UNIT-2

FUNDAMENTAL ANALYSIS

FUNDAMENTAL ANALYSIS:
Fundamental analysis is a study of certain factors, such as financial statements, external
factors, news, events and trends in the industry to determine the true value of a stock.

OBJECTIVES OF FUNDAMENTAL ANALYSIS:

1. To conduct a company's stock valuation and predict its probable price evolution.
2. To make a projection on its business performance.
3. To evaluate its management and make internal business decisions.
4. To calculate its risk.
USES/APPLICATIONS OF FUNDAMENTAL ANALYSIS
1. Fundamental Analysis is used to evaluate a lot of information about the past performance
and the expected future performance of companies, industries and the economy as a
whole as before taking the investment decision.
2. Fundamental analysis is really a logical and systematic approach to estimating the future
dividends and share price. Fundamental analysis is performed on historical and present
data, but with the goal of making financial forecasts.
3. Fundamental analysis is a method used for evaluating a security or asset by attempting to
measure its intrinsic value by examining related economic, financial and other qualitative
and quanlitative factors.
4. Fundamental analysts attempt to study everything that can affect the security's value,
Including macroeconomic factors (like the overall economy and industry conditions) and
Individually specific factors.
5. The fundamental approach is based on an in-depth and all-around study of the underlying
forces of the economy, conducted to provide data that can be used to forecast future
prices and market developments.
6. Fundamental analysis can be composed of many different aspects dividuals of the
economy as the whole, the analysis of an industry or that of an individual company. A
combination of the data is used to establish the true current value of the underlying asset
determine whether they are over or under-valued and to predict the future value of the
underlying asset based on this information.
7. It helps an investor obtain information about the overall state of the market, and state of a
specific security as compared to other securities. attractivere

STEPS INVOLVED IN FUNDAMENTAL ANALYSIS

1. Get familiar with the company: If are considering a certain company for long-term
investment, first try to study it in as much detail as possible. Go through the website,
learn about its product, market, how it has been performing, its future goals and past
decisions Once you know as much as possible about the business, are going to be in a 1
better position to evaluate the other variables.
2. Read the financial reports: After gaining a full understanding of the company, may look
into the financial reports, such as the balance sheets, profit-and-loss statements, operating
costs, cash flow, revenue and expenses. Check whether the net profit has been on the rise
in the past five years. If this is so, then it is a positive sign. May also calculate the
compounded annual growth rate (CAGR). Can find financial reports of a company in
trading and investing platforms online.
3. Check the debt: Debt can impact the growth potential and performance of a company
negatively. It is advisable to refrain from investing in companies that have high debt, as
this can affect the returns. The ideal debt-equity ratio is less than one. Look for a
company with this debt-equity ratio for safer investments.
4. Study the competitors: Competition is an important factor in determining whether
company can scale and grow as effectively as it aims to. If the competitors have a better
reputation in the market and produce better quality products, the chances of the company
succeeding can be less. It is better to go with a company that has already established itself
as a leader in the market and that enjoys a better reputation than its competitors.
5. Analyze the future prospects: Some products are seasonal and may even lose their
significance with time. Others can be evergreen products or they may have a use for
customers regularly in the foreseeable future. Analyze these aspects to see if the company
has the potential to grow and sustain itself in the long run. Diminishing product values
results in decreasing stock values.
6. Review all aspects periodically: Micro-and macroeconomic changes can affect the price
and valuation of companies. The occurrence of new events and the innovation of
technolog can make certain products obsolete or enhance their existing value. This makes
it importa to remain aware of the current happenings, read industry-relevant news and
follow to company closely. This can help plan to hold or sell investments.

TYPES OF FUNDAMENTAL ANALYSIS

1. Qualitative approach: Qualitative fundamental analysis focus more on the subjective
and unquantifiable aspects of an entity to determine its stock value. Rather than analyzing
the quantifiable data, it studies factors like the brand value, employee satisfaction, how
efficient or experienced the management is, customer feedback and other details.
It may not possible to measure these factors in numeric terms, but they can indicate the
overall position and potential of the business in the market. Using qualitative analysis
alone may not give the most accurate prediction. Combining it with quantitative analysis
may be a better strategy.
2. Quantitative analysis: A quantitative analysis considers the quantitative or numerical
factors to estimate the value of a stock. It is primarily based on statistics and
mathematical calculations. Quantitative analysis is useful in almost any field that
comprises any kind of quantitative data, statistics or figures that analysts can study to
draw conclusions or make behavioral predictions. Even governments and banks employ
quantitative analysis to make informed economic and financial decisions.
3. Top-down approach: The top-down approach begins by looking at the broader economic
variables that may influence the prices or values of stocks. These may include the current
gross domestic product (GDP), environmental or geopolitical events. These variables can 2
affect the monetary conditions of the entire economy of a country at large, rather than just
 a particular sector, company or business. For instance, a natural calamity can hinder the
production of goods or slow it down. If the government introduces new policies to
support and encourage entrepreneurship, it can have a positive effect by allowing new
businesses to continue operations.
4. Bottom-up approach: The bottom-up approach is the exact opposite of the top-down
approach. It starts by studying the specific details and internal factors associated with the
company or business. The microeconomic variables have precedence over the
macroeconomic ones. These microeconomic variables may include customer base and
satisfaction, qualified human resources, suppliers and distribution channels, competition,
Investors and publicity. For example, customers play a crucial role and defining the
success of a business. If there is enough demand or customers for a product or service,
then the business is likely to succeed

