Terminology in Equity and Debt Markets

Where this chapter sits

Chapter 3 carries 2% of the paper. It is the definitions chapter that everything from Chapter 8 (Financial Analysis, 12%) and Chapter 10 (Valuation Principles, 12%) rests on — so the return on learning it well is far higher than 2%.

The exam: 120 minutes, 100 marks, 60% to pass, 25% negative marking.

Equity versus debt — the six differences

Equity capital is available to the company's use for as long as it is needed; debt capital will have to be returned after the specified time.

Equity investors do not enjoy any fixed annual return on the principal invested; debt investors earn a fixed rate of interest on the principal and get back the principal at maturity.

Equity investors are owners of the business; debt investors are lenders to the business.

Equity investors participate in the management of the business; debt investors do not.

Residual profits of the business belong to the equity investors; debt investors' claim is restricted to the periodic fixed interest and principal repayment on maturity.

Equity represents a risky, long-term, growth-oriented investment that can show a high volatility in performance. Debt represents a relatively lower risk, steady, income-oriented investment.

The workbook's illustration of why equity return is higher: if a business borrows funds at 12% and is able to earn a return of 14% on the assets created by such borrowing, the debt investor receives only 12% as promised. But the excess 2% earned by the assets benefits the equity investor.

And the downside runs the same way: if the return is lower than the borrowing cost, the equity shareholders have to forego some portion of their share of return to fulfil the commitment to the lenders. When the business fails, there are very few chances that they would get back their original investment even.

The five notions of value

On face value: shares may be issued to the investors at the face value, or a price higher (premium) than the face value, or at a price lower (discount). The face value does not usually change unless the company decides to split or consolidate its shares — it would reduce (in case of split) or increase (in case of consolidation).

And why it matters: the face value of a share is important for calculating the dividend payable. If a company with Face value of ₹10 declares 30% dividend, it means dividend of ₹3 per share. However, if a company with Face value of ₹2 declares 30% dividend, it means dividend of ₹0.60 per share.

On book value: the assets of the company are listed in the balance sheet at its book value, i.e., cost less depreciation. The realizable value of these assets may be different from book value and is never known with certainty.

On intrinsic value, the workbook quotes Warren Buffett: "It is the discounted value of the cash that can be taken out of a business during its remaining life." When one uses the word discounting, the appropriate rate to discount holds the key, and this discounting rate is usually the required rate of return of the investor adjusted for the nature of the business, its unique risks.

Market value versus intrinsic value

Intrinsic value is the estimated value per equity share, based on the future earning potential of a company. Market price is the price at which the share trades in the stock market. Intrinsic value may be equal to, less than or more than the market price at any point in time.

If the intrinsic value is perceived to be more than market value, the scrip is said to be undervalued. If intrinsic value is perceived to be less than market value, the scrip is said to be overvalued. The goal of investment strategies is to buy undervalued shares and sell overvalued ones.

But the workbook is honest about the difficulty: it is tough to make these evaluations correctly and consistently, because what is being priced is the unknown future of the company.

And it adds a caution that runs through the whole syllabus: equity investing requires identifying and exploiting inefficiencies and is not amenable to mathematical formulation. Qualitative factors... make equity investing an art as well as science. Stock markets... feature a social ecosystem of complex human behaviour. Investment decisions are influenced by behavioural and cognitive limitations of individuals acting in a group.

Market capitalisation

Market Capitalization is the value placed by the various market players collectively for the entire company, as reflected in the current market price. It is computed as market price per share multiplied by total number of outstanding shares.

Worked: a company which has issued 1 lakh shares and currently trades at ₹20 would have Market Cap of ₹20 lakh.

The cut-offs are not fixed: there is no specific size for the cut-off of large, mid, or small cap stocks. It is therefore common to consider the top 50 to 100 stocks by market capitalisation as large cap, the next 200 to 500 stocks as mid cap, and the remaining all as small cap stocks. The ranking is dependent on a floating value threshold, changing according to a market, period, regulatory definition.

And a macro use: the ratio of market cap to GDP of a country is a relevant measure of the size and importance of the stock market of a country.

Enterprise Value

Enterprise Value refers to the overall value of the business. A business is funded by various sources of capital, however EV focusses only on the capital that is gainfully employed in the business.

Standalone EV:

EV = [Market Value of common equity of the Parent + Market Value of preferred capital of the Parent + Market Value of Debt of the Parent] − (cash, cash equivalents and non-operating/non-strategic financial investments of the parent only)

Consolidated EV additionally includes value of non-controlling interest and the market value of preferred capital and debt of the subsidiary, deducting the subsidiary's cash, cash equivalents and non-operating/non-strategic financial investments as well.

