CFA Level 1 · Complete Topic · 11 Chapters

The Definitive Equity Investments Master Guide

Every chapter of the Equity Investments topic in one place — securities, valuation, DDM, relative valuation, NAV, market efficiency, indexes, market organization, and the full company & industry analysis toolkit — with live calculators, a formula vault, and a complete question bank.

📚Coverage11 Chapters

🧮Live Calculators4 Tools

🧾Formula Vault30 Formulas

🧠Mastery CheckQuestion Bank

🎯 Question Bank 🧮 Live Calculators 🃏 Flashcards

Chapter 1 · Foundations

Overview of Equity Securities

LOS A

Types of Equity Securities

👑

1. Common Shares (Equity)

Common shareholders are the REAL OWNERS of the company.

Residual Claim — paid LAST, after debt and preference holders.
Voting Power — appoint the Board of Directors.
Returns = Dividends (not mandatory) + Capital Appreciation.
HIGHEST RISK equity security.

🛡️

2. Preference Shares (Preferred Stock)

"Preference" over common shares in two ways:

Liquidation Preference — paid before common shareholders.
Fixed Dividend — e.g., 8% of ₹100 = ₹8.
Dividends paid only out of PROFITS.
Generally NO voting rights.

Sub-Types of Preference Shares

A. Cumulative vs Non-Cumulative

Feature	Cumulative	Non-Cumulative
Missed Dividends	Accumulated, paid later	Lost forever
Risk Level	Less Risky	More Risky

Example: Promised ₹8, only ₹7 profit available → cumulative: ₹1 paid later; non-cumulative: ₹1 lost forever.

B. Participating vs Non-Participating

Feature	Participating	Non-Participating
Extra Dividend	Yes (if profits exceed threshold)	No (fixed only)
Risk Level	Less Risky	More Risky

Example: Fixed = ₹8. If profits boom, participating may get ₹10–₹12.

C. Convertible Preference Shares

Can be converted into common equity at investor's option using a Conversion Ratio.

If market price > redemption → CONVERT
If market price ≤ redemption → TAKE CASH
LESS RISKY — investor has the option (right, not obligation).

D. Callable vs Puttable

	Callable	Puttable
Right Holder	Company ("C for C")	Investor
Action	Buy back at Call Price	Sell back at Put Price
Investor Impact	Capital gain CAPPED	Capital loss LIMITED
Risk	More Risky	Less Risky

Callable example: FV ₹100, Call ₹102 → max gain ₹2 (even if market hits ₹110, called at ₹102).

Risk Hierarchy (Highest → Lowest)

#1Common SharesResidual claim, no guaranteed dividend

#2Non-Participating PreferenceNo upside potential

#3Non-Cumulative PreferenceMissed dividends lost

#4Callable PreferenceGain capped by company

#5General PreferenceFixed dividend, priority

#6Participating PreferenceExtra dividend potential

#7Cumulative PreferenceMissed dividends accumulated

#8Puttable PreferenceLoss limited

#9Convertible PreferenceLowest — option to convert

LOS B

Voting Power — Statutory vs Cumulative

1. Statutory (Straight) Voting

Each share = 1 vote per director seat. Majority controls everything.

Example: Jio (3 seats A, B, C)

Ambani 60% → 60–60–0 votes
Vikas 40% → 0–0–40 votes
Result: A✓(60%), B✓(60%), C✗(40%)

⚠ Minority gets ZERO board representation despite 40% ownership.

2. Cumulative Voting Good Governance

Total votes = Ownership% × seats. Can pool all votes onto one candidate.

Same Example with Cumulative

Ambani 180% total → 90–90–0
Vikas 120% total → 0–0–120
Result: A✓, B✓, C✓ — all elected

✓ Minority gets proportional board seat representation.

LOS C

Dual Class Equity Structures

Different classes of equity shares with different voting rights. Examples: Tata Motors & Tata Motors DVR, Facebook (Meta), Alphabet (Google).

How Dual Class Works (Zuckerberg Example)

Zuckerberg invests ₹60 (30% capital) | Public invests ₹140 (70% capital)
Without dual class: Zuckerberg gets only 30% votes → loses control
With dual class: Class 1 with super-voting rights → Zuckerberg gets 60% voting with only 30% capital

⚠️

Governance Assessment

BAD GOVERNANCE

Promoters control with LESS capital invested
Disproportionate voting power vs economic ownership
Minority shareholders have limited say despite higher contribution
Management accountability is reduced

LOS D

Public vs Private Equity

Aspect	Public Equity (Reliance, TCS)	Private Equity (Startups)
Liquidity	HIGH — easy to buy/sell	LOW — illiquid
Governance	STRONG — strict SEBI compliance	WEAKER — less oversight
Disclosure	HIGH — regular reporting, audits	LOWER — minimal requirements
Reporting Cost	HIGH — audits, AGM, reports	LOWER — no audit/AGM costs
Short-term Pressure	HIGH — quarterly results matter	LOW — no stock market pressure
Focus	Short-term profitability	Long-term goals
Growth Potential	Lower	HIGHER

Real example: TCS/Infosys didn't invest heavily in AI because it would reduce short-term ROE and stock price — they missed the AI trend. TCS dropped from ₹4,500 to ₹2,200. Public equity short-term pressure has a real cost.

LOS E

Foreign Equity Investments — ADR, GDR, Global Registered Shares

Why Foreign Investors Hesitate to Invest in India

1. Weak Governance
SEBI framework weaker than US/UK; fear of manipulation; weak enforcement.

2. Currency (Rupee) Risk
Even 5% INR gain can become a USD loss if rupee depreciates. Example: ₹100→₹105 but $1: ₹100→₹117 ⇒ USD return = NEGATIVE.

ADR

American Depository Receipt

Listed on US markets
Trades in USD
Must follow SEC / US GAAP
Examples: HDFC Bank, ICICI Bank, Infosys, Wipro
Represents MULTIPLE shares (e.g. 3 shares = 1 ADR @ $23.54 → $7.85/share ≈ ₹746)

GDR

Global Depository Receipt

Listed OUTSIDE US (London, Luxembourg)
Currency still USD (not GBP!)
Multiple shares clubbed
Example: Reliance GDR on London Stock Exchange

GRS

Global Registered Shares

Listed on MULTIPLE exchanges simultaneously
Purpose: Visibility, NOT raising capital
Companies are already large: Meta, Alphabet, Amazon
Like listing on both 99acres + MagicBricks

Feature	Sponsored	Unsponsored
Direct Public Sale	Yes	No — via Depository Bank
Rules & Regulations	More	Less
Voting Power	Public	Depository Bank
Speed	Slower	Faster
Company–Public Link	Yes (direct)	No

Book Value vs Market Value

Market Value: Price at which a stock is currently traded. (HDFC Bank @ ₹750)

Book Value: Total money invested by owners + reinvested profits.

FORMULA

Book Value = Equity Share Capital + Retained Earnings P/B Ratio = Market Price per ShareBook Value per Share

HDFC Bank Example: Price ₹750.50, BV ₹363.59 → P/B = 2.07
For every ₹1 invested by owners, market pays ₹2.07. Banking stocks typically trade at P/B of 2–3.

LOS H

ROE vs Required Rate of Return

Required Rate of Return: Minimum return investor expects. Always positive (Nifty ~12%).

ROE: Actual return earned by company. Can be positive OR negative.

FORMULA

ROE = Net IncomeAverage Book Value Avg BV = Opening BV + Closing BV2

Decision Rule: ROE ≥ Required Return → INVEST
ROE rising is POSITIVE when: Net Income rises FASTER than Book Value.
Year 1: Capital ₹100, Profit ₹20 (20%). Year 2: Capital ₹120, Profit ₹30 (25%) → ROE improved ✓

LOS I

Role of Equity in Financing — Uses of Equity Capital

🏢

1. Productive Assets

Land, plant, machinery (CapEx)

📈

2. Investments

MFs, FDs, other companies

📦

3. Working Capital

Inventory, raw materials

🧾

4. Expenses

Operating, admin, salaries

Chapter 2 · Valuation Foundations

Equity Valuation — Concepts & Methods

Concept A

Market Price vs Intrinsic (Fair) Value

Current Market Price (CMP)

The price at which the share is currently being bought/sold in the market.

Example: Reliance @ ₹1,300

Intrinsic / Fair Value

The TRUE value of a stock per an analyst's calculation/model. Analyst-specific.

Analyst A: ₹1,500 | Analyst B: ₹1,200 (Jefferies vs JP Morgan)

Scenario	Condition	Action	Remark
UNDERVALUED	FV (₹1,500) > CMP (₹1,300)	BUY	Cheap; will rise to fair value
FAIRLY VALUED	FV = CMP	HOLD	No mispricing
OVERVALUED	FV (₹1,200) < CMP (₹1,300)	DO NOT BUY / SELL	Expensive; will fall

Three Conditions to Profit from Valuation

1 Mispricing must exist

Market price ≠ intrinsic value

2 Followed by FEW analysts

Mispricing more likely; many analysts = efficient

3 Price must CONVERGE

Market must eventually recognize true value

Concept B

Methods of Equity Valuation

⚖️

1. Relative Valuation

Compares with similar listed companies using multiples.

Property analogy: Similar 250 sq.yd. plot sold for ₹2 crore → yours is also ₹2 crore.
Equity example: HDFC P/E = 17x. ICICI EPS = ₹10 → Fair Value ICICI = 10 × 17 = ₹170

When to use Comparables exist; mature industries (banking, FMCG).

📊

2. Absolute Valuation

Values a company on its own merits.

A. NAV: For distressed companies, asset-focused

B. DCF: Forecast future cash flows, discount to PV

• DDM — for dividend-paying (ITC, Infosys, PFC, REC)

• FCFE — for non-dividend payers (Reliance, Zomato, PW)

When to Use NAV vs DCF (Real Examples)

Aspect	DCF	NAV
When to Use	Healthy company, no comparable	Financial distress
Focus	Future cash flows / profits	Current tangible assets
Interest in...	The BUSINESS	The ASSETS
Examples	Physics Wallah, Zomato, new-age startups	Reliance Communications (spectrum), Jet Airways (aircraft)

"We are NOT interested in your BUSINESS. We are MORE interested in your ASSETS." — NAV logic (Aggarwal Sweets / Jet Airways acquisitions)

Concept C

Types of Dividends & Corporate Actions

1. Regular Cash Dividend Sticky

Periodic dividends from profits — STICKY in nature (if paid today, likely to continue).

Examples: ITC, TCS, Infosys, PFC, REC, Coal India, NTPC

Analogy: ₹100/month pocket money — expected to continue.

2. Special Dividend One-time

One-time, non-recurring dividend due to extraordinary profits. NOT sticky.