TOOLS OF FUNDAMENTAL ANALYSIS

1. Earnings per share: Earnings per share (EPS) refers to a company's earnings and the
total number of shares they own. By dividing the net income of an investment by the total
number of outstanding shares, an investor can learn about the company's overall
performance.
2. Price to sales ratio: Price to sales ratio refers to the price of products in correlation with
the number of sales. This helps investors better understand how much the share price
increases In revenue.
3. Price to earnings ratio: The price to earnings ratio is the value of a company using
measurements from current share prices and earnings per share. By dividing the current
sales prices of shares with the earnings per share, investors can learn more about the
Intrinsic value of an investment.
4. Price to book ratio: The price to book ratio is the comparison of a company's market
value to its book value, which is the amount of equity that's available to shareholders.
You can calculate this by dividing the last closing price of an investment by its book
value.
5. Return on equity: Return on equity refers to a measurement of financial performance.
An investor can calculate the return on equity by dividing the company's net income by
shareholder equity
6. Dividend payout ratio: The dividend payout ratio refers to the total value of dividends
that a company pays to its shareholders in relation to the net income of the company. This
calculation provides an investor with valuable information, including the company's net
income and how much they pay their investors.
7. Trend analysis: Trend analysis is the consideration of business trends. This may include
the trend of growth or profits over a specific period.
8. Future projections: A fundamental analysis may also include future projections.
Predicting future revenue includes an evaluation of the previous performance of
investments over a two- to five-year span.
9. Corporate governance: Corporate governance refers to business and federal policies that
may affect the success of the business. It includes an evaluation of compliance 3
requirements and transparency in new policies.
10. Ratio analysis: Ratio analysis is the consideration of the liquidity of a business. By
comparing the balance sheet and income statements, analysts can predict a business
equity.

TOP-DOWN VS. BOTTOM-UP FUNDAMENTAL ANALYSIS

Fundamental analysis can be either top-down or bottom-up. An investor who follows the top-
down approach starts the analysis with the consideration of the health of the overall
economy. Alternatively, there is the bottom-up approach. Instead of starting the analysis
from the larger scale, the bottom-up approach immediately dives into the analysis of
individual stocks.

Top-down Analysis

Steps investors can take to implement this strategy.:

Step 1: Analyse the overall economic conditions

The first step in the top-down approach is to analyse the overall economic conditions. This
involves examining macroeconomic indicators such as Gross Domestic Product (GDP),
inflation, interest rates, and unemployment rates. By analysing these factors, investors can get
a sense of the overall health of the economy and identify sectors that are likely to perform
well in the current economic environment. For example, when interest rates are low, it may
be a good time to invest in sectors such as real estate and consumer goods, as consumers may
have more disposable income to spend on these types of products.

Step 2: Examine industry trends

The next step in the top-down approach is to examine industry trends. This involves
identifying sectors that are likely to perform well in the current economic environment.
Investors can examine industry trends by analysing data such as market size, growth rates,
and competitive landscape. For example, if the healthcare industry is growing rapidly
due to an aging population, it may be a good time to invest in healthcare shares. Similarly, if
the technology sector is experiencing rapid growth due to increased demand for digital
services, it may be a good time to invest in technology shares.
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Step 3: Identify companies within the chosen industry
Once potential sectors have been identified, the next step in the top-down approach is to
identify companies within those sectors that are likely to perform well. This involves
analysing individual companies’ financial statements, competitive advantages, and growth
potential. Investors should look for companies with strong financial performance, such as
high revenue growth, strong profitability, and low debt levels. Additionally, investors should
consider the company’s competitive advantages, such as a strong brand, intellectual property,
and distribution network.

Step 4: Evaluate the company’s management team

In addition to analysing the company’s financial performance and competitive advantages,
investors should also evaluate the company’s management team. This involves examining the
CEO’s track record, their vision for the company, and their ability to execute on their
strategy. Investors should also consider the company’s corporate governance practices, such
as the independence of the board of directors, the structure of executive compensation, and
the company’s approach to risk management.