On inputs: the value for the individual components should be based on their fair market value. However, since it is difficult to obtain fair market value for unlisted securities and bank debt, an analyst may use the balance sheet values as a proxy if the fair market value is not available.

The workbook's worked example. A company with common equity ₹12.5 crore, preferred capital ₹8.5 crore, debt outstanding ₹6.4 crore, cash and equivalents ₹2.5 crore, financial investments ₹1.4 crore, whose 10,00,000 shares of ₹10 face value trade at ₹340:

Market capitalisation = 340 × 10,00,000 = ₹34 crores.

EV = 34.0 + 8.5 + 6.4 − 2.5 − 1.4 = ₹45.0 crores.

Notice that the book value of equity (₹12.5 crore) is discarded entirely in favour of the market capitalisation, while the unlisted preferred capital and debt are taken at book value as a proxy.

Earnings and the multiples

Earnings are profits in a business, and can be defined at several levels:

• Net profits are the profits available to the equity owners
• EBIT is available to be apportioned amongst lenders, government, and owners
• EBITDA is the earning available to a business to recover the capital invested in tangible and intangible assets, and later to be apportioned amongst lenders, government, and owners

Three time perspectives: earnings of previous years are called historical earnings · trailing earnings refer to the earnings of the most recent period up to the present, calculated on a rolling basis — the variants being Trailing Twelve Months (TTM) and Trailing 4 Quarters · earnings computed based on future revenue and cost projections are called forward earnings.

Why trailing matters: these measures are quite useful when the analysts undertake valuation of any firm at any point in time, especially when it is not the financial or quarterly year end.

EPS = Net Profit ÷ Number of shares outstanding — more precisely the weighted average outstanding shares, weighted by time for which they are outstanding. For a company with Net Profit of ₹10 lakh and outstanding shares 2 lakh, the EPS would be ₹5.

DPS. Dividend is generally declared as a percentage of the face value of the shares. 40% dividend declared by a company will translate into a dividend of ₹4 per share with a face value of ₹10.

Dividend per Share divided by Earnings per Share is known as Dividend Payout Ratio.

PE ratio

Price to Earnings Ratio measures the price that the market is willing to pay for every 1 rupee of earnings of a company.

PE = Market price per share ÷ Earnings per share

When one refers to a stock trading at PE multiple of 12x, it means the stock is trading at twelve times its earnings.

The limitation of historical PE: the prices change dynamically, while the reported earning is updated every quarter. Therefore, prices tend to move even after the historical earning per share is known, in anticipation of the future earnings.

So the focus shifts forward: if it is expected that earnings of a firm will grow, then the market will be willing to pay a higher multiple per rupee of earning. The focus is, therefore, on "prospective" PE or how much the current price is discounting the future earnings.

The workbook's example explains why current PE exceeds forward PE for a growing company: the numerator of both variants of PE is same, however, the denominator is different, and next year's earnings are higher.

As a market indicator: it is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE multiple moves high when prices run ahead of the earnings numbers. When markets correct and uncertainty about future earnings increases, the PE multiple also drops. A value investor, who would like to pick up stocks when they are cheap, may be interested to purchase when PE is low.

And a caution against a lazy comparison: usually, the PE multiple of a stable, large and well-known company is likely to be higher than the PE multiple the market is willing to pay for another smaller, less known, and risky company in the same sector. However, this statement is not like a gospel truth. Smaller and riskier companies may command higher PE due to their higher growth expectations.

Price-to-Sales

P/S Ratio = Current Market Price ÷ Annual Net Sales per Share, or equivalently Market capitalization ÷ Annual Net Sales.

Worked: with annual net sales ₹1 crore, 10 lakh shares and CMP ₹40 — annual net sales per share = 1 crore ÷ 10 lakh = 10, so P/S = 40 ÷ 10 = 4.

All else held constant, a company with lower P/S ratio relative to its peers indicates that the stock is relatively undervalued. But the company's future profit potential and the level of financial and other risks can result in market assigning a premium or discount, and a drop in the revenue growth rate will be a high risk for these stocks.

Its special use: this ratio is especially useful for companies in industries that are temporarily going through a phase of negative profits (i.e., losses). In such cases earnings based multiple would be meaningless.

Price-to-Book Value

P/BV measures a company's current market price of its equity share vis-à-vis its book value of equity. Book value is calculated by dividing net-worth by the number of outstanding equity shares.

Worked: equity capital ₹10 lakh, reserves and surplus ₹50 lakh, 6 lakh shares, CMP ₹20.