Triggers: Sale of division (ITC Hotels demerger), windfall gains, exceptional year

Analogy: Diwali ₹1,000 (vs regular ₹100) — one-time reward.

Stock Split, Bonus Shares, Reverse Split — Essentially the Same Concept

3. Stock Split / Bonus Shares

Divide one share into multiple → price drops, count rises, net worth unchanged.

MRF Example (10:1 split):
Before: 1 share × ₹1,25,000 = ₹1,25,000
After: 10 shares × ₹12,500 = ₹1,25,000 ✓

Purpose: Improve liquidity. Reliance does bonus issues; Berkshire never splits (Buffett wants exclusivity).

4. Reverse Stock Split

Combine multiple shares into one → price rises, count drops, net worth unchanged.

Vodafone Example (10:1 reverse):
Before: 10 shares × ₹15 = ₹150
After: 1 share × ₹150 = ₹150 ✓

Done by: Weak/poorly performing companies to lift price.

5. Share Repurchase / Buyback

Company buys back its own shares at a premium to market price — tax-efficient alternative to dividends.

TCS Example: Market Price ₹3,800, Buyback ₹4,500 → Shareholder gets extra ₹700 (like dividend, lower tax).

Reduces outstanding shares → EPS improves.

Summary — Corporate Action Effects

Action	Price	Shares	Net Worth	Purpose
Regular Dividend	No direct effect	No change	↑ Cash	Reward shareholders
Special Dividend	No direct effect	No change	↑ Cash (1x)	Extraordinary profits
Stock Split / Bonus	↓ Decreases	↑ Increases	No change	Improve liquidity
Reverse Split	↑ Increases	↓ Decreases	No change	Boost perceived value
Share Buyback	No direct effect	↓ Decreases	↑ Cash (premium)	Tax-efficient reward

Concept D

Dividend Payment Chronology — Timeline

June 3

Declaration Date

COMPANY

Announces ₹10/share dividend. NO money paid yet.

June 15

Ex-Dividend Date

LAW

First day buyer does NOT get dividend. Price drops by dividend amount.

June 16

Holder of Record

COMPANY

"Snapshot" of shareholders — they get paid.

June 24

Payment Date

LAW

Within 21 working days. Cash credited.

Mnemonic & Mechanics

Sequence: COMPANY → LAW → COMPANY → LAW

Ex-Dividend Date = Holder of Record Date - 1 Business Day

Settlement India: T+2. Buy on June 14 → settle June 16 → get dividend. Buy June 15 → settle June 17 → no dividend.

Price impact: Before Ex-Date: ₹300 (incl. div). On Ex-Date: ₹290 (drops by ₹10).

Concept E

Discounted Cash Flow (DCF) — Numericals

DCF FORMULA

PV = CF₁(1+r)¹ + CF₂(1+r)² + … + CF_n(1+r)ⁿ

Numerical 1 — Single Period

• Last dividend: $1.00, next +5%
• Sell price after 1 year: $13.45
• Required rate: 13.2%

Year 1 CF: $1.05 (div) + $13.45 (sale) = $14.50

PV: 14.50 / 1.132 = $12.81

Answer: Pay max $12.81 today.

Numerical 2 — Multi Period

• Dividend $1.50, growing 8% / year
• Sell after 3 years for $51
• Required rate: 12%

D1: $1.62 | D2: $1.7496 | D3: $1.8896

Y3 total: $1.8896 + $51 = $52.8896

PV1=$1.4464 | PV2=$1.3948 | PV3=$37.6370

Answer: Fair value today = $40.48

BA II Plus Calculator — Cash Flow Function

1. CF → 2nd → CLR WORK

2. CF0 = 0 ↓↓ | C01 = 1.62 ↓↓ | C02 = 1.7496 ↓↓ | C03 = 52.8896 ↵

3. NPV → I = 12 ↓ → CPT → 40.48

Chapter 3 · DDM Family

Dividend Discount Models (Single & Multi-Stage)

Single-Stage

The Gordon Growth Model

GORDON GROWTH FORMULA

P₀ = D₁r - g

P₀ = intrinsic value today | D₁ = dividend at end of Year 1 | r = required return | g = constant growth (forever)

⚠ Critical: r MUST be > g, else formula breaks down.

Derivation via Geometric Progression

Arithmetic: 2, 4, 6, 8...
Geometric: 2, 4, 8, 16... (multiplier)
Increasing GP: Cannot sum to infinity
Declining GP: Can sum → converges

Sum = First Term1 - Common Ratio

Example: 64,32,16,8... (ratio 0.5) → Sum = 64/0.5 = 128

Verification with D₁=10, g=4%, r=12%

Year	Dividend	PV
1	10.00	8.9286
2	10.40	8.2908
3	10.816	7.6986

Common ratio of PVs = 0.9286 ✓ Declining GP
Sum = 8.9286 / 0.0714 = ₹125

Direct: D₁/(r−g) = 10/0.08 = ₹125 ✓

ITC Practical Valuation Example

CMP: ₹279.10

Dividend Yield: 5.19%

Next Dividend: ₹10

g: 4% (Indian economy)

r: 12% (Nifty historical)

Formula: 10 / (0.12 − 0.04)

Fair Value of ITC = ₹125 (AI tools refine to ₹250–₹278)

Understand WHY DDM works for ITC but NOT for Reliance. ITC Div Yield = 5.19% vs Reliance = 0.46%.

Special Case

Preferred Stock Valuation (g = 0)

Preferred stock has a fixed dividend forever, so g = 0 always.

P₀ = Dr

Double-Star Note: Dividend is CONSTANT, g = 0, received TILL INFINITY.

Example

• Face Value = ₹100
• Dividend = ₹5 fixed forever
• Required return = 8%

P₀ = 5 / 0.08 = ₹62.50

Analogy: Pay ₹62.50 once → ₹5 dividend every year forever, like a Bank FD.

Growth

Sustainable Growth Rate Calculation

g = ROE × Retention Ratio = ROE × (1 - Dividend Payout)

Derivation

Year 1: Capital ₹100, ROE 20%, Payout 10%

Earnings = ₹20 | Div = ₹2 | Retained = ₹18

New Capital = ₹118

Year 2: Earnings = 118 × 20% = ₹23.60

Growth = (23.60 − 20)/20 = 18%

Formula check: 20% × (1 − 0.10) = 18% ✓

Example Problem

• Dividend Payout = 25% → Retention = 75%
• ROE = 21%

g = 21% × 75% = 15.75%

Key Insight: More retention → more growth. 100% retention → g = ROE = 20%. Zero retention → g = 0%.

Multi-Stage

Two-Stage Dividend Discount Model

When to use: Company growing faster than economy NOW, will slow down later.
Examples: Physics Wallah, Zomato, Eternal, new tech startups. NOT for: ITC, HUL (use Gordon Growth).

Worked Example

• Recent dividend D₀ = ₹1
• Growth Years 1–2 = 15%
• Growth thereafter = 5% (forever)
• Required return r = 11%

Step 1 — Dividend Timeline

Year	Calc	D
1	1 × 1.15	1.15
2	1.15 × 1.15	1.3225
3	1.3225 × 1.05	1.3886

Step 2 — Terminal Value @ Y2

P₂ = D₃r-g = 1.38860.06 = 23.1438

Step 3 — Cash Flows

Y1: 1.15 | Y2: 1.3225 + 23.1438 = 24.4663

Step 4 — Discount to Today

P₀ = 1.151.11 + 24.46631.2321 = 1.0360 + 19.8574

P₀ = ₹20.89

Special

Deferred Dividend Problem

Setup

• NO dividend for first 3 years
• First dividend at END of Year 4
• Earnings Y4 = ₹1.64, Payout = 50%
• Constant growth after = 5%
• Required return = 10%

Solution

Step 1: D₄ = 1.64 × 50% = ₹0.82

Step 2: Value at Y3 = D₄/(r−g) = 0.82/0.05 = ₹16.40

Step 3: Discount Y3 → today

P₀ = 16.40 / (1.10)³ = 16.40/1.331

P₀ = ₹12.32

Key Rule: If first dividend is at Year n → Terminal value is at Year (n−1), then discount back to Year 0.

When to Use Which Valuation Model?

MATURE & STABLE

Single-Stage Gordon

• ITC, HUL (Unilever)
• Infosys, PFC, REC
• Constant growth, dividend payers

NEW & HIGH-GROWTH

Multi-Stage DDM / FCFE

• Physics Wallah, Zomato
• Eternal, new tech startups
• High growth → stable

PREFERRED STOCK

P₀ = D / r

• Fixed dividend forever
• g = 0
• Bank FD analogy

Common Mistakes to Avoid

Mistake	Correction
Using D₀ instead of D₁	Always use NEXT period's dividend in numerator
Forgetting r > g condition	If r ≤ g, Gordon Growth is INVALID
Wrong timing of terminal value	First div at Year n → Value at Year (n−1)
Multi-stage for young companies skipped	Young companies NEED multi-stage
DDM for non-dividend payers	Use FCFE for Reliance, Zomato

Chapter 4 · Multiples

Relative Valuation & EV/EBITDA

Approach 1

Method of Comparable (Comparable Company Analysis)

Compare two or more similar stocks to determine which is undervalued (BUY) or overvalued (DO NOT BUY).

Property Analogy

• Property A: ₹1,00,000/sq.yd | Property B: ₹1,20,000/sq.yd
• Average rate = ₹1,10,000/sq.yd
• A < Avg → CHEAPER → BUY | B > Avg → EXPENSIVE → DO NOT BUY

⚠ Important Caution

A cheap multiple ≠ blind BUY. Understand WHY it's cheap.

IndusInd Bank: Low PE (10x) BUT governance issues, earnings manipulation → DO NOT BUY

HDFC Bank: Cheap PE + quality + good governance → BUY

Location Matters Analogy

Connaught Place: ₹5L/sq.yd (Prime)
Seemapuri: ₹10K/sq.yd (Slum)

Cheap ≠ better. A stock may be cheap for valid reasons (poor management, declining business, regulatory issues).

PE Ratio — Logic and Calculation

Understanding PE Logically

Bank FD: Deposit ₹100 → ₹107 after 1 year (7% interest).

PE of FD = 1007 = 14.28

To earn ₹1 from FD → invest ₹14.28. Quality stock at PE ~14–15 = GOOD VALUE. PE 60–70 = TOO HIGH.

