Investing in Stocks — the ground floor

Equity is ownership

Companies raise money in two ways. Equity makes the investor an owner. Debt makes the investor a lender.

Equity shareholders have a residual claim — a claim on what is left after all liabilities are paid. Because they are owners:

• The company is not contractually obliged to repay their money.
• It is not obliged to make periodic payments to them, as it must with interest to lenders.
• They get voting rights. With a sizeable holding, they can participate in management.

Shareholders look for capital appreciation and dividend income. Neither is assured. Dividends depend on profitability; appreciation depends on stock market conditions. Since all residual benefits go to them, equity investors expect a higher return than lenders.

The choice between debt and equity is a trade-off: lower but stable return, or higher return with extra risk. Most investors split their capital between the two based on expected return, time period, risk appetite and needs.

Diversification — two dimensions

Equity is riskier than bonds and many other assets. The most meaningful way to reduce that risk is diversification, and the workbook names two kinds:

• Cross-sectional — hold many kinds of businesses at one point in time, and across geographies.
• Time series — stay invested over a long period, so bad times are cancelled by good times. Hence the advice: "time in the market", not "timing the market".

It works because business sectors behave in relatively less correlated ways. "Don't put all your eggs in one basket."

Behind this sit business cycles:

• Counter-cyclical or defensive businesses may be at their peak when the cycle is in its trough.
• Recession-proof businesses do better in a recession.
• Leading sectors come out of recession faster. Lagging sectors go into recession later.

Risks of equity investment

Impact cost is the percentage price movement caused by a given order size (the workbook uses ₹1 lakh as an example) from the average of the best bid and offer. It is calculated for both buy and sell sides. Thinly traded stocks have high impact cost. Lower impact cost = more liquid.

Other macro factors — inflation, fuel prices, interest rates, growth, slowdown — also move stock markets.

The equity market

Listed investments are more liquid and, because of listing norms, more regulated with better disclosure than unlisted ones. Listing is the process by which companies meeting an exchange's eligibility criteria are admitted for trading.

Preference shares

They rank above equity for dividends and for distribution of net assets on liquidation. They generally do not carry voting rights unless stated. Like debt they often have a fixed dividend; like equity they can be perpetual. So they are called hybrid or blended securities.

These can combine — cumulative participating, non-cumulative non-participating, and so on.

Differential voting rights

The usual principle is "one share, one vote". Shares with DVRs can carry superior voting (several votes per share), inferior voting (a fraction of a vote), or different dividend rights.

• The Companies Act, 1956 was amended in 2000 to permit DVRs.
• Tata Motors was one of the first in India, in 2008: DVRs with 1/10 voting rights and 5% higher dividend than ordinary shares.
• Others: Pantaloon Retail (now Future Enterprises), Gujarat NRE Coke, Jain Irrigation Systems.
• DVRs are popular in the West but have not gained momentum in India.

Size classes

By market capitalisation: ultra large cap, large cap, mid cap, small cap, micro cap. Each has its own risk-return-liquidity profile. Large caps as a group show lower return variability than small caps. Investors can also invest in global equities within RBI's restrictions.

Equity research

The aim of equity research is to estimate a stock's intrinsic value, compare it with market price, and decide to buy, hold or sell.

Sell-side vs buy-side

Fundamental analysis

Intrinsic value depends on economic factors — future earnings or cash flows, interest rates and risk. Buy if market price is below intrinsic value, do not buy or sell if above, after transaction costs. Fundamental analysts believe price may differ from value but will eventually merge with it. An analyst who estimates value better than others earns above-average returns.

Top-down vs bottom-up using the EIC framework (Economy, Industry, Company):

• Top-down: scan the economy → pick industries → zero in on companies.
• Bottom-up: start with company factors → move up to macro factors.

Economy analysis

Fiscal policy — tax cuts encourage spending; removing subsidies or adding tax discourages it. Monetary policy — reducing money supply affects expansion plans and working capital of all businesses.

Analysts track GDP, inflation, interest rates, unemployment, and releases such as WPI, CPI, IIP and GDP growth. Banks and financial institutions are among the most interest-sensitive; pharmaceuticals are less affected.

The stock market is a leading economic indicator — it improves before the economy does, because prices reflect expectations of future activity.

Industry analysis

Different sectors perform differently across the business cycle:

Industry life cycle:

1. Introduction — modest sales, very small or negative profits, small market, high development costs.
2. Growth — market develops, few firms, little competition, high margins. Rapid growth then attracts competitors and margins move toward normal.
3. Maturity — generally the longest phase. Industry growth matches the economy. High competition, normal margins; firms differ by cost control.
4. Deceleration and decline — sales fall as demand shifts; margins squeezed; some firms make losses.

Porter's five forces determine the intensity of competition, and hence profitability:

Company analysis

The final step of top-down. Macro analysis decides how much equity exposure; industry analysis picks industries with above-average risk-adjusted prospects; company analysis finds the best companies in those industries.

Company analysis is not the same as stock valuation. It identifies strengths, weaknesses, opportunities and threats, which feed into intrinsic value. And the workbook's key warning: a good company need not be a good investment — its stock may be trading far above intrinsic value.

Tools:

• Financial statement analysis — P&L, balance sheet, cash flow; ratios compared with industry trends and historical averages.
• SWOT — strengths and weaknesses are internal; opportunities and threats are external (favourable tax, consumer shifts; stringent regulation, big competitor, changing technology).
• Competitive strategy — defensive (deflect competitive forces) or aggressive (use strengths to change them). Porter's two major strategies: cost leadership and differentiation.
• Business model — What does the company do and how? Who are its customers and why do they buy? How does it serve them? "Do I understand the business?" No analyst should move on without answering it precisely.