Step 5: Determine the company’s valuation

Once potential companies have been identified, the final step in the top-down approach is to
determine the company’s valuation. This involves comparing the company’s current stock
price to its intrinsic value.

Bottom-Up Analysis

Steps to Implement the Bottom-Up Approach.

Step 1: Identify Potential Investment Opportunities

The first step in the bottom-up approach is to identify a potential investment opportunity.
This involves conducting research to identify companies that have a strong financial
performance and growth potential. This may for example happens when investment analysts
are made aware that a company may have a good product in the market or have a competitive
advantage. This can put such a company on the analyst’s radar as a possible good
investment.

Step 2: Analyse the Company’s Financial Statements

Once a potential investment opportunity has been identified, the next step is to analyse the
company’s financial statements. This involves examining the company’s balance sheet,
income statement, and cash flow statement to determine its financial health. 5
Investors pay close attention to key financial metrics such as revenue growth, profitability,
debt levels, and cash flow. These metrics can provide insight into the company’s financial
performance and its ability to generate future cash flow and reinvest in the business.

Step 3: Assess the Company’s Management Team

In addition to analysing the company’s financial statements, analysists will also assess the
company’s management team. This involves evaluating the CEO’s track record, their vision
for the company, and their ability to execute on their strategy.
As part of this step, it is also important to consider the company’s corporate governance
practices, such as the independence of the board of directors, the structure of executive
compensation, and the company’s approach to risk management. All of this will give
investment analysts a sense of how the company operates and if there are any growth
opportunities worth investing in.

Step 4: Consider the Company’s Competitive Advantages

Another important factor to consider when analysing individual companies is their
competitive advantages. This includes factors such as the company’s brand, intellectual
property, patents, and distribution network. Companies that have strong competitive
advantages may be able to maintain market share and generate sustainable profits over the
long term.

Step 5: Determine the Company’s Valuation

Once the company’s financial performance, management team, and competitive advantages
have been assessed, the final step in the bottom-up approach is to determine the company’s
valuation. This involves comparing the company’s current share price to its intrinsic value.
Intrinsic value is a financial term used to describe the true or inherent value of an asset or
investment. The goal is to identify whether the company may be worth more based on the
valuations which is then compared to what it is trading for on an exchange.

Limitations of Fundamental Analysis:

1. Time-Consuming Process
Fundamental analysis involves a deep dive into financial statements, economic indicators,
company management, and market conditions. This extensive research requires significant
time and effort, which may not be feasible for every investor, especially those who are not
investing full-time.
2. Impact of External Factors
While fundamental analysis focuses on a company’s intrinsic value, it can sometimes
overlook the potential impact of external events or market sentiments. Political events,
economic downturns, sudden market trends, or global crises can affect stock prices
independently of the company’s fundamentals.
3. Subjectivity in Analysis
Interpreting financial statements and predicting future performance involve a degree of
subjectivity. Different analysts may have different opinions on the same set of data, leading
to varied conclusions about a stock’s intrinsic value. This subjectivity can make fundamental
analysis more of an art than a strict science.
4. Historical Data
Fundamental analysis often relies on historical data to predict future performance. However,
past performance is not always a reliable indicator of future success. Changes in industry
dynamics, competition, or management can significantly alter a company’s growth trajectory. 6
5. Market Efficiency
The Efficient Market Hypothesis (EMH) suggests that at any given time, stock prices fully
reflect all available information. If the markets are indeed efficient, trying to find
undervalued stocks through fundamental analysis might be less effective since all information
is already priced in.
6. Ignoring Technical Factors
Fundamental analysis primarily focuses on a company’s value and does not take into account
the stock’s price movements or market trends, which are central to technical analysis.
Sometimes, these technical factors can offer trading opportunities that fundamental analysis
might miss.
7. Lagging Indicator
By the time a fundamental analysis identifies a potentially undervalued stock, the market may
have already begun adjusting the price to reflect this. In rapidly moving markets, this lag can
mean missing out on initial gains.
8. Industry and Sector Blind Spots
For investors focusing exclusively on bottom-up fundamental analysis, there’s a risk of
missing broader industry or sector issues that could affect a company’s performance. This
approach can overlook macroeconomic factors that impact investment performance across the
board.
9. Quantitative Focus
While fundamental analysis involves qualitative factors like management quality, much of
the focus is on quantitative data from financial statements. Intangible assets, brand value, or
industry trends might be undervalued in this analysis framework.
10. Rapid Changes in Business Models
In today’s fast-paced economic environment, new technologies and business models can
quickly disrupt industries. Fundamental analysis might not fully account for these rapid
changes, especially for industries experiencing significant innovation.