HDFC vs ICICI Decision

	HDFC Bank	ICICI Bank
Price	₹750.40	₹1,259.20
EPS	₹49.28	₹74.77
PE	15.22	16.84

Avg PE = (15.22+16.84)/2 = 16.03

Decision: HDFC PE (15.22) < Avg → BUY HDFC ✓
ICICI PE (16.84) > Avg → DO NOT BUY

Other Multiples (When Earnings Negative)

Problem with PE

Physics Wallah: Price ₹100, Earnings −₹1 → PE = −100 (MEANINGLESS)

Alternative Multiples

• Price/Sales (P/S)
• Price/Book Value (P/BV)
• Price/Cash Flow (P/CF)

PW: P/S = 6.77 → ₹6.77 for every ₹1 of sales

Approach 2

Method of Fundamental (Fundamental PE)

Tells what PE a stock SHOULD trade at (Fair Value PE). Derived from Gordon Growth.

Derivation

From Gordon: $P_0 = \frac{D_1}{r-g}$. Divide both sides by E₁:

P₀E₁ = DPRr - g

Leading (Forward) PE

P₀E₁ = DPRr - g

E₁ = next year's earnings

Trailing (Current) PE

P₀E₀ = DPR × (1+g)r - g

E₀ = current reported earnings

Condition	Interpretation	Action
Fundamental PE > Market PE	Stock UNDERVALUED	BUY
Fundamental PE < Market PE	Stock OVERVALUED	DO NOT BUY

Example 1

• DPR = 30%, R = 13%, G = 6%

0.300.13 - 0.06 = 0.300.07 = 4.28

Fundamental PE = 4.28x

Example 2

• DPR = 60%, R = 15%, G = 7%

0.600.15 - 0.07 = 0.600.08 = 7.5

Fundamental PE = 7.5x

Multiple

EV/EBITDA Multiple

When to use: Extensively used for MANUFACTURING companies (Dabur, HUL).

EVEBITDA = Enterprise ValueEBITDA

EBITDA

Earnings Before Interest, Tax, Depreciation & Amortization. Think: cash profits.

Enterprise Value (EV)

Price the market is willing to pay for ALL assets. If you sold ALL assets today, what would you get?

⚠ EV ≠ Net Worth!

House Analogy — EV vs Net Worth

Case	House (= EV)	Loan	Cash	EV	Net Worth
A	₹3 Cr	0	0	₹3 Cr	₹3 Cr
B	₹3 Cr	₹1 Cr	0	₹3 Cr	₹2 Cr
C	₹3 Cr	₹1 Cr	₹50 L	₹3 Cr	₹2.5 Cr

EV = Market Value of Equity + Market Value of Debt - Cash & Investments Equity Value = EV - Debt + Cash & Investments

Real Example — Hindustan Unilever (HUL) Valuation

Step 1 — Lowest EV/EBITDA (5 yrs)

Year	EV/EBITDA
1	35x
2	38x
3	34x
4	33x
5	31.88x ← LOWEST

Conservative approach

Step 2–5 — Calculation

EBITDA: ₹1,45,540 lakhs
EV: 31.88 × 1,45,540 = ₹46,39,815.2 lakhs
− Total Debt: ₹14,780 lakhs
+ Cash & STI: ₹69,930 lakhs
= Equity Value: ₹46,94,965.2 lakhs
Shares Outstanding: 2,349.6 million (234.96 Cr)
Value per Share = ₹1,998 ≈ ₹2,000

Conclusion: Fair Value HUL ≈ ₹2,000. CMP ≈ ₹2,100. If HUL falls to ₹2,000 → AGGRESSIVELY BUY. Historical movement: ₹2,376 → ₹2,050 (US-Iran tensions) → ₹1,550.

EV/EBITDA — Detailed Calculation Example

Given Data

• Number of shares = 2,00,000
• Price per share = ₹40
• Long-term Debt (Book) = ₹9,00,000
• Long-term Debt (Market) = ₹6,00,000
• Short-term Debt (Book) = ₹12,00,000
• Cash = ₹2,50,000
• EBITDA = ₹1,00,000

Solution

MV Equity: 2,00,000 × 40 = ₹80,00,000
MV Debt: 6,00,000 + 12,00,000 = ₹18,00,000
(ST Debt: book ≈ market)
EV: 80L + 18L − 2.5L = ₹95,50,000

EV/EBITDA = 95,50,000 / 1,00,000 = 9.55

Chapter 5 · Asset-Based

Net Asset Value (NAV) Method

NAV is the price you should pay for a company based on its assets, not its earnings power.

NAV = Fair Value of Assets - Liabilities NAV per Share = NAVNumber of Shares

✓ WHEN to Use NAV

Company in FINANCIAL DISTRESS
You care about ASSETS, not earnings
Asset values are STABLE
Examples: Jet Airways (aircraft), Reliance Communications (spectrum)

✗ WHEN NOT to Use NAV

HYPERINFLATION (inflation > 100% over 3 yrs)
Companies with mostly INTANGIBLE assets (software)
Healthy growing companies (Reliance won't sell at NAV)

NAV Calculation — Worked Example

Given: 2,000 shares. Fixed Assets MV = 120% of BV. All other items: MV = BV.

ASSETS (Fair Value)

Item	Value
Cash	₹10,000
Accounts Receivable	₹20,000
Inventory	₹500
Fixed Assets (₹1,20,000 × 1.20)	₹1,44,000
Total Assets	₹1,74,500

LIABILITIES

Item	Value
Accounts Payable	₹5,000
Notes (Short-term)	₹30,000
Term Loan	₹45,000
Total Liabilities	₹80,000

NAV = 1,74,500 − 80,000 = ₹94,500

NAV per Share = 94,500 / 2,000 = ₹47.25

Master Decision Table — When to Use Which Method

Method	When to Use
DDM	Dividend-paying companies, stable growth (ITC, Infosys)
DCF / FCFE	No comparable companies; non-dividend payers (Reliance, Zomato)
Relative — Comparable	Comparable companies available (HDFC vs ICICI)
Relative — Fundamental	Determine fair PE from fundamentals
EV/EBITDA	Manufacturing companies (HUL, Dabur)
NAV	Financially distressed; asset-heavy companies

Advantages & Disadvantages of All Methods

DDM

+ Advantages:

Easy to compute
Simple formula

− Disadvantages:

Sensitive to G, R inputs
Assumes dividends continue forever
Small Δ in g/r → large Δ valuation

Relative Valuation

+ Advantages:

Easy to compute
Simple comparison

− Disadvantages:

Sensitive to multiple chosen
Comparables may not exist (Reliance, ITC, PW)
Multiple answers possible (PE→HDFC, P/BV→ICICI)

NAV

+ Advantages:

Provides FLOOR VALUE (min)
Tells minimum price to pay

− Disadvantages:

Only for distressed companies
NOT during hyperinflation
Not for intangible-asset companies

Chapter 6 · Market Behavior

Market Efficiency & Behavioral Finance

Meaning of Market Efficiency

Stock prices REFLECT all available information. NO mispricing — prices fully, quickly, rationally reflect data.

⚠ Common Trap

"If market is efficient, making money is easy."

❌ WRONG.

✓ Correct Answer

Efficient market → No undervalued stocks → Making money is VERY DIFFICULT.

→ Invest PASSIVELY (not actively)

Active vs Passive Investing

Approach	Active	Passive
Approach	Use brain to pick stocks	Replicate index without thinking
Research	Individual stock research	Copy index weights (HDFC 10%, Reliance 8%)
Goal	Beat the market	Match the market

More efficient markets → No mispricing → Manage money PASSIVELY rather than ACTIVELY.

Market Value vs Intrinsic (Fundamental) Value

MARKET VALUE

Price at which you can BUY or SELL today. Reliance @ ₹1,300.

INTRINSIC VALUE

Analyst's calculated value — person-specific.

Jefferies says ₹1,500 | JP Morgan says ₹1,200 — different analysts, different intrinsic values.

Six Factors Promoting Market Efficiency

Large Number of Participants

More buyers/sellers → better price discovery

Greater Data Availability

Better info flow → faster price reflection

Lower Transaction Costs

High costs discourage trading

Foreign Investors Allowed

More capital → better discovery

Short Selling Allowed

Corrects overvalued stocks

Restrictions on Insider Trading

⭐ Only good restriction. Mukesh Ambani can't trade Reliance

Four Forms of Market Efficiency (Master Table)

Important Rule: As efficiency ↑ → Making money becomes more difficult. Shift from ACTIVE to PASSIVE.

Form	Prices Reflect	What Works?	Strategy
Weak-Form INEFFICIENT	NOTHING	Technical ✓ Fundamental ✓ Insider ✓ — ALL work	ACTIVE
Weak-Form EFFICIENT (= Semi-Strong Inefficient)	Market Data only (Price + Volume)	Technical ✗ \| Fundamental ✓ Insider ✓	ACTIVE
Semi-Strong EFFICIENT (= Strong-Form Inefficient)	ALL Public Data	Technical ✗ Fundamental ✗ \| ONLY Insider ✓	PASSIVE
Strong-Form EFFICIENT	ALL Public + ALL Private	NOTHING works (Technical ✗ Fundamental ✗ Insider ✗)	PASSIVE

Exam Question Patterns

Q-Type 1

"Made money using TECHNICAL ANALYSIS"

→ Weak-Form INEFFICIENT

Q-Type 2

"FUNDAMENTAL ANALYST"

→ Weak-Form EFFICIENT (more correct)

Virat > Rohit is more accurate than Virat > Vikas

Q-Type 3

"INSIDER TRADING worked"

→ Semi-Strong EFFICIENT

Three Analysis Types Explained

Technical Analysis

Charts, candlestick patterns, support/resistance. Short-term traders. Also for commodities like Gold.

Fundamental Analysis

Research competitors, profitability, industry. Long-term capital appreciation, buy & hold.

Insider Trading

ILLEGAL in India. CEO/auditors trading on non-public info. Banned for Ambani, HDFC auditors (EY).

Anomalies in Market Efficiency

Important: Anomalies are NOT violations of market efficiency. They result from POOR RESEARCH METHODOLOGY. Like saying "Vaibhav Suryavanshi scored most runs THIS IPL" doesn't mean he's the best of ALL IPLs.

1. January Effect (US) / April Effect (India)

Markets fall Dec, rise Jan. Two reasons:

A. Tax Loss Harvesting:
₹1 Cr profit, 10% tax = ₹10 L owed. ₹90 L unrealized loss in Reliance → Sell in Dec, book loss → Net profit ₹10 L → Tax ₹1 L (saved ₹9 L). Buy back in Jan.

B. Window Dressing:
Fund managers sell controversial stocks (Vodafone) before reporting period → Buy back in Jan.

2. Momentum vs Overreaction Effect

Momentum: "Stock rose 40x, will keep rising" → BUY using charts

Overreaction: "Rose too much, will fall now" → SELL using charts

Both use TECHNICAL → assume Weak-Form Inefficient.
Example: SSSC $41 → $600 in 1 year.