BV = (10 + 50) lakh ÷ 6 lakh = ₹10. P/BV = 20 ÷ 10 = 2x.

Its limitation: most assets on the books of the company are shown at their historical cost less depreciation and not their realizable/liquidation value. However, in a company which has been building reserves from sustained profitability, the book value is an important indicator of value.

Reading a P/BV below 1: it indicates the company is trading below its book value, and hence the stock is deemed to be undervalued. However, it is pertinent to ask, "Why is the market pricing the share at a price less than BV?" The workbook answers its own question: there may be several reasons... including the poor investments made by the firm in the past which need to be written down subsequently. Not all stocks that trade at a discount on their book values are bargains.

Where P/BV works best: it is a useful measure to value stocks where the earnings are negative and the more widely used PE ratio is not applicable. It is a good measure to value stocks of companies such as in the banking and financial institutions, because their balance sheets carry liabilities and monetary assets on the asset side, which are mostly valued at the ongoing market prices. However, for sectors such as the services, where assets are limited, this valuation method may not be relevant.

Differential Voting Rights

A DVR is just like a normal share of a company, except that it carries less than 1 voting right per share. Such an instrument is useful for issuers who wish to raise capital without diluting voting rights, and attracts investors who wish to invest only for dividends and capital appreciation and are not really bothered about voting rights.

DVRs typically trade as a separate category of instrument and are available at a discount to the common shares.

The Companies Act, 2013 eligibility conditions: a dividend of at least 10% over the preceding 3 years, and such shares shall not exceed 25% of the total post-issue paid up capital of the company.

Indian examples named: Tata Motors and Pantaloons.

Debt market terminology

A debt security denotes a contract between the issuer (company) and the lender (investor) which allows the issuer to borrow a sum of money at pre-determined terms. The features include the principal, coupon, the maturity, the frequency of coupon payment, and a collateral, if any.

Secured versus unsecured: some debt securities, called secured debt, also give investors rights over the assets of the issuing company. If there is a default on interest or principal payments, those assets can be sold to repay the investors. Investors with unsecured debt do not enjoy this option.

Listing: debt securities that are issued in a public issue are mandatorily listed on stock exchanges... so that they can be traded in the secondary market. Unlisted securities must be held until maturity or traded in the Over the Counter market.

Face Value — the nominal or par value of the debt paper, representing how much loan is represented by that debt paper. Coupon payment, throughout the term of the paper, is paid as a percentage of this amount.

And the point that matters when a bond trades: irrespective of the price at which a debt security is bought or sold in the secondary market, the issuer is liable to repay only the principal, represented by the face value, on maturity.

Coupon Rate — the regular fixed payment made on the bond, expressed as a percentage of its face value. A vocabulary caution: it is advisable not to refer to coupon rate as interest rate, in finance profession, because interest rate refers to the broad market rate at which borrowing and lending is happening, which at its base level is controlled by the central bank.

Worked: an 8.24GS2018 with face value ₹1000 would pay ₹82.40 as coupon each year. G-Secs pay coupon semi-annually, so the investor would get ₹41.2 every 6 months, and the last coupon payment will be received on the maturity date along with the principal.

Maturity — also called tenor or term to maturity. Maturity is a very significant parameter for bond investors as this is the single largest factor contributing to changes in bond prices and the market risk in bond investment is linked to it. The term to maturity keeps reducing with each passing day and finally becomes "zero" on the date the bond matures.

Market Price — the various players in the market collectively bring their intelligence to price the bond based on the ongoing market interest rates, inflation, and the default risk perceived in the bond.

And the central relationship in all of fixed income: because the value of a bond is the aggregate of the discounted value of the future cashflows from the bond, discounted at the market interest rates or required rate of returns of the investors, market price of bond and the interest rates are negatively related or inversely related. When the market interest rates increase the bond prices fall down, and when the interest rates fall down, the bond prices increase.

The four return measures

Holding Period Return

HPR is the return earned on an investment during a specific period when it was bought and held by the investor. Three components: coupon payments, interest on reinvested coupons, and a gain or loss at the time of selling the bond.

Worked: an investor purchases a bond at ₹104, earns ₹8 as coupon, which he reinvests at 7% for a period of 1 year, and finally sells the bond at ₹110 after 1 year.

HPR = [8 + (8 × 7%) + (110 − 104)] ÷ 104 = 14.00%

Its weakness, stated plainly: HPR is a crude return... It does not consider the aspect of compounding. Therefore, this return should neither be equated nor compared to any annualised version of return.

Current Yield

Current Yield = Coupon ÷ Current market price.

