the industry average-For many companies a P/E ratio in this range may be considered fair value.
PE is above the industry average (let’s say 25 vs. 20) either the stock is overvalued (and should be sold) or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
PE is way above the industry average (let’s say 40 vs. 20) -A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble. Example of such a stock is RNRL

While this article may serve as an introduction to the highly useful concept of PE ratio,the infomation given above is by no means exhaustive, the ratio is subject to a considerable degree of interpretation. Some extensive reading on the topic and experience in fundamental analysis can help an analyst sharpen his expertise in dealing with ratio.

Monday, June 14, 2010

The ways market indices are determined.


In any particular time period several stocks appreciate in value and several others depreciate. It is easy to miss the big picture when we look at the individual stock prices. On the National Stock exchange (NSE) alone shares of more than 1900 companies are available for trading. So, except for the periods when the markets move decisively pushing up almost all the stocks or hammering down almost all the stocks, it is pretty hard to gauge the performance of the “overall” market looking at the performance of the individual stocks in the time period considered. This is where market indices come to our rescue. Market indices may be structured to mirror a section of the market or the market as a whole. For instance the Bombay Stock Exchange’s (BSE) Sensex (Sensex is derived from the words Sensitive and Index) tracks stocks of 30 biggest and the most actively traded companies listed on the BSE and serves as a good proxy to measure the performance of stocks of large companies. National Stock Exchange’s (NSE) Nifty tracks 50 biggest and most actively traded stocks on the NSE. There are several other indices developed and maintained by the NSE and the BSE. These indices are either designed on the basis of market cap (size) of the companies or are based on specific sectors. CNX MIDCAP is an example of an index designed on the former basis and BANK NIFTY is an index based on the later basis.
A full list of all the NSE Indices and BSE Indices is available at the following links:

http://www.nse-india.com/
http://www.bseindia.com/

Mutual Funds often follow either the market cap strategy or the sectoral strategy i.e. a particular mutual fund may invest in mid-cap stocks or in the technology stocks only. A mutual fund follows a sectoral strategy will most likely choose the appropriate sectoral index as its benchmark and aims to outperform the chosen benchmark. Likewise large-cap, mid-cap, small-cap, micro-cap oriented mutual funds will measure their performance against large-cap, mid-cap, small-cap, micro-cap indices respectively. Also a few mutual funds use the index strategy to invest i.e. these funds invest in the same stocks as those comprise the index and in the same proportions as the index so that the returns they produce closely match index returns. We will dedicate a separate post to mutual funds sometime later.
For, now let us see how the values of these indices calculated. There are two steps in which the index values are calculated .The first step of course is the selection of stocks that make up the index, the stocks selected must be representative of the sector on which the index is based or in case of size based indices must have appropriate the market capitalisation. After the first step is over, the weights to be ascribed to the index constituents are determined. Based on how the weights are determined the indices may be divided into three categories:

1) Price weighted Indices
2) Value Weighted Indices
3) Un-weighted Indices

Price Weighted indices- These are based on the arithmetic average of the “prices” of the stocks constituting the index. The steps involved are
1) Select a date as the base date. Take the arithmetic average of the prices on the base date. Further divide this by a number (called “the index divisor”) so that the arithmetic average becomes a standard base value (say 100 or 1000).
2) For index calculation on any date after the base date, take the arithmetic average of the prices on that day and again divide by the index divisor determined in the step 1.

Price weighted indices are inherently flawed. This is simply because a bigger company with a lower share price has less impact on the index than a smaller company with a greater share price. Sample this, Bajaj Auto (Current Market Price Rs 2200 approx) is much smaller a company than Reliance Industries Limited (CMP Rs 1000 approx) in terms of profits and market capitalisation. While Bajaj autos earned a profit of Rs 570 crores in the quarter ending March 2010, RIL earned a profit of whopping Rs 4800 crores in the same period. Still such an index would place a higher weight on Bajaj Auto than RIL. Bahut naa-insaafi hai !!.

Before we discuss the next big defect with the price weighted indices let us discuss what stock splits are .When the share price of a company’s stock rises to such a great value that it becomes costly to acquire even a single share of the company, the company may decide to split a share into several shares. There is another reason for stock splits i.e. when share a reaches a high value an ordinary investor may get psychologically wary of entering the stock (the “pehle se hi itna badha hua hai, ab aur kya badega” psychology). Suppose you own 10000 shares of Reliance Industries Limited (CMP Rs 1000 approx), so that your holdings in RIL are worth 1 crore rupees approx (a very welcome scenario indeed!!) and the company decides to split its shares 10-1(10 for 1).Post split you will end up owning 1lac shares and the price of each share would approximate Rs 100 so that the worth of your holdings remains unchanged. However, a few companies do not seem to believe the above two arguments for stock splits given above, for ex, the price of single share of Berkshire Hathaway (Warren Buffet’s company) is around-hold your breath ladies and gentlemen- 1.1 lac USD. Closer home the price of a single share of MMTC is Rs 30000 approx.

The figure below shows the one year price chart of telecom major Bharti Airtel.Notice the vertical fall in the price of the stock indicates the split.