3. Size Effect

Small-caps OUTPERFORM large-caps.

HDFC Bank (Large) ← struggles to grow 40%
AU Small Bank ← can grow 40–50%

⚠ Caveat: Small-caps carry MORE RISK. Risk-adjusted returns may NOT beat large-caps.

Assumes Weak-Form Inefficient / Semi-Strong Inefficient.

4. Value vs Growth Stocks

Value: Cheap valuations (HDFC PE 15)

Growth: Expensive (NVIDIA PE 57)

Buffett belief: Value > Growth. Requires Fundamental Analysis → Assumes Weak-Form Efficient / Semi-Strong Inefficient.

5. IPOs are Undervalued

Popular belief: "IPOs give quick money."

REALITY: Majority of IPOs do NOT perform well. Belief is generally WRONG.

6. ETFs Should Trade at NAV

ETF should = iNAV (Indicative NAV).

SBI Nifty 50 ETF: iNAV ₹250.61 vs Price ₹250.42 (diff ₹0.19).

Difference NOT significant enough to exploit.

Behavioral Finance — Investor Behaviors

Studies how investors behave — RATIONALLY or IRRATIONALLY?

👥1. Herding & Information Cascade

Other investors MIMIC big/informed investor's decisions.

Example: "Rakesh Jhunjhunwala bought Tata Motors" → many follow.

✓ Makes market MORE efficient (informed investor's research spreads → price corrects).

📉2. Loss Aversion

People DISLIKE losses MORE than they LIKE equivalent gains.

Finding ₹500 (happy) vs Losing ₹500 (very sad — bigger emotion).

During COVID: rational = BUY (cheap stocks); actual = SOLD (panic).

🔁3. Representativeness

Assuming the past will REPEAT in the future.

"Gold rose 40 yrs → will keep rising" / "Property never gave losses."

Past ≠ guarantee of future.

🖼️4. Narrow Framing

Looking at things from a very NARROW perspective.

Example: "US-Iran war → why India falls?" Missing: Iran oil → ↑ oil prices → ↑ India inflation.

⚓5. Disposition Effect

AVOID realizing losses. Hold losers too long.

Holding ₹2 Cr loss positions, hoping for recovery.

vs Loss Aversion: LA panics & books losses too fast. DE holds & never books.

🐌6. Overconfidence & Conservatism

SLOW to react to new data.

Conservatism: "HDFC won't fall" despite governance issues.

Overconfidence: Hold NVIDIA despite negative news.

Key MCQ Solutions

Q1: Informationally efficient market means...▸

(a) Active fund managers earn abnormal returns ✗

(b) Security prices reflect new data quickly ✓ — DEFINITION

Q2: Meaning of Intrinsic Value▸

(a) Changes through time as new data is released ✓

(b) Price for buying/selling ✗ (that's market value)

Q3: Short Selling and Market Efficiency▸

Short selling PROMOTES market efficiency. Allows correction of overvalued stocks. Should be ALLOWED.

Q4: Weak-Form Efficient market reflects what?▸

Only MARKET DATA (Price + Volume).

Q5: Performance of money managers tends to be...▸

INFERIOR on risk-adjusted basis. Even if 17% vs Nifty 12%, must check RISK. Analogy: Person A drives 100 km/h fast; Person B drives 60 km/h safe — risk-adjusted, B may be better.

Q6: With respect to anomalies...▸

Reported anomalies are NOT violations. They result from POOR RESEARCH METHODOLOGY.

Q7: Meaning of Loss Aversion▸

We dislike losses MORE than we like comparable gains.

Chapter 7 · Indexes

Security Market Indexes

What Are Indexes?

Indexes represent PERFORMANCE — they tell us how a market, asset class, or segment is performing.

1. Asset Class Performance

How much did EQUITY, REAL ESTATE, COMMODITIES earn?

2. Security Market (Broader)

Overall stock market: NIFTY 50, SENSEX 30, S&P 500

3. Segment / Sector

NIFTY BANK, NIFTY IT, NIFTY AUTO

Cricket Team Analogy

India = 100+ Crore people. World Cup team = 11 players representing entire country.
NSE has 2,400+ stocks. NIFTY 50 has 50 stocks representing the market.

Constituents = individual stocks in an index. Reconstitution = changing constituents.

Examples of Past Reconstitution:
• Yes Bank, Indiabulls Housing Finance — REMOVED (poor performance/scandals)
• Adani Enterprises, Zomato — ADDED (good performance)

Two Types of Returns

PRICE RETURN

Only PRICE movement (capital appreciation). NO dividends.

Price Return = P₁ - P₀P₀

TOTAL RETURN

Includes BOTH price AND dividends. Always ≥ Price Return.

Total Return = P₁ + D - P₀P₀

Example

Stock bought ₹100, became ₹110, gave ₹2 dividend.

Price Return: (110−100)/100 = 10% | Total Return: (110+2−100)/100 = 12%

Five Weight Systems (Most Important Topic)

1. Price Weighted

Buy ONE share of EACH stock. Higher price stock gets more weight automatically.

⚠ KEY POINT: Company size is NOT determined by stock price!

MRF @ ₹1,22,000 (smaller) vs Reliance @ ₹1,200 (much bigger — ~₹20 L Cr MCap).

Reliance issued MANY shares; MRF issued FEW. Size = Market Cap, not price.

Stock	P₀	P₁	Div
A	₹100	₹110	₹1
B	₹50	₹52	₹1

Price Return:
P₀ Portfolio = 100+50 = ₹150
P₁ Portfolio = 110+52 = ₹162
Return = (162−150)/150 = 8%

Total Return:
P₁+Div = 110+1+52+1 = ₹164
Return = (164−150)/150 = 9.33%

⭐ KEY CHARACTERISTIC: Divisor Adjustment for Stock Split

Stocks: 10, 20, 60 → Avg = 30. Stock C 3-for-1 split → 10, 20, 20. New Divisor = 50/30 = 1.667.

MCQ: P₁ = 12, 19, 22 → Index = (12+19+22)/1.667 = 53/1.667 = 31.79

2. Equal Weighted

Invest EQUAL amount in EACH stock. Same weight regardless of price/size.

Method 1: Assume ₹6,000 in each

Prices: A=10, B=20, C=30 | After 1yr: 11, 24, 31

Shares: A=600, B=300, C=200
Final Value: 6,600+7,200+6,200 = ₹20,000
Return = (20,000−18,000)/18,000 = 11.11%

Method 2: Quick Method

A return: 10% | B return: 20% | C return: 3.33%

Avg = (10+20+3.33)/3 = 11.11% ✓

⭐ KEY CHARACTERISTIC: Needs MOST FREQUENT Rebalancing

Weights change as soon as prices move. NIFTY 50 Equal Weight rebalanced QUARTERLY (theoretically daily).

MCQ Example: Total Return with Dividends

P₀: 10, 20, 30. P₁+Div: 12.75, 20, 32.
Returns: 27.5%, 0%, 6.67% → Avg = 11.4%

3. Market Cap Weighted

Weight = Stock's Market Cap / Total Market Cap. Higher MCap → Higher weight.

Market Cap = Price × Outstanding Shares

⭐ KEY CHARACTERISTIC: MOMENTUM EFFECT

MCap ↑ → Weight ↑. Bigger gets bigger. Example: Yes Bank in NIFTY 50 when big, removed when small.

Worked Example

Stock	P₀	Shares	MCap₀ (L)	P₁	MCap₁ (L)
MNO	2,500	5,000	125	2,700	135
QRS	3,500	7,500	262.5	2,500	187.5
XYZ	1,500	10,000	150	1,600	160
Total			537.5		482.5

Price Return: (482.5−537.5)/537.5 = −10.23%

With dividends 100, 150, 100 → New total = ₹508.75 L → Total Return = −5.35%

4. Free Float Market Cap Weighted NIFTY 50 uses this

Excludes promoter holding. Only shares available to public are weighted.

Free Float MCap = Market Cap × Public Holding %

Why This Matters: Reliance vs HDFC Bank

Stock	MCap (₹L Cr)	Promoter %	Public %	Free Float MCap
Reliance	17	~51%	~49%	₹8.33 L Cr
HDFC Bank	11	<2%	~98%+	₹10.78 L Cr

→ HDFC Bank gets MORE weight in NIFTY 50 than Reliance!

NIFTY 50 Top Weights

1. HDFC Bank: 10.56% | 2. ICICI Bank: 8.32% | 3. Reliance: 8.27%

HDFC & ICICI are professionally managed — low promoter holding → high free float → higher weight.

Worked Example

Stock	Shares	Public %	P₀	P₁
A	5,000	90%	40	45
B	2,000	100%	68	60

FF MCap₀: A = 5,000×40×0.9 = ₹1,80,000 | B = 2,000×68×1.0 = ₹1,36,000 → Total = ₹3,16,000
FF MCap₁: A = 5,000×45×0.9 = ₹2,02,500 | B = 2,000×60×1.0 = ₹1,20,000 → Total = ₹3,22,000

Return: 6,000/3,16,000 ≈ 2.06% → Ending value of ₹100 portfolio = ₹102.06

5. Fundamental Weighted

Weight based on FUNDAMENTAL factors (most commonly: Earnings Yield or Low PE).

Earnings Yield = EarningsPrice = 1PE

Rental Property Analogy

	Value	Rent	Yield	PE
Property A	₹100	₹10	10%	10x
Property B	₹100	₹20	20%	5x

→ Buy B (higher yield, lower PE, cheaper)

⭐ KEY CHARACTERISTICS

Value Tilt: More weight to cheaper stocks
CONTRARIAN EFFECT: If price rises too much → Earnings Yield falls → Weight DECREASES

Opposite of Market Cap (which has Momentum Effect)!

Summary Table — All Weight Systems

Weight System	Key Characteristics
Price Weighted	Buy 1 share each; higher price = more weight. ⭐ Divisor adjusts for stock split
Equal Weighted	Equal amount each; ⭐ Needs MOST FREQUENT rebalancing
Market Cap Weighted	Weight ∝ MCap; ⭐ MOMENTUM EFFECT (bigger gets bigger)
Free Float MCap	Used by NIFTY 50; excludes promoter holding; higher public holding = higher weight
Fundamental	Weight based on Earnings Yield; ⭐ CONTRARIAN EFFECT (Value Tilt)

Weight Systems — Worked Numerical Examples 🧮

1 · Price Weighted — return

Buy 1 share of each. A: ₹100→₹110, B: ₹50→₹52.

