SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Module 1: Introduction to Securities

Investment: Meaning & Definition

Investing is the process of purchasing an object with the intention of accumulating wealth through
regular income or sales profits.

An investment avenue means investing money in something. It is often referred to as investment alternatives
or investment strategies. There are numerous methods to categories investing possibilities.

Surprisingly, no investment strategy can guarantee a high rate of return with any risk. Danger and reward are
proportionate in the real world; that is, the greater the risk, the larger the return. It is vital, however, to maintain
a solid, long-term portfolio that benefits you, not the bank. This establishes the basis for investor profiling.

When selecting an investing plan, the investor‘s risk tolerance should meet the product‘s risk tolerance. It is
vital for an individual to recognise his or her personal risk tolerance. Certain assets have the potential to
generate better inflation-adjusted returns than others, but they also have a higher failure rate.

Between these two groups, an investor should comprehend the distinction between financial and nonfinancial
assets. It encompasses both market-linked assets such as stocks and mutual funds and fixed income products
such as bank fixed deposits and PPFs, the latter of which include physical assets such as gold and real estate
and is more prevalent in India.

Types of Avenues of Investment

There are wide ranges of investment opportunities available in India. You can look at the following
types of avenues of investment to understand it.

1. Derivatives Market
Derivatives are a subset of the indirect asset investment category. The derivatives market is now
expanding. It enables you to leverage your money more effectively, manage your risks, and engage in
speculation. Financial instruments include forwards, futures, options, swaps, and other derivatives.

2. Mutual Funds Investments

A mutual fund is a professionally managed investment vehicle that aggregates money from a variety of
investors to purchase equities. They can invest in a variety of securities. Mutual funds may invest in gold,
equities, bonds, or a combination of the three. They can be dealt with in an aggressive or quiet manner.
The fund manager selects the securities that will generate returns, whereas passive funds, also known as
exchange traded funds (ETFs), invest in indices. Equity mutual funds are classed according to their market
capitalization or industry exposure.
For example, pension funds invest in debt mutual funds due of their stable returns and low risk. The funds
invest in fixed-income securities such as corporate and government bonds, as well as treasury bills,
commercial paper, and other money market instruments. On the other hand, debt mutual funds are neither
risk-free nor guaranteed.

3. Debentures / Bonds
They are long-term investments that generate a predictable cash flow stream based on the interest rate
set at the time of purchase. They believe to be less hazardous. The identity of the issuer determines the risk
level of debentures or bonds. Examples include government securities, savings bonds, and public sector unit
bonds.

4. Fixed Deposits
Fixed deposits are a very popular investment option in India, and for good reason. They are known as
low-risk investments since they promise a fixed rate of return for a specified period of time.
Financial institutions offer FDs. The interest rate on a deposit might vary between deposits and over time.
While FDs have a lock-in period, the majority of financial institutions continue to offer loans and overdrafts
during that time.

5. PPF (Public Provident Fund)

It is a 15-year lock-in savings scheme given by the Indian government that enables investors to
gradually accumulate assets. On the other hand, PPF investments are tax deductible and widely regarded as
secure. The government adjusts the PPF interest rate quarterly. Investors who meet certain conditions may
also be eligible for partial withdrawals and loans.

6. EPF (Employee Provident Fund)

It is a retirement savings plan that is available only to salaried employees. Monthly contributions are
deductible from employee‘s paychecks, and the employer contributes to the organization‘s corpus. Under
Section 80C of the Income Tax Act of 1961, EPFs are tax deductible, and the ultimate distribution is tax-free.

7. NPS (National Pension Scheme)

The National Pension System (NPS) is an Indian government-run retirement pension plan. You can
build a corpus that will give you with a steady income stream in the event that you lose your job. After
retirement, investors may make partial withdrawals from the fund.

8. Property / Real Estate

Investing in real estate is one of the most popular financial strategies available today. On the other
hand, personal property should never be viewed as an investment. Along with residential real estate, other
sectors such as office, commercial, warehouse, student housing, data centres, and shared spaces are
attracting investor interest.
The location of a property has a considerable effect on its value and rental income. Capital appreciation and
rental income are two ways that real estate investments generate revenue. In comparison to other asset
classes, real estate is extremely illiquid.