EIC Framework
EIC (Economy, Industry, Company) analysis framework is a fundamental approach used in
the investment decision-making process, providing a structured way to examine the
macroeconomic environment, the specific industry, and individual companies.
1. Economic analysis
Economic analysis is one of the studies that form part of the fundamental analysis. This
relates to study about the economy in detail and analyses whether economic conditions are
favorable for the companies to prosper or not.
1. Gross Domestic Product (GDP) - GDP indicates the rate of growth of the
economy. GDP represents the aggregate value of the goods and services produced in
the economy. GDP consists of personal consumption expenditure, gross private
domestic investment and government expenditure on goods and services and net
export of goods and services.
2. Savings And Investment - It is obvious that growth requires investment which in
turn requires substantial amount of domestic savings. Stock market is a channel
through which the savings of the investors are made available to the corporate
bodies. Savings are distributed over various assets like equity shares, deposits,
mutual fund units, real estate and bullion. The saving and investment patterns of the
public affect the stock to a great extent.
3. Inflation - Along with the growth of GDP, if the inflation rate also increases, then
the real rate of growth would be very little. The demand in the consumer product 7
industry is significantly affected. The industries which come under the government
 price control policy may lose the market, for example Sugar. The government
control over this industry, affects the price of the sugar and thereby the profitability
of the industry itself. If there is a mild level of inflation, it is good to the stock
market but high rate of inflation is harmful to the stock market
4. Interest Rates - The interest rate affects the cost of financing to the firms. A
decrease in interest rate implies lower cost of finance for firms and more
profitability. More money is available at a lower interest rate for the brokers who
are doing business with borrowed money.
5. Budget - The budget draft provides an elaborate account of the government
revenues and expenditures. A deficit budget may lead to high rate of inflation
and adversely affect the cost of production. Surplus budget may result in deflation.
Hence, balanced budget is highly favorable to the stock market.
6. The Tax Structure - Every year in March, the business community eagerly awaits
the Government's announcement regarding the tax policy. Concessions and
incentives given to a certain industry encourages investment in that particular
industry. Tax reliefs given to savings encourage savings.
7. The Balance Of Payment - The balance of payment is the record of a country's
money receipts from and payments abroad. The difference bt6ween receipts and
payments may be surplus or deficit. Balance of payment is a measure of the strength
of rupee on external account. If the deficit increases, the rupee may depreciate
against other currencies, thereby, affecting the cost of imports. The industries
involved in the export and import are considerably affected by the changes in
foreign exchange rate. The volatility of the foreign exchange rate affects the
investment of the foreign institutional investors in the Indian stock market. A
favorable balance of payment renders a positive effect on the stock market.
8. Monsoon And Agriculture - Agriculture is directly and indirectly linked with the
industries. For example, Sugar, Cotton, Textile and Food processing industries
depend upon agriculture for raw-material. Fertilizer and insecticide industries are
supplying inputs to the agriculture. A good monsoon leads to higher demand for
input and results in bumper crop. This would lead to optimism in the stock market.
When the monsoon is bad, agricultural and hydro power production would suffer.
They cast a shadow on the share market.
9. Infrastructure Facilities - Infrastructure facilities are essential for the growth of
industrial and agricultural sector. A wide net work of communication system is a
must for the growth of the economy. Regular supply of power without any power
cut would boost the production. Banking and financial sectors also should be
sound enough to provide adequate support to the industry and agriculture. Good
infrastructure facilities affect the stock market favorably. In India even though
infrastructure facilities have been developed, still they are not adequate. The
government has liberalized its policy regarding the communication, transport and
power sector. For example, power sector has been opened up to the foreign investors
with assured rates of returns.
10. Demographic Factors - The demographic data provides details about the
population by age, occupation, literacy and geographic location. This is needed to
forecast the demand for the consumer goods. The population by age indicates the
availability of able work force.
2. Industry analysis
8
Industry analysis is a type of investment research that begins by focusing on the
status of an industry. The purpose is to predict the profitability and business growth of the
industry in the future. Industry analysis covers sales and earnings trend, government policy
on the industry, competitive conditions, stock price trend, and so on.
TYPES OF INDUSTRY ANALYSIS

There are three commonly used and important methods of performing industry analysis.
The three methods are:
1. Competitive Forces Model (Porter’s 5 Forces)
2. Broad Factors Analysis (PEST Analysis)
3. SWOT Analysis

I. Competitive Forces Model (Porter’s 5 Forces)

One of the most famous models ever developed for industry analysis, famously known as
Porter’s 5 Forces. According to Porter, analysis of the five forces gives an accurate
impression of the industry and makes analysis easier