• Begin = 100 + 50 = ₹150 · End = 110 + 52 = ₹162
• Price Return = (162−150)/150 = 8%
• With ₹1 dividend each → End 164 → Total Return = 14/150 = 9.33%

2 · Equal Weighted — two methods

A: ₹10→₹11, B: ₹20→₹24, C: ₹30→₹31.

• Method A (₹6,000 each → ₹18,000): end 6,600+7,200+6,200 = 20,000 → (20,000−18,000)/18,000 = 11.11%
• Method B (faster): average of returns 10%, 20%, 3.33% = 11.11%

Equal-weight return = simple average of constituent returns (no amount to assume).

3 · Market Cap Weighted — weights

A MCap ₹100 Cr, B MCap ₹50 Cr (total ₹150 Cr).

• Weight A = 100/150 = 66.67% · Weight B = 50/150 = 33.33%
• MCap = Price × Shares Outstanding → bigger cap = bigger weight (momentum)

4 · Price Weighted — stock-split divisor

P₀ = 10, 20, 60 → divisor 3 → index = 90/3 = 30.

• C splits 3:1 → prices 10, 20, 20 (sum 50). Value must NOT jump, so set new divisor: 50/x = 30 → x = 1.667
• Next day P₁ = 12, 19, 22 (sum 53) → index = 53/1.667 = 31.79

5 · Fundamental Weighted — earnings yield / P/E

Weight by a fundamental such as earnings yield = Earnings ÷ Price (the inverse of P/E). Two ₹100 assets:

Asset	Price	Income	Earnings Yield	P/E
A	₹100	₹10	10%	10×
B	₹100	₹20	20%	5×

Value tilt: more weight to the "cheaper" stock (higher earnings yield / lower P/E — here B). Contrarian effect: if a stock's price runs up too far, its weight FALLS — the opposite of market-cap's momentum.

Indexes 101 — What They Measure & Return Types

What an index represents

• Asset-class performance (equity, real estate, commodities)
• The whole security market (Nifty 50, Sensex 30, S&P 500)
• A market segment (Nifty Bank, Nifty IT, Nifty Auto)

Built as a portfolio of stocks = constituents; changing them = reconstitution (like swapping players on a cricket team).

Price vs Total return

• Price Return = (P₁ − P₀) / P₀ — price move only
• Total Return = (P₁ + Dividends − P₀) / P₀ — includes dividends
• ₹100 → ₹110 = 10% price; + ₹5 dividend = 15% total

Nifty 50 since inception ≈ 10% price return, ≈ 12.38% total return.

Index Construction — 4 Decisions

Target Market

Entire stock market? Banking only? IT only?

Which Securities to Include

NIFTY 50 = Top 50 by Free Float MCap

Weight System

NIFTY 50: Free Float MCap. NIFTY 50 EW: Equal

Reconstitution & Rebalancing Frequency

Reconstitution: Every 6 months (March, September)

Reconstitution in Practice

NIFTY 50 Bottom (likely OUT)

• 49th: Wipro — FF MCap ₹58,000 Cr
• 50th: HDFC Life — FF MCap ₹63,000 Cr

NIFTY Next 50 Top (likely IN)

• Adani Power — FF MCap ₹1,00,000 Cr
• Divis Lab — FF MCap ₹84,000 Cr

Prediction: Wipro (₹58K Cr) < Adani Power (₹1L Cr) → swap likely.
Past examples: Indigo, Max Healthcare INCLUDED. IndusInd Bank, Hero MotoCorp EXCLUDED.

Practical Indexes in India

Broad Market Indexes

• NIFTY 50: 50 cos, Free Float MCap. Price Return ~10%, Total Return ~12.38% since inception
• NIFTY 50 Equal Weight: 50 cos, 2% each, quarterly rebalance
• NIFTY 100 Equal Weight: 100 cos, 1% each
• SENSEX 30: 30 cos, Free Float MCap (BSE)

Sectoral Indexes

• NIFTY BANK — Banking
• NIFTY IT — Information Technology
• NIFTY AUTO — Automobiles
• NIFTY PHARMA — Pharmaceuticals

Rebalancing vs Reconstitution

Reconstitution (Recomposition)

Replacing constituents based on eligibility. Market cap falls below threshold → removed; rises above → added.

Rebalancing

Adjusting weights back to target. Prices move → actual weights drift → sell overweight, buy underweight to restore targets (esp. equal-weighted indexes).

Rebalancing during Reconstitution — funding the gap

• OUT: Wipro (FF MCap ₹50,000 Cr) → selling raises ₹50,000 Cr
• IN: Adani Power (FF MCap ₹90,000 Cr) → needs ₹90,000 Cr
• Gap of ₹40,000 Cr → raised by trimming the other 49 stocks

Key: when the incoming company has a higher weight than the outgoing one, existing constituents must also be SOLD to fund the difference.

5 Uses of Security Market Indexes

Reflect Market Sentiment

Captures overall mood — war → Nifty falls; trade deal → Nifty rises.

Benchmark Active Managers

Fund vs index: 9% vs 12% = underperform; 15% vs 12% = alpha.

Launch ETFs / Passive Funds

You CAN invest in Nifty 50 — via a Nifty 50 ETF that tracks it 1:1.

PROXY for Asset Class

In asset-allocation models. Nifty 50 represents (not equals) Indian equity.

PROXY for Systematic Risk

β = Cov(stock, market) ÷ Var(market); index is the "market" proxy.

⚠ Exam trap: uses 4 & 5 MUST include the word "PROXY" — without it the answer is marked wrong.

Equity Index Types — Style & Multi-Market

Style Indexes

Split by market cap, then by style (Value vs Growth). E.g. Nifty 50 Value 20 = the 20 cheapest of the top 50.

• Value: cheap valuations · Growth: expensive, future growth priced in
• Returns since inception: Nifty 50 12.38% vs Value 20 17.59%
• Buffett-style value investing, but via an ETF (less risky than single stocks)

Multi-Market Indexes

Span multiple countries. E.g. MSCI World Index (Morgan Stanley) — 23 developed economies.

• Top holdings: NVIDIA, Apple, Microsoft
• US ~72%, Japan 5%, UK 3%, Canada 3%, France 2%
• India is NOT included (developed markets only)

4 equity types: Broad Market · Sectoral · Style · Multi-Market.

Fixed Income (Bond) Indexes

Bond = you lend to a company/government, repaid with interest. Government is the biggest borrower.

Classified 5 ways

• Issuer — government vs non-government (corporate)
• Collateral — secured vs unsecured
• Coupon — high / low / zero coupon
• Maturity — 1yr, 2yr, 5yr, 10yr…
• Credit risk — govt ≈ zero; AAA/AA low; B/C/D high (higher risk → higher return)

Aggregate index = captures the TOTAL bonds issued in an economy.

Feature	Equity (Nifty 50)	Fixed Income
Constituents	50	Thousands
Turnover	Low	Very high (bonds mature & are replaced)
Liquidity	Liquid	Illiquid
Pricing	Transparent, market	Dealer-dependent
Replication	Easy	Very difficult

Why high turnover? bonds have a finite life — they mature and EXIT, new issues ENTER. Why illiquid? like property, you must ask a dealer for the price.

Alternative Investment Indexes

Commodity

• Weighting problem — no market-cap concept (gold vs crude vs silver?)
• Prices are FUTURES, not spot — cash-settled, no physical delivery
• MCX gold ≠ jeweller (spot) price — there's a difference

Real Estate

• Appraisal Index
• Repeat-Sales Index
• Index of REITs

(Detail comes in Alternative Investments.)

Hedge Fund

• Voluntary, self-reported returns
• Upward / survivorship bias — only good results reported
• No verification mechanism

⚠ Exam Traps & Critical Words

• "PROXY" — required for the asset-class & systematic-risk uses. Missing it = wrong.
• "Free-Float Market Cap" — Nifty 50 weights use free-float, not total market cap.
• Don't confuse rebalancing (restore weights) with reconstitution (change constituents).
• Commodity index prices are futures, not spot.
• Fixed-income indexes are hard to replicate; hedge-fund indexes are upward-biased.

Chapter 8 · Market Structure

Market Organization & Structure

Functions of the Financial System

1. Facilitate Saving & Borrowing

Savers deposit, banks lend to businesses (Tata, Reliance, Adani).

Interest rates must be BALANCED:

• Too HIGH → Savers happy, businesses don't borrow
• Too LOW → Businesses borrow, savers don't deposit
• OPTIMAL → Both active

2. Efficient Capital Allocation

Money should NOT remain idle. Capital must flow to MOST PRODUCTIVE uses for economic growth.

3. Key Entities

• SAVE — households
• BORROW — businesses, govt
• ISSUE EQUITY — companies
• MANAGE RISK — insurance
• EXCHANGE assets — exchanges
• FACILITATE — banks

Classification of Assets and Markets (8 Pairs)

1. Financial vs Real Asset

Financial: Bank FD, Shares, Bonds, MFs

Real: Property, Gold, Commodities, Real Estate

2. Debt vs Equity

Debt: Fixed interest (6–7%), principal back. Bank FD

Equity: Dividend + Capital Appreciation (Buy ₹100, Sell ₹120 = ₹20 + Dividend)

Real Estate Analogy: Equity = Real Estate (rent+appr); Debt = FD (interest only)

3. Public vs Private Securities

Public: Listed (Reliance, TCS) — easily tradable

Private: Not listed — limited buyers

4. Physical vs Financial Derivatives

Physical: On commodities (Gold, Metal derivatives)

Financial: On stocks (Reliance futures, Index futures)

5. Spot vs Future

Spot: Buy/sell NOW, immediate payment & delivery

Future: Buy/sell LATER (gold after 6 months)

6. Primary vs Secondary Market

Primary: Buy from COMPANY (IPO, Rights, Private Placement)

Secondary: Buy from MARKET (NSE/BSE) — from other investors

7. Money vs Capital Market

Money: Short-term (< 1 yr) — T-Bills, Commercial Paper

Capital: Long-term (≥ 1 yr) — Bonds, Stocks

8. Traditional vs Alternative

Traditional: Bank FD, Bonds, Stocks/Equity

Alternative: Real Estate, Gold, Commodities, Bitcoin, Art, Wine

Market Participants & Intermediaries

👥

1. Broker — Zerodha, 99acres

Provides PLATFORM only. Connects buyer & seller at SAME TIME. Does NOT buy/sell itself. Earns commission.

🏪

2. Dealer — Spinny, Car Dealers

Provides LIQUIDITY. Connects at DIFFERENT times. BUYS from seller first, SELLS to buyer later. Takes INVENTORY RISK.