9. Invest in Gold
While gold jewelry is the most traditional form of investment for Indians, it raises worries about security
and the high expense of ‗making charges.‘ While purchasing gold coins or biscuits is a viable alternative, gold
ETFs may be a better option. Investing in gold paper through exchange-traded funds (ETFs) is a safer and
more cost-effective way to do so. You can also learn how to check purity of gold, if have interest in it. Despite
the widespread belief that jewellery is a liquid asset, many ignorant investors are duped into acquiring
duplicate or mixed pieces of jewellery without completing adequate research or from a dodgy jeweler.

10. Life Insurance & General Insurance

Life insurance policies protect against risk in the case of an accident, they are not consider as
investments. On the other hand, many Indians view insurance as an investment. Life insurance is a means of
safeguarding one‘s future. Other investment options seek profit; however life insurance is design to safeguard
our family in the event of an unexpected calamity.

11. Equity Share

Equity, also called shares or scrip‘s, is the basic building blocks of a company. A company‘s ownership
is determined on the basis of its shareholding. Shares are, by far, the most glamorous financial instruments for
investment for the simple reason that, over the long term, they offer the highest returns. Predictably, they‘re
also the riskiest investment option.

Investment v/s Gambling v/s Speculation v/s Arbitration v/s Hedging

Basis Of
Investment Speculation
Comparison
 Purchase of an asset/security for securing Executing a risky financial transaction
Meaning
stable returns with the hope of profit-making

Time Horizon Long Term Short-term generally less than a year

Risk Levels Moderate High

Deployment of
An investor using funds of self Borrowed funds
funds

Aggressive with an element of

Investor attitude Cautious and Conservative
carelessness

Fundamental and Basic factors, i.e., Financial Technical charts, Market psychology,
Decision criteria
performance of the company/sector and individual opinion

Expectations of
Modest but continuous A high rate of return.
Returns

Speculation vs. Gambling

Speculation and gambling are two different actions used to increase wealth under conditions of risk or
uncertainty. However, these two terms are very different in the world of investing. Gambling refers to wagering
money in an event that has an uncertain outcome in hopes of winning more money, whereas speculation
involves taking a calculated risk in an uncertain outcome. Speculation involves some sort of positive expected
return on investment—even though the end result may very well be a loss. While the expected return for
gambling is negative for the player—even though some people may get lucky and win.

Speculation
Speculation involves calculating risk and conducting research before entering a financial transaction. A
speculator buys or sells assets in hopes of having a bigger potential gain than the amount he risks. A
speculator takes risks and knows that the more risk they assume, in theory, the higher their potential gain.
However, they also know they may lose more than their potential gain.

For example, an investor may speculate that a market index will increase due to strong economic
numbers by buying one contract in one market futures contract. If their analysis is correct, they may be able to
sell the futures contract for more than they paid, within a short- to medium-term period. However, if they are
wrong, the investor can lose more than their expected risk.

Gambling
Converse to speculation, gambling involves a game of chance. Generally, the odds are stacked against
gamblers. When gambling, the probability of losing an investment is usually higher than the probability of
winning more than the investment. In comparison to speculation, gambling has a higher risk of losing the
investment.

For example, a gambler opts to play a game of American roulette instead of speculating in the stock
market. The gambler only places their bets on single numbers. However, the payout is only 35 to 1, while the
odds against them winning are 37 to 1. So if a gambler bets $2 on a single number, their potential gambling
income is $70 (35*$2) but the odds of them winning is approximately 1/37.

Key Differences
Although there may be some superficial similarities between the two concepts, a strict definition of both
speculation and gambling reveals the principle differences between them. A standard dictionary defines
speculation as a risky type of investment, where investing means to put money to use, by purchase or
expenditure, in something offering profitable returns, especially interest or income. The same dictionary defines
gambling as follows: To play at any game of chance for stakes. To stake or risk money, or anything of value,
on the outcome of something involving chance; bet; wager.

Arbitrage
 Arbitrage is a financial strategy that involves the purchase of a security on one market and the sale of
the same security for a slightly higher price on another.
 Speculation is based on assumptions and hunches.
 Arbitrage involves a limited amount of risk, while the risk of loss and profit is greater with speculation.
 Anyone can engage in speculation, but arbitrage is mainly used by large, institutional investors and
hedge funds.

