Investing in stocks — the ground floor

Equity versus debt

The workbook starts with a simple split. Equity means ownership in a company. Debt means lending money in exchange for fixed interest. The primary difference is the risk–reward ratio: equity typically offers higher returns with greater risk; debt offers stable returns with lower risk.

Stock prices move with company performance, industry trends, economic conditions and market sentiment. That volatility is the risk — and also the source of the reward.

Two ways equity pays you

Capital appreciation — the share price rises and you sell at a profit. Over the long term, equity markets have historically outpaced inflation and other asset classes.

Dividends — companies distribute part of their earnings. Dividends are not guaranteed; they depend on profitability. Companies with a history of consistent dividends are typically seen as financially stable.

Three features of equity

• Residual claim. Equity holders are the last to be paid in liquidation, after all debts and liabilities. Higher risk, but they keep all the remaining profits when things go well.
• Voting rights. Especially common stock holders — electing the board, approving mergers, big decisions.
• Ownership. Unlike debt investors who receive only fixed interest, equity investors have unlimited profit potential.

The three risks of equity

The contrast is with systematic risks — interest rates, inflation, economic downturns — which hit all companies. And note: all the Chapter 1 risks apply to equity too.

Two kinds of diversification

• Cross-sectional diversification — holding equities across different industries, sectors and geographies at a given time.
• Time diversification — staying invested over long periods so ups and downs balance out. "Time in the market beats timing the market."

Diversification works because returns across sectors have lower correlation. Business cycles matter: defensive or recession-proof businesses can thrive in recessions while others lag or lead the recovery.

Equity research: finding intrinsic value

Equity research analyses a company's financial and non-financial information, its sector, competitors and the economy. The goal is to estimate intrinsic value, compare it with market price, and decide to buy, hold or sell.

Fundamental analysis determines intrinsic value from economic factors — future earnings or cash flows, interest rates and risk. The rule:

• Buy if market price is below intrinsic value.
• Sell if market price is above intrinsic value.
• But the gap must be enough to cover transaction costs.

Fundamental analysts believe price may differ from value for a while, but eventually converges to it. Someone who estimates value better than others earns above-average returns by buying undervalued securities.

Top-down and bottom-up

• Top-down — start with the economy, then pick industries, then zero in on companies. This is the EIC order.
• Bottom-up — evaluate a company's prospects and add it if it suits the stated investment objective.

The EIC framework

E — Economy. Analysts check:

From these they judge whether the economy is in expansion, peak, contraction or recession. A positive outlook → move to industry analysis.

I — Industry.

• Life cycle: introduction, growth, maturity, decline. Growth-phase industries offer the best opportunities.
• Demand and supply: high demand plus limited supply gives pricing power.
• Competition: Porter's Five Forces — threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitutes, industry rivalry.
• Regulation: banking and healthcare are heavily regulated.
• Technology: can create new leaders and disrupt old ones.

C — Company.

• Financial statements: revenue and profit growth; high ROE and ROA signal efficient use of capital; low debt means stability; strong cash flows.
• Management quality: track record, vision, decision-making.
• Competitive advantage: brand, unique products, cost leadership.
• Valuation metrics: P/E, P/B, EV/EBITDA.

Price is a fact; value is an opinion

Price comes from the market and is known to all. Value is the result of someone's analysis at a point in time. Because inputs are uncertain, valuation is at best an educated estimate — an art as well as a science. The purpose: judge whether a stock is fairly priced, over-priced or under-priced.

Valuation family 1: Discounted Cash Flow

The value of an investment today equals the sum of expected future cash flows, adjusted for the time value of money. Three models:

The simplest DDM is the Gordon Growth Model: P0 = D1 ÷ (r − g).

FCFF = EBIT × (1 − tax rate) + Depreciation − Capital expenditure − Change in working capital. Then Equity value = EV − Debt + Cash.

FCFE = Net income + Depreciation − Capital expenditure − Change in working capital + Net borrowing.

CAPM: re = Rf + β × (Rm − Rf). A higher beta means higher risk, a higher discount rate, and so a lower present value of future cash flows.

The choice between DDM, FCFF and FCFE depends on dividend policy, capital structure and the nature of cash flows.

Valuation family 2: Asset-based

Used for asset-heavy businesses whose assets appear at close to fair market value — financial institutions, real estate firms, gold, gems and jewellery.

• Value of the firm = adjusted current market values of net tangible, intangible, financial and net current assets.
• Value of equity = value of firm less all outsider liabilities.

The big weakness: it ignores future profits and cash flows and future value creation from research and innovation. Also called Replacement Value — what you would pay to create the business, brand and size.

Valuation family 3: Relative (multiples)

Compare a company's multiples with similar companies, the sector, the market, or its own past.

Non-financial metrics are used too: average revenue per user or per MB (telecom), plant load factor (power), occupancy rates (hotels), footfall (retail).

Technical analysis

Technical analysts assume everything — fundamentals, economy, sentiment — is already reflected in the price. So they do not analyse the business. They study price and volume history to forecast direction. They are sometimes called chartists.

Three essential assumptions:

1. Past prices show the underlying trend and its direction.
2. Volume shows the strength of the trend.
3. The time span observed affects the trend's strength or weakness.

Key tools: support (lots of buying interest) and resistance (lots of selling interest); line, bar and candlestick charts; moving averages to smooth out daily noise. A breakout on strong volume suggests the trend has accelerated; a trend on falling volume may be weakening.

Technical analysis is used for short-term trading, not necessarily long-term investing.