1. Intensity of industry rivalry

The number of participants in the industry and their respective market shares are a direct
representation of the competitiveness of the industry. These are directly affected by all the
factors mentioned above. Lack of differentiation in products tends to add to the intensity of
competition. High exit costs such as high fixed assets, government restrictions, labor
unions, etc. also make the competitors fight the battle a little harder.
2. Threat of potential entrants

This indicates the ease with which new firms can enter the market of a particular industry.
If it is easy to enter an industry, companies face the constant risk of new competitors. If the
entry is difficult, whichever company enjoys little competitive advantage reaps the benefits
for a longer period. Also, under difficult entry circumstances, companies face a constant
set of competitors.
3. Bargaining power of suppliers

This refers to the bargaining power of suppliers. If the industry relies on a small number of
suppliers, they enjoy a considerable amount of bargaining power. This can particularly
affect small businesses because it directly influences the quality and the price of the final
product. 9
4. Bargaining power of buyers
 The complete opposite happens when the bargaining power lies with the customers. If
consumers/buyers enjoy market power, they are in a position to negotiate lower prices,
better quality, or additional services and discounts. This is the case in an industry with
more competitors but with a single buyer constituting a large share of the industry’s sales.
5. Threat of substitute goods/services

The industry is always competing with another industry producing a similar substitute
product. Hence, all firms in an industry have potential competitors from other industries.
This takes a toll on their profitability because they are unable to charge exorbitant prices.
Substitutes can take two forms – products with the same function/quality but lesser price,
or products of the same price but of better quality or providing more utility.
II. Broad Factors Analysis (PESTLE Analysis)

Broad Factors Analysis, also commonly called the PESTLE Analysis stands for Political,
Economic, Social and Technological. PESTLE analysis is a useful framework for
analyzing the external environment.
1. Political Factors:
Political factors that impact an industry include specific policies and regulations related to
things like taxes, environmental regulation, tariffs, trade policies, labor laws, ease of doing
business, and overall political stability.
2. Economic Factors:
The economic forces that have an impact include inflation, exchange rates (FX), interest
rates, GDP growth rates, conditions in the capital markets (ability to access capital), etc.
3. Social Factors:
The social impact on an industry refers to trends among people and includes things such as
population growth, demographics (age, gender, etc.), and trends in behavior such as health,
fashion, and social movements.
4. Technological Factors:
The technological aspect of PEST analysis incorporates factors such as advancements and
developments that change the way a business operates and the ways in which people live
their lives (e.g., the advent of the internet).
5. Legal Factors:
The legal aspects checks how labor laws, employment contracts, industry regulations and
other legal requirements can influence a company.
6. Environmental Factors:
This analysis studies the potential impacts of environmental issues , such as climate change
on the business.
III. SWOT Analysis

SWOT Analysis stands for Strengths, Weaknesses, Opportunities, and Threats. It

can be a great way of summarizing various industry forces and determining their 10
implications for the business in question.
1. Strengths: Factors that give the industry an edge over the others
2. Weaknesses: Factors that keep businesses at a disadvantage
3. Opportunities: Factors present in the economy and external environment that
positively impact the performance and profitability
4. Threats: Factors present in the economy and external environment that negatively
impact the performance and profitability

INDUSTRY LIFE CYCLE

The industry life cycle refers to the evolution of an industry or business through four
stages based on the business characteristics commonly displayed in each phase.
Phases:
1. Introduction Phase
The introduction, or startup, phase involves the development and early marketing of a new
product or service. Innovators often create new businesses to enable the production and
proliferation of the new offering. Information about the products and industry participants is
often limited, so demand tends to be unclear. During this stage, consumers of the goods and
services need to learn more about them, while the new providers are still developing and
honing the offering.
Example: Artifitial intelligence industry

2. Growth Phase
In this second phase, consumers have come to understand the value of the new offering,
business, or industry. Demand grows rapidly. A handful of important players usually
becomes apparent, and they compete to establish a share of the new market. Immediate
profits usually are not a top priority as companies spend on research and development or
marketing.
Example: Computer industry
3. Maturity Phase
The maturity phase begins with a shakeout period, during which sales growth slows, focus
shifts toward expense reduction, and consolidation occurs (as companies begin to merge or
acquire each other). Some firms attain economies of scale, hampering the sustainability of
smaller competitors. Growth can continue.
Example: Food and agriculture industry
4. Decline Phase
The decline phase marks the end of an industry's or business' ability to support growth.
Obsolescence and evolving end markets (end users) negatively impact demand, leading to
declining revenues. This creates margin pressure, forcing weaker competitors out of the
industry.