Vikas sells car to Spinny @ ₹50K → Spinny sells to Akash @ ₹60K (10 days) → ₹10K profit

Aspect	BROKER	DEALER
Timing	Same time	Different time
Role	Platform only	Takes inventory
Price Risk	None	Bears price risk
Income	Commission/Fee	Spread/Profit

↔️

3. Arbitrageur

Exploits MISPRICING across markets. Buys CHEAP in one, sells EXPENSIVE in another. RISK-FREE profit. Makes markets EFFICIENT.

Example: Onions ₹10 (A), ₹15 (B) → buy A, sell B → ₹5 profit/kg

🛡️

4. Insurance Company

Creates DIVERSIFIED POOL OF RISK. Multiple risk types, geographically diverse.

Only Kolkata insured → flood = huge loss. All India → risk spread.

🏛️

5. Clearing House — NSCCL

Reduces COUNTERPARTY RISK. Ensures buyer gets shares, seller gets payment. Promotes market integrity.

🌙

6. ATS / Dark Pools — Bloomberg

Platform for INSTITUTIONAL clients. Less regulated, no public disclosure. Rakesh Jhunjhunwala deals directly with mutual funds via Bloomberg → no market impact.

Long Position, Short Position & Leverage

LONG (Bullish)

BUY first, SELL later. Want price UP. FIX your COST.

Example: Mom buys gold @ ₹14,200/g, sells @ ₹15,000/g → Profit ₹800

SHORT (Bearish)

SELL first, BUY later. Want price DOWN. FIX your SELLING PRICE.

Steps:
1. BORROW shares
2. SELL in market @ ₹100
3. Wait for price to fall to ₹80
4. BUY back @ ₹80
5. RETURN shares
Profit = ₹20

Leverage — The Catalyst

Leverage Ratio = AssetEquity ROE with Leverage = Asset Return % × Leverage Ratio

Using BORROWED money to invest. Acts as catalyst: gains AND losses MAGNIFIED.

Case 1 — No Leverage (100% Equity)

Asset = ₹100 | Equity = ₹100 | Debt = ₹0
Leverage Ratio = 100/100 = 1.0

Scenario	Asset	ROE
+20% gain	₹120	+20%
−20% loss	₹80	−20%

Range: −20% to +20%

Case 2 — With Leverage (60% E, 40% D, 0% int)

Asset = ₹100 | Equity = ₹60 | Debt = ₹40
Leverage Ratio = 100/60 = 1.6667

Scenario	Net	ROE
+20% gain	₹80	+33.33%
−20% loss	₹40	−33.33%

✓ Verification: 20% × 1.6667 = 33.33%

Comparison & Interpretation

	No Leverage	With Leverage
Gain Scenario	+20%	+33.33%
Loss Scenario	−20%	−33.33%
Leverage Ratio	1.0	1.6667

✓ Gains AND losses both increased by 66.67%

For every ₹1 equity → control ₹1.6667 assets, borrowed ₹0.6667. Volatility amplified by 1.6667x.

Margin Call — When Broker Calls For More Money

P^* = P₀ × (1 - Initial Margin)1 - Maintenance Margin

Intuition

• Numerator [P₀ × (1−IM)] = LOAN AMOUNT
• Denominator [(1−MM)] = Maximum loan % allowed
• When loan % crosses maintenance threshold → MARGIN CALL

Worked Example

P₀ = ₹100
Initial Margin = 40%
Maintenance Margin = 25%

Step 1: Loan = 100 × (1−0.4) = ₹60. Equity = ₹40.

Step 2: P* = (100 × 0.6) / (1 − 0.25) = 60/0.75 = ₹80

Margin Call Price: ₹80.00

Price	Loan	Loan %	Status
₹100	₹60	60.0%	Normal
₹90	₹60	66.67%	Monitoring
₹85	₹60	70.59%	Warning
₹80	₹60	75.00%	MARGIN CALL
₹60	₹60	100.00%	Critical

Participants by Behaviour — Hedger, Investor, Trader, Arbitrageur

Hedger

Takes an OFFSETTING position to REDUCE risk & minimise uncertainty.

E.g. health/car insurance; a US exporter hedging BRL depreciation with currency futures.

Arbitrageur

Exploits MISPRICING across markets for RISK-FREE profit. Makes markets efficient.

Investor

BUYS & HOLDS long-term. Uses Fundamental Analysis (company, industry, financials).

E.g. Buffett (Coca-Cola), Jhunjhunwala (Titan). Invests to risk appetite.

Trader

Buys/sells/holds SHORT-term. Uses Technical Analysis (charts, moving averages, volume, candles).

Participant	Horizon	Analysis	Goal
Investor	Long-term	Fundamental	Capital appreciation
Trader	Short-term	Technical	Quick price-move profits
Hedger	As needed	Risk-based	Risk minimisation
Arbitrageur	Immediate	Price comparison	Risk-free profit

Exchange-Traded Funds (ETFs)

A passive fund that replicates an index and trades on an exchange like a stock. Created by mutual-fund companies, backed by real shares, very low expense ratio.

How an SBI Nifty 50 ETF works

• Collects ₹10,000 Cr → splits into units @ ₹10, lists on the exchange
• Invests the full amount in Nifty 50 stocks at the SAME weights (HDFC 10% → 10% of fund)
• As Nifty moves, the ETF value moves 1:1

	ETF (Passive)	Active Mutual Fund
Aim	MATCH the index	BEAT the index
Manager	Tracks index	Picks stocks
Expense ratio	Very low	Higher
Holdings	Transparent	Discretionary

Open-Ended vs Close-Ended Funds

Open-Ended

Transact DIRECTLY with the fund at NAV. Fund continuously issues/redeems units → size varies.

E.g. Parag Parikh Flexi Cap — invest/redeem anytime at NAV.

Close-Ended

Fixed units; trade in the SECONDARY MARKET at market price (premium/discount to NAV), NOT with the fund.

Analogy: Open-ended = buy direct from DLF; Close-ended = buy the flat from an existing owner.

Forward vs Future Contracts

Feature	Forward	Future
Venue	OTC (private)	Exchange
Terms	Customised	Standardised
Counterparty risk	HIGH	ZERO (clearing house)
Liquidity / exit	Low / difficult	High / easy
Margin	Negotiable	Mandatory (initial margin)
Regulation	Minimal	High

Forward's problem: hard to exit + counterparty risk. Future's edge: standardised, no counterparty risk, transparent.

Worked Numericals — Leverage, Returns & Margin

Q1 · Leverage ratio from initial margin

IM = 55% → Equity ₹55 on a ₹100 asset, Debt ₹45.
Leverage = Asset/Equity = 100/55 = 1.818 (also = 1 ÷ IM).

Q2 · Leveraged return

Buy 200 sh @ ₹50 = ₹10,000; Leverage 2.5 → Equity = 10,000/2.5 = ₹4,000, Debt ₹6,000.
Sell @ ₹60 = ₹12,000; repay ₹6,000 → ₹6,000 left.
Return = (6,000−4,000)/4,000 = +50% (= 20% × 2.5).

Q3 · Return with commission, dividend & interest

Buy 500 sh @ ₹32 = ₹16,000; IM 75% → Equity ₹12,000, Debt ₹4,000. Buy commission ₹10.

Sell @ ₹28 = ₹14,000 − ₹10 sell commission = ₹13,990.

Repay debt + 2% interest = 4,000 + 80 = ₹4,080 → ₹9,910 left.

+ Dividend 500 × ₹0.55 = ₹275 → ₹10,185.

Outflow = 12,000 + 10 = ₹12,010. Return = (10,185 − 12,010)/12,010 ≈ −15.4%.

Buy commission ADDS to cost; sell commission SUBTRACTS; interest SUBTRACTS; dividend ADDS.

Q4 · Short-sale margin

Short 200 sh @ ₹47 → proceeds ₹9,400 (held by lender). Margin 40% = ₹3,760 you deposit on top. Margin protects the lender if price RISES.

Q5 · Margin call price

P₀ = ₹25, IM 50%, MM 30%.
P* = 25 × (1−0.50)/(1−0.30) = 12.5/0.70 = ₹17.86. Below this → margin call.

Execution Instructions — Orders

1. Market Order

Buy/sell IMMEDIATELY at BEST available price. No price specified.

• Executes INSTANTLY
• Speed > Price
• Use for urgent news, immediate execution
• Risk: May get worse price than expected

2. Limit Order

Buy/sell at SPECIFIC price or better. Only executes if market reaches your price.

• You SPECIFY exact price
• May or may not execute
• Default validity: SINGLE DAY
• Buy Bajaj @ ₹950 (CMP ₹1,000)

4 Sub-Types of Limit Orders

Market = Bid ₹1,000 / Ask ₹1,010 (Best Bid: highest buyer | Best Ask: lowest seller)

A. Take the Market

Price EQUALS or CROSSES best opposite quote. EXECUTES IMMEDIATELY.

Buyer ≥ Best Ask | Seller ≤ Best Bid

Buy ≥ ₹1,010 → fills @ ₹1,010

B. Make a New Market

Price BETWEEN best bid & ask. Become SOLE best. PENDING.

Buy @ ₹1,005 → market becomes 1,005 – 1,010

C. Make the Market

Price EQUALS best bid or ask. JOIN existing queue. PENDING.

Buy @ ₹1,000 → join buyer A at best bid

D. Behind the Market

Price WORSE than best. Far from execution.

Buyer < Best Bid | Seller > Best Ask

Buy @ ₹950 → only fills if price falls

Summary Table — Buyer Side (Market: Bid ₹1,000 | Ask ₹1,010)

Order Type	Buyer Price	Result
TAKE MARKET	≥ ₹1,010	EXECUTES immediately
MAKE NEW MARKET	₹1,001–1,009	PENDING, SOLE best bid
MAKE MARKET	= ₹1,000	PENDING, JOIN existing
BEHIND MARKET	< ₹1,000	PENDING, far from execution

Summary Table — Seller Side

Order Type	Seller Price	Result
TAKE MARKET	≤ ₹1,000	EXECUTES immediately
MAKE NEW MARKET	₹1,001–1,009	PENDING, SOLE best ask
MAKE MARKET	= ₹1,010	PENDING, JOIN existing
BEHIND MARKET	> ₹1,010	PENDING, far from execution

Order Matching Principle (NSE/BSE)

Key Rules

Best Buyer: Offers HIGHEST price
Best Seller: Offers LOWEST price
When Buyer's price ≥ Seller's price → ORDER EXECUTES

Priority of Execution

1 PRICE — Best price gets executed first
2 DISPLAY — Displayed orders preferred over hidden
3 TIME — Earlier order preferred

Bid Book — DESCENDING

Highest bid at top: 1000, 990, 980...

Ask Book — ASCENDING

Lowest ask at top: 1010, 1020, 1030...

