Financially Yours – The Finance Guide

Table of Content

Section A: Accounting and ratios

1. Financial Statements 3
2. Liquidity Ratios 4
3. Turnover Ratios 5
4. Profitability Ratios 6
5. Solvency Ratios 7

Section B: Mergers and Acquisitions, Corporate/Business Valuation

1. Types of M&A, Synergies, Services in M&A sector 9

2. Valuation Approaches 12
3. Intrinsic Valuations (Discounted Cash Flow) 12
4. Approaches to value equity: Firm Value and Equity Value Approach 14
5. Steps In DCF 14
6. How to Estimate Cash flows (CF), Discounting Rate (r), Beta, Growth (g), Terminal Value 16
7. Relative Valuations (Comparable and Multiples Approach) 21
8. Commonly used Multiples and Relevance for Industry 22

Section C: Private Equity and Venture Capital

Part A: Financing, Investments and Performance in Private Equity

1. Introduction to Private Equity 24

2. Who Invests in Private Equity 27
3. The Mechanics of Investing 27
4. Management Fees and Profit Incentives 28
5. Private Equity Cash Flows 28
6. Assessing the Performance of Private Equity Investments 29
7. Summary 30

Part B: Portfolio Targeting and Shortlisting

1. De-construct Top Line 31

2. Estimating Volume Growth for The Company 31
3. Estimating Price Growth for The Company 31
4. Getting to The Bottomline 32
5. Estimating Changes in Margins for a Company 32
6. Estimating the Unit Economics of a Company 32
7. Other Important Factors to Consider 32

Part C: Preparation Strategy Based on Past Interviews 34

Section D: Fintech, Derivatives, Credit Risk

1. Fintech Industry – Growth factors 35

2. Derivatives 39
3. Risk 42

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Section E: Addendum

1. Fundamental Analysis for Investing 46

2. Monetary Policy Tools 51
3. Stock Pitch for a company 54
4. Capital Budgeting 63
5. Investment Philosophy 71

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Section A: Accounting and Ratios

Three types of Financial Statements

1. Balance Sheet – A statement of the financial position of an enterprise as at a given date.

It has three major components-

a) Assets – Tangible objects or Intangible rights owned or controlled by an entity as a result of

past transactions or events, which carry probable future benefits.

b) Liabilities – Obligations of the entity to provide service or transfer assets in future as a result
of past transactions or events.

c) Owner’s Equity or Capital – Refers to the interests of the owners in the assets of the
enterprise. It is the residual interest in the assets of an entity that remains after deducting its
liabilities.

Accounting Equation: Total Assets = Total Liabilities + Owner’s Equity

Owner’s
Equity Total
Assets
Total
Liabilities

2. Income Statement – A statement of the financial performance of an enterprise over a given

period. It has major three components-

a) Revenues – Inflows of cash, receivables or other considerations from delivering or producing

goods, rendering services, or other activities that constitute the entity’s ongoing major or central
operations

b) Expenses – Outflows of cash or other considerations from delivering or producing goods or

services that constitute the entity’s ongoing major or central operations. Their benefits do not
extend beyond the accounting period.

c) Gains and losses - increases (decreases) in equity or net assets from peripheral or incidental
transactions.

3. Cash Flow Statement – A statement reporting the entity’s cash inflow and outflow during a
given period. The cash flows are classified under three major heads-

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a) Operating Cash Flows – Includes flow of cash from day-to-day operations of the entity.
b) Investing Cash Flows – Includes flow of cash from the acquisition or sale of property, plant, and
equipment, of a subsidiary or segment, and purchase or sale of investments in other firms.
c) Financing Cash Flows – Includes flow of cash from issuance or retirement of debt and
equity securities and dividends paid to stockholders.

Accounting Process- Record to report (R2R) is a finance and accounting management process that
involves collecting, processing and presenting accurate financial data. R2R provides strategic,
financial and operational feedback on the performance of the organization to inform management
and other stakeholders.

Current assets: include cash and other assets that will be converted into cash or used up within one
year or an operating cycle, whichever is greater.

Non-Current Assets: Assets that do not meet the definition of current assets

Current liabilities: obligations that will be satisfied within one year or an operating cycle, whichever
is greater.

Non-Current Liabilities: Liabilities that do not meet the definition of current liabilities.

Financial Ratios
Financial ratios are created with the use of numerical values taken from financial statements to gain
meaningful information about a company. The numbers found on a company’s financial statements
– balance sheet, income statement, and cash flow statement – are used to perform quantitative
analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return,
valuation, and more.

Uses:
1. Track Company Performance – Determining individual financial ratios per period and tracking
the change in their values over time is done to spot trends that may be developing in a company.
This is an analysis of performance over time.
2. Compare Company Performance - Comparing financial ratios with that of major competitors is
done to identify whether a company is performing better or worse than the industry average.
This is a cross-sectional analysis across different companies.
3. Benchmarking- Companies may set internal targets for what they want their ratio analysis
calculations to be equal to.

Liquidity Ratios
Liquidity ratios are used to indicate a company’s short-term debt-paying ability. Usually, short-term
creditors such as suppliers and bankers are interested in assessing the liquidity of a company. The
most used liquidity ratios are the current ratio and quick ratio.

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1. Current Ratio: It measures a company's ability to pay off its current liabilities (payable within one
year) with its current assets such as cash, accounts receivable and inventories. The higher the
ratio, the better the company's liquidity position.
Current Ratio = Current Assets
Current Liabilities

2. Quick Ratio: Also known as the Acid Test Ratio, it measures a company's ability to meet its short-
term obligations with its most liquid assets and therefore excludes inventories and prepaid
expenses from its current assets.
Quick Ratio = Quick Assets
Current Liabilities

where Quick Assets = Current Assets – Inventories – Prepaid Expenses

3. Cash Ratio: The cash ratio measures a company’s ability to pay off short-term liabilities with cash
and cash equivalents

Cash Ratio = Cash and Cash Equivalents

Current Liabilities

Turnover Ratios
The concept is useful for determining the efficiency with which a business utilizes its assets. In most
cases, a high asset turnover ratio is considered good, since it implies that receivables are collected
quickly, fixed assets are heavily utilized, and little excess inventory is kept on hand.

1. Accounts receivable turnover ratio: The accounts receivables turnover ratio measures the
number of times a company collects its average accounts receivable balance. It is a quantification
of a company's effectiveness in collecting outstanding balances from clients and managing its line
of the credit process. It can be impacted by the corporate credit policy, payment terms, the
accuracy of billings, the activity level of the collections staff, etc.

Accounts Receivable = Net Credit Sale

Turnover Ratio Average Accounts Receivable

2. Inventory turnover ratio: The inventory turnover ratio measures how many times a company’s
inventory is sold and replaced over a given period. It can be impacted by the type of production
process flow system used, the presence of obsolete inventory, management's policy for filling
orders, etc.

Inventory = Cost of Goods Sold

Turnover Ratio Average Inventory

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3. Asset Turnover Ratio: The asset turnover ratio measures the value of a company's sales or
revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of
the efficiency with which a company is using its assets to generate revenue.

Asset = Net Sales

Turnover Ratio Average Total Assets

Profitability Ratios
Profitability ratios measure the income or operating success of an enterprise for a given period of
time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. It also
affects the company’s liquidity position and the company’s ability to grow. Commonly used
profitability ratios are net income margin, return on assets and return on equity.

1. Return on Assets: Return on assets is an overall measure of profitability. It is calculated by dividing

net income by average assets for the period. It shows how effective a company is in deploying
assets to generate sales and eventually profits.

Return on Assets = Net Income (PAT) * 100

Average Total Assets

2. Return on Equity: It is a ratio that measures profitability from the viewpoint of the common
stockholder measuring their ability to earn a return on their equity investments.

Return on Equity = Net Income – Preference dividend * 100

Average Equity

When preferred stock is present, preferred dividend requirements are deducted from net income to
determine income available to common stockholders, and in that case, may be referred to as Return
on common stockholders’ equity.

Another way to look at Return on Equity is Du Pont Analysis. Du Pont chart shows the relationships
between return on investment, assets turnover, and the profit margin. If the profit margin is low or
trending down, the manager can examine the individual expense items to identify and then correct
the problem.

ROE = Net Profit Margin X Total Assets Turnover X Equity Multiplier

ROE = Net Income X Sales X Assets

Sales Assets Equity

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According to DuPont Analysis ROE is affected by
a) Operating efficiency, which is measured by the profit margin

b) Asset use efficiency, which is affected by total asset turnover

c) Financial Leverage, which is measured by equity multiplier (assets/equity)

ROE is prone to three problems:

a) The Timing Problem: Many business opportunities require the sacrifice of present earnings in
anticipation of future earnings. This is true when a company introduces a new product
involving high start-up costs. If we calculate the company´s ROE after the introduction of the
new product, the ROE is low.

b) The Risk Problem: it says nothing about what risks a company has taken to generate its ROE.

c) The Value Problem: ROE measures the return on a shareholder´s investment, but the
investment figure used is the book value of shareholder´s equity, not the market value. a high
ROE may not be synonymous with a high return on investment to shareholders.

3. Earnings per share (EPS) of common stock is a measure of net income earned on each share of
common stock. It is calculated by dividing net income by the number of weighted average common
shares outstanding during the year.

EPS = Net Income

Average outstanding number of shares

Solvency Ratio
It is used to measure an enterprise’s ability to meet its debt obligations and is used often by
prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient
to meet its short-and long-term liabilities.

1. Debt to Total Assets Ratio: It measures the percentage of a company’s assets that are
financed by creditors, indicating the degree of leverage.

Debt to Total Assets Ratio = Total Debt (short term + long term)
Total Assets

2. Debt - Equity Ratio: It is used to compare creditor financing to owner financing. It

demonstrates what proportion of equity and debt the firm is using to finance its assets.

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Debt Equity Ratio = Total Debt

Shareholder’s Equity

3. Interest Coverage Ratio: It indicates the company’s ability to meet interest payments as they
come due. It is a widely used metric by rating agencies while determining the credit rating of
a debt instrument of a company.

Interest Coverage Ratio = Earnings Before Interest and Tax

Interest Expense

4. Debt Service Coverage Ratio: The debt-service coverage ratio (DSCR) is a measurement of a
firm's available operating income to pay current debt obligations. The DSCR shows investors
whether a company has enough income to pay its debts.

Debt Service Coverage Ratio = Net Operating Income

Interest + Principal Obligations

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Section B: Mergers and Acquisitions, Corporate/Business Valuation

Mergers and Acquisition
Consolidation:

Consolidated financial statements are the combined financial statements of a parent company and
its subsidiaries. Consolidated financial statements present an aggregated look at the financial
position of a parent company and its subsidiaries, and they provide a picture of the overall health of
an entire group of companies as opposed to one company's standalone position.

Minority Interest:

A minority interest is ownership or interest of less than 50% of an enterprise. The term can refer to
either stock ownership or a partnership interest in a company. The minority interest of a company is
held by an investor or another organization other than the parent company.

A minority interest shows up just below the shareholder’s equity and above the noncurrent liabilities
on the balance sheet of companies with a majority interest in a company. This represents the
proportion of its subsidiaries owned by minority shareholders.

Example: MN Corporation owns 80% of XYZ Inc., which is a $100 million company. MN records a $20
million as minority interest to represent the 20% of XYZ Inc. it does not own. XYZ Inc. generates $10
million in net income. As a result, MN recognizes $2 million—or 20% of $10 million—of net income
attributable to minority interest on its income statement. Correspondingly, MN marks up the $20
million minority interest by $2 million on the balance sheet. The minority interest investors do not
record anything unless they receive dividends, which are booked as income.

Joint Venture (JV):

A joint venture is an arrangement where two or more independent companies come together to
form a legal undertaking generally for a stipulated period of time or a specific purpose or project. It
may be a temporary or a permanent one. For example, Maruti Ltd. of India and Suzuki Ltd. of Japan
come together to set up Maruti Suzuki India Ltd.

A JV is different from a merger in a way that the operations of a JV are different from the core
operations of the co-ventures. This creates a distinction in the businesses of the companies. In the
case of a merger, all the businesses are merged together without any distinction.

Associate:

An associate is an entity over which the investor has significant influence.

Significant influence means the power to participate in the financial and operating policy decisions
of the investee but is not in control or joint control of those policies. Significant influence is usually
acquired by purchasing more than 20% of voting power but less than 50%.

Merger:

A merger is a combination of two companies to form a single independent company where both
companies cease to exist independently and the shareholders have their shares in the old company
exchanged for an equal proportion of shares in the merged entity. Example- Vodafone merging with
Idea.

Acquisition:

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Involves the purchase of an entity that continues to operate, but does so under the control of the
acquirer. Takeover can take place with or without the support of the management and board of the
target company. Example- Shell acquiring BG Group

Essentially both mergers and acquisitions are methods used to achieve strategic objectives. In
practice, the terms merger, acquisition and takeover are often used interchangeably.

Synergy
The motive behind an M&A deal is to achieve some synergies. A synergy is any effect that increases
the value of a merged firm above the combined value of the two separate firms. In basic terms,
synergies mean that 1+1 > 2

Various types of Synergies

Revenue Synergies Cost Synergies Capital Synergies

Description Recurring synergies from Recurring synergies from Primarily capex and working capital
incremental increases in realized cost savings across reductions. Tax benefits are in
revenues compared with corporate functions addition to balance sheet synergies.
standalone companies
Importance in Usually regarded as an add-on The central argument in many Typically, only a minor role, high
Deal Decision to cost synergies transactions importance in specific sectors, such
as financial institutions.
Synergy Cross-selling General & Admin costs Inventory reductions
Breakdown Pricing Procurement and COGS Financing terms
Additional distribution Sales & Marketing costs Better capital allocation
Innovation R&D costs Elimination of duplicate capex
Other operating costs Tax optimization
Ability to
control
achievement Low High Low High Low High
Time to
achieve
Fast Slow Fast Slow Fast Slow
Costs to Low for the rollout of One full run rate of synergies, Renegotiation of financing terms can
Achieve products on existing platforms on average incur costs
Dis-synergies possible Includes contract termination Tax optimization might require cost
costs for external advice.
What services does a company offer to clients in M&A

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What is an IPO?

Initial Public Offer (IPO) - An initial public offer of shares or IPO is the first sale of a corporation’s
common shares to common public at large. The main purpose of an IPO is to raise equity capital for
further growth of the business. Eligibility criteria for raising capital from public investors are defined
by SEBI in its regulations and include minimum requirements for net tangible assets, profitability and
net worth.

Why do companies raise capital?