3. Company analysis

Company analysis contains an evaluation & examination of a company, its

financial health & prospects, management strategy or marketing activities & its
strengths & weaknesses. There are two types of company analysis namely qualitative and 11
quantitative
I. Qualitative Fundamentals

The qualitative analysis captures the company’s aspects or risks difficult to measure
in numbers- such as management competencies and credibility, competitive strategies,
R&D capabilities, brand recall, and others.
a) Business Model: A business model describes the company’s plans for earning
revenues, its products and services, the target market so as to maintain its
profitability. Companies need to constantly update, innovate and be able to
withstand any technological disruption, adopt efficient marketing and business
strategies for their smooth functioning without which they may run into losses and
eventually get wiped out from the market.
b) Competitive Advantage: Investors should usually prefer to invest in those
companies that have been able to develop competitive advantages for themselves
in terms of cost advantage, quality, brand, distribution network, etc. This helps
the company to create an economic trench around the business, thus helping the
company to keep competitors at bay and enjoy longevity, growth, profits, and
dominate the market share. A company with a competitive advantage usually
generates greater value not only for the company but also for its shareholders,
over the long term.
c) Management: Sound management with strong credibility always works for the
betterment of the company and its employees and also generates wealth for the
shareholders. Thus, it is always in the interest of the shareholders to be associated
with trustworthy and competent management rather than with management having
questionable credibility.
d) Corporate Governance: This is the framework of rules, practices, and processes
which direct and control the firms as well as involves balancing the interests
between management, directors, and stakeholders. Investors should always invest
in companies that are run ethically, fairly, transparently, and efficiently and whose
management respects its shareholders’ rights and interests.
II. Quantitative Fundamentals:
These are the measurable factors that influence the value of a firm. The biggest source of
quantitative data is Financial Statements, analyzing which helps investors to make better
investment decisions.
a) The Balance Sheet
This statement records a company’s assets, liabilities, and equity at a particular point
in time. It shows investors the financial structure of a company, listing down what a
company owns and owes, thus helping to determine a company’s real worth.
b) Income Statement
It reports the financial performance of a company over a period of time. Publicly listed
companies present their Income Statements quarterly or annually. It provides investors
with an insight into how the net revenues realized by a company are transformed into net
earnings (profit or loss).
c) Cash Flow Statement
This is a very important financial statement, as it shows the true cash or liquidity position
of a company. It provides information on the cash inflows and outflows over a period of
time. It is difficult to manipulate the cash position of a company; therefore it is used as a
concrete measure of a company’s performance.
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Valuation of Securities

DEBENTURES
The word ‘debenture’ it self is a derivation of the Latin word ‘debere’ which means
to borrow or loan. Debentures are written instruments of debt that companies issue under
their common seal. They are similar to a loan certificate.
A debenture is a type of bond or other debt instrument that is unsecured by
collateral. Since debentures have no collateral backing, they must rely on the
creditworthiness and reputation of the issuer for support.

Features

The important features of debentures are as follows:

1. Debenture holders are the creditors of the company carrying a fixed rate of interest.
2. Debenture is redeemed after a fixed period of time.
3. Debentures may be either secured or unsecured.
4. Interest payable on a debenture is a charge against profit and hence it is a tax-
deductible expenditure.
5. Debenture holders do not enjoy any voting right.
6. Interest on debenture is payable even if there is a loss.
Advantages

1. Issue of debenture does not result in dilution of interest of equity shareholders as

they do not have right either to vote or take part in the management of the company.
2. Interest on debenture is a tax deductible expenditure and thus it saves income tax.

3. Cost of debenture is relatively lower than preference shares and equity shares.

4. Issue of debentures is advantageous during times of inflation.

5. Interest on debenture is payable even if there is a loss, so debenture holders bear no

risk.
Disadvantages

1. Payment of interest on debenture is obligatory and hence it becomes burden if the

company incurs loss.
2. Debentures are issued to trade on equity but too much dependence on debentures
increases the financial risk of the company.
3. Redemption of debenture involves a larger amount of cash outflow.
4. During depression, the profit of the company goes on declining and it becomes
difficult for the company to pay interest.
Different Types of Debentures:

1. From the Point of view of Security 13

  Secured Debentures: Secured debentures are that kind of debentures where a
charge is being established on the properties or assets of the enterprise for the
purpose of any payment. The charge might be either floating or fixed. The fixed
charge is established against those assets which come under the enterprise’s
possession for the purpose to use in activities not meant for sale whereas floating
charge comprises of all assets excluding
those accredited to the secured creditors. A fixed charge is established on a particular
asset whereas a floating charge is on the general assets of the enterprise.
 Unsecured Debentures: They do not have a particular charge on the assets of the
enterprise. However, a floating charge may be established on these debentures by
default. Usually, these types of debentures are not circulated.
2. From the Point of view of Tenure