Worked: if the 8.24GS2018 is trading at ₹104, the current yield = 8.24 ÷ 104 = 7.92%.

Its weakness: this method does not consider future cash flows coming from the bond, which is the biggest drawback and hence this method is not really used widely. It can be compared to the dividend yield of a stock.

Yield to Maturity

YTM takes into consideration all future cash flows coming from the bond — coupons, reinvestment income on the coupons, and the redemption value — and equates the present values of these cash flows to the prevailing market price.

The rate which equates the present outflow with the present value of future inflows is known as YTM. YTM can also be understood as the Internal Rate of Return of a bond investment, and can be calculated by trial-and-error method... It can also be calculated using the XIRR function in Excel.

The critical qualifier: it is the yield the investor enjoys only when the bond is held till maturity.

Two shortcomings: first, it assumes that the investor will hold the bond till maturity, which may or may not be the case. Second, it assumes that the coupons received periodically are reinvested for the remaining tenor of the bond at the same rate throughout the tenor. That second assumption implies that interest rates would remain same for the entire tenor and that the rates would also be same across tenors, which means the yield curve would be static and flat.

But it survives because: YTM has its own advantages, the biggest of which being that it is simple and quick computation and hence it is widely used.

Realised Yield

YTM is applicable only when the investor holds the bond investment till maturity and reinvests the coupons at YTM. But what if an investor holds the bond for a period less than the remaining years to maturity and sells it either for a gain or loss? In such cases one needs to calculate the Realised Yield.

The numerator is the sum of accumulated value of the coupons during the holding period invested at the reinvestment rate, and the sale proceeds received from selling the bond at the end of the holding period. The denominator is the purchase price of the bond. This formula gives the annualized return.

The workbook's worked case: ₹1000 invested, held for 5 years against an original maturity of 10 years, sold for ₹1050, coupon 12% paid annually, coupons reinvested at 14%. The answer: 0.130009 or 13%.

And the contrast with HPR: there is another variant of this holding period return, known as "Realised Yield", which is a more appropriate measure of return, which considers compounding and it can be represented as percentage annualised yield.

Duration

Duration measures the weighted average time by which an investor would receive the original amount of money invested in a bond. The present value of the various cashflows of the bond till its term are the weights used in the calculation. Duration is usually less than the term to maturity of the bond. This is usually called the Macaulay's Duration.

Modified Duration = Macaulay's Duration ÷ (1 + y)

When Macaulay's Duration is modified, then it becomes a metric of sensitivity of the price of a bond to changes in interest rates.

Bonds with high modified duration experience greater increases in price when interest rates decline and greater losses in price when rates increase, compared to bonds with lower modified duration.

Duration thus incorporates the tenor, coupon and yield in its calculation, and the three relationships are:

• Higher the time to maturity, higher the duration and hence higher the interest rate risk of the bond
• Lower the coupon rate, higher the duration and hence higher the interest rate risk of the bond
• Lower the yield, higher the duration and hence higher the interest rate risk of the bond

And it changes over time: the duration of a bond is not a static number but will change with a change in the tenor and yield of the bond. As a bond comes closer to maturity, its duration also decreases and makes the bond less risky.

Types of bonds

Zero-Coupon Bonds — bonds which do not pay coupon in their entire term. Such bonds are issued at a discount to their face values and are redeemed at par. The return on these bonds is not in the form of periodic payment of interest but in the form of difference between the issue price and redemption value.

Their risk: while in rupee terms the returns may be same for an investor, inherently, Zeroes carry more interest rate risk due to their higher duration than a coupon paying bond of the same maturity.

Their appeal to issuers: there is no intermittent strain during the life of the bond to make periodic coupon payments. Cash remains within the company, and repayment of the loan would be in one shot as a bullet payment at the maturity.

Examples: Treasury Bills, Commercial Papers and Certificate of Deposits are short-term zero-coupon bonds and are also known as Money Market instruments — money market is that segment of the Debt market in which securities of less than 1 year are issued and traded. ZCBs of very long tenure are issued at a steep discount to their face values. Such ZCBs are also known as Deep Discount Bonds — with IDBI and the Kisan Vikas Patra given as examples.

Floating-Rate Bonds — bonds whose coupon is not fixed but is reset periodically with reference to a defined benchmark, which could be the inflation index or inter-bank rates or call rates. Resetting the coupon periodically ensures that these bonds pay interest that reflects current market rates, so these bonds carry lower interest rate risk or "price risk".

They are especially useful for investors in a rising interest rate scenario, and reset typically every 6 months. In some cases there is a maximum and minimum limit to the coupon rates, referred to as "Cap" and "Floor". Developed markets also have bonds whose coupons move inversely to the benchmark. These are known as "inverse floaters".