General corporate process- working capital, operating expenses, capex

Research & Development- develop a new product or service

Organic Business Growth- growing the business organically

Future Acquisitions- generate capital to acquire another business

Debt Repayments- recapitalization to pay off existing debt

IPO Process

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Corporate/Business Valuation
Valuation: Approaches
Different valuation models are used to value the financial and non-financial assets of a company. It is
necessary to know the various models of valuations and what drives the value in each case. All models
can be classified under 2 broad approaches:

Intrinsic Valuation
Relative Valuation
In this valuation, the
Value of an asset or
present value of Valuation the company is
expected future Approaches determined by
cashflows from the
looking at the price
assets is evaluated to
of comparable assets
reach the valuation.
relative to common
Discounted cash flow Intrinsic Relative variable(s) like
model and dividend Valuation Valuation earnings, cashflows,
discount model are
book value, sales,
examples for Intrinsic
Relative Valuation number of products
Valuation.
etc.

Markets are always inefficient, they either overvalue or undervalue securities. However, in the long
run, prices are set to correct themselves. By calculating the fair value, investors evaluate if securities
are over-valued or under-valued and make buy and sell decisions.

Intrinsic Valuations (Discounted Cash Flow)

Intrinsic Valuation is also called Discounted Cash Flow model (DCF). It is the present value of all the
future cash flows an asset can generate.

The idea behind the approach is that people would value the asset only based on its future cash-
generating ability.

3 major elements are estimated for DCF:

1. Life of the asset (n)

We need the life of an asset to know how long the asset can give us cash flows
2. Cashflow of the asset (CF)
To ascertain this, we generally calculate the growth (g) of the cash flows of the years
3. Discount Rate applicable (r)
This is to ascertain the present value of the assets

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Different DCF Models

Zero Growth Model
(CF is constant)
On the basis of
Cashflows
Constant Growth Model
growth, DCF can (g is constant)
be divided into
various models. Differential Growth Model
(Nothing is constant)

Zero Growth:

Here, it is assumed that the cashflows received are constant over the years. For example Every year a
company pays out INR 10 as a dividend for n years.

Value = D
r

Constant Growth Model

Here, it is assumed that the cashflows received are growing at a constant over the years. For example,
Company starts by paying out INR 10 as a dividend and increases it by 10% every year for n years.

Value = D1__
r-g

Differential Growth Model

This is the model which is closest to reality. Here, it is assumed that the cash flows change every year
for some years before assuming a constant growth rate till perpetuity.

Value = CF1__ + CF2__ + CF23__ +…. CFn__

(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n

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Approaches to value equity

Firm Value Approach

Equity Value Approach
(PV is value of the entire
(PV is value of equity claim
firm and reflects the value
on the Firm)
of all claims on the firm)

Cash flows (CF) that are Cash flows (CF) that are
considered are cashflows considered are cashflows
from assets, prior to any from assets, after debt
debt payments but after payments and after firm
firm has reinvested to has made reinvestments
create growth assets needed for future growths

Discount Rate (r) reflects

the cost of raising both Discount Rate (r) only
debt and equity financing reflects the cost of raising
in propotion if their use i.e. equity financing
WACC

Steps in DCF

Estimate the rate or rates to use in the valuation. Discount rate

can either be Cost of Equity or Cost of Capital

Estimte the current earnings and cash flows on assets. Cash flow
can either be CF to Equity of CF to Firm

Estimate the future earnings and cash flows on the firm being
valued, generally by estimating an expected growth rate in
earnings

Estimate when the firm will reach "stable growth" and what
characteristics (risk and cash flow) it will have when it does

Choose the right DCF model for the asset and value it

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How to Estimate Cash flows (CF)

Cashflows

Firm Valuation Equity Valuation

Approach Approach
(FCFF) (FCFE)

Free Cash Flow to Firm (FCFF)

This is a broader definition of cash flow wherein we look at not just the equity investor in the asset,
but at the total cash flows generated by the asset for both the equity investor and the lender. This
cash flow, before debt payments but after operating expenses and taxes, is called the cash flow to the
firm (FCFF) This can be calculated by any of the flowing methods:

FCFF = CFO - Capital Expenditure + Interest (1-Tax)

FCFF = Net Income + D&A + Interest (1-Tax) - Capital Expenditure -

Investment in non-cash WCF

FCFF = EBIT (1-Tax) + D&A - Capital Expenditure - Investment in

non-cash WC

FCFF = EBITDA (1-Tax) + (D&A*Tax) - Capital Expenditure -

Investment in non-cash WC

Where, Net Capital Expenditure = Capex – D&A

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Ways to calculate FCFF-

Free Cash Flow to Equity (FCFE)

These are the cash flows generated by the asset after all expenses and taxes and after payments due
on the debt. This cash flow, which is after debt payments, operating expenses, and taxes, is called the
cash flow to equity investors (FCFE)

FCFE = EBIT - Interest - Tax + D&A - Capital Expenditure -

Investment in non-cash WCF + Net Borrowings

FCFE = Net Income + D&A - Capital Expenditure - Investment in

non-cash WCF + Net Borrowings

How to Estimate Discounting Rate (r)

The cost of capital or discounting rate (r) is the minimum return expected by whoever is providing the
capital for a business.

We use the Cost of Equity (Ke) for discounting FCFE under the Equity valuation approach & Cost of
Capital (WACC) for discounting FCFF under the Firm valuation approach.

Key Terminologies

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Cost of Debt (kd) •Return expected by debt providers

Cost of Equity (ke) •Return expected by equity shareholders

•Calculation of firm's cost of capital in which kd and ke are

WACC propotionately weighted

•Measure of the systematic risk of an asset compared to market

Beta risk

•Rate of return of an investment with zero (or negligible) risk,

Risk Free Rate (rf) eg: govt. bonds

WACC or Cost of Capital

WACC = ke * E__ + kd (1-t) * D__
(E+D) (E+D)

Weight Weight
of Equity of Debt

Cost of Equity
The capital Asset Pricing Model (CAPM) is the most commonly used model to estimate the cost of
equity. As per CAPM,

Ke= rf + (rm – rf) * Beta

Where, rm = Estimated market return (%)

rm – rf = Market risk premium
Beta = Beta of the stock
rf = Risk-free Rate

Cost of Debt
The cost of debt is the rate at which you can borrow, it will reflect the firm’s default risk and the level
of interest rates in the market.

The two most widely used approaches to estimating the cost of debt are:

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1. Yield to Maturity (YTM) on a straight bond outstanding from the firm: This has limited use as very
few firms have long-term straight bonds that are liquid and widely traded
2. Estimating a default spread based upon the rating: The limitation of this approach is that different
bonds of a firm have a different ratings. Generally, the median rating is used as the cost of debt.

Estimating Beta
There are 2 approaches to calculating Beta:

1. Top-Down Approach

Beta is the covariance between the return on an asset and the return on the market portfolio divided
by the variance of the market. This is the top-down approach to calculating beta.

2. Bottom-Up Approach

Instead of calculating beta from regression directly (top-down approach), sometimes bottom-up beta
is used.

The bottom-up beta is a better estimate than the top-down beta because

1. The standard error of the beta estimate will be much lower

2. The betas can reflect the current (and even expected future) mix of businesses that the firm is in
rather than the historical mix

The bottom-up beta can be estimated by doing the following:

Find out the businesses that a firm operates in

Find the unlevered betas of other firms in the industry. Find regression betas of publicly traded firms in each of these businesses.
Compute the simple average across regression betas to arrive at an average beta for these publicly traded firms.

Unlever this average beta using the average debt to equity ratio across the publicly traded firms in the sample

Take a weighted (by sales or operating income) average of these unlevered betas of different business

Lever up using the firm’s debt/equity ratio

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Beta is determined by 3 factors:

1. Industry in which the firm operates

The more sensitive a business is to market conditions, the higher its beta
2. Degree of operating leverage
High fixed cost relative to total cost-high is operating leverage. High operating leverage results in
higher beta
3. Degree of financial leverage
High financial leverage leads to high beta

Beta is of 2 types

Beta

Levered Unlevered
Beta Beta

Unlevered Beta

• The beta of an unleveraged firm (unlevered beta) is determined by the type of business and
operating leverage. This is also called Asset beta.
• Since different companies have different financial leverage (i.e., different D/E), if we want to
estimate the beta of the asset (irrespective of how it is financed), it is known as Unlevered beta.

Levered Beta

• The beta of a leveraged firm (levered beta) is determined by the riskiness of the business & its
financial leverage. It is expected that firms that face high business risk should be reluctant to
take on financial leverage
• From the below relationship below, it is obvious that the higher the Debt proportion – the higher
will be the Beta of a company

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How to estimate growth (g)

There are 3 methods to estimate growth in earnings:

1. History:
The historical growth in earnings per share is usually a good starting point for growth estimation
2. Competitors:
Analysts estimate growth in earnings per share for many firms. It is useful to know what their
estimates are.
3. Fundamentals:
Finally, all growth in earnings can be traced to two fundamentals - how much the firm is
investing in new projects, and what returns these projects are making for the firm.

Fundamentals Approach

1. When looking at growth in operating income [NOPAT i.e., EBIT(1-t)], the definitions are

• Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t)

• Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity-Cash)
• The expected Growth rate in Operating Income = Reinvestment Rate * ROC

2. When looking at growth in earnings per share, these inputs can be cast as follows:

• Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio (b)

• Return on Investment = ROE = Net Income/Book Value of Equity

Expected growth in earnings (g) = b * ROE

Where, b = retention ratio

ROE = Return on equity

Terminal Value
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash
flows forever. Since we cannot estimate cash flows forever, we estimate cash flows for a “growth
period” and then estimate a terminal value, to capture the value at the end of the period

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Estimating Terminal Value

When a firm’s cash flows grow at a constant rate forever, the present value of those cash flows can
be written as:

Terminal Value = _FCFFn+1_ or _FCFEn+1_

WACC-g Ke-g

(In firm valuation) (In equity valuation)

Points to remember while calculating terminal g

• The stable growth rate cannot exceed the growth rate of the economy
• in practice, cash flows for an explicit period are estimated for not more than 10 years
• The reinvestment rate and growth rate in a stable period should be in sync with each other

Summary of Formulas
Firm Value Approach Equity Value Approach

where, where,
TV: Terminal Value PT: Terminal Value
WACC: Weighted average cost of capital Ke: Cost of equity

Relative Valuations (Comparable and Multiples Approach)

What is Relative Valuation?

The “value” of any asset can be estimated by looking at how the market prices “similar” or
‘comparable” assets. The idea behind relative valuation is the price of an asset is whatever the
market is willing to pay for it and that the intrinsic value of an asset is impossible (or close to
impossible) to estimate.

To understand relative valuation in layman's terms, let us take an example. You want to estimate the
value of your office.

The area of your office is 5000 sq. ft. Let’s say you don’t have any other information but you come to
know that a similar office in your immediate neighbourhood was sold for Rs. 4.5 Crore a few days
back. The only difference between your office and the other one is of area.

The area of another house is 4500 sq. ft vs 5000 sq. ft of your house. Using this, we can say that
value of your house is approximately Rs. 5 Crore.

This is a case of relative valuation where:

• Your office – the asset you want to value

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• Neighbour’s house – Comparable

• Price per sq. ft (Rs. 10000 per sq. ft) – Multiple

What do you need to calculate the Relative Value of an asset?

1. An identical asset, or a group of comparable or similar assets

2. A standardized measure of value (in equity, this is obtained by dividing the price by a common
variable, such as earnings or book value)

How to calculate Multiple:

Multiples are just a standardized measure of price. The numerator is what you are paying for the
asset (e.g., Market value of equity / firm value/enterprise value) while the denominator is what you
are getting in return (eg. Revenue / Earnings / Cash flow / Book value)

__Value___
Multiple =
Value Driver

Can be re-written as:

Value = Value Driver * Multiple

Some commonly used multiples are:

• EV / book value
• Enterprise value / EBITDA
• EV/ Sales
• EV/EBIT
• Price Earnings Ratio: Market price per share / Earnings per share
• PEG Ratio: PE ratio/ Expected Growth Rate in EPS
• Price to book ratio: Price / Book Value of assets

Enterprise value multiples are not affected by the capital structure and hence better to use

Relevant Multiples

S.No. Multiple Why is it used

1 EV / Revenue Used for unprofitable or fast-growing companies or as a
reference
2 EV / EBITDA Widely used
3 EV/(EBITDA-Capex) Used for capital-intensive industries
4 EV/ EBIT Widely used
5 EV / Free cash flows Increasingly used – focuses on cash generation, only good for
mature firms
6 P/E Widely used, but impacted by capital structure and accounting
issues
7 Price / Book Value Used for balance sheet-driven companies (e.g., banks,
insurance, real estate)
8 EV / Rooms Used for Hotels
9 EV/Subscribers Used for telecom, publisher, cab (user) companies

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Practical Use of certain Variables

P/E EV/EBITDA P/BV P/S

• Building and • Building and • Banks • Automobiles
Construction Construction
• Engineering • Metals and Mining • Paper • Defence (E/S)
• Defence • Chemicals • Engineering
• Healthcare • Engineering • Luxury Goods
• Oil and Gas • Defence
• Luxury Goods • Food Produces
• Technology • Healthcare
• Utilities • Leisure
• Telecom
• Transport

Types of Comparable

Trade Comparables Transaction Comparables

Transactions that have occurred in

the recent past are considered as
You select public traded multiples. When acquiring control
(>50% equity stake), trading comps
companies in same may not be the best indicator of
industry as comparables value as a few new elements like
control enter the picture.

Intrinsic Valuation V/S Relative Valuation

Intrinsic Valuation Relative Valuation

Market mistakes in intrinsic value take a longer Market mistakes in relative valuation are
time to correct and hence are considered more corrected more quickly as they stand out
suitable for investors with a longer horizon
Harder to do as it requires many explicit In relative valuation also, you make
assumptions. Also, can be manipulated to give assumptions. Only thing is that here, the
the value one wants assumptions are implicit
Less exposed to market perception and moods Hugely driven by market sentiment
More difficult to explain to a layperson Easier to explain to a layperson

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Section C: Private Equity and Venture Capital

PART A: Financing, Investments and Performance in Private Equity

1. Introduction to Private Equity

A private equity investment can occur at virtually every stage of a company’s life cycle. Four
common subclasses of private equity are:

Types of
Private Equity
Venture
Capital
Leveraged
Buyout
Mezzanine
Debt
Distressed
Debt

Venture capital (“VC”) is an important source of financing for start-up companies or those in the
early process of developing products and services that do not yet have access to public funding by
means of stock offerings or debt issues. Most VC investments are in rapidly growing companies, with
a heavy concentration on the technology or life sciences sectors.

There are several stages of VC investing, which often mark financial and/or operational milestones
for the VC-backed company. As these companies grow and proceed from one round of financing to
the next, their valuations often increase. These rounds are often referred to as series A, B, C and so
on.