 Redeemable Debentures: These debentures are those debentures that are due on
the cessation of the time frame either in a lump-sum or in instalments during the
lifetime of the enterprise. Debentures can be reclaimed either at a premium or at
par.
 Irredeemable Debentures: These debentures are also called as Perpetual
Debentures as the company doesn’t give any attempt for the repayment of money
acquired or borrowed by circulating such debentures. These debentures are
repayable on the closing up of an enterprise or on the expiry (end) of a long period.
3. From the Point of view of Convertibility

 Convertible Debentures: Debentures which are changeable to equity shares or in

any other security either at the choice of the enterprise or the debenture holders are
called convertible debentures. These debentures are either entirely convertible or
partly changeable.
 Non-Convertible Debentures: The debentures which can’t be changed into shares
or in other securities are called Non-Convertible Debentures. Most debentures
circulated by enterprises fall in this class.
4. From Coupon Rate Point of view

 Specific Coupon Rate Debentures: Such debentures are circulated with a

mentioned rate of interest, and it is known as the coupon rate.
 Zero-Coupon Rate Debentures: These debentures don’t normally carry a
particular rate of interest. In order to restore the investors, such type of debentures
are circulated at a considerable discount and the difference between the nominal
value and the circulated price is treated as the amount of interest associated to the
duration of the debentures.
5. From the view Point of Registration

 Registered Debentures: These debentures are such debentures within which all
details comprising addresses, names and particulars of holding of the debenture
holders are filed in a register kept by the enterprise. Such debentures can be moved
only by performing a normal transfer deed.
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 Bearer Debentures: These debentures are debentures which can be transferred
 by way of delivery and the company does not keep any record of the debenture
holders Interest on debentures is paid to a person who produces the interest coupon
attached to such debentures.
PREFERENCE SHARES

Preference shares, more commonly referred to as preferred stock, are shares of a

company’s stock with dividends that are paid out to shareholders before common stock
dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled
to be paid from company assets before common stockholders.

Features of Preference Shares

The following are the features of preference shares:

1. Preferential dividend option for shareholders.

2. Preference shareholders do not have the right to vote.

3. Shareholders have a right to claim the assets in case of a wind up of the company.

4. Fixed dividend payout for shareholders, irrespective of profit earned.

5. Acts as a source of hybrid financing.

Types Of Preference Shares

a. Cumulative Preference Shares: When unpaid dividends on preference shares are

treated as arrears and are carried forward to subsequent years, then such preference shares
are known as cumulative preference shares. It means unpaid dividend on such shares is
accumulated till it is paid off in full.
b. Non-cumulative Preference Shares: Non-cumulative preference shares are those type
of preference shares, which have right to get fixed rate of dividend out of the profits of
current year only. They do not carry the right to receive arrears of dividend. If a company
fails to pay dividend in a particular year then that need not to be paid out of future profits.
c. Redeemable Preference Shares: Those preference shares, which can be redeemed
or repaid after the expiry of a fixed period or after giving the prescribed notice as desired
by the company, are known as redeemable preference shares. Terms of redemption are
announced at the time of issue of such shares.
d. Non-redeemable Preference Shares: Those preference shares, which cannot be
redeemed during the life time of the company, are known as non-redeemable preference
shares. The amount of such shares is paid at the time of liquidation of the company.
e. Participating Preference Shares: Those preference shares, which have right to
participate in any surplus profit of the company after paying the equity shareholders, in
addition to the fixed rate of their dividend, are called participating preference shares.
f. Non-participating Preference Shares: Preference shares, which have no right to
participate on the surplus profit or in any surplus on liquidation of the company, are called
non-participating preference shares.
g. Convertible Preference Shares: Those preference shares, which can be converted 15
into equity shares at the option of the holders after a fixed period according to the terms
 and conditions of their issue, are known as convertible preference shares.
h. Non-convertible Preference Shares: Preference shares, which are not convertible
into equity shares, are called non-convertible preference shares.
EQUITY SHARES

Equity shares also known as ordinary shares or common shares represents

ownership in a company and confer a proportional claim on its assets and earnings. When
investor purchase equity shares, they become shareholders and in essence partial owners of
the company. These shares are considered as vital component of a company’s capital
structure, alongside debt and preference shares.
Features of equity shares