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small differences
in price. Arbitrage is possible because of inefficiencies in the market.

Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one market such as a financial
market in the like the National Stock Exchange (NSE) while simultaneously selling the same stock on a
different market like the Bombay Stock Exchange (BSE).
Hedging
Hedging is a tactic used by traders to minimize possible risk, and thereby loss in income resulting from
changes in the movement, in price levels.

An investor will hedge against possible losses by entering into an investment that allows the investor to
take a position to offset any losses, in the event that the worse happens. It acts like a security measure, or an
insurance coverage against suffering substantial losses. Hedging can be done by financial instruments such as
stocks, futures, options, swaps and forwards, and usually employ complex investment strategies such as short
selling and taking long positions.

Hedging can be understood better with an example. Airlines consistently purchase fuel to run their
operations. However, the price of fuel is extremely volatile and so most airlines attempt to guard against this
risk by taking on a hedge that sets the price of fuel at a maximum cap. This can be done through financial
instruments such as a swap or option.

Arbitrage v/s Hedging

Arbitrage and hedging are both techniques that are used by traders that operate in a volatile financial
environment. However, these techniques are quite different to each other and are used for different purposes.
Arbitrage is usually used by a trader who seeks to make large profits through market inefficiencies. On the
other hand, hedging is used by traders as an insurance policy to guard against any potential losses. Arbitrage
and hedging are similar to each other in that they both require investors to anticipate movements in the market
and use financial instruments to benefit from those movements.

Hedging Factors to be considered for Investment

Return, risk, correlation and cost as the four factors to consider when it comes to currency hedging.
Investment is made because it serves some objective for an investor. Depending on the life stage and risk
appetite of the investor, there are three main objectives of investment: safety, growth and income. Every
investor invests with a specific objective in mind, and each investment has its own unique set of benefits and
risks. Let us understand these objectives in detail.

Safety
While no investment option is completely safe, there are products that are preferred by investors who
are risk averse. Some individuals invest with an objective of keeping their money safe, irrespective of the rate
of return they receive on their capital. Such near-safe products include fixed deposits, savings accounts,
government bonds, etc.

Growth
While safety is an important objective for many investors, a majority of them invests to receive capital
gains, which means that they want the invested amount to grow. There are several options in the market that
offer this benefit. These include stocks, mutual funds, gold, property, commodities, etc. It is important to note
that capital gains attract taxes, the percentage of which varies according to the number of years of investment.

Income
Some individuals invest with the objective of generating a second source of income. Consequently,
they invest in products that offer returns regularly like bank fixed deposits, corporate and government bonds,
etc. Other objectives

While the aforementioned objectives are the most common ones among investors today, some other
objectives include:

Tax exemptions
Some people invest their money in various financial products solely for reducing their tax liability. Some
products offer tax exemptions while many offer tax benefits on long-term profits.

Liquidity
 Many investment options are not liquid. This means they cannot be sold and converted into cash instantly.
However, some people prefer investing in options that can be used during emergencies. Such liquid
instruments include stock, money market instruments and exchange-traded funds, to name a few.

Risk
The dictionary meaning of risk is the possibility of loss or injury; risk the possibility of not getting the
expected return. The difference between expected return and actual return is called the risk in investment.
Investment situation may be high risk, medium and low risk investment;
 Buying government securities - low risk
 Buying shares of an existing Profit making company - Medium risk
 Buying shares of a new company - High risk

Risk & Return Analysis

In investing, risk and return are highly correlated. Increased potential returns on investment usually go
hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk,
competitive risk, international risk, and market risk. Return refers to either gains or losses made from trading a
security.

The return on an investment is expressed as a percentage and considered a random variable that
takes any value within a given range. Several factors influence the type of returns that investors can expect
from trading in the markets.

Diversification allows investors to reduce the overall risk associated with their portfolio but may limit
potential returns. Making investments in only one market sector may, if that sector significantly outperforms the
overall market, generate superior returns, but should the sector decline then you may experience lower returns
than could have been achieved with a broadly diversified portfolio.

Risk and return in financial management is the risk associated with a certain investment and its returns.
Usually, high-risk investments yield better financial returns, and low-risk investments yield lower returns. That
is, the risk of a particular investment is directly related to the returns earned from it.