Generally, early-stage VC investors seek to acquire relatively large ownership interests in their
portfolio companies to maximize the proceeds they receive at exit value. The risk associated with
venture capital is heightened by the fact that the companies may have little or no track record. VC-
backed companies may have unproven management teams and products and may be generating
very little in terms of revenues or earnings.

Leveraged Buyout

A leveraged buyout also referred to as a “buyout” or “LBO,” is a strategy that typically involves the
acquisition of a relatively mature business, from either a public or private company. As the name
implies, leveraged buyouts are financed with debt, commonly in the form of bank debt or high-yield
bonds. Typically, these securities, especially the high-yield bond portion, are either rated below
investment grade or unrated.

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Strategies among LBO firms can differ considerably. Some focus on consolidating large, fragmented
industries. This is also known as a “buy-and-build” strategy. By contrast, other firms focus on
turnaround or operational improvement situations. There are also “growth-oriented” LBO firms that
will purchase unwanted business units, such as a division of a larger corporation that is deemed
nonessential to the core business or parent company.

Mezzanine Debt

Mezzanine debt occurs when a hybrid debt issue is subordinated to another debt issue from the
same issuer. Mezzanine debt has embedded equity instruments attached, often known as warrants,
which increase the value of the subordinated debt and allow greater flexibility when dealing with
bondholders. In practice, mezzanine debt behaves more like a stock than debt because the
embedded options make the conversion of the debt into stock very attractive.

Mezzanine debt bridges the gap between debt and equity financing and is one of the highest-risk
forms of debt. It is senior to pure equity but subordinate to pure debt. However, this means that it
also offers some of the highest returns when compared to other debt types. Mezzanine financing is
typically employed to help finance leveraged buyouts when lower-cost financing alternatives, such
as high-yield debt, are not available.

Distressed Debt

Distressed debt private equity firms typically buy corporate bonds of companies that have either
filed for bankruptcy or appear likely to do so in the near future. There are two distinct strategies
within distressed debt investing.

The first strategy is often referred to as “debt to control,” where an investor seeks to gain control of
a company through a bankruptcy or reorganization process. Using this strategy, the investor first
becomes a major creditor of the target company by purchasing a company’s bonds or senior bank
debt at steeply discounted prices. The distressed debt investor’s status as a creditor gives the
investor the leverage needed to make or influence important decisions during the reorganization of
a company—a process that may ultimately enable a company to emerge from bankruptcy
protection.

As part of this process, distressed debt firms will exchange the debt obligations of a company in
return for newly issued equity in the reorganized company, often at very attractive valuations. This
type of distressed debt investing is often used as a relatively “cheap” means of taking control of
companies that have good assets, but have too much debt on their balance sheets. An example in
India would include Piramal India Resurgence Fund (India RF)

The second primary distressed debt investment strategy is a trading strategy (commonly employed
by hedge funds) in which an investor purchases distressed debt and seeks to profit as the underlying
company recovers and its debt appreciates. This strategy hinges on the investor’s ability to identify
companies that are currently in financial distress, but look likely to recover in the near future.

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How Investors Profit from Distressed Debt Investing (shown in chart)

Identify Good
Companies with Bad
Balance Sheets

Accumulate Debt at
Discounts to Par

Debt Defaults
Control company by
converting debt to equity
at low entry valuation
Exit through IPO or sale

Debt Recovers
Earn high current cash
return and gain on
principal until sale or
maturity of debt

Structural Advantages of Private Equity Vs Public Equity (Enunciated in the table below)

Consideration Private Equity Public Equity

Due diligence » Access to proprietary information » Access to public filings
Portfolio company capital » Optimized for particular company and » Subject to public market norms
structure situation
Control of investment » Typically, full control or significant » Proxy voting
influence; hands-on and heavy board
involvement
Investor value-added » Access to resources such as capital » Typically, passive investing,
capabilities markets expertise, industry contacts, although larger institutional
senior management recruiting and growth shareholders can exert
capital influence
Time horizon » Commitment to long-term value creation, » Short-term pressure to meet
no public market pressure quarterly earnings can
compromise long-term goals
Exit options » IPO, M&A, dividend recapitalization, » Sell at market
secondary (fund-to-fund) transactions

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2. Who Invests in Private Equity

In the 1980s, commitments to private equity funds were made primarily by institutions. Today public
and private pension funds, foundations, and endowments tend to allocate anywhere from 6-13% of
their portfolios to private equity, depending on their risk-return objectives and their need for
liquidity.

CONTRIBUTION PERCENTAGE OF GLOBAL PRIVATE EQUITY CAPITAL COMMITMENTS BY

INVESTOR TYPES

Others Include - Corporate Investors, Superannuation Schemes, Government Agencies, Investment

Companies, Family Offices

3. The Mechanics of Investing

The mechanics of private equity investing are illustrated in the figure below. Most private equity
investors access the asset class through capital commitments to private equity limited partnerships.
These limited partnerships then make direct investments in companies or funds (e.g., funds of funds).

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General Partner/Limited Partner Relationship

The manager of a partnership is called the “general partner,” while the individuals and institutional
investors who provide the majority of the capital are called the “limited partners.” Typically, the
general partner will also contribute at least 1% of the total commitments raised to the partnership,
and principals of the firm may also invest additional personal capital in the fund.
The general partner is responsible for reviewing investment opportunities and has authority over
investment decisions. Limited partners have no discretion over investment decisions and do not take
part in day-to-day management activities.

Capital Calls

In a private equity partnership, capital is drawn down from the limited partners in a series of events
known as “capital calls.” Private equity managers generally only call capital when they are ready to
make an investment. Calling capital without making an investment, acts as a “cash drag” on
performance.

Since fund managers are compensated on performance, they are motivated to closely match capital
calls with their investment pace. The period of time in which the partnership is allowed to make new
investments is called the “investment period. Most funds have five- to six-year investment periods
that begin once operations commence. Limited partners are contractually obligated to honour their
capital calls as dictated by the terms of the limited partnership agreement

4. Management Fees and Profit Incentives

In most private equity partnerships, a general partner receives a management fee and a percentage
of the profits or “carried interest.” Typical management fees run between 1.5% and 2.5% of total
capital commitments per year during the commitment period.

The management fee is charged on “invested capital”. In addition to a management fee, a general
partner will also earn a carried interest, which is a profit incentive for the general partner (typically
20% of gross profits, although some firms take as much as 30%). The carried interest is intended to
provide the manager with the bulk of its compensation and helps align its interests with those of the
limited partners.

Many funds also have a “preferred return” feature, which is the minimum IRR that the manager
must generate for investors before sharing in profits. The preferred return ensures that the private
equity manager will share in the profits of the fund only to the extent that the investments perform
at a minimum “acceptable” level, commonly 7-8% for LBO funds. If a manager does not exceed the
fund’s specified preferred return, it is not entitled to take its carried interest.

5. Private Equity Cash Flows

In the early years of the life of a fund, the cash flows are predominantly negative for investors as
cash is called by a partnership. In the latter years of a fund, cash begins to flow back to investors in
the form of distributions from realized investments, assuming that portfolio companies are sold and
profits are realized. The typical holding period for a portfolio company investment in a private equity
fund is three to five years before it is realized. Prevailing economic and capital market conditions will
also influence the holding period.

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Hypothetical Cash Flow of A Private Equity Partnership

Note: This chart is provided for illustrative purposes only and is not reflective of any actual fund or
investment. The chart assumes a 1.9x return multiple over ten years, which represents an IRR of
15.2%.

6. Assessing the Performance of Private Equity Investments

Two metrics are typically used to assess the performance of private equity investments: the internal
rate of return (“IRR”) and the cash-on-cash return multiple.

Internal Rate of Return

Strictly defined, the IRR is the discount rate that sets the net present value of a series of cash flows
equal to zero. Using an IRR allows investors to measure the performance of a series of periodic
uneven positive and negative cash flows. This feature is especially relevant in the context of private
equity investing because capital is drawn down and invested over time (negative cash flows) with
distributions paid out over time (positive cash flows). This contrasts with many traditional
investments that consist of one lump-sum investment and one cash-out, which tends to make
performance calculations

Despite its advantages, the IRR does have several drawbacks. It places too much weight on
investments that return capital after short investment periods, even if the absolute dollar returns lag
behind those of their peers

Another drawback is the lack of an industry-standard in computing IRRs. Different private equity
firms may use slightly different methodologies in computing their investments’ IRRs. Even a small
change in the methodology can have a dramatic impact on the results.

Return Multiple

As an alternative to the IRR, the return multiple corrects one of the main IRR drawbacks: placing too
much weight on early distributions. Return multiples are simply a calculation of the monies invested
versus the monies returned, which is not sensitive to the timing of distributions

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However, the return multiple also has a drawback: it fails to take into account a basic premise of
investing—the time value of money, or the fact that a dollar today is worth more than a dollar
tomorrow due to inflation and the opportunity cost of tying up capital in investments.

Interpreting Private Equity Performance

We think it is prudent for investors to use both the IRR and return multiple together in evaluating
performance. A high IRR generated by “quick hits” is not typically a sustainable investment strategy
that produces long-term wealth. Similarly, a high return multiple is not attractive if it takes an undue
amount of time to generate. Striking a balance between the two metrics may be a sensible way to
think about performance measurement.

Years 1 2 3 4 5 Annual Return

IRR Multiple
Cash Flows
Investment ($25) ($75) $145 $0 $5 36% 1.5x
A
Investment ($50) ($50) $75 $25 $100 31% 2.0x
B

Based on the above table, an investor who evaluated the two sample investments strictly on the basis
of their IRRs would prefer Investment A to Investment B. However, on closer examination, Investment
B generates 100% more “cash profit” than Investment A (i.e., a return multiple of 2.0 times versus a
return multiple of 1.5 times), even though Investment B's IRR is five percentage points lower.

In our view, neither investment is technically “better” than the other: selecting between the two
choices may depend on an investor’s personal circumstances and access to other opportunities. For
example, an investor who had continuous access to fast-returning investments might prefer
Investment A so that the proceeds could be reinvested quickly into other high-returning
opportunities. But, if not, Investment B might be more attractive, its lower IRR notwithstanding.

7. Summary

Private equity investing can play an important role in a well-diversified portfolio. It seeks to achieve
excess risk-adjusted returns through value-added investing that exploits market dislocations and
unique business opportunities. Private equity investments have significantly outperformed the
broader public equity markets over 10- and 20-year trailing periods and have the potential to
provide investors with the opportunities to diversify their portfolios outside of traditional markets.

However, because of the nature of private equity investments, extreme care and diligence should be
taken when making such investments. Information is less widely disseminated; risks can be difficult
to evaluate and investments may be illiquid for many years. These characteristics highlight the
importance of accessing this asset class through experienced and diligent private equity teams.

Investing in this asset class is intended for investors who are willing to bear the high economic risks
of the investment in pursuit of superior returns. Of course, past performance is no guarantee of
future results and real results may vary

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PART B: Portfolio Targeting and Shortlisting

1. De-Construct Top Line

Referring to the breakup given in the company’s investor presentation could be a good indicator of
the relevant criteria for the company & the industry.

2. Estimating Volume Growth for The Company

A useful check is to verify the growth projection with the historical growth rates of the company to
see whether they are reasonable. In case the short-term growth projection involves recovery from
COVID-19, have supporting data facts to show the pace of recovery.

3. Estimating Price Growth for The Company

A list of illustrative (non-exhaustive) factors to be considered for estimating a change in prices is:

• Market share/ market positioning: Different peers may occupy different positions in the market
and pricing growth will depend on yield growth in the segment rather than the overall market
• Product functionalities vs competitors: Product functionalities may vary across peers and the
yield improvement may depend on growth in customer segment rather than the overall market
• Capacity utilization: Higher utilization peers may command more pricing power than lower
utilization players
• Inflation expectation: Inflation expectations can influence pricing indirectly by pushing costs
up/down
• Margin-based pricing: For non-differentiated products and services, the product may be priced
on a cost + margin basis. For those categories, cost drivers will explain the margins
• Other factors: competitive dynamics, IP protection on innovation, demand sensitivity in the
market, number of intermediaries in the marketing chain

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4. Getting To The Bottomline

5. Estimating Changes in Margins for a Company

Split each cost head into the maximum level of detail available and compare it with industry figures
to identify key differences in cost structure between various companies. This could point to a
sustainable competitive advantage for the company.

6. Estimating The Unit Economics of a Company

A good way of summarising the business model of the company is to estimate the unit economics of
a company wherein one establishes profitability at the unit level. The unit could differ based on the
industry. For illustrative purposes, unit economics for the cement industry.

Key Pointers:

• In addition to estimating the profitability per unit, do estimate the unit Return on Capital
employed based on estimates of capital investment required for setting up a capacity of 1
tonne/ bag of cement
• Triangulate it with other metrics like NPV, IRR and payback period at a unit level, which would
help in furthering your business understanding
• Analysing differences in unit economics between competitors could help in quantifying the
competitive advantage enjoyed by the company in relation to its competitors

7. Other Important Factors to Consider

• Working capital – understand the working capital cycle of the industry (in terms of receivables,
inventory and payable days) – see how the company can improve the cycle. Understand how
much investment in working capital is required each year
• Fixed assets – understand the committed and likely investment in fixed assets by the firm, and
also the nature of the expenditure – whether it is replacement capex or capex for expansion
• Leverage – understand the extent of leverage by the firm in terms of – Debt to Equity, Debt to
EBITDA, Interest Coverage and DSCR – this can show if there are chances that the company can
come into immediate distress and if the company has the capacity to expand by leveraging more
• Dupont Analysis – This tool is a way to break down the Return on Equity and helps in identifying
the return drivers of the company

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PART C: Preparation Strategy Based on Past Interviews

Overall, the candidate needs to demonstrate a strong grasp of both the operational and financial
side of the business, especially how the two relate to each other (e.g., How would an asset-light
strategy show up on a P&L).