Now, consider a hypothetical index with a value 600 comprised of almost two equal sized companies, A and B, each having their shares priced at Rs 1000. Since (1000+1000)/2=1000, the divisor must be 1.67 so as to translate the simple arithmetic average to the index value (1000/1.67=600). At this point of time the two shares have an equal weight in the index, i.e. a 1% increase in either stock will affect the index equally. Now suppose the management of company A decides to split the stock 10-1, so that its price of share changes to Rs100. The value of the index using 1.67 as the index divisor comes out to be ((1000+100)/2)/1.67 =329. To ensure that a price weighted index does not reduce in value post a stock split the value of the divisor needs to be adjusted. Since in the present example the index needs to have a value of 600 post split the new divisor value is 0.916 , so that ((1000+100)/2)/0.916 (=600) equals the pre split index value. Having seen the mechanics of index divisor adjustment in the event of a stock split we come to the second major defect of price weighed indices. You must have noticed that post split the weight of the splitting stock has reduced relative to the other stock. That is 1% percent increase in the value of stock A will affect the index much less than 1% percent increase in stock B. In general faster growing companies split more often than slower growing ones. For example, try finding out the number of times the stocks of Infosys Tech. or Unitech have split since they got listed. I can bet(without googling and verifying) that the number of splits experienced by the above mentioned companies is much higher than by slower growing companies like HUL or Cipla. Since, there is a constant reduction in the index weight of the rapidly growing companies (and stock splitting companies), this type of index understates (underreports) the market performance. If all this leads you to believe that no stock exchanges in countries with well developed capital markets would be following the price weighing methodology to measure the index value here’s the real shocker, Dow Jones uses the price weighting technique to measure its flagship Dow Jones Industrial Average Index(DJIA) in spite of the clear cut warts of the technique.

3) Market Cap Weighted Index- A company’s market cap is a measure of the size of a company and is measured as Price of Each Share*No of Shares outstanding. Here outstanding shares refer to the number of shares issued – no of shares bought back (and extinguished) by the company. We shall postpone the discussion of share buybacks for a later post. Every time the company splits its shares the number of shares outstanding increase and the share price decreases by the same percentage, so that the product (i.e. the market cap) remains constant. Every time the share price of a company changes its market capitalisation changes. The value of index at any point of time is “directly proportional” to the arithmetic average market cap of the stocks comprising the index adjusted of course by a divisor to get to the base value (such as 100) at the base date. There are two distinct advantages of these types of indices over the previously discussed price weighted indices i.e. these indices rightfully give more weights to companies with larger market caps and increase in value of these types of indices is truly reflective of increase in the wealth of the holders of the script. Likewise for decrease in the index values .The second advantage being that the divisor need not be adjusted for splits and the weight of the stock does reduce post splits. Another refinement of the market capitalisation index weighting methodology is the free float market capitalisation methodology. Freely floating shares of a company are the shares available for trading, as opposed to the non tradable shares held by the promoters. Companies differ vastly in terms of the percentages of stake held by the promoters, for ex Infosys the promoter stake is around 16% (well distributed among the promoter families) and rest 84% is available to the public. Contrast this to the more than 70% of Wipro’s stake being held by Mr Azim Premji alone, which is one of the reasons why Mr. Premji was once upon a time the 2rd richest person in the world and Mr Narayanamurthy with his less than 0.5% stake in Infosys will probably never feature even in the list of 500 richest in the world. The free float market cap is calculated by multiplying the price of the share with the number of freely floating shares. An index based on this strategy is better than the index based on the pure market cap strategy as changes in it represent the true increase in value of market investors. Sensex used to be a market cap weighted index but later switched to the free float market capitalisation methodology.

Unweighted Indices: An unweighted index assumes equal Rupee/Dollar worth investments in each stock representing the index on the base date. For ex if on the base date an unweighted index is to be constructed using two component stocks X & Y with share prices Rs 10 and Rs100, the index can be constructed by taking arithmetic average of the values of 10 stocks of X and a single stock of Y, and then selecting the divisor that the value becomes the desired base value. The advantage of this again is that this type of index need not be adjusted for splits. The disadvantage of these types of indexes is obvious i.e. they give equal weightage to all the stocks representing the index irrespective of their size i.e. a 1% increase in value of Bajaj Autos or a 1% increase in the value of RIL will affect the index equally, which is not of course fair, since RIL is likely to be held by much larger number of market investors than Bajaj Autos.
PS : Hope you have enjoyed reading this post as much as we have enjoyed writing this. Please post your comments/suggestions/feedback , as it would help us determine whether our efforts are directed in the right direction. Happy reading!!

Friday, June 11, 2010

Welcome!!