The risk and return analysis aim to help investors find the best investments. Hence, investors use many
methods to analyze and evaluate the market, industry, and company. Diversification of the portfolio, i.e.,
choosing an optimal mix of different investment options, can reduce the risk and amplify returns.

Types of Risk Appetite

Risk appetite is the amount of risk an organization is willing to take in pursuit of objectives it deems
have value.
Risk appetite can also be described as an organization's risk capacity, or the maximum amount
of residual risk it will accept after controls and other measures have been put in place.

Risk tolerance, by contrast, is the amount of deviation from its risk appetite that an organization is
willing to accept to achieve a specific objective based on parameters that include industry and vertical
standards.

1. Maximization: Always choosing the highest risk option in any decision. This is rare as such individuals or
organizations wouldn't survive long.

2. Maximax: A strategy that maximizes the chance of a maximum return irrespective of risk. For example, a
gambler who heads to the biggest paying game in a casino without regard to probabilities.

3. Risk Seeking: An attraction to risk. This includes individuals who are comfortable with high risk but are only
willing to take calculated risks that are rational. For example, an investor who buys stocks those are equally
likely to go up 2x or fall 49% within a month. The term risk seeking can also apply to uncalculated risk taking.
4. Pareto Risk: An individual who believes that 80% of gains come from 20% of risk. Such individuals are only
willing to take risks that have a very attractive risk-reward ratio. For example, a traveler who is willing to take
flights on a reputable airline but unwilling to take unlicensed motorcycle taxis.

5. Risk Adverse: A tendency to prefer the safest choices in every list of options. In some cases, efforts to
avoid risk can create larger secondary risks. The classic example of this is an investor who avoids all risk who
fails to preserve the value of their wealth due to inflation. Avoidance of risk and uncertainty is a key objective
here.

6. Minimalist: A preference to minimize a dread risk at any cost. This is typically irrational and based on
emotions of fear and protective instincts. Preference for ultra-safe business delivery options that have a low
degree of inherent risk and only have a potential for limited reward.

7. Minimization: A preference to minimize every risk, whatever the cost. This may apply in areas such as
safety engineering where it is simply unacceptable for a particular type of safety incident to occur.

8. Risk Neutral: Comfort with risk that is taken for a good reason such as risks that are taken rationally based
on an analysis of risk-reward. For example, an individual who makes a risky career choice who knows it may
be a difficult path but is willing to face this risk to reach a goal they feel is important.

9. Cautious: Preference for safe delivery options that have a low degree of residual risk and may only have
limited potential for reward.

10. Open: Willing to consider all potential delivery options and choose the one that is most likely to result in
successful delivery while also providing an acceptable level of reward (and value for money etc.).

11. Hungry: Eager to be innovative and to choose options offering potentially higher business rewards, despite
greater inherent risk.

Types of Risk in Investment

All investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or
potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek
higher returns to compensate themselves for taking such risks.

Here are 9 types of investment risk you may be exposed to as an investor:

1. Market Risk – the risk that your investments may decrease in value due to economic developments or
events that affect the entire market. There are four types of market risk:

a. Equity risk – the risk that share prices in general will fluctuate.
b. Interest rate risk – the risk that interest rates will fluctuate and impact the value of a debt
investment (like bonds) Interest rate changes can affect a bond‘s value. If bonds are held to maturity
the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth
more or less than the face value. Rising interest rates will make newly issued bonds more appealing to
investors because the newer bonds will have a higher rate of interest than older ones. To sell an older
bond with a lower interest rate, you might have to sell it at a discount.

c. Currency risk – the risk that exchange rates will fluctuate and impact the value of an investment in
a foreign currency.
d. Commodity risk – the risk that commodity (crude oil, corn, etc.) prices will change and impact the
value of an investment.

2. Liquidity Risk – Liquidity refers to how easy it is to buy or sell an investment. Liquidity risk is the risk of not
being able to sell your investments at a certain price when you want to. For example, some investments may
require you to hold them for a certain length of time before you can sell.
3. Concentration Risk – the risk of loss when all your investment money is concentrated in one type of
investment. Diversification can minimize this risk by owning different types of investments in different industries
and locations.