Elements of both PE+IB preparation are recommended. Other specifics are detailed below:

Technical/Industry Knowledge

Detailed understanding of all drivers for industry and company. Granular understanding of what
moves revenues, costs and multiples for the chosen industry and how firms are positioned within
the industry

• Strong grasp of FRA and Corporate Finance (Ashwath Damodaran videos on Intrinsic Value and
Relative Valuation)
• A structured response to “How to Evaluate an investment opportunity”
• What-if scenarios – similar to a consulting case (in shorter form)

About the Industry

• Different stages and rounds

• Difference between Angel funding, VC Funding and PE funding, LBO and Distressed Debt
• Difference between PE, VC, Asset Reconstruction Companies, etc.
• The capital structure of the PE funds and their investors
• Assessing PE Performance
• Private Equity and Public Equity Comparison

GENERAL AWARENESS

• Major PE funds in India and their investing philosophy. Some Examples are British International
(CDC), The Rohatyn Group, Piramal Alternatives, Multiple Alternatives, GEF Capital, Baring Asia
Private Equity
• Latest Deals and Funding rounds (optional but preferable) – Use deals in ET Prime and venture
intelligence resources in Library
https://www.ventureintelligence.com/dealsnew/index.php?value=1/

COMPANY-SPECIFIC QUESTIONS

• Portfolio of the company and recent deals

• One portfolio company you would invest in, one portfolio company you would not invest in
• View on the Private Equity sector (in case of a sector-specific PE)

HR QUESTIONS

• Why PE?
• Do you invest? (If not) How can we trust you to manage investors’ money if you are not
confident investing your own money?
• Strong probing questions on the company/industry where you have worked in the past. Be on
top of the financials of key players in the industry
• What are your key weaknesses/strengths?
• The ability to do quick mental math is appreciated in PE interviews

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Section D: Fintech, Derivatives, Credit Risk

Fintech is a portmanteau of financial technology that describes an emerging financial services sector
in the 21st century. Originally, the term applied to technology applied to the back-end of established
consumer and trade financial institutions. Since the end of the first decade of the 21st century, the
term has expanded to include any technological innovation in the financial sector, including
innovations in financial literacy and education, retail banking, investment and even crypto-currencies
like bitcoin.
The term financial technology can apply to any innovation in how people transact business, from the
invention of digital money to double-entry bookkeeping. Since the internet revolution and the mobile
internet revolution, however, financial technology has grown explosively, and fintech, which originally
referred to computer technology applied to the back office of banks or trading firms, now describes a
broad variety of technological interventions into personal and commercial finance. According to EY's
Fintech Adoption Index, one-third of consumers utilize at least two or more fintech services and those
consumers are also increasingly aware of fintech as a part of their daily lives.

Reasons For Growth of the Fintech Sector

1. Unbanked Population
The country had an unbanked population of approximately 19 Crore people out of a population of 120
Crore people. This is the second largest number followed by China. This has presented opportunities
to take on the untapped market and provide people with banking solutions

2. Low Insurance Penetration

The country had a very low insurance penetration, especially in the non-life insurance segment. Major
fintech corporates were able to remove the hindrance of agents and provide people with low-cost
insurance with high convenience.

3. Suboptimal Portfolio
More than 88% of the wealth of the citizens of the country was earlier invested in safe financial
instruments such as Bank FDs. With the rise in awareness of people and platforms such as Zerodha
which have made the entire process much easier, there has been a sharp increase in retail investors.

4. Financial Inclusion and Government Initiatives

The government has launched various initiatives such as DBT, and PM Bima Yojana to promote
financial awareness among people and to introduce them to the banking industry. Initiatives such as
Jan Dhan Yojana have led to an increase in the depositors in the rural parts which have led to a way
for financial products specifically for these customers.

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Evolution
of Startups

Payments Insurance Lending Wealth Regulatory

Who are the Users

B2B (Business to Business)
Obtaining loans from banks for capital financing has been one of the primary tasks for most
businesses. But with the advent of fintech, businesses can easily get loans, financing, and other
financial services through mobile technology. Additionally, cloud-based platforms and even customer-
relationship management services like Salesforce (CRM) - provides B2B services that allow companies
to interact with financial data to help improve their services.
B2C (Business to Consumer)
Cash apps like PayPal, Venmo and Apple Pay all allow clients or customers to transfer money via the
internet or mobile technology, and budgeting apps like Mint allow customers to manage their finances
and expenses. Much of the banking industry's first forays into fintech were focused on B2C
applications like lending and payment services Moreover, a noticeable shift toward mobile banking,
better availability of information, data, and more accurate analytics and decentralization of access are
some of the trends that are bound to create opportunities for all user groups to interact in heretofore
unprecedented ways.

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Monetisation Model

Fintech Landscape in India

In India, the rise of fintech companies has been primarily responsible for the formidable changes that
happened in the banking and financial sector since the global financial crisis of 2008. Fintech has,
among others, enabled cost optimisation, and improved customer interaction and ease of
transaction. Since 2010, fintech has played a crucial role in unbundling banking services from a
centralised system, setting payments, performing maturity transformation, sharing risk, and allocating
capital. Fintech players function as the fourth segment of the Indian financial system, alongside large
and mid-size banks, small finance banks, and regional, rural and cooperative banks.

In 2020, India continued to lead fintech investments in the Asia Pacific region, raising US$ 2 billion
across 121 deals. PhonePe alone raised US$ 788 million across three transactions. The following year,
the segment saw exponential growth in funding, receiving over US$ 8 billion across various stages of
investment. The National Association of Software and Service Companies (NASSCOM) 2020 report had
predicted that India would have 50 tech unicorns (of all kinds) by the end of 2021, but in fact, it
surpassed that number and produced 16 fintech unicorns by June 2021. Globally, there have been 187
fintech unicorns, of which 18 are in India. Most of them, including the exponentially growing mobile
wallets, are complementing existing financial service providers rather than replacing them.

The strength of India’s fintech industry is evident from the diversity of its fintech base. A few years
ago, the payment and alternative finance segment constituted over 90 per cent of India’s investment
flows; by 2020, SaaS fintech saw investments of US$ 145 million, while insurance fintech got US$ 215
million. Most of the new players have not received seed funding but straightway began raising funds
through public rounds. They have re-bundled a variety of financial services under a single umbrella,
monetising the data and user base. Many are providing products and services at the same time. Pine
Labs, for example, which was primarily a POS/payment gateway firm has now added new value-added
services for merchants, rewards and loyalty points, consumer financing, neo-banking as well as
merchant lending. Similarly, Yono, which was primarily a digital banking platform, now also provides
pre-approved consumer loans, insurance, and e-commerce.
Fintech companies in India are focusing on lending to both retail customers and micro, small and
medium enterprises (MSMEs). The ecosystem includes a variety of new services including real-time
payments, faster disbursal of loans, investment advisory, insurance advisory and distribution, and
peer-to-peer lending that traditionally required human capital.

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Key Investment Highlights

1. Global fintech investment was US$210 billion across a record 5,684 deals in 2021 – up from
US$125 billion across 3,674 deals in 2020.
2. Payments remained the hottest area of fintech investment in 2021, with US$51.7 billion in
investment globally.
3. Record levels of investment were seen in blockchain and crypto (US$30.2 billion), cybersecurity
(US$4.85 billion) and wealth tech (US$1.62 billion) in 2021.
4. Other fintech areas also saw robust funding in 2021, including insurance (US$14.4 billion), regtech
(US$9.9 billion).
5. Cross-border fintech M&A deal value more than tripled year-over-year – to $36.2 billion. Total
fintech-focused M&A deal value rose from US$76 billion in 2020 to US$83.1 billion in 2021.
6. PE funding to fintech more than doubled from its previous high – with US$12.2 billion in
investment in 2021 compared to a peak of US$5.2 billion in 2018.
7. VC investment in fintech globally more than doubled year-over-year – from US$46 billion in 2020
to a record US$115 billion investment in 2021. Median VC deal sizes grew significantly for all deal
stages between 2020 and 2021, including Angel and Seed US$1.4 million to US$2.2 million), Early
Stage (US$4.6 million to US$7 million), and Late Stage (US$12.7 million to US$24.6 million).
8. Total fintech investment in the Americas reached US$105 billion in 2021, including a record
US$64.5 billion in VC funding. The US accounted for US$88 billion in total funding and US$52.7
billion in VC funding. EMEA saw US$77 billion in fintech investment in 2021, including a record
US$31.1 billion in VC funding. Fintech investment in the Asia-Pacific region almost doubled – from
US$14.7 billion in 2020 to US$27.5 billion in 2021.
9. Corporate VC investment in fintech was incredibly robust in 2021 at US$50 billion, with both the
Americas (US$29.7 billion) and EMEA (US$11.3 billion) seeing record levels of investment.

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Derivatives
A derivative is a security that derives its value from the value or return of another asset
or security.
A physical exchange exists for many options contracts and futures contracts. Exchange-
traded derivatives are standardized and backed by a clearinghouse.

Forwards and swaps are custom instruments and are traded/created by dealers in a
market with no central location. A dealer market with no central location is referred to
as an over-the-counter market. They are largely unregulated markets and each contract
is with a counterparty, which may expose the owner of a derivative to default risk (when
the counterparty does not honour their commitment).

Derivatives

Exchange Over the

Traded Counter

Futures Options Forwards Swaps

Forward Contracts
• In a forward contract, one party agrees to buy and the counterparty to sell a physical or financial
asset at a specific price on a specific date in the future.
• A party may enter into the contract to speculate on the future price of an asset, but more often
a party seeks to enter into a forward contract to hedge an existing exposure to the risk of asset
price or interest rate changes. A forward contract can be used to reduce or eliminate uncertainty
about the future price of an asset it plans to buy or sell at a later date.
• Neither party to the contract makes a payment at the initiation of a forward contract. If the
expected future price of the asset increases over the life of the contract, the right to buy at the
forward price (i.e., the price specified in the forward contract) will have a positive value, and the
obligation to sell will have an equal negative value. If the expected future price of the asset falls
below the forward price, the result is the opposite and the right to sell (at an above-market
price) will have a positive value.
• The party to the forward contract who agrees to buy the financial or physical asset has a long
forward position and is called the long.
• The party to the forward contract who agrees to sell or deliver the asset has a short forward
position and is called the short.

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• In a cash-settled forward contract, one party pays cash to the other when the contract expires
based on the difference between the forward price and the market price of the underlying asset
(i.e., the spot price) at the settlement date.

Futures Contracts

• A futures contract is a forward contract that is standardized and exchange-traded.

• A clearinghouse is a counterparty to all futures contracts. Forwards are contracts
with the originating counterparty and therefore have counterparty (credit) risk.
The government regulates futures markets.
• A major difference between forwards and futures is futures contracts have standardized
contract terms. For each commodity or financial asset, listed futures contracts specify
the quality and quantity of assets required under the contract and the delivery procedure
(For deliverable contracts). The exchange sets the minimum price fluctuation (called the
tick size), daily price move limit, settlement date, and trading times for each
contract.
• The long has agreed to buy the asset at the contract price at the settlement date, and the short
has agreed to sell at that price. The number of futures contracts of a specific kind (e.g., coffee
beans for June delivery) that are outstanding at any given time is known as the open interest.
Open interest increases when traders enter new long and short positions and
decreases when traders exit existing positions.
• Each futures exchange has a clearinghouse. The clearinghouse guarantees traders in the
futures market will honour their obligations. The clearinghouse does this by splitting each
trade once it is made and acting as the opposite side of each position. The clearinghouse
acts as the buyer to every seller and the seller to every buyer. By doing this, the
clearinghouse allows either side of the trade to reverse positions at a future date without
having to contact the other side of the initial trade. This allows traders to enter the
market knowing that they will be able to reverse or reduce their position. The guarantee
of the clearinghouse removes counterparty risk (i.e., the risk that the counterparty to
trade will not fulfil their obligation at settlement) from futures contracts.
• Each day, the margin balance in a futures account is adjusted for any gains and losses in the
value of the futures position based on the new settlement price, a process called the mark to
market or marking to market. The initial margin is the amount that must be deposited in a
futures account before a trade may be made. The initial margin per contract is relatively low and
equals about one day’s maximum price fluctuation on the total value of the assets covered by
the contract.
Maintenance margin is the minimum amount of margin that must be maintained in a
futures account. If the margin balance in the account falls below the maintenance margin
through the daily settlement of gains and losses (from changes in the futures price),
additional funds must be deposited to bring the margin balance back up to the initial
margin amount.

Differences between Forwards and Futures

FORWARDS FUTURES
Private contracts Traded in active secondary markets
Customised Standardised
Less regulation, greater counterparty risk More regulated, backed by a clearinghouse

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Swaps
• Swaps are agreements to exchange a series of payments on periodic settlement dates over a
certain time period (e.g., quarterly payments over two years).

• At each settlement date, the two payments are netted so that only one (net) payment is made.
The party with the greater liability makes a payment to the other party.

• The length of the swap is termed the tenor of the swap and the contract ends on the
termination date.

Swaps are similar to forwards in several ways:

1. Swaps typically require no payment by either party at the initiation.

2. Swaps are custom instruments.
3. Swaps are not traded in any organized secondary market.
4. Swaps are largely unregulated.
5. Default risk is an important aspect of contracts.
6. Most participants in the swaps market are large institutions.

In the simplest type of swap, a plain vanilla interest rate swap, one party makes fixed-
rate interest payments on a notional principal amount specified in the swap in return for
floating-rate payments from the other party. In a plain vanilla interest rate swap, the party who
wants floating-rate interest payments agrees to pay fixed-rate interest and has the pay-fixed side of
the swap. The counterparty, who receives the fixed payments and agrees to pay variable-rate
interest, has the pay-floating side of the swap and is called the floating-rate payer. The payments
owed by one party to the other are based on a notional principal that is stated in the swap contract.

Options
• An option contract gives its owner the right, but not the obligation, to either buy or sell an
underlying asset at a given price (the exercise price or strike price).
• While an option buyer can choose whether to exercise an option, the seller is obligated to
perform if the buyer exercises the option.
• The owner of a call option has the right to purchase the underlying asset at a specific price for a
specified time period.
• The owner of a put option has the right to sell the underlying asset at a specific price for a
specified time period.
• The price of an option is also referred to as the option premium.
• American options may be exercised at any time up to and including the contract’s
• expiration date.
• European options can be exercised only on the contract’s expiration date.
• The seller of an option is also called the option writer. There are four possible options for
positions:
1. Long call: the buyer of a call option—has the right to buy an underlying asset.
2. Short call: the writer (seller) of a call option—has the obligation to sell the
underlying asset.

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3. Long put: the buyer of a put option—has the right to sell the underlying asset.
4. Short put: the writer (seller) of a put option—has the obligation to buy the
underlying asset.

Arbitrage

Arbitrage is an important concept in valuing (pricing) derivative securities. In its purest sense,
arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding a portfolio of
assets that produces a certain (riskless) return, then an arbitrage opportunity exists.

Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until
they affect supply and demand enough to bring asset prices to efficient (No-arbitrage) levels.

There are two arbitrage arguments that are particularly useful in the study and use of derivatives.