1. Permanent Shares: Equity shares are permanent in nature. The shares are
permanent assets of a company. And are returned only when the company winds
up.
2. Significant Returns: Equity shares have the potential to generate significant returns
to the shareholders. However, these are risky investment options. In other words,
equity shares are highly volatile. The price movements can be drastic and are
dependent on multiple internal and external factors. Therefore, investors with
suitable risk tolerance levels should only consider investing in these.
3. Dividends: Equity shareholders share the profits of a company. In other words, a
company may distribute dividends to its shareholders from its annual profits.
However, a company is under no obligation to distribute dividends. In case a
company doesn’t make good profits and doesn’t have surplus cash flow, it can
choose not to give dividends to its shareholders.
4. Voting Rights: Most equity shareholders have voting rights. This allows them to
select the people who will govern the company. Choosing effective managers assists
the company to enhance its annual turnover. As a result, investors can receive
higher average dividend income.
5. Additional Profits: Equity shareholders are eligible for additional profits a
company makes. It, in turn, increases the wealth of the investor.
6. Liquidity: Equity shares are highly liquid investments. The shares are trade on the
stock exchanges. As a result, you can buy and sell the share anytime during trading
hours. Therefore, one does not have to worry about liquidating their shares.
7. Limited Liability: Losses a company makes doesn’t affect the ordinary
shareholders. In other words, the shareholders are not liable for the company’s debt
obligations. The only effect is the decrease in the price of the stocks. This will have
an impact on the return on investment for a shareholder.

Advantages of Equity shares

The following are the advantages of investing in equity shares:

1. High Returns: Equity shares have the potential to generate high returns as they are
high- risk investments. Higher the risk, the higher the reward. The shares are highly 16
volatile, and the prices fluctuate owing to many factors. Demand, supply, economic
 factors, company performance, geo-political factors, etc., all impact the share price.
2. Voting Rights: Equity shareholders enjoy voting rights. They can vote for or
against corporate policies and business decisions.
3. Limited Legal Obligations: Though equity shareholders own a part of the
company, they have limited legal liabilities.
4. Liquidity: These shares trade on the stock exchange. Buying and selling them is
quite easy.
Disadvantages of Equity shares

The following are the risks and disadvantages of investing in equity shares:
1. Company’s Performance: The performance of the share largely depends on the
company’s performance. When the company is not performing and is unable to make
profits, the equity shareholder will not receive any dividends.
2. Capital Loss: Since equity shares are high-risk, high-reward investments, the
probability of capital loss is also high. Due to many internal and external factors, the
share price fluctuates. A negative impact may lead to a capital loss for the investors.
3. Volatility: Volatility in share prices can be for many reasons. The market sentiments
drive the share prices up and down. Timing the markets is an impossible strategy to
adopt. The share prices fluctuate within seconds and microseconds.

Types of Equity share

1. Authorized Share Capital- This amount is the highest amount an organization can
issue. This amount can be changed time as per the companies recommendation and with
the help of few formalities.
2. Issued Share Capital- This is the approved capital which an organization gives to the
investors.
3. Subscribed Share Capital- This is a portion of the issued capital which an investor
accepts and agrees upon.
4. Paid Up Capital- This is a section of the subscribed capital, that the investors give.
Paid- up capital is the money that an organization really invests in the company’s
operation.
5. Right Share- These are those type of share that an organization issue to their existing
stockholders. This type of share is issued by the company to preserve the proprietary
rights of old investors.
6. Bonus Share- When a business split the stock to its stockholders in the dividend form,
we call it a bonus share.
7. Sweat Equity Share- This type of share is allocated only to the outstanding workers or
executives of an organization for their excellent work on providing intellectual property
rights to an organization.

Valuation of Equity 17
The Dividend Discount Method is one of the popular methods for finding out
 the price of the stocks and helping investors be aware of the expected returns. This is
based on assumptions, which makes it far off from any kind of reality check against the
estimated stock prices. The use of this model is recommended to investors and entities
operating on a large scale.

Dividend discount model

1. Zero-Growth Dividend Discount Model – This model assumes that all the dividends
paid by the stock remain the same forever until infinite. The zero-growth model
assumes that the dividend always stays the same, i.e., there is no growth in dividends.
Therefore, the stock price would be equal to the annual dividends divided by the
required rate of return.
2. Constant Growth Dividend Discount Model – This dividend discount model assumes
dividends grow at a fixed percentage. They are not variable and are consistent
throughout.
3. Super growth model/Variable Growth Dividend Discount Model or Non-Constant
Growth – This model may divide the growth into two or three phases. The first one
will be a fast initial phase, then a slower transition phase, and ultimately ends with a
lower rate for the infinite period. The purpose of the supernormal growth model is to
value a stock that is expected to have higher than normal growth in dividend payments
for some period in the future. After this supernormal growth, the dividend is expected to
go back to normal with constant growth.

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