4. Credit Risk – Also referred to as default risk, this applies to debt investments such as bonds. It is the risk
that the government or company that issued the bond will be unable to pay the interest or repay the principal at
maturity. The bond‘s credit rating can help you evaluate credit risk. A credit rating of AAA represents the
lowest credit risk.

5. Reinvestment risk – the risk of loss if you reinvest your investment returns as a lower interest rate.

6. Inflation risk – the risk of loss in your purchasing power if your investment does not keep up with inflation.
Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for
investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is
that inflation will erode returns.

7. Horizon risk – the risk that your investment timeline (or horizon) may change because of an unexpected life
event. For example, the loss of a job may cause you to have to sell your investments earlier than you
expected.
8. Longevity risk – the risk of outliving your savings or investments.

9. Foreign investment risk – the risk of loss when you invest in foreign countries. This can include investing
in equities in foreign companies, or simply making any investment with an entity that is not based in India.

Business risk: The risk associated with the unique circumstances of a particular company as they might affect
the price of the company‘s securities. It can be affected by a number of issues such as changes in share
prices, employee layoffs, gains or losses of contracts and changes in management.

Market/systemic risk: The day-to-day fluctuation in a stock‘s price (also known as volatility). Market risk
applies mainly to stocks and options. In general, stocks tend to perform well during a bull market and poorly
during a bear market.

Default risk: The risk that a company or individual will be unable to pay the contractual interest or principal on
its debt obligations (bonds or debentures). Government bonds, especially those issued by the federal
government, have the least amount of default risk and least amount of returns. Corporate bonds tend to have
the highest amount of default risk, but also have higher interest rates.

Foreign exchange or currency risk: Currency exchange rates can change the price of an investment.
Foreign exchange risk applies to all financial instruments that are in a currency other than your domestic
currency. There is a possibility that a profit may be negated once a profit from a foreign investment is
converted to domestic currency, especially if exchange rates have changed since the investment was made.

Inflation risk: The possibility that the value of assets or income will decrease as inflation shrinks the
purchasing power of a currency. Inflation causes money to decrease in value over time, and does so whether
the money is invested or not.

Interest rate risk: Investments such as bonds, Guaranteed Investment Certificates and mortgage-based
investments will fluctuate in value when interest rates change. When the interest rates go up, the value of
fixed-rate investments drops. When the interest rates go down, the value of fixed-rate investments increases.

Liquidity risk: The risk coming from the lack of marketability of an investment that cannot be bought or sold
quickly enough to prevent or minimize a loss. To sell the investment, you may need to accept a lower price.

Mortgage risk: The risk that the individual or company that borrows the money will fail to make timely principal
and interest payments in accordance with the terms of the mortgage.
Opportunity risk: The risk that a better opportunity may present itself after an irreversible decision has been
made.

Political risk: Return on an investment could suffer as a result of instability or political changes in a country.
For example, the action of the United Kingdom voting to withdraw from the European Union caused the British
pound to drop in value.

Unsystematic risk: Sometimes referred to as ―specific risk‖. Unsystematic risk affects a very small number of
assets. An example is news that affects a specific stock such as a sudden employee strike.

Common Methods of Measurement for Investment Risk Management

Risk management is the analysis of an investment's returns compared to its risk with the expectation that a
greater degree of risk is supposed to be compensated by a higher expected return.
 Risk—or the probability of a loss—can be measured using statistical methods that are historical
predictors of investment risk and volatility.
 Commonly used risk management techniques include standard deviation, Sharpe ratio, and beta.
 Value at Risk and other variations not only quantify a potential dollar impact but assess a confidence
interval of the likelihood of an outcome.
 Risk management also oversees systematic risk and unsystematic risk, the two broad types of risk
impacting all investments.

Standard Deviation
Standard deviation measures the dispersion of data from its expected value. The standard deviation is
commonly used to measure the historical volatility associated with an investment relative to its annual rate of
return. It indicates how much of the current return is deviating from its expected historical normal returns. For
example, a stock that has high standard deviation experiences higher volatility and is therefore considered
riskier.
Standard deviation is most useful in conjunction with an investment's average return to evaluate the dispersion
from historical results. Standard deviation is calculated by dividing the square root of the sum of squared
differences from an investment's mean by the number of items contained in the data set.