The first is based on the law of one price. Two securities or portfolios that have identical cash flows
in the future, regardless of future events, should have the same price. If A and B have identical
future payoffs and A is priced lower than B, buy A and sell B. You have an immediate profit, and the
payoff on A will satisfy the (future) liability of being short on

The second type of arbitrage requires an investment. If a portfolio of securities or assets will have a
certain payoff in the future, there is no risk in investing in that portfolio. In order to prevent
profitable arbitrage, it must be the case that the return on the portfolio is the risk-free rate. If the
certain return on the portfolio is greater than the risk-free rate, the arbitrage would be to borrow at
Rf, invest in the portfolio, and keep the excess of the portfolio return above the risk-free rate that
must be paid on the loan. If the portfolio’s certain return is less than Rf, we could sell the portfolio,
invest the proceeds at Rf, and earn more than it will cost to buy back the portfolio at a future date.

Credit Risk

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations. It is the risk to earnings or capital arising from a counterparty’s failure to
meet the terms of any contract with the lender. Traditionally, it refers to the risk that a lender may
not receive the owed principal and interest.

Credit risk can be measured by the 5Cs of the credit framework-

1. Character – What is the business, and reputation of the organisation as well as the owners? Is
the client trustworthy and honest? What are his savings/investment habits? Past offences.
2. Capacity – Will the business generate adequate cash flows to be able to repay debt and interest
payments? The lender looks at the profitability margins and cash flows of the borrower under
this criteria.
3. Capital – Check the existing capital structure i.e. the proportion of debt and equity of the
borrower. Also, check the existing financial situation of the borrower
4. Collateral – What is the amount and type of collateral that the borrower is providing? Are those
assets liquid or not? More the collateral lesser the risk.

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5. Conditions – External conditions that can negatively impact the borrower. PESTEL analysis and
Porter’s 5 forces can be done to assess the same. Check the industry and macroeconomic factors
such as GDP growth rate, inflation, interest rates, consumer spending etc.

Expected loss = Probability of default X Loss given default X Exposure

The probability of default depends on 2 factors –

1. Ability to pay 2. Willingness to pay

Exposure is the maximum potential loss a lender may incur if the borrower defaults. Basically, it
means the outstanding principal amount of the loan

The Probability of Default (PD) is the probability of an Obligor defaulting (Credit Event) on some
obligation.

Loss-given default (LGD) is the amount of money a financial institution loses when a borrower
defaults on a loan, after taking into consideration any recovery, represented as a percentage of total
exposure at the time of loss.

How do we measure credit risk?

Credit ratings are the most commonly used key parameter to measure and monitor exposure. Higher
the rating lesser the probability of default. The ratings are provided by various agencies such as
Moody’s, S&P, and Cibil.

There are qualitative and quantitative factors to assess the creditworthiness of the clients-

Qualitative methods –

1. Look at the Balance Sheet whether it is diversified or not. Does a major portion of assets of the
client include unfavourable assets such as cryptocurrency? Thus we look at the mix of assets and
the percentage of total assets in each segment. We have to also look at the authenticity of the
assets, and the usefulness of the asset as a source of repayment or collateral.
2. Look at the cash flows – Cash Flows should be stable and adequately diversified. We should look
at recurring cash flows. There should not be any duplication of sources.
(Note- For high net-worth individuals, the main sources of cash inflows are dividends, interest
income and salaries. The major outflows are income tax payments, interest payments and living
expenses.)
3. Transparency – What are the sources of financial information? How much extra information is
the client providing willingly? Identify the sources of income and cash flows of the client. Check
whether the assets are located in a single country or in multiple countries. How much
percentage of the assets are verified?
4. Contingencies- Check for obligations that are not fully detailed or are omitted like public
settlements, impending divorce and pending lawsuits. Take a comprehensive look to determine
if the borrower has any obligations that are not fully detailed or may be omitted. This can be in
the form of contingent debt, pending lawsuits, personal guarantees impending divorces etc.

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Quantitative methods –

In quantitative analysis, various ratios are used to assess the creditworthiness of the borrower. The
major ratios applicable for lending to high net-worth individuals are -

Interest coverage ratio = EBIT / Interest expenses

Difference between Debt service coverage ratio and interest coverage ratio –

The difference between DSCR and the interest coverage ratio is that the interest coverage ratio only
covers interest expenses. In reality, cash outflows include the principal amounts too which are
covered in DSCR. Coming to the numerator Interest Coverage ratio takes EBIT (which is not a pure
cash figure) whereas DSCR takes net recurring cash flow. Coming to the denominator, the Interest
coverage ratio takes into account only interest payments whereas DSCR covers interest plus
principal as well.

Verified assets – Borrowers claim an amount that they possess in assets. However, that amount is
subject to verification by an official from the lender. The higher the percentage of verified assets, the
better it is.

Encumbered assets –

• Encumbered security or asset is owned by one entity, but there is also a legal claim to that
asset by another entity.
• These claims may be due to the owner of the asset owing money to a creditor who uses that
asset as collateral.
• Encumbered assets are subject to restrictions on their use or sale.

Thus, assets can be grouped into 4 categories-

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Encumberance

Collateral -

Ideal collateral should be easy to value, liquid, less prone to periods of boom and busts and should
be controllable.

Given below is a list of assets for collateral in order of preference from lender points of view-

1. Cash / CDs
2. Diversified marketable securities
3. Concentrated stock position
4. Life insurance, Diversified hedge funds
5. Jets and yachts
6. Commercial real estate, fine arts
7. Private Equity
8. Unsecured loans
9. Pre – IPO

Covenants –

Contractual expectations are agreed upon by the lender and borrower. These tell the dos and don’ts
to the borrower.

If violated, the lender can ask for full repayment of debt or negotiate remedial actions. Example of
positive covenants (Do’s) –

• The borrower has to maintain a debt-equity ratio of xx.

• The borrower has to maintain a minimum net worth of xx

Example of negative covenants (Don’ts)-

• The borrower can’t raise additional debt or sell assets without the prior consent of lenders.

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Section E: Addendum
Fundamental Analysis
What is Fundamental Analysis?

Fundamental Analysis is like peeling an onion layer-by-layer to understand the true value of a stock.
Here, we scrutinize the stock by understanding the company's current financial position, earnings, and
future business prospects. This evaluation or analysis is done from the perspective of a long-term
investor. Here, one is concerned about the long-term gains based on the ability of a company to stay
afloat, capitalize on their strengths and materialize their potential in the coming future rather than
basing their investments on short-term gains due to market hype or change in temporary economic
conditions.

The true value or intrinsic value of a stock is calculated by assessing various qualitative and
quantitative factors that include understanding the economy, the industry, the competitors and the
company itself. There are two kinds of valuation – Intrinsic and Relative. Intrinsic valuation consists of
understanding the stock’s true price through the expected returns of the company; one popular
method is DCF – Discounted Cash Flows. This involves the investor making a lot of assumptions in
terms of growth rate, discounting rate, tax, interest expense, etc. Relative valuation consists of peer-
to-peer comparison in the same industry.

How is Fundamental Analysis different from Technical Analysis?

Both of these approaches are used by investors to analyse and make decisions about investments,
here are the differences between the two:

Points of Difference Fundamental Analysis Technical Analysis

Philosophy It assumes that a market may It assumes that historical trends
misprice a security in the short term help understand future market
but it will reflect its underlying price behaviour. It is not concerned with
in the long term. the intrinsic value of any firm.
Focus Primarily looks at the intrinsic value Focuses on historical price, stock
of a company by assessing its movement and volume data to
financial health, competitive predict future trends and potential
position, business model, price. The approach remains the
management, future growth, and same for all kinds of assets traded
other economic factors. in the secondary market, and there
is no individual effort put in to
study each stock separately.
Time Horizon Typically done for long-term Often used for short-term trading
investments as it is concerned with (period can be as small as minutes)
the underlying value of a company. to get gains based on stock price
Investors hold onto these movement in the secondary
investments for an extended market, as it relies on trends in the
period. immediate price action.

Management of Risk The risk of an investment can be Tools such as stop loss (setting a
evaluated by assessing the ceiling on loss that can be borne by

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company’s financials, business investors) are used post-analysis to

model, market position, etc. manage financial risk.
Tools for assessment Financial statements, annual Charts, technical indicators
reports, economic indicators, (moving averages, candlesticks
macro factors. Information patterns), resistance and support,
overload could also lead to analysis volume data.
paralysis.

How to select a company

There are two approaches to selecting a company, a top-down approach and a bottom-up approach.

The top-down approach helps an investor methodically and holistically select the shares they want to
invest in. It incorporates consideration of macroeconomic factors and makes them better positioned
for overall portfolio risk by facilitating strategic asset allocation across various industries with good
potential. However, this approach also has demerits of its own. It limits flexibility and requires a great
deal of study. It also focuses more on large-cap stocks and less on smaller companies with limited
resources. Therefore, one might lose out on some gems that belong to a not-so-attractive industry.

The Bottom-up approach involves spending a lot of time on a particular stock and analysing all the
financial statements, products, market dominance, etc. Here, industry and economy are analysed as
a part of stock analysis and not as a filter. This approach helps in identifying companies that are
outperforming even when economic conditions are not favourable. It also requires a lot of hit and trial
effort in picking out stocks to analyse without any prior basis. Unlike the top-down approach, it does
not help in managing overall portfolio risk across industries.

Understanding the Economy (E)

This includes delving deep into the current state of the economy and critically analysing the macro
factors such as GDP, employment, interest rates, taxation, etc. One can also use the PESTLE
Framework (Political, Economic, Social, Technological, Legal, Environmental) to understand the
aspects of the current business environment. The goal is to find out the outperforming sectors/
industries given the current market conditions.

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Industry Analysis (I)

Upon shortlisting promising industries based on macro factors, one can evaluate the industry through
the following metrics:

- Porter’s Five Forces: For an ideal industry, the bargaining power of customers should be low,
the bargaining power of suppliers should be low, there should be limited threat of new entrants
and substitutes and lastly, the competitive rivalry should be low. It is to be noted that it is almost
impossible to find such an industry that checks all these boxes, an investor should look for a
healthy favourable mix of these forces.

- Regulations operating the industry: An industry could be favoured by the regulations imposed
because of its economic, social or environmental impact. One should go over these regulations
and changes to understand the industry’s growth potential. For example, the introduction of
biodiesel and mandates around the same will significantly impact the ethanol industry.
- Growth drivers for the industry: Such drivers ensure the relevance of the industry in the future
also the pace at which it could grow in the coming years.
- Industry size: One can look into whether an industry is operating at a desired market size or is
currently at a nascent stage. Another crucial aspect to consider is the stage in the industry life
cycle, i.e. introduction, growth, maturity and decline. This helps an investor chart the potential
future trajectory for the industry.
- Industry Challenges: It is essential to evaluate the challenges an industry faces, and whether
they could be mitigated in the long term or hinder its growth significantly.

Company Analysis (C)

There are extensive qualitative and quantitative components of Fundamental Analysis that are
examined to understand the true price or the true potential of a stock/company.

Quantitative Components:

(All these components can be used for relative valuation across competitors)

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- Financial Analysis: This includes studying the last 7-10 years of financials to understand how
well the company has been performing in the industry across time and across
peers/competitors. Through this analysis, one evaluates the financial strength, performance
and overall stability of a company.
-
Step 1: Assess profitability: The first step is to analyse the profitability i.e. net profit ratio, and
gross profit ratio. Good companies should carry a decent profit ratio, the difference between
net profit and gross profit ranges across different industries.

Step 2: Analyse Revenue trends and operating margins: A rational investor would expect
increasing sales and consistent and considerable operating margins (if not increasing) over the
last 5-7 years. This ensures stable performance that is likely to continue in the future. Evaluating
sales trends is especially important when a company is in negative profits. There are a lot of
new-age companies that are showing promising increases in sales and are on the verge of hitting
break-even/profits.

Step 3: Evaluate Financial Stability: This is done by examining assets, liabilities and equity to
ensure the company’s ability to make its short-term and long-term obligations i.e. its exposure
to financial risk. It can be assessed by checking debt levels, liquidity and contingent liabilities.
Some ratios like Debt to Equity, Current Ratio, etc. can be used.

Step 4: Analyse cash flows: It is an essential step to understand how the company looks after its
operating, investing and financing activities.

- Ratio Analysis: Ratios such as ROCE (Return on Capital Employed), and ROE (Return on Equity)
help understand long-term expected gains and capital structure decisions of the company. A
working capital analysis (quick ratio, liquid ratio) clarifies how efficiently the company is
managing its short-term assets and liabilities. The operating cycle and cash conversion cycle can
further be looked into to assess how well the company is managing its working capital to
generate sales and profits.

- Segment Analysis: This would consist of evaluating the product mix delivered by a company
and the kind of customers it is targeting through the same. A changing product mix indicates
the products and customer segments that the management is focusing on. Different products
have different profit margins and a change in product mix can impact profitability. Focus on a
very niche customer base with limited products might not guarantee ever-increasing sales.

Qualitative Components:

- Business Model: A business model is a framework through which a company creates, delivers
and captures value. It describes core aspects of how the business generates revenue, optimizes
its costs and sustains over time. It is crucial for one to examine the business model of the
company. Some important questions are – How is the business model of the company different
from its competitors? Is the business model sustainable? Are there any potential challenges that
can arise in this model? Is the business model flexible for future growth? Is the business model
replicable? Is there any threat of major disruption due to changing customer tastes and
preferences, technology, etc?

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- Moat: Moat refers to a sustainable competitive advantage that creates a barrier and protects
the company from any possible threats of losing market share to new entrants or existing
competitors. This ensures that the company will always remain a going concern. Some elements
of Moat are – cost leadership, brand strength, network effects, switching costs, regulatory
advantages, intellectual property, economies of scale, and distribution channels.

- Management of the Company: Management plays a pivotal role in any business. It is important
for a company to have a management with a decided vision and mission in their minds to lead
the company. It is also vital for the management to have a decent public image, through which
the shareholders can connect to the company. One should check management’s interviews with
journalists or at various forums to look at the company from their point of view. The company’s
Annual Report’s MD&A (Management’s Discussion and Analysis) section and investors’ con-call
transcripts provide insight into the direction that management wants to take the company
forward. The management should also be stable, regular change in the Board of Directors or
CXOs does not bode well for the company and reduces investor confidence.

- Growth story: A robust growth narrative can contribute to a company’s overall value and
attractiveness to investors. The growth story highlights the connection between growth and
enhanced earnings. Investors are attracted to companies that have the potential to expand their
market presence and guarantee an ongoing demand for their products/services. Additionally,
companies with a diversified and well-executed growth strategy may be better equipped to
mitigate certain risks. To sum it up, this should be a story about how this stock is likely to
outperform investor expectations, leading to a higher intrinsic value than the current market
price.

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Monetary Policy Tools Used by RBI

Monetary Policy concerns with the supply/control of money. It consists of actions taken by the
Central Bank to manage the money supply in pursuit of macroeconomic goals. Money is required to
run the economy, but both excess and shortage of it are bad for the economy and polity. Monetary
Policy intends to achieve this balance by regulating Money supply, influencing economic growth,
interest rates, borrowing and price level.