Display vs Hidden Orders

Display Order

• Quantity & price VISIBLE to all
• Gets PRIORITY over hidden at same price
• Example: "Buy 1000 @ ₹1000" — everyone sees

Hidden Order

• Quantity NOT visible
• Used by large investors
• Lower priority at same price

Why Hide? Large orders MOVE the market. If everyone knows you want 1 lakh shares, sellers raise prices. Hidden orders protect large traders from market impact.

Validity Instructions (When Order Expires)

1. Day Order (Default)

Valid for ONE trading day. Cancelled at market close. Most common.

2. Good Till Cancelled (GTC)

Remains UNTIL YOU CANCEL. Across multiple days. "Buy at ₹900" stays active for weeks/months.

3. Good On Open / At Open

Executes at MARKET OPEN only.

4. Good On Close / At Close

Executes at MARKET CLOSE only.

5. Immediate or Cancel (IOC)

Execute immediately OR cancel immediately. Partial fills are cancelled. "Buy 500 @ ₹100 — fill or cancel".

Stop Loss Order

Limits losses by automatically selling (or buying) when price reaches trigger level.

1. Stop Loss SELL Order (For LONG)

• You OWN the stock (LONG)
• Fear: Price might FALL

Example:
Bought Bajaj Finance @ ₹900
Trigger: ₹850 | Limit: ₹840
When price hits ₹850 → system sells 840–850
Max loss/share: ₹60 (900−840)

2. Stop Loss BUY Order (For SHORT)

• You SHORT SOLD the stock
• Fear: Price might RISE

Example:
Short sold @ ₹900
Trigger: ₹950 | Limit: ₹960
When price hits ₹950 → buys 950–960
Max loss/share: ₹60 (960−900)

Primary Market (Detailed)

Where companies sell securities DIRECTLY to investors.

1. IPO

First time selling to public. Becomes publicly listed.

2. Right Issue

New shares to EXISTING shareholders. Usually at DISCOUNT.

Trade ₹100, Rights ₹95

3. Private Placement / QIP

Sold to QUALIFIED/INSTITUTIONAL investors only. Not general public.

Bajaj raises ₹100 Cr from mutual funds

Investment Banking Services

1. Underwritten Offering (Firm Commitment)

• Bank GUARANTEES to buy all shares
• Bank bears ALL risk
• Company gets GUARANTEED money Day 1

SpaceX Example:
Wants ₹100 Cr → Citibank buys @ ₹90 Cr
Sells to public @ ₹100 Cr → Profit ₹10 Cr
If unsold → Citibank bears loss
SpaceX gets ₹90 Cr regardless
Used for: STRONG demand, sure-shot issues

2. Best Efforts Offering

• Bank acts as BROKER/AGENT only
• Charges COMMISSION on shares sold
• Company bears risk
• No guarantee

Vikas Classes Example:
Wants ₹100 Cr → Citibank "I'll try" + Kotak "I'll try"
Citi sells ₹30 Cr, Kotak ₹10 Cr → Total ₹40 Cr
Banks get commission on sold amount only
Used for: UNCERTAIN demand, risky issues

Aspect	Underwritten	Best Efforts
Risk	Bank bears	Company bears
Guarantee	Yes (to company)	No
Bank's Role	Buys first	Agent only
Bank's Income	Spread (buy-sell)	Commission
Used For	Strong demand	Uncertain demand

Types of Markets (5 Categories)

1. Order-Driven

Order matching principle. No dealer in price setting.

NSE, BSE

2. Quote-Driven (Dealer)

Dealers provide liquidity via inventory. Earn spread.

Spinny, OTC markets

3. Brokered

Broker provides platform. Matches buyers/sellers. Commission.

Zerodha, 99acres

4. Call Market

Trades at SPECIFIC TIMES, SINGLE UNIFORM PRICE.

Pre-open session (9:00–9:15 AM)

5. Continuous

Trades CONTINUOUSLY. Real-time demand/supply.

Regular session 9:15 AM – 3:30 PM

How Opening Price Is Determined (Call Market Mechanism)

Market Timings

• 9:00–9:15 AM: PRE-OPEN SESSION (Call Market) — orders collected, no trading
• 9:15:01 AM: CALL MARKET — opening auction (1 sec)
• 9:15:02 AM – 3:30 PM: CONTINUOUS MARKET
• 3:30 PM – 4:00 PM: CLOSING SESSION

Method: Cumulative demand & supply at each price level. Price with MAXIMUM tradable quantity is selected. All matched trades execute at SINGLE UNIFORM PRICE.

Detailed Worked Example

Buyers (Bid Book — Descending)

Buyer	Qty	Price
A	7	₹12
B	15	₹11
C	2	₹10

Sellers (Ask Book — Ascending)

Seller	Qty	Price
Z	9	₹10
Y	6	₹11
X	2	₹12

Step 1–3: Cumulative + Tradable

Price	Cum. Buy	Cum. Sell	Tradable = MIN
₹12	7	17	MIN(7,17) = 7
₹11	22	15	MIN(22,15) = 15 ⭐ MAX
₹10	24	9	MIN(24,9) = 9

⭐ Opening Price = ₹11

⭐ Max Tradable Qty = 15 shares

Step 5: Allocation at ₹11

• Z sells all 9 shares @ ₹11

• Y sells 6 shares @ ₹11 → Total sold: 15

• A buys 7 @ ₹11 (wanted at ₹12 — BENEFIT)

• B buys 8 @ ₹11 (FAIR) → Total bought: 15

Remaining after open: B has 7 pending @ ₹11 | X has 2 @ ₹12 | C has 2 @ ₹10

Continuous market begins at 9:15:02 AM with these pending orders.

Well-Functioning Financial System (4 Pillars)

🗂️

Complete Markets

Borrowers borrow, savers save, balanced rates

🛣️

Allocational Efficiency

Capital flows to most productive uses

•

Informational Efficiency

Prices reflect all info quickly

⚙️

Operational Efficiency

Low transaction costs, easy trading

Role of Regulators (SEBI)

✓ Objectives of Market Regulation

Minimize Agency Problems
Reduce conflicts (custodian issues, counterparty risk)
Ensure Fair & Orderly Markets
No manipulation, transparent operations, equal opportunity
Protect Unsophisticated Investors
Retail protection, ban misleading influencers, accurate info

✗ NOT an Objective

Guarantee returns to investors
Ensure risk-free rate of return
Make markets profitable

Regulator's job is to make market EFFICIENT, not profitable.

Chapter 9 · Company Analysis

Company Analysis — Past & Present

Overview

5 Learning Outcome Statements covered
Mainly a theory-based chapter — no heavy calculations
Focus: how equity analysts analyze companies, forecast revenues, evaluate costs & assess business models

Concept A · Equity Research Reports

An Equity Research Report is a detailed analysis where the analyst understands the products, identifies competitive advantages, analyzes ratios, builds projected financials, performs valuation to reach a Target Price, and gives a Buy/Sell/Hold call.

💡 Example: Reliance trades ₹1,300, target ₹1,400 → Buy (upside). Target ₹1,000 → Don't buy (downside risk).

Two Types of Reports

Initiating Coverage	Subsequent Report
First-time, detailed & comprehensive report	Update to existing coverage
Full company description, industry overview, competitive positioning, ESG, detailed valuation	Triggered by new data; updates only recommendation, target price, rationale & model
Audience: those not yet knowledgeable about the company	For existing followers

⚠ Subsequent reports do NOT include: company description, competitive positioning, industry overview, ESG.

Components of an Initiating Coverage Report

Component	Description
1. Front Matter	Company name, analyst, CMP, target price, recommendation
2. Rationale	Reasons behind the Buy/Sell/Hold call
3. Company Description	Products, services, business model
4. Industry & Competitive Positioning	Industry analysis + competitive advantages
5. Financial Analysis	Ratios, projected statements, valuation
6. ESG Factors	Environmental, Social, Governance
7. Risk Factors	Upside/downside risks that could change the rating

ESG Factors

E · Environmental	S · Social	G · Governance
Impact of products on the environment (paper cuts trees, diesel, cigarettes/liquor)	Impact on society — beneficial or harmful?	Quality of management & compliance (violating regulator norms = bad governance)

Risk Factors

Identify both upside & downside risks that could change your rating later (e.g., a new cloud technology disrupting Infosys).

⭐ Risk factors appear in BOTH Initiating Coverage AND Subsequent reports.

Concept B · Business Model

Understand what the company sells, who the customers and major suppliers are, and the payment terms.

💡 Example (a CFA coaching business): Product = coaching · Customers = commerce students · Supplier = LMS provider · Payment terms = how fees are charged.

Four Sources of Data

Source	Description	Example
1. Company-Provided	Annual reports, investor presentations	Company's own annual report
2. Public Third-Party	Free data sources	News articles, free research
3. Proprietary Third-Party	Paid research reports	CRISIL, ICRA, Bloomberg
4. Proprietary Primary	Self-conducted research	Visiting cinemas, checking ticket sales

Revenue Forecasting — Two Approaches

Top-Down	Bottom-Up
Starts with the macroeconomic environment	Starts directly with company data
Used for large companies	Used for ALL companies (especially small)
GDP growth → sector share → company share → revenue	Last year's revenue → # students → fee/student → forecast

⭐ Key rule: Small companies → only Bottom-Up works. Large companies → both.

Pricing Power

Has Pricing Power	No Pricing Power
Low competition	High competition
High barriers to entry	Low barriers to entry
High switching costs	Easy to switch
No close substitutes	Many substitutes

Examples — No power: CFA teachers, cab aggregators (price-sensitive). Has power: electricity company (you can't refuse it), large FMCG with strong distribution (HUL).

Market Share vs Market Size

Term	Definition	Formula
Market Size	Total revenue of ALL companies in that category	Σ competitors' revenue
Market Share	One company's portion of the market	Company Revenue ÷ Market Size

Worked Example — Market Size

Market Size = Revenue ÷ Market Share = 500m ÷ 0.10 = ₹5,000m = ₹5 billion

Note: 1 billion = 1,000 million.

Concept C · Cost Analysis

Fixed Cost	Variable Cost
Does NOT change with output	Changes with output
Office rent (fixed regardless of students)	Calculators (1 student = 1 calculator)
Paid even if revenue is ZERO	Zero if output is zero

Which Structure Is Better?

Small Companies	Large Companies
Variable costs preferred — downside protected	Can handle fixed costs (stable revenue)
Max loss = break-even (₹0)	Can leverage fixed costs for higher profit

🍽️ Restaurant: fixed rent ₹20 lakh → lose ₹20 lakh even at ₹0 revenue. Variable rent (10% of revenue) → if revenue = 0, rent = 0. Small/new businesses prefer variable costs; fixed costs create leverage risk.