Sharpe Ratio
The Sharpe ratio measures investment performance by considering associated risks. To calculate the
Sharpe ratio, the risk-free rate of return is removed from the overall expected return of an investment. The
remaining return is then divided by the associated investment‘s standard deviation. The result is a ratio that
compares the return specific to an investment with the associated level of volatility an investor is required to
assume for holding the investment. The Sharpe ratio serves as an indicator of whether an investment's return
is worth the associated risk.

The Sharpe ratio is calculated by subtracting the risk-free rate of return from an investment's total return. Then,
divide this result by the standard deviation of the investment's excess return.

Beta
Beta measures the amount of systematic risk an individual security or sector has relative to the entire
stock market. The market is always the beta benchmark an investment is compared to, and the market always
has a beta of one.
If a security's beta is equal to one, the security has exactly the same volatility profile as the broad market. A
security with a beta greater than one means it is more volatile than the market. A security with a beta less than
one means it is less volatile than the market.

Beta is calculated by dividing the covariance of the excess returns of an investment and the market by the
variance of the excess market returns over the risk-free rate.

Value at Risk (VaR)

 Value at Risk (VaR) is a statistical measurement used to assess the level of risk associated with a
portfolio or company. The VaR measures the maximum potential loss with a degree of confidence for a
specified period. For example, suppose a portfolio of investments has a one-year 10% VaR of $5 million.
Therefore, the portfolio has a 10% chance of losing $5 million over a one-year period.

Alpha and Beta:

Alpha and beta are measures of external risk. This means that they compare the variation in the value
of an asset to an external benchmark. In the case of alpha, if the asset in question outperforms the benchmark,
it is said to have a positive alpha. If it underperforms the external benchmark, then it is said to have a negative
alpha.
The case with beta is slightly different. Beta compares the volatility of the asset as compared to the
benchmark. For instance, if the value of the benchmark rose by 50% whereas that of the asset rose by 80%, it
is said to have a higher beta.

R-Squared:
R-squared is a measure of the correlation between the asset and the underlying benchmark. An
investment with an r-squared value of 80 is likely to mirror the movements of the benchmark index more
accurately as compared to another investment that has a benchmark value of 60.

_______________________________________________________________________________
Module 2: Security Analysis

Introduction to Fixed & Variable Income Securities

A fixed-income security is an investment that provides a return through fixed periodic interest payments
and the eventual return of principal at maturity. Unlike variable-income securities, where payments change
based on an underlying measure, such as short-term interest rates, the returns of a fixed-income security are
known.

 Fixed-Income securities provide investors with a stream of fixed periodic interest payments and the
eventual return of principal at maturity.
 Bonds are the most common type of fixed-income security.
 Different bonds have different terms and credit ratings assigned to them based on the financial viability
of the issuer.
 The most common types of fixed income securities are corporate, government and treasury bonds and
bank deposit certificates.

Although variable income products are considered more risky (higher volatility) than fixed income
products, they provide a better return, and that‘s why they are so important in portfolios.

The term variable-income security refers to investments that provide their owners with a rate of return
that is dynamic and determined by market forces. Variable-income securities provide investors with both
greater risks as well as rewards.

Variable-income securities, also known as variable-rate securities, are typically valued by investors
looking for higher returns than those offered by fixed-income securities. The classic example of a variable-
income security is common stock, which can offer investors virtually unlimited up-side growth as well as the
complete loss of principal. In exchange for this risk, investors in these securities demand higher returns than
their fixed-income counterparts.

The most common example of variable income investments are stocks, or shares. Its prices are always
changing and it‘s not easy to know how much money the investor is going to make, or if it is going to make any
at all.

Equity Valuation Models

Equity valuation is a blanket term and is used to refer to all tools and techniques used by investors to
find out the true value of a company‘s equity. In finance, valuation is a process of determining the fair market
value of an asset. Equity valuation therefore refers to the process of determining the fair market value of equity
securities.

The whole system of stock markets is based upon the idea of equity valuation. The stock markets have
a wide variety of stocks on offer, whose perceived market value changed every minute because of the change
in information that the market receives on a real time basis.