Maintaining price stability (by keeping inflation in control) and Reducing unemployment (growth
requires credit at a reasonable rate) are the most important goals of monetary policy.

Relationship between money supply and inflation:

Inflation is a general increase in the prices of goods and services in an economy over a period of
time. The rapid increase in money supply/ money incomes with the public, which exceeds the supply
of goods and services causes inflation. With people having more money in their hands and supply
remaining fixed, ‘too much money chases too few goods and prices are driven up. Thus, the
monetary policy comes into the picture, where with the help of the below-mentioned tools, the
central bank changes the interest rates, which in turn determines the money supply in the economy
and ultimately leads to inflation being in control.

Recently, we have seen how the RBI has increased interest rates to get inflation under control. The
retail inflation based on the Consumer Price Index (CPI) dropped to 6.7 per cent in July 2022 after
touching a record high of 7.8 per cent in April 2022. This, however, still remained above the RBI’s
comfort level of 6 per cent. Hence, RBI Maintained its stance of increasing CRR to get it in control.

Cash Reserve Ratio: The cash Reserve Ratio is the mandatory percentage of shares a bank has to
keep with the Reserve Bank of India in liquid cash to combat inflation and keep liquidity in check. It is
the ratio of a bank’s cash holdings with RBI to its total deposit liabilities. Banks hold CRR with the RBI
and no interest is earned on the balance held. If RBI wants to reduce the money supply, it increases
the CRR and vice versa. With increased rates, banks would not have adequate funds to lend, forcing
them to lend at higher interest rates. Higher lending rate discourages people from borrowing, hence
leading to controlling inflation.

The main defect of the CRR mechanism is that an increase in CRR has undesirable effects on a bank’s
profits. However, since changing the CRR involves no interest cost to the government, it remains a
favourite option in India.

Statutory Liquidity Ratio: Statutory Liquidity Ratio is the share of a bank’s deposits kept with RBI in
the form of Liquid assets to ensure the bank’s solvency and money flow in the economy. The
government imposes an obligation on the banks to use a proportion of cash to buy government
securities. When the RBI wants to reduce the money supply, it increases the SLR limits and vice
versa.

Bank Rate: Based on the monetary policies, commercial banks can take loans from the central bank
for the long term. The interest rate charged by the RBI on these long-term loans and advances to the
banks is known as the bank rate. If the bank rate is high, then banks are discouraged from borrowing
funds from RBI against which they can advance loans. Moreover, a rise in Bank rates is usually

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followed by a rise in interest rates banks charge on their loans as they see it as a signal that RBI
intends to reduce the money supply.

The bank rate is one of the central bank’s primary tools for providing a long-term liquidity window to
the banks and acting as a lender of last resort. When a bank is in trouble (for example: due to a bank
run), this becomes a guaranteed source of emergency funds. Thus, when a bank makes use of this
source of funds, it opens itself to significant speculation about its financial health.

Repo Rate: The Repo Rate is the interest rate at which RBI lends money to the banks for a short
term. With the help of the Repo Rate, RBI can regulate the inflation and liquidity of the economy of
the country. The repo mechanism is a versatile and popular instrument for injecting or absorbing
short-term liquidity. A hike in repo rate discourages banks from borrowing from RBI and hence leads
to banks having fewer funds to lend, ultimately leading to a lesser money supply in the economy.

Reverse Repo Rate: Reverse Repo Rate is the rate at which commercial banks give loans to the RBI.
Reverse Repo Rate helps to regulate the money supply in the economy. A hike in the reverse repo
rate (which is always below the repo rate) encourages banks to park money with RBI when they are
unable to lend it. By parking money with RBI, banks earn some interest rate. In the absence of this,
the banks have to keep the money that they are unable to lend to them, without any interest
earning.

Marginal Standing Facility Rate: The rate at which the scheduled banks can borrow funds overnight
from RBI against government securities. In case there is a shortage of government bonds to keep as
collateral, the banks can avail of the Marginal Standing Facility.

Rates as of 11.11.23:

Cash Reserve Ratio 4.5%

Statutory Liquidity Ratio 18%
Bank Rate 6.75%
Repo Rate 6.50%
Reverse Repo Rate 3.35%
Marginal Standing Facility Rate 6.75%

Exchange Rate

The exchange rate between two countries is the price at which residents of the country trade with
each other. It is the price/ value of one currency (home currency) expressed in terms of another
currency (foreign currency). It is usually quoted as the number of units of domestic currency (Indian
Rs) required to purchase a unit of foreign currency (US $).

Types of Exchange Rate System:

Fixed Exchange Rate System – Also called the Pegged exchange rate system, exchange rates are set
at officially determined levels rather than by free market forces, and maintained through frequent
forex market intervention. The purpose of this system is the maintain a country’s currency value
within a narrow band and to allow for more predictability and stability of the currency value. More

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predictability and stability help attract foreign investment and give foreign businesses more
confidence to invest.

Having good forex reserves works in favour of countries adopting the fixed exchange rate system.
China is one of the famous countries adopting this fixed exchange rate system.

Flexible Exchange Rate System - Also called the Floating exchange rate system, it is a system in
which the central bank allows the exchange rate to adjust to equate supply and demand for foreign
currency. The hallmark of this system is the determination of the exchange rate with almost no or
less intervention from the central bank. Central Banks intervene if the situation demands, but not to
the extent under a fixed system.

Ideally, the Forex reserves should be adequate to cover 3 to 4 months of imports ( India currently
has reserves to cover 8 to 10 months of imports). A country should have forex exchange to cover/
pay for 100% of short-term ( having maturity of 1 year or less) external debt.

•Nominal Exchange Rate is the relative price of the currencies of two countries.

•Real Exchange Rate is the relative price of the goods of two countries. It tells us the rate at which
we can trade the goods of one country for the goods of another.

• It is inversely related to trade balance. For example, if domestic goods are relatively cheap, the
demand for imported products will be low as well as the quantity of net exports will be high.

How Policies Affect Real Exchange Rate

•Fiscal Policy at home: If the government reduces national savings by increasing government
purchases or cutting taxes, the amount of domestic currency available to be invested abroad
reduces. This makes the domestic currency more valuable leading to a rise in exchange rates.

•Fiscal Policy Abroad: If the foreign government increases government purchases or cuts taxes, this
reduces world savings and raises the world interest rates; the increase in world interest rates
reduces domestic investment. The overall change in policy raises the supply of domestic currency to
be invested abroad and makes it less valuable leading to a fall in exchange rates.

•Shifts in Investment Abroad: If, for example, the government takes initiatives to encourage
investment demand at home, higher investment reduces the supply of domestic currency abroad
and raises the exchange rates.

•Protectionist Trade Policies: The subsequent increase in the price of domestic goods, owing to
higher demand, results in an appreciation of real exchange rates

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Stock Pitch for a company

What is a stock pitch?

A stock pitch is a presentation or written summary that argues for or against investing in a
company's stock. It can be a key part of interviews for hedge funds and asset management
companies.

This is a very common question asked in Finance interviews, especially for Investment Banking and
PE/VC roles. The interviewer may either give you the option of choosing a particular stock or
industry from your own choice or give you a stock of a company to pitch basis your CV and work
experience. This question helps hiring managers determine whether you have the basic knowledge
required for the role you want. It may also allow you to show your ability to prepare for a stock pitch
with an investor. You can give a detailed definition and example of one that you developed on your
own. This allows you to show employers your abilities in investment management, hedge funds,
equity research or private equities.

Hiring managers want to see how much you know about the company and industry in which you
have invested or have related experience on your CV. They want to check how much you research,
know about and follow about particular companies and industries. Further, it gives an idea to the
investors as to what basis do you follow to invest, what are the parameters that you check, the
performances and indicators that you follow, how well you track the performances of the company
over time as well as in comparison to the industry peers. Further, it gives an idea to the interviewer
on how well you know to invest your money and how careful you are with it, because they believe
that if you are not careful and well versed with your money, it would be difficult for them to trust
you with the company or public money.

For some roles stock pitch may also be useful in the day-to-day work, e.g. stock pitch can be used to
send emails to hedge fund professionals, investors and the public to access their money and give
them an insight into the thought process and the research of the company. Secondly, it may be used
on the job for asset management companies. The stock pitch may differ basis the audience, the
details focused on it vary depending on whether you are pitching to investors, the public, directors,
investment purposes etc.

Business model:

A business model is a plan that describes how a company creates, delivers, and captures value. It
outlines the company's core strategy, target market, products or services, revenue streams, and cost
structure. A well-defined business model is essential for a company's success, as it provides a
roadmap for how the company will achieve its goals.

Key components of a business model:

Value proposition: What unique value does the company offer to its customers? How can the
business create value for the customers and the economy as a whole? What is the Unique selling

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proposition (USP) of the company? How does the company differentiate itself from other companies
in different and similar industries?

Target market: Who are the company's ideal customers? What are the customers that the company
should look for from an earning perspective? Which type of customers should it look to target?
Whether they target other corporate’s being a B2B business or if it is a B2C business whether they
target rich and premium customers selling high products or try and serve the masses by selling lower
value products

Channels: How does the company reach its target market? The modes it uses to reach customers
like

a) Direct sales: In direct sales, companies sell their products or services directly to their
customers, either through their own sales force or online.
b) Retail: In retail, companies sell their products or services through third-party retailers, such
as department stores or online retailers.
c) E-commerce: In e-commerce, companies sell their products or services directly to their
customers online.
d) Social media: social media can be used by companies to connect with their customers,
promote their products or services, and provide customer support.
e) Email: Email can be used by companies to send marketing messages, product updates, and
customer support messages.
f) Telephone: The telephone can be used by companies to provide customer support and sales
assistance.
g) Self-service: Self-service channels, such as knowledge bases and FAQs, allow customers to
find answers to their questions without having to contact a customer service representative

Customer relationships: What type of relationship does the company want to have with its
customers? Customer relationship refers to the interactions and ongoing connections a business has
with its customers. It encompasses all the touchpoints and experiences customers have with the
company, from initial contact to post-purchase follow-up. Strong customer relationships are
essential for businesses to thrive in today's competitive marketplace.

Revenue streams: How does the company generate revenue?

In business, a revenue stream is any source from which a company generates income. Revenue
streams can be derived from the sale of goods or services, as well as from other sources such as
investments, royalties, and fees. It's crucial for businesses to have multiple revenue streams to
reduce their reliance on a single source of income and mitigate financial risks.

Types of Revenue Streams:

a) Sales of Goods or Services: This is the most common type of revenue stream, where a
company generates income by selling products or services to customers. Examples include
physical products like clothing, electronics, or machinery, or intangible services like
consulting, accounting, or software development.

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b) Investment Income: Companies can generate income through investments in stocks, bonds,
or real estate. Investment income can come in the form of dividends, interest payments, or
capital gains.
c) Royalties: Companies can receive royalties for the use of their intellectual property, such as
patents, copyrights, or trademarks. For instance, a music producer might earn royalties from
the sale of songs they have written or produced.
d) Fees: Companies can charge fees for providing services, such as consulting fees, membership
fees, or service fees. For example, a gym might charge membership fees to access its
facilities and classes.
e) Advertising: Companies can generate income by selling advertising space or time on their
websites, publications, or broadcasts. For example, social media platforms like Facebook and
Instagram earn revenue by displaying ads to their users.
f) Data Monetization: Companies can collect and sell user data to third parties for marketing
or research purposes. This has become a common practice in the digital age, with companies
like Google and Facebook heavily relying on data monetization for their revenue.

Diversifying Revenue Streams:

Diversifying revenue streams is a crucial strategy for businesses to reduce their reliance on a single
source of income and mitigate financial risks. By having multiple revenue streams, businesses can
better weather economic downturns or changes in customer preferences. Additionally, diversifying
revenue streams can open up new growth opportunities and enhance the overall financial stability
of a company.

Key resources: What resources does the company need to deliver its value proposition? Key
resources are the essential assets and inputs that a company needs to operate and achieve its
objectives. They encompass the underlying elements that enable a business to create and deliver
value to its customers. Key resources can be tangible or intangible, physical or non-physical, and
they play a crucial role in determining a company's competitive advantage and sustainability.

Types of Key Resources:

a) Physical Resources: These are tangible assets that a company uses to produce or deliver its
products or services. Examples include machinery, equipment, tools, buildings, vehicles, and
inventory.
b) Human Resources: These are the people who work for a company and contribute their skills,
knowledge, and expertise to its operations. Examples include employees, managers,
consultants, and contractors.
c) Intellectual Resources: These are intangible assets that protect a company's intellectual
property and give it a competitive edge. Examples include patents, copyrights, trademarks,
brand names, and trade secrets.
d) Financial Resources: These are the funds that a company uses to operate and invest in its
growth. Examples include cash, credit, equity, and investments.

Key activities: What activities does the company need to perform to deliver its value proposition? In
a business model, key activities are the crucial actions a company must take to deliver its value

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proposition, reach its target market, maintain customer relationships, and generate revenue
streams. These activities define how a company operates and creates value for its customers. They
encompass the essential processes, procedures, and tasks that enable a business to achieve its
objectives.

Types of Key Activities:

a) Production: These activities involve designing, manufacturing, and delivering products or

services to customers. Examples include research and development, product
development, quality control, supply chain management, and distribution.

b) Problem-solving: These activities involve providing solutions to specific customer

problems or challenges. Examples include consulting services, technical support,
maintenance, and repair services.

c) Platform/network management: These activities involve operating and maintaining a

platform or network that connects multiple stakeholders. Examples include managing a
marketplace, social media platform, or payment network.

d) Marketing and sales: These activities involve promoting and selling products or services to
reach and acquire new customers. Examples include advertising, marketing campaigns,
sales processes, and customer relationship management.

e) Customer relationship management: These activities involve building and maintaining

relationships with customers to increase loyalty and repeat business. Examples include
customer support, account management, loyalty programs, and customer feedback
management.

Key partnerships: Who are the company's key partners? With whom does the company conduct its
business? Who are the major suppliers, customers and other long-term stakeholders of the
company? What are the contractual terms of the company with those stakeholders?

Cost structure: What are the company's key costs? What are the major costs heads of the company
whether it is manufacturing, procurement cost, employee cost, or technological cost?

Types of business models:

There are many different types of business models, but some of the most common include:

• Brick-and-mortar retail: This is the traditional model of retail, where products are sold in
physical stores.
• E-commerce: This is the model of retail where products are sold online.
• Subscription: This model involves customers paying a recurring fee for access to a product or
service.
• Freemium: This model involves offering a basic product or service for free while charging for
premium features or upgrades.