Hi all ,
Whoever said necessity is the mother of invention could not have been more correct. Because the joining of 2010-12 batch has been delayed and it is likely that the PGP2s and PGP1s won't have much face to face interaction till the start of their respective 5th and 2nd terms,it was thought that the use of online media is the ideal(quick, conveinient and free) way to interact, engage and welcome the PGP1 batch. So here we kickstart the brand new SOFIA blog. Through this blog we will endeavor to inform and educate the new batch about the topics of interest in the field of finance. We may also plan a few contests the prizes for which will be awarded once you join the institute and become members of the SOFIA club. While we understand that the some of the posts may appear to be too basic to a few people who hold active interest in the field, our intention will be to keep the posts simple yet informative as our goal is not to intimidate but to inform.
Needless to say we welcome both bouquets and brickbats on the posts, your feedback and suggestions will go a long way in improving the blog. If you feel the need to contribute, please mail your articles/posts to sofia@gim.ac.in .The reader contributions are subject to approval of the majority of the SOFIA Senior Core Comittee members
Regards
Team SOFIA

The two major ways stock market experts arrive at price targets

There has always been a deluge of misinformation going around about the functioning of stock markets. So much so that people who lack knowledge about it often liken it to a gambler’s den. But, as we will try and explain in this piece, there is a method to the madness that the markets are. Those of you, who have only had a ringside view of the stock markets till now, must have surely wondered about the techniques that the market participants to use to arrive at the stock price targets.

The market analysts may be broadly classified into two categories

1) The Fundamental Analysts

2) The Technical Analysts (also known as the “Chartists”)

Let’s a have brief look into the two types of analysis without going into much details

Fundamental Analysis: This usually involves a three stage process. The first stage involves comparison of the economies around the world to find out the ones which are likely to outperform the rest. Now, a bit of good news for those who think that the first step involves a tedious and a long drawn process. Leading economists around the world believe that India’s GDP is poised to grow at a healthy rate of 7-9% in the next 8-10 years to come. So, it is seems a safe option to place your bets on India and directly move to the second step. After identification of the strongest economies is complete, the 2nd stage involves the identification of industries in the best performing economies. For example, at some point of time you may decide that the prospects of steel companies look good, given the strong sales registered by automobile companies or the banking sector has performed well in the past and there is no reason why such a good performance may not be repeated in the future. The third step involves comparison of different companies in a particular industry (selected in the step 2). Comparison of companies involves comparison of business models, sales growth trends, profit margins trends (whether growing or declining) and a host of other factors. The analyst may also conduct a SWOT analysis (Strengths, Weaknesses, Opportunities and Threats) of various companies of the industry selected. This step involves a good deal of number crunching and company financial statements (Balance Sheet, Profit and Loss statement and Cash-Flow statement among others) are a major input to the process. The analyst then arrives at the intrinsic value of the share of various companies. The intrinsic value is the value the number that “should have been” the price of the stock as opposed to the price at which its currently selling i.e. Current Market Price (CMP). If this value is above the current market price the analyst buys the stock for himself or issues a BUY call for the others to follow. This is because fundamental analysts that markets behave in a rational behaviour and they believe that sooner or later the actions of the various market participants will eventually make the market price equal to the intrinsic value. If several stocks within an industry are good buys to the analyst, he/she may restrict himself to issuing buy calls for only 1/2/3 stocks depending upon the percentage difference between the CMP and the intrinsic value. Some of the famous fundamental analysts include Warren Buffet, Benjamin Graham and our own Rakesh Jhunjhunwala.

Technical Analysis: There is a fundamental difference between how technical analysts and fundamental analysts analyse securities (pun intended). Pure technical analysts don’t feel the need to look at the state of the economy, or the state of various industries or the financial situation of various companies. They try to predict the new price of the share from the stock charts (Hence the name Chartists). That is, they attempt to use the past price movement (among other factors) to forecast new prices. Technical analysts aim to cash in on the price trends .i .e. at any point of time the stock may be in an uptrend, downtrend, or maybe displaying no significant trend. Also a stock that may be in a “long term uptrend” may simultaneously be in a “short term downtrend”. Some of the indicators that indicate the establishment and strength of a trend are MACD, RSI, DMAs so on and so forth. As of now we won’t delve deep into these indicators. The concept of support and resistances however can illustrate one of the causes as to why technical analysis may work. Suppose it is observed in the past that the stock of XYZ Corporation hovers between Rs 80 and Rs 100 .i.e. the stock exhibits a strong tendency to fall upon rising to the level of 100 and stock exhibits a tendency to bounce upwards upon falling to 80, 80 becomes a support as it offers a support to the price of a stock and 100 becomes a resistance as it offers resistance to the upward movement of the stock. The reasons for existence of supports and resistances are not far to seek, if a technical analyst has observed twice the stock bouncing back from 80 in the past, he will start thinking it will bounce back again once it hits 80.Now imagine hundred and thousands of analysts(some with extremely deep pockets) sharing the belief and starting to buy when the price touches a support(i.e 80 in the current example), the price will have a tendency to move up due to improved buying and the support becomes a self-fulfilling prophecy. Some of the famous technical analysts are Charles Dow(he founded the Dow Jones index), John Lane (who famously said “Make trend your friend”) and Ralph Eliott.So, we hope that armed with this knowledge, you pray to God every time somebody proclaims that investing in the stock market is “satta”, “jua” or “gambling” and say “God please pardon them , for they know not what they are saying”.