Equity valuation therefore is the backbone of the modern financial system. It enables companies with
sound business models to command a premium in the market. On the other hand, it ensures that companies
whose fundamentals are weak witness a drop in their valuation. The art and science of equity valuation
therefore enables the modern economic system to efficiently allocate scare capital resources amongst various
market participants.

1. Market Value Method

Market value is the easiest valuation concept to understand. It simply means the value of the company
or an asset as denoted by its ongoing market price. As market prices vary wildly, so does the market value of
any company or any asset which is listed on it.
 Furthermore, you can use this method to find estimates on the value of business ownership
interest, security, and intangible assets. While using this approach, it analyses the sale of each asset similar to
their own and further adjustments are made to minimize the difference. Regardless of the asset, adjustments
are made and some of those adjustments are the quantity, quality, and size.

2. Discounted Cash Flow

 DCF is the net present value (NPV) of cash flows projected by the company. DCF is based on the
principle that the value of a business or asset is intrinsically based on its capability to generate cash
flows.
 Hence, DCF relies more on the fundamental expectations of the business than on public market factors
or historical models. It is a more theoretical approach that relies on various assumptions.
 A DCF analysis helps yield the overall value of a business (i.e., enterprise value), including both debt
and equity.
 While calculating this, the present value (PV) of expected future cash flows is calculated. The
disadvantage of this technique is an estimation of future cash flow & terminal value along with an
appropriate risk-adjusted discount rate.
 All these inputs are subject to substantial subjective judgment. Any small change in input changes the
equity valuation significantly. If the value is higher than the cost, the investment opportunity needs to be
considered.

3. Comparable Company Analysis

 This equity valuation method involves comparing public companies‘ operating metrics and valuation
models with those of target companies.
 Using equity valuation multiple is the quickest way of valuing a company. It is also useful in comparing
companies that do comparable company analysis. The focus is to capture the firm‘s operating &
financial characteristics, such as future expected growth in a single number. This number is then
multiplied by a financial metric to yield enterprise value.
 This equity valuation method is used for a target business with an identifiable stream of revenue or
earnings, which the business can maintain. For businesses still at the development stage, projected
revenue or earnings are used as the basis of valuation models.

4. Asset-Based Valuation
 The asset-based valuation method considers the value of the assets and liabilities of a business. Under
this approach, the value of a business is equal to the difference between the value of all its relevant
assets and the value of all its relevant liabilities.
 A company's equity value is determined based on the fair market value of net assets owned by the
company. This method is most often used for entities with a going concern, as this approach
emphasizes outstanding liabilities determining net asset value.

5. Sum of Parts Valuation Method

A conglomerate with diversified business interests may require a different valuation model. Here we
value each business separately and add up the equity valuations. This approach is called a sum of parts
valuation method.

6. Book-Value Approach.
A company's equity value is determined based on its previous acquisition cost. This method is only
relevant for companies with minimal growth that might have undergone a recent acquisition. The book value
method is the price paid for that asset minus depreciation. The loss of value in an asset (depreciation) can
include many aspects such as wear and tear of machinery and equipment over a period of time.
In companies where the growth is minor and there might be less residual value, the book value method
will be used.

7. Multiplier Models
The multiplier models determine the value of a company by analyzing and comparing the company's
financial ratios. For example, a popular multiple is the price-earnings ratio. Other commonly used multiples are
sales, book value, and cash flow per share.
 There are other multiples, which are based on the enterprise value (EV), for example, EV/EBITDA,
EV/EBIT, and EV/ Unlevered free cash flow (UFCF). These multiples are commonly used for valuing private
firms.

8. Intrinsic Value
In simple words, intrinsic value is that value which is imbibed in the asset. For instance, a machine may
provide certain incremental benefits to its user over and above what manual labor could have. As such the
machine provides incremental cash flows to the firm and has some amount of intrinsic value.

The value of a firm is nothing but the sum total of the value that will be provided by its assets over some
selected time horizon. As such, just like the intrinsic value of an asset can be estimated, similarly the intrinsic
value of an entire firm can also be estimated.

It is important to understand that the intrinsic value can only be accurately understood and calculated
by someone who has an in-depth knowledge of the nature of the firm and the industry. Hence, while
considering intrinsic value, one must compare and contrast the opinions of multiple analysts.

For more detailed explanation visit: https://www.wallstreetmojo.com/valuation-methods/