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• Advertising: This model involves generating revenue by selling advertising space or time.
• Data monetization: This model involves collecting and selling user data

The business model may also speak about the MOAT of the company. It is used to describe the
competitive advantage of the company. An economic moat is the long-term sustainable competitive
advantage that protects it from its competitors and external threats.
There are many different types of economic moats, but some of the most common include:

1. Cost advantage: This is when a company is able to produce its products or services at a
lower cost than its competitors. This can be due to economies of scale, superior
technology, or access to cheaper resources.
2. Switching costs: This is when it is costly or inconvenient for customers to switch from one
company's products or services to another. This can be due to factors such as the need for
specialized training, the difficulty of switching data, or the high cost of switching equipment.
3. Network effects: This is when the value of a product or service increases as more people use
it. This can be due to factors such as the ability to find more matches on a dating
website, the ease of connecting with friends on a social media platform, or the availability of
more apps for a smartphone.
4. Intangible assets: This is when a company has valuable intangible assets, such as a strong
brand name, a loyal customer base, or a secret formula. These assets can be difficult to
replicate, giving the company a competitive advantage.
5. Switching barriers: High switching barriers make it difficult and costly for customers to
switch from one company's products or services to those of another competitor. This can
include factors such as data compatibility, long-term contracts, or high switching costs.
6. Branding: A strong brand reputation can lead to customer loyalty and make it difficult for
competitors to attract customers.
7. Intellectual property: Patents, copyrights, and trademarks can protect a company's
intellectual property and prevent competitors from copying its products or services.
8. Customer relationships: Strong customer relationships can make it difficult for competitors
to steal customers away.
9. First-mover advantage: Companies that are first to market with a new product or service
often have a significant competitive advantage.
10. Ecosystem: A strong ecosystem of partners and suppliers can give a company a competitive
advantage
Hence understanding the business model is of utmost importance from an investor point of view for
the company. It helps to evaluate the company fundamentals and whether it is investible from the
investor's perspective.

1) Business details:
Details of the business number of offices, number of factories, number of employees, annual
production and change in such annual production, operating margin and performance of the
business, location of the factories, brand name and image of the company. SWOT analysis of
the company as compared to other industry peers and any specific changes and growth over

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the period, details on how to capitalize on the opportunities using their strengths and avoid
threats due to their weaknesses.

2) Ratios:
Profitability ratios (Net profit, ROE, ROCE, ROI), Leverage ratios (Debt equity ratio, debt asset
ratio), Liquidity ratio (Current ratio, quick ratio, cash ratio), Industry-specific ratios (ARPU,
PLF, ASK): all the ratios need to be compared over 3-5 years period to show changes and also
to be compared we with the ratio of the industry peers. Working capital and turnover of the
company, the performance of the company over the last quarter and last year.
The different types of ratios are:

• Liquidity Ratios:

Liquidity ratios gauge a company's capacity to satisfy its short-term obligations.

a) Current Ratio: Current Ratio = Current Assets / Current Liabilities

b) Acid Test Ratio: Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities
c) Quick Ratio: Quick Ratio = (Cash & Cash Equivalents + Marketable Securities +
Accounts Receivables) / Current Liabilities

• Profitability Ratios:

Profitability ratios gauge a company's capacity to turn revenue into profit.

a) Gross Profit Ratio: Gross Profit Ratio = (Net Sales - Cost of Goods Sold) / Net
Sales
b) Operating Profit Ratio: Operating Profit Ratio = (Net Sales - Cost of Goods Sold -
Operating Expenses) / Net Sales
c) Net Profit Ratio: Net Profit Ratio = (Net Income) / Net Sales
d) Return on Equity (ROE): ROE = (Net Income) / (Shareholder's Equity)
e) Return on Assets (ROA): ROA = (Net Income) / (Average Total Assets)

• Solvency Ratios:

Solvency ratios evaluate a company's long-term capacity to pay its obligations.

a) Debt-to-Equity Ratio: Debt-to-Equity Ratio = (Total Liabilities) / (Shareholder's

Equity)
b) Debt-to-Asset Ratio: Debt-to-Asset Ratio = (Total Liabilities) / (Total Assets)

• Activity Ratios:

Activity ratios quantify how effectively a company uses its assets and liabilities to
generate revenue.

a) Inventory Turnover Ratio: Inventory Turnover Ratio = (Cost of Goods Sold) /

(Average Inventory)
b) Accounts Receivable Turnover Ratio: Accounts Receivable Turnover Ratio = (Net
Credit Sales) / (Average Accounts Receivable)

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c) Fixed Asset Turnover Ratio: Fixed Asset Turnover Ratio = (Net Sales) / (Average
Net Fixed Assets)

• Efficiency Ratios:

Efficiency ratios examine how effectively a company spends its resources and generates
revenue.

a) Expense Ratio: Expense Ratio = (Total Expenses) / (Net Sales)

b) Working Capital Turnover Ratio: Working Capital Turnover Ratio = (Net Sales) /
(Average Working Capital)

3) Valuation:

Valuation of the company by the most appropriate method based on factors like the
Industry to which it belongs, availability of data, cash flow, dividend declaration, industry
peers, and number of diversified businesses. Valuation involves various questions as to why
the valuation is needed and what the purpose for which it is carried out, whether it is for
raising funds, carrying out mergers and acquisitions etc. The valuation of a company can vary
based on the audience being pitched to. This is because different investors have different
risk appetites and return expectations. For example, venture capitalists are typically willing
to invest in higher-risk, higher-growth companies, while private equity firms are typically
more focused on companies with a proven track record and lower-risk profiles. Investors will
also consider company-specific factors such as its size, growth rate, product market fit, and
market opportunity.

Here are some examples of how valuation may vary based on the audience:

• Venture capitalists: Venture capitalists are typically looking for high-growth potential
and may be willing to invest in companies with early-stage products or services.
• Private equity firms: Private equity firms are typically looking for more mature
companies with a proven track record of profitability.
• Strategic acquirers: Strategic acquirers are companies that are looking to buy other
companies in order to expand their business or enter new markets.
• Public investors: Public investors are individuals or institutions that invest in publicly
traded companies.

In general, the valuation of a company will be higher if the audience is made up of investors
who are looking for high-growth potential. The valuation will be lower if the audience is
made up of investors who are looking for more mature companies with a proven track
record of profitability.

In addition to the type of investor, the valuation of a company can also be affected by a
number of other factors, such as the company's stage of development, its financials, and the
overall market conditions.

It is important to note that there is no one-size-fits-all approach to valuation. The valuation

of a company will depend on the specific circumstances of the company and the audience

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being pitched to. A qualified business appraiser can help you determine the most
appropriate valuation method for your company and prepare a persuasive pitch to potential
investors. Basis these factors different valuation techniques might be used like the DCF
method, Relative valuation basis appropriate ratio, sum of parts valuation etc. A range of the
future price can also be formed of the future price basis valuation using different methods
to triangulate the final future expected price of the company. The different methods of
valuations are:

a. DCF method: The most famous is the discounted cash flow method wherein the
future expected cashflows of the company are discounted to the present day to get
the value of the company. It assumed that the value of the company is the Present
value of the future expected cash flows. If the entire firm is being valued then the
cash flow for the firm may be discounted at the Weighted average cost of capital to
get the firm value i.e., value of debt and equity. To value the equity shares the free
cash flow to equity shareholders may be discounted at the cost of equity to get the
value of equity. This method is most relevant when the company is profitable with
positive cash flows.
b. Dividend Discount Model: This model assumes that the value of the company is the
present value of all the future dividends receivable by the company. Hence, the value
of the firm is the present value of all the future dividends receivable by the company,
the dividends may be predicted for the forecasted period or the dividends may be
predicted for perpetuity. This method is most relevant for mature companies which
have a history of paying stable dividends.
c. Relative valuation: This method is used to value the company relative to other
similar companies. The ratios like P/E, and EV/EBITDA ratios of the other companies
are taken to arrive at the value of our target company. Relative valuation is more
accurate if credible data from other comparable companies are available. This
method is most relevant when reliable data about the company profits and cash
flows is not available
d. Sum of parts valuation: This method is most relevant for large conglomerates in
diversified businesses. The different business verticals of the company are valued and
then to calculate the total value of the company the value of the different business
verticals is summed up to find the value of the entire company.
e. Comparable transaction method: This method is most relevant for companies in case
of a takeover where data about a similar transaction of a similar company is available
and the value for the similar transaction becomes the base for the company. The
transaction value includes the business premium of a similar transaction hence the
value of this method may be the highest.

Besides valuation, a lot of the other details need to be mentioned by the company as
such why is the valuation of the company being done, if it is being done to raise money,
what is the source from which the money is being raised, how much money is being
raised, for what purpose will it be used and the source of repayments of these finds
including details probability of such repayment by the company, whether the company
has enough financial worthiness to be able to repay the loan and such money is times of
contingencies, from where the funds are being raised and how raising such funds will
impact the financials and future plans of the company.

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4) CAPEX and M&A:

Details of current CAPEX and long-term investment that the company has made and future
plans of the investments and CAPEX that the company has planned, future scope of
investment and opportunities that the company may have. Details of recent M&A deals
done by the company future M&A deals planned or announced by the company and the
expected synergetic benefits out of the same.
The source of funds from where the company is carrying out such acquisitions, mergers and
capital expenditure is also important for the company to know the sustainability of the
company as well as the long-term growth. The various sources of funds may be:
a) Existing funds and reserves: The company may carry out capital expenditure and
finance mergers and acquisitions from its reserves and past profits which may have
been earned by it earlier and are currently in the reserves of the company
b) Raising equity share capital: The company may raise fresh equity share capital from its
existing investors or from new investors either privately or from the public through
capital markets to fund these expenses.
c) Issuing debentures: The company may issue bonds and debentures to raise money
from the public and will have to pay periodic interest in the amount raised to fund the
expenses for capital expenditure and acquiring other companies.
d) Bank loan: The company may raise money through loans and borrowings from banks,
NBFC and other public finance institutions to pay for the expenditure. Often these bank
loans may come with covenants and various other terms and conditions.

5) Management Quality:
Fundamental analysis of the company in terms of the management structure and Board of
Directors: their education, experience, past track record, independence, performance since
joining the company, and relevant experience in the sector. History of violations and
penalties levied on the company, details of major cases against the company and contingent
liability against the company

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Capital Budgeting
The types of decisions required to be made by the management of a company are

a) Financing Decision- It is related to from where and how a business should acquire funds. The
factors which affect this decision are :
i) Cost- The source selected shall be the most cost-efficient.
ii) Risk- Debt is typically a riskier source for the firm in comparison to equity because of
fixed financial obligations.
iii) Control- If existing investors want to retain control of their business they shall issue
minimum equity.
iv) Cash flow position- Companies with better cash flow can encourage investor’s
confidence and raise capital at lower cost.
v) Condition of the market- During a boom period issue of equity is in the majority but
during a depression, a firm will have to use debt.

b) Investing Decision- Also known as Capital Budgeting Decisions. A company’s assets and
resources are rare and must be put to their utmost utilization. A firm should pick where to
invest in order to gain the highest conceivable returns. This decision relates to the careful
selection of assets in which funds will be invested by the firms. Factors affecting this decision
are:
i) Opportunity cost- This is referred to as the best opportunity foregone. For ex- with
an available piece of land, you can either rent it or build a factory and manufacture
garments. If you choose to build a factory then the renting option is your
opportunity cost.
ii) Time period- Capital budgeting decisions have a long-term focus, as these
investments involve significant financial commitments and often extend over several
years or even decades.
iii) Risk- refers to uncertainty in future cash flows. They are of two types i.e. one which
affects only the firm, and the other which affects the whole market. It includes
liquidity risk, market risk, business risk, regulatory risk, systematic, and unsystematic
risk etc.
iv) Cash flow analysis- This involves estimating the cash inflows and outflows
associated with the project over its life.

c) Dividend Decision- Relates to the distribution of profits earned by the organization. The
major alternatives are whether to retain the earnings profit or to distribute to the
shareholders. Factors affecting this decision are:
i) Earnings- An organization having higher and stable earnings can announce a higher
dividend than an organization with lower income.
ii) Development opportunity/Growth opportunity- Organizations having scope for
growth by reinvesting their earnings are better off by retaining the profits to earn a
higher return on capital employed. Usually, smaller organizations do not pay
dividends to fund growth.

The Investing decision in corporate finance is to find the best alternative option/project to invest.

Objective-

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a) The amount of capital any business has available for new projects is limited; management
often uses capital budgeting techniques to determine which projects will yield the best
return over an applicable period.
b) Maximizing shareholder value refers to improving the market value of the company’s share.
It prioritises long-term goals. It values the time value of money and acknowledges
uncertainty and risks.
c) Maximizing profits refers to generating significant profits for the company. It prioritises
short-term goals. It disregards the time value of money and disregards uncertainty and risks.
d) Earn higher than the available opportunity costs
e) Prevent under or over-utilising CAPEX

The most commonly used methods in Cap budgeting are

NPV analysis- the difference between the present value of cash inflows and the present value of
cash outflows over a period of time.

Objective – Analyze the profitability of a projected investment or project using cash flows

How to calculate?

Step 1: Identify the number of periods based on the useful life of the asset or life of the project. It
can be either finite or perpetual.

Stable growth 2 stage DCF Multi-stage/three-stage model

In case of mature In a two-stage model, the first In a multi-stage model, the first
businesses where the stage is the near term and is stage is a high-growth period.
scope for expansion or often referred to as the Usually, in the case of Internet-
growth is limited stable forecast period. This can be the based startups, the business
growth rate is used where next three, five, or ten years. can grow at exorbitantly at
it is assumed that the We will forecast the operating 100-200% in the initial 3-4
years.
business will continue to performance of the business in
grow at a constant rate detail and arrive at the cash
In the 2nd stage the growth of
for perpetuity. flows of the business for each the business is still high but
year of this period. less in comparison to the first
stage like 30-40%. The cash
For the 2nd stage we then flows for this period can be
assume that post that period ascertained relatively
the business grows at a accurately than the perpetual
constant rate for perpetuity. stage.

In the 3rd stage it assumed

that the business grows at a
constant rate for perpetuity
and the growth rate declines. It
is also called the terminal
stage.

Step 2: Estimate the cash inflows and outflows occurring at different points in time

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Step 3: Estimate an appropriate discounting rate based on the Cost of capital of the company.
Capital structure/source of finance is a relevant parameter for determining the cost of capital.

Step 4: Discount cash flows to the current period based on two major components a) the forecast
period and b) the terminal value. The forecast period is typically 3-5 years for a normal business
because this is a reasonable amount of time to make detailed assumptions. Anything beyond that
becomes a real guessing game, which is where the terminal value comes in. For e.g.- When
launching a new project it is reasonable to forecast the initial 3-4 year sales. However, post that it is
difficult to understand the market share that the product will be able to retain/acquire in the long
run.