There are over 6,000 companies listed in India. Better to own a few you understand than many you do not.

Sector-specific parameters:

Estimating intrinsic value

"Price is a fact, but value is an opinion." Valuation is both art and science, and its output is at best an educated estimate. Its purpose is to judge whether a stock is fairly priced, over-priced or under-priced.

Three approaches:

1. Discounted cash flow (DCF)

Most appropriate when you know the stream of future cash flows, their timing, and the discount rate. Core principle: the intrinsic value of any asset equals the present value of future benefits from owning it.

Profits are accounting estimates, not facts, so valuers prefer cash flows:

• FCFF — cash left for lenders and owners after capex and working capital. Discounted at WACC to value the firm.
• FCFE — cash left for owners only. Discounted at cost of equity to value equity.

They are "free" because every other stakeholder — including the business itself, through capex and working capital — has been provided for first.

Since equity is perpetual, analysts forecast confidently for some years, then add a terminal value using a stable growth rate — the workbook suggests long-term GDP growth or inflation as a proxy. Terminal value can also be set with a multiple such as EV/EBITDA or price/ARPU.

Cost of equity comes from CAPM. Cost of debt is the prevailing rate for borrowers of comparable credit quality.

2. Asset-based approach

Used for asset-heavy businesses whose assets are shown near fair market value — financial institutions, real estate, gold, gems and jewellery. Firm value = adjusted market value of net tangible, intangible, financial and net current assets. Equity value = firm value less all outside liabilities. Weakness: ignores future profits, cash flows and innovation.

3. Relative (multiple-based) valuation

Used when the valuer lacks information for DCF and does not trust book values. Take a multiple from comparable firms, average it, and multiply by the target's metric. Assumption: a confectionery company should not be worth more than similar listed confectionery companies.

The numerator is usually Price or Enterprise Value. The denominator can be profits, revenue, cash flow, book value — or non-financial metrics such as ARMB and ARPU (telecom), Plant Load Factor (power), occupancy (hotels), footfall (retail).

Popular multiples:

• P/E — price ÷ EPS. Trailing: last four quarters' EPS. Forward: next four quarters' expected EPS. Current: latest annual EPS. A P/E of 10 means investors pay ₹10 per ₹1 of earnings. Limitations: estimates may be wrong, negative EPS is hard to interpret, ratios change constantly, market P/Es swing with the economy.
• P/BV — price ÷ book value per share. Book value per share = shareholders' equity (excluding miscellaneous assets) ÷ shares outstanding. Price below book means either undervaluation or "value-less" assets / fictitious reserves. Limited by historical cost; widely used for banks and financial services.
• P/S — market cap ÷ last 12 months' sales. Useful when earnings may be manipulated (sales are less prone), for loss-making firms, and for high-volume, low-margin businesses.
• PEG — brings growth into the P/E. PEG of 1 = valued in line with expected EPS growth; below 1 = undervalued; above 1 = overvalued. Only as good as the growth estimate.
• EVA — "economic profit": net after-tax operating profit minus (invested capital × cost of capital).
• MVA — current market value minus capital contributed by investors. Positive = value added; negative = value destroyed.
• EV/EBITDA — EV = market cap of equity + market value of debt − excess cash. Useful for capital-intensive firms not yet profitable at PAT or EBIT level. "No one pays cash to acquire cash."
• EV/Sales — more comprehensive than P/S because it counts debt as well as equity.

Which tool for which sector?

Trading vs transaction multiples. Trading multiples use market prices of completed trades. Transaction multiples use acquisition prices paid by strategic acquirers.

Technical analysis

Technical analysts assume all information is already in the price. They do not analyse fundamentals. They study price and volume patterns to forecast direction. They are also called chartists.

Three essentials: past prices show trend and direction; volume shows the trend's strength; the time span observed affects the trend's strength.

Six assumptions:

1. Price is set by supply and demand.
2. Supply and demand are driven by rational and irrational factors.
3. Price adjustments are not instantaneous — prices move in trends.
4. Trends persist for appreciable lengths of time.
5. Trends change with shifts in supply and demand.
6. Those shifts can be detected in the market's own action.

Support = a level with lots of buying interest. Resistance = a level with lots of selling interest. Near resistance, a holder may book profits. A break of support or resistance on strong volume suggests the trend has accelerated. A trend without volume support may be weak.

Charts: line, bar, candlestick.

Popular rules:

• Trend-line analysis — rising, flat and declining channels.
• Moving averages — the most popular indicator; commonly 5, 10, 30, 50, 100 and 200 days. One simple strategy in the workbook: buy when price is sufficiently below the moving average, sell when sufficiently above.
• Bollinger bands — use the normal distribution. Two standard deviations above the moving average may mean overbought; two below, oversold.

These techniques also apply to bonds, wherever price and volume data exist.

Technical vs fundamental. Fundamental compares intrinsic value with price. Technical ignores fair value, uses historical data, and suits short-term trading rather than long-term investing. Technicians see two advantages: less dependence on financial statements (which miss psychological and non-financial factors), and time saved on data collection.

Corporate governance

Qualitative aspects are as important, if not more. Governance is the cornerstone of evaluating a business. It affects shareholders, employees, customers and society, and is reflected in laws, contracts, listing standards and audit.

Analysts should look at independent directors — qualifications, experience, meeting attendance, contribution — and may interact with them. Good governance can be used as a filter for the investment universe.