Convertible Bonds — issued with the option to investors to convert the amount invested by them into equity of the issuer company. They may be compulsorily convertible or optionally convertible, and fully or partly convertible.

The accounting consequence: on conversion of debt into equity, debt is removed from the balance sheet and equity capital is increased. This dilutes the earning per share of the stock.

Principal-Protected Note (PPN) — aims at providing protection of the principal amount invested, if the investment is held to maturity. Typically, a portion of the amount is invested in debt in such a way that it matures to the principal amount on expiry of the term of the note. The remaining portion is invested in equity, derivatives, commodities and other products which have the potential of generating high returns.

Although this is marketed as a debt paper, it is a synthetic product constructed by financial engineering — combination of debt and derivative structures.

And the warning: it must be clearly understood that principal protection does not mean absence of credit risk. Investors in PPNs are exposed to the credit risk of issuers. Several NBFCs have issued PPNs titled Equity Linked Bonds or Commodity Linked Bonds.

Inflation-Protected Securities — debt instruments, being fixed income products, run the risk of delivering negative real returns during high inflation periods.

Inflation Indexed Bonds (IIB) are a category of government securities issued by the RBI in which both principal and interest are adjusted for inflation. These bonds have a fixed real coupon rate which is applied to the inflation adjusted principal on each interest payment date. On maturity, the higher of the face value or inflation adjusted principal is paid out. The inflation adjustment to the principal is done by multiplying it with the index ratio, which is calculated by dividing the reference index on the settlement date by the reference index on the date of issue. The Wholesale Price Index (WPI) is the inflation measure that is considered.

The retail variant: Inflation-Indexed National Saving Securities-Cumulative 2013, of 10-year tenor, available to retail resident individuals, minors, HUFs, and charities, carrying a fixed interest of 1.5% and an inflation rate calculated on the basis of the Consumer Price Index (CPI). The interest is compounded every six months and cumulated and is payable with the principal on maturity. The fixed rate of interest is the floor and is payable even if there is deflation.

Note the difference in index: IIBs use the WPI; the retail IINSS-C uses the CPI.

Foreign currency bonds and External (Euro) bonds — as in Chapter 2. Masala bonds shift the currency risk to the investor, unlike foreign currency bonds which create currency risk for the issuer. And a practical caution: hedging the foreign currency risks through derivative contracts may remove or reduce the benefits of interest rate differential.

Perpetual bonds — bonds which do not have a stated maturity date. Thus, the issuer does not have any obligation to redeem it. The investors are entitled to periodic coupon. If these bonds are issued with a callability feature, then these bonds can be bought back or called by the issuer at their discretion.

Several banks in India have issued perpetual bonds to raise Additional Tier 1 (AT1) capital as per Basel III norms. The five features that increase their risk:

1. AT1 perpetual bonds do not have a fixed maturity date
2. They are subordinate to deposits, loans from other banks and all other bonds
3. The coupon can be paid only from distributable profits; if the issuer does not have distributable profits, they cannot pay coupon
4. The coupon is non-cumulative
5. The bonds can be converted into equity by the issuer upon the happening of a pre-specified contingent event

Commodity market terminology

Spot Price — the current market price at which a commodity can be bought or sold for immediate delivery, derived based on the supply and demand of the commodity. The commodity derivatives exchanges need spot price information on a daily basis to be used as the basis for the commodity futures contracts, and these prices are used for determining the Final Settlement Price, which is very important in case of cash settlement of any commodity futures or in case of delivery default by a short seller.

Basis = Spot Price − Futures Price. Basis plays an important role in understanding the extent of relation between spot price and futures prices.

Contango — when the futures price is higher than the spot price of an underlying asset, so market participants may expect the spot price to go up in the near future.

Backwardation — when the futures price is lower than the spot price of an underlying, so market participants may expect the spot price to come down in the near future.

Cost of Carry — the cost involved in carrying the commodity from the date of purchase from the spot market till the date of delivery of the futures contract. It involves the cost of storage, insurance, transportation, cost of financing and other relevant costs.

Worked: if the cost of 10 grams of gold in the spot market is ₹1,02,000 and the cost-of-carry is 8% per annum, the fair value of a 3-month futures contract will be F = 1,02,000 + {1,02,000 × 8% × (3/12)} = 1,02,000 + 2,040 = ₹1,04,040.

Delivery — unlike other financial instruments, which are transacted in demat form, commodities are deliverable contracts, which means upon expiry of the futures contract, those contracts are settled through delivery of the commodity between buyer and seller.