Step 5: Add the Discounted cash flows to calculate NPV

For Finite Period

For Perpetuity with a stable growth rate

NPV= CF/(r – g) – Initial Investment

PV= CF/r
For 2-stage DCF

Decision rule

IF NPV > 0 or Opportunity cost, then accept the project

IF NPV < 0 or Opportunity cost, then reject the project

If NPV = Initial Investment or Opportunity cost, then practically you should be indifferent about
whether to accept the project or go for the next best alternative foregone

Pros Cons

Incorporates time value of money. Heavily dependent on assumptions

Simple way to determine if a project Not useful for comparing projects of

delivers value. different sizes, as the largest projects
typically generate the highest absolute
returns, but not in terms of return on
capital as percentage.

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Considers a company's cost of capital. May omit hidden costs such as opportunity
costs and organizational costs.

Accounts for the inherent uncertainty of Purely quantitative in nature and does not
projections by most heavily discounting far- consider qualitative factors.
future estimates

Practical Applications

Typically NPV is used in evaluating

1. Real Estate Investment:

2. Manufacturing Expansion:

3. Tech Start-up Investment:

4. Oil Exploration Projects:

5. New Product Development:

6. Renewable Energy Investments:

It is not limited to these investments, businesses use it to decide whether to make large purchase or
not

IRR- Basically that discounting rate which makes the NPV of a project 0. But it is much more than
that. IRR is the annual rate of growth that an investment is expected to generate. It is
termed internal because it depends only on the cash flows of the investment being analyzed and
excludes external factors, such as returns available elsewhere like the risk-free rate, inflation,
the cost of capital, or financial risk.

Objectives-

a) Investors determine the investment return of by comparing projects’ potential rates of

annual return over time.
b) Estimate actual performance of an investment in percentage terms
c) an indicator of the profitability, efficiency, quality, or yield of an investment.

There are at least two different ways to measure the IRR for an investment:

a) Project IRR assumes that the cash flows directly benefit the project
b) Equity IRR considers the returns for the shareholders of the company after the debt has
been serviced.

Decision Rule

IF IRR > Discounting rate or Investor’s expectations, then accept the project

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IF IRR < Discounting rate or Investor’s expectations, then reject the project

Note: For capital budgeting decisions, the cost of capital is more relevant as it the cost of using
acquired funds.

Pros Cons
Incorporates Time value of money When the cash flows of the investment are
unconventional, i.e. when the sign of the
cash flows changes more than once, for
example when positive cash flows are
followed by negative ones and then by
positive ones then the investment may
result in multiple IRRs
Simple to interpret Ignores Size of Project
Ignores Future Costs
Ignores Reinvestment Rates
Ignores Timing of cash flows
Ignores time period of different projects

Practical Applications

Internal Rate of Return is widely used in analyzing investments for private equity and venture
capital, which involves multiple cash investments over the life of a business and a cash flow at the
end through an IPO or sale of the business.

NPV IRR
Considers size/quantum of cash flows Ignores the Size of Project
NPV takes cognizance of the value of capital IRR doesn’t look at the prevailing rate of
cost or the market rate of interest. interest on the market, and its purpose is to
find the maximum rates of interest that will
encourage earnings to be made from the
invested amount
NPV is much more reliable when compared IRR approach does not give reliable
to IRR and is the best approach when estimates in terms of ranking mutually
ranking projects that are mutually exclusive projects
exclusive.
Projects, where cash inflows of larger The time period of different projects
magnitude occur earlier, will have higher doesn’t matter in the IRR approach
NPV
Different projects with different time The IRR approach will give multiple IRRs
periods may show larger or smaller NPV. * increasing difficulty in making a choice
In case of unconventional cash flows, NPV
will give one simple, reliable result

To compare projects with different maturities Effective annual annuity method is used. It is usually
used to compare mutually exclusive projects with different unequal maturity periods. It is calculated
in 3 steps-

1. Calculate the NPV of different projects.

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2. Find the annuity with the PV equal to the project’s NPV over its life at the cost of capital of the
firm.
3. Select the project with the highest EAA.

Suppose that Sally’s Doughnut Shop is considering purchasing one of two machines. Machine A is a
dough mixing machine that has a useful life of 6 years. During this time, the machine will enable Sally
to realize significant cost savings and represents an NPV of $4 million.

Machine B is an icing machine with a useful life of 4 years. During this time, the machine will allow
Sally’s to reduce icing waste and represent an NPV of $3 million. Sally’s Doughnut Shop has a cost of
capital of 10%. Which machine should the company invest in?

Using the Equivalent Annual Annuity method:

To counter the limitations of IRR as an approach to capital budgeting Modified IRR is also used. The
modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's
cost of capital and that the outlays are financed at the firm's financing cost.

But even then, most decisions related to capital budgeting are evaluated using the NPV approach
because of

a) Ranking mutually exclusive projects

b) Working with unconventional cash flows
c) Working with projects with different time periods
d) Scale of cash flows

Payback Period- Number of periods required to recover the original cash investment or length of
time an investment reaches breakeven point.

Objectives-

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Compare projects and calculate the period in years to get back the original investment

Decision Rule

Choose projects with a lower payback period

Pros Cons
Very simple to calculate Doesn’t account for Time value of money
Reflects liquidity and risk of the project Doesn’t account for inflow of cash after
payback period
Helpful in sectors with a high degree of Doesn’t account for opportunity cost,
uncertainty or that experience quick inflation or interest rate risk
technological change. This uncertainty
makes it challenging to forecast the coming
year's yearly cash inflows. Utilizing and
working on projects with short payback
periods helps lower the risk of a loss due to
obsolescence.
A project's profitability is not assured by its
shorter payback period.

Practical applications

Industrial and manufacturing sectors use payback period in order to gauge as to how long it will take
to recover the initial investment.

Infrastructure projects that are capital intensive use payback period because they are relatively risky
involving high initial investment and this method helps ascertain as to how long it will take to turn
the project profitable. For ex- roads, railways, highways, hospitals etc.

Companies that are cash-strapped and don’t have a lot of capital to spend may also focus on a
payback period since they are going to need the money soon.

Profitability Index - The ratio between the present value of future cash flows and the initial
investment. It simply tells how much value per dollar of investment the project is creating for the
investors.

Objectives-

a) Ranking various projects because it lets investors quantify the value created per each
investment unit.
b) To identify if the costs outweigh the benefits.

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Decision Rule

IF PI > 1, Generally accept the project, because it signifies an NPV of future cash flows greater than
the Initial investment

IF PI < 1, Reject the project, because it signifies an NPV of future cash flows lesser than the initial
investment

Pros Cons
Assistance in ranking different projects Ignores the scale of project
Ignores the opportunity cost
Ignores time period of projects

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Investment Philosophy
What Is Investment Philosophy?

An investment philosophy is a set of beliefs and principles that guide an investor's decision-making
process. It considers one's goals, risk tolerance, time horizon, and expectations. It usually guides the
investment decisions in the long term.

Types of Investment Philosophies

Value Investing

▪ It involves picking stocks that appear to be trading for less than their intrinsic value.
▪ Stocks go through periods of higher and lower demand leading to price fluctuations. If the
company's fundamentals are the same, and its future opportunities are unchanged, then the
value of the shares is largely the same even though the price differs. This gives the
opportunity to value investors to buy or sell shares and profit.

Important principles/qualities for value investing:

▪ The margin of safety principle is one of the keys to successful value investing. It is based on
the premise that buying stocks at bargain prices gives a better chance of earning a profit and
reduces losses in case the stock does not perform as expected.
▪ Value Investing Requires Diligence and Patience. Fundamental analysis is a very important
component.
▪ Value Investors do not follow the Herd and possess the characteristics of contrarians. For
example, Market crashes, unnoticed & unglamorous stocks, bad news, and cyclicality.
✓ Market crashes: An investor who bought fundamentally strong stocks during the
COVID pandemic when SENSEX fell below 30,000 levels would have made lucrative
returns in less than a year.
✓ Unnoticed & unglamorous stocks: Rakesh Jhunjhunwala earned his first big profit in
1986 when he bought Tata Tea shares. He bought 5,000 shares of Tata Tea at just Rs
43 and later that stock rose to Rs 143 within three months.
✓ Bad news: After Hindenburg’s report in Jan’23, Adani Enterprises Ltd plunged from a
peak of around 4,100 (in Dec’22) to lows of 1,017 in Feb’23. However, it rebounded
to 2,600+ in May’23.
✓ Cyclicality: Cyclical stocks rise and fall with the economic cycle. This seeming
predictability in the movement of these stocks’ prices leads some investors to
attempt to time the market. They buy the shares at a low point in the business cycle
and sell them at a high point.
▪ Popular Value Investors:
- Warren Buffet: “Be fearful when others are greedy, and greedy when others are fearful”
- Benjamin Graham: “Investing is not about beating others at their game. It is about
controlling yourself at your own game.”
- Charlie Munger: “The big money is not in the buying and the selling, but in the waiting”

Contrarian Investing

▪ Contrarian investing is a strategy of going against prevailing market trends or sentiment.

However, it also requires serious research to ensure that the crowd is indeed wrong.

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▪ The idea is that markets are subject to herding behaviour augmented by fear and greed
(called Herd mentality), making markets periodically over- and under-priced.
▪ For example, Rakesh Jhunjhunwala was shorting when stock markets were booming rapidly
by Harshad Mehta and ultimately profited after the market crash.
▪ "The time to buy is when there's blood in the streets" - Baron Rothschild
▪ “The most pessimistic times are the best times to buy, and the most optimistic times are the
best times to sell” - John Templeton

Growth Investing

▪ Growth investors invest in growth stocks— young or small companies whose earnings are
expected to increase at an above-average rate compared to their industry or the overall
market. However, such companies are untried, and thus often pose a fairly high risk.
▪ These stocks do not pay dividends as they reinvest the profits for rapid business growth.
▪ Companies with high growth potential, innovative products, expanding markets, and
dominant positions in the industry can be considered for growth investing.
▪ These companies have a high PE ratio due to the high Present Value of Growth
Opportunities (PVGO). Thus, they are risky and investors may lose money if expansion plans
do not crystalize.
▪ Currently, High-growth sectors include IT, Healthcare, renewable energy, EVs, FinTech and E-
commerce.
▪ Notable Growth Investors:
- Thomas Rowe Price: “Change is the investor’s only certainty”
- Philip Fisher: "If the growth rate is so good that in another ten years, the company might
well have quadrupled, is it really of such great concern whether at the moment the stock
might or might not be 35% overpriced?"
- Peter Lynch: "Time is on your side when you own shares of superior companies."
▪ Difference between value investing and growth investing:
Value Investing Growth Investing
Share is undervalued with respect to Company /Industry has growth potential.
intrinsic value. So, the share price will grow So, the company/industry will grow.
Low PE ratio High PE ratio
Pays dividends No dividends
Less risky due to the Margin of safety Risky due to volatility and

Socially Responsible Investing

The practice of investing money in companies and funds that have positive social impacts while also
expecting returns (financial gains).

For example, an investor avoids investments in companies that produce or sell addictive substances
like alcohol, gambling, and tobacco. Alternatively, in favour of seeking out companies that are
engaged in social justice, environmental sustainability, and alternative energy/clean technology
efforts.

ESG Investing

▪ Environmental, social, and governance (ESG) investing refers to a set of standards for a
company’s behaviour used by socially conscious investors to screen potential investments.

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▪ Several financial firms have come out with ESG ratings and scoring systems.
▪ Environmental issues may include corporate climate policies, energy use, waste, pollution,
natural resource conservation, and treatment of animals.
▪ Social aspects look at the company’s relationships with internal and external stakeholders,
for example, employees, suppliers, local communities etc.
▪ Governance refers to ensuring a company uses accurate and transparent accounting
methods, pursues integrity and diversity in selecting its leadership, and is accountable to
shareholders.
▪ Pros:
- ESG criteria can help investors avoid the blowups that occur when companies operate in
a risky or unethical manner.
- Companies that perform well on ESG metrics attract and retain talent as they often
engage employees as they see their jobs as more meaningful, which results in a culture
of respect.
▪ Cons:
- Inability to hold the full universe of stocks available in the market which may give
lucrative returns like tobacco and defence.
- Greenwashing - Companies claim that their products are more environmentally friendly
than they actually are. This can make customers lose trust in a company, ultimately
damaging their reputation.

Difference between Social Responsibility Investing and ESG Investing

Socially Responsible Investing ESG Investing

Puts a premium on positive social change by Decision-making considers how environmental,
considering both financial returns and moral social, and governance (ESG) risks and
values in investment decisions opportunities can have material impacts on
companies’ performance
Considers sustainable practices such as Considers ESG factors for screening companies
environmental stewardship, consumer
protection, human rights, and racial and gender
diversity
Broader in scope Relatively narrow in scope

Investor Biases

Bias is an irrational assumption or belief that affects the ability to decide based on facts and
evidence. Investors are as vulnerable as anyone to making decisions clouded by prejudices or biases.
When investors take biased action, they fail to acknowledge evidence that contradicts their
assumptions.

Common Biases in Investing

Cognitive dissonance: Avoidance of uncomfortable facts that contradict one's convictions. Because
investors do not admit that their decision was incorrect, but instead blame the circumstances or
choices.

Confirmation bias: Favouring information that confirms previously existing beliefs. The tendency of
people to pay close attention to information that confirms their belief and ignore information that
contradicts it

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Endowment effect: Over-valuing the things that one owns just because she owns them. It translates
to people being willing to sell at higher prices and buy at lower prices for goods of equal value.

Disposition effect: Tendency to sell investments that are doing well and hang onto losers. We are
risk-averse with our gains and We are risk-seeking when it comes to losses.

Representative bias: Judgments are snapped because of a situation's similarities to an earlier

matter. Investors are prone to believe that a history of a remarkable performance of a given firm is
“representative” of a general performance that the firm will continue to generate into the future.

Media bias and Internet information bias: Uncritical acceptance of widely-reported opinions and
assumptions.

Illusion of control bias: Cognitive belief where investors overestimate their ability to influence
outcomes. The tendency of investors to believe that they have a certain degree of control over the
outcomes of investment markets even when people have no actual influence over what happens.

Herd mentality: refers to investors' tendency to follow and copy what other investors are doing.
They are largely influenced by emotion and instinct, rather than by their own independent analysis.

Gambler fallacy: A cognitive bias that occurs when traders assume that the likelihood of a price
trend continuing is reduced as time passes. This can lead to traders prematurely closing positions, as
they wrongly believe that the trend is less likely to continue.

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