Concept D · Leverage Analysis

"In finance, Fixed Cost is known as LEVERAGE."

Operating Leverage	Financial Leverage
Fixed costs of operations (rent, salaries)	Fixed costs of financing (loan interest)
Measured by DOL · amplifies EBIT	Measured by DFL · amplifies EAT

Three Leverage Ratios

DOL

%Δ EBIT ÷ %Δ Sales
= Contribution ÷ EBIT

Contribution = Revenue − Variable Cost

DFL

%Δ EAT ÷ %Δ EBIT
= EBIT ÷ EBT

DTL

%Δ EAT ÷ %Δ Sales
= DOL × DFL

Numerical Example

Particulars	2015	2016	% Change
Units Sold	100	120	+20%
Revenue	₹1,000	₹1,200	+20%
Variable Cost	₹200	₹240	+20%
Contribution	₹800	₹960	+20%
Operating Fixed Cost	₹50	₹50	0%
EBIT	₹750	₹910	+21.33%
Interest	₹70	₹70	0%
EBT	₹680	₹840	+23.53%
EAT (after 10% tax)	₹612	₹756	+23.53%

Ratio	Calculation	Result
DOL	800 ÷ 750	1.0667
DFL	750 ÷ 680	1.1029
DTL	1.0667 × 1.1029	1.1765

⚠️ Double-edged sword: Sales ↑20% → profit ↑23.53% (good); Sales ↓20% → profit ↓23.53% (bad). We dislike volatility, so small firms avoid fixed costs. If ALL costs were variable → DOL = DFL = DTL = 1 (no amplification).

Economies of Scale vs Scope

Economies of Scale	Economies of Scope
Manufacturing gets more efficient; per-unit cost falls as output rises	Add new products using existing infrastructure; costs don't rise proportionally
Making rotis — each takes less time	Teaching CFA + adding Financial Modeling in the same office

Both → profit margins increase.

Concept E · Cash Conversion Cycle

Cash Conversion Cycle = Debtor Days + Inventory Days − Creditor Days

Component	Meaning
Debtor Days	Days customers take to pay you (money to receive)
Inventory Days	Days to sell inventory (money stuck in stock)
Creditor Days	Days you take to pay suppliers (money you hold)

Cycle	Meaning
Positive	Money is stuck in the business
Zero	Neutral
Negative	You hold others' money — BEST (bargaining power)

Unilever (2016)

Debtor 20 + Inventory 52 = 72 days stuck; Creditor 140 → CCC = −66 days. Others owe Unilever money for 66 days → market leadership & bargaining power.

Haldiram's: Debtor 0 (cash only) + Inventory 0 (sells instantly) − Creditor 40 → CCC = −40 days — excellent.

Practice Questions

Q1: Which statement about a subsequent report is MOST accurate?▸

✅ It updates the recommendation in light of new data.
❌ "Primary audience is those not knowledgeable" and "provides industry overview / competitive positioning / ESG" belong to Initiating Coverage.

Q2: Research data from Bloomberg is what type?▸

✅ Proprietary Third-Party Data (paid, third-party).

Q3: Revenue ₹500m, market share 10% — find market size.▸

Market Size = 500m ÷ 0.10 = ₹5,000m = ₹5 billion.

Q4: Units 10,000; price ₹5; VC ₹3; op-fixed ₹8,000 — find DOL.▸

Revenue ₹50,000; VC ₹30,000; Contribution ₹20,000; EBIT ₹12,000.
DOL = Contribution ÷ EBIT = 20,000 ÷ 12,000 = 1.667.

Q5: Upside/downside risks are included in…▸

✅ Both Initiating Coverage AND Subsequent reports.

Q6: A natural-resource company with cheap energy sells output at…▸

✅ Market Price — but a lower input cost means better margins (e.g., Tata Motors buying steel from Tata Steel).

Q7: First step in a company's capital investment?▸

✅ Identify / evaluate where the company can invest. Order: identify opportunities → forecast cash flows → compare profitability → invest where highest.

Quick Revision Summary

Concept	Key Points
Research Reports	Initiating (detailed, first time) vs Subsequent (update only)
Business Model	Products, customers, suppliers, payment terms
Data Sources	Company → Public → Proprietary third-party → Primary research
Revenue Forecast	Top-down (macro → company) vs Bottom-up (company directly)
Pricing Power	Low competition + high barriers + no substitutes
Costs	Fixed = leverage (risky for small cos); Variable = safer
Leverage	DOL = Contribution/EBIT · DFL = EBIT/EBT · DTL = DOL × DFL
Economies	Scale = lower per-unit cost; Scope = new products, same infrastructure
Cash Conversion	Negative = best (holding others' money); Positive = money stuck

🎯 Exam Strategy

Theory-heavy chapter — focus on concepts, not calculations.
Curriculum case studies are not tested in MCQs — skim them.
Do the Learning Ecosystem questions after this revision.

Chapter 10 · Industry Analysis

Industry & Competitive Analysis

The 5 Steps of Industry Analysis

Before valuing a company (Maruti, HUL…), first understand its industry and its competitive position.

Define the industry

Which industry does it operate in? (PW → Education, Maruti → Autos)

Survey the industry

Its size, growth, profitability & trends over time.

Analyse industry structure

Structure → profitability. Tool: Porter's Five Forces.

Analyse external forces

"Industry themes." Tool: PESTLE.

Competitive strategy

Cost leadership · Differentiation · Focus.

Industry Size, Company Types & Market Share

Growth vs Mature

• Growth: grow FASTER than the economy (Zepto, PW, new entrants)
• Mature: grow ≈ economy (usually <10%) — HUL, TCS, Reliance

Cyclical vs Defensive

• Cyclical: earnings VOLATILE, cycle/rate-sensitive — autos (Maruti), DLF, steel, industrials
• Defensive: earnings STABLE regardless of economy — FMCG, pharma, utilities

Rates ↓ → more cars/homes bought → Maruti/DLF earnings ↑ (and vice-versa).

Size & Market Share

• Industry size = total annual sales of the product across the whole industry (India passenger vehicles = ₹100 Cr).
• Market share = one company's % of that industry revenue (Maruti 10% of ₹100 Cr = ₹10 Cr).

Industry Concentration & the HHI

High concentration

• Few players rule (Telecom: Jio 55%, Airtel 45%)
• Pricing power: YES → strong, stable profits

Low concentration

• Many players, nobody has power (thousands of tutors)
• Pricing power: NO → weak, unstable profits

HHI — Herfindahl-Hirschman Index

Square each player's % share (as a whole number) and add them up.

HHI	Concentration
< 1,500	Low (many players, no power)
1,500 – 2,500	Moderate
> 2,500	Highly concentrated (few players rule)

Examples: Telecom 55²+45² = 5,050. Shares 50/30/20 → 2,500+900+400 = 3,800. More concentrated → better profits.

Finding Comparables & Classification (GICS)

GICS hierarchy — remember the order

Sector → Industry Group → Industry → Sub-Industry

Classified by products & services. Screening software (Capital IQ) filters on GICS to find comparables — JK Tyre → Auto Ancillary → Tyre → heavy-duty (MRF, Ceat, Apollo).

Other systems & limits

• ICB (used by indexes), RBICS
• Commercial (GICS) updated MORE often than government systems
• Multi-product firms get misclassified (Reliance = oil OR telecom?)

⚠ Grouping by geography

• By head-office location or listing location ✓
• NEVER by revenue geography (least likely) ✗

Tata Motors earns via JLR (UK/China) yet lists as India; TCS earns from US/EU.

Porter's Five Forces (structure → profitability)

Threat of new entrants

How easy to enter? (licences, capital)

Threat of substitutes

Can another product replace yours?

Bargaining power of buyers

Fewer, bigger buyers = more power.

Bargaining power of suppliers

Can suppliers pressure you?

Rivalry among competitors

How tough is existing competition?

Jio: hard to enter; buyers & suppliers powerless (crores of each); only substitutes (Starlink) & rivalry (Airtel) hurt → 3 of 5 in favour → high profitability. A tutor: easy entry, many substitutes, few students, high rivalry → low profitability. Power depends on NUMBERS.

PESTLE (external forces / "industry themes")

Letter	Factor	Example
P	Political	Election-time price controls; coaching norms
E	Economic	Interest rates → hits Maruti, DLF
S	Social	Liquor, cigarettes viewed negatively
T	Technological	AI threatening IT (TCS, Infosys)
L	Legal	Patents/copyright — pharma, films, music piracy
E	Environmental	Paper firms cut trees → heavy env. impact

Also a Demographic external factor — a country's age/gender mix affects industry growth.

Sustaining innovation

You IMPROVE your own product; you don't harm others (a tutor upgrading webcam → proper camera). Defensive.

Disruptive innovation ("Innovator's Dilemma")

Your move DISRUPTS existing businesses (PW cheap coaching; AI vs TCS/Infosys; a cheap legal-forms app vs law firms).

Three Generic Competitive Strategies

Cost Leadership

Sell very cheap to a LARGE market (DMart, Jio). Needs low cost → economies of scale, efficiency, favourable raw-material access.

⚠ NOT customer service / proximity (DMart stores are far, yet cheap).

Differentiation

Claim your product is different/better (every toothpaste "has salt"; a tutor teaches "differently").

⚠ Risk: becomes too EXPENSIVE while trying to be different.

Focus (Niche)

Target a small/niche segment only (Gucci, Rolls-Royce). Premium positioning, very limited customer base.

⚠ Exam Memory Map

• Concentration → measured by the HHI.
• Profitability / structure → Porter's Five Forces.
• External themes → PESTLE.
• Grouping by geography → never by revenue geography.
• Cost leadership → high volume + efficiency, not customer service/proximity.
• NOT a Porter force: barriers to EXIT, power of regulators, company life-cycle position.
• GICS classifies by products/services, updated more often than government systems.

Chapter 11 · Forecasting · 11–14%

Company Analysis — Forecasting

Why We Forecast — the Market Prices the Future

To value a share you forecast its future financial statements — because a share moves on expected future profits & cash flow, not today's. The market reacts spontaneously and in advance.

Example: TCS & Infosys fell >50% from highs — not because profits dropped yet, but because AI put a question mark on future profits. Price fell before the profit decline. Everything depends on profitability & cash flow.

What to Forecast — Revenue Drives Everything

The one rule

REVENUE is the only item you forecast independently. Everything else is expressed relative to revenue: expenses = % of sales · working capital = % of sales · capex = % of sales.

Category	Meaning	Examples
With clear drivers	Predictable, measurable	Revenue, COGS, fixed SG&A
Without clear drivers	Irregular, non-recurring	Consulting/commission income, one-time gains
Summary items	Calculated results	Gross profit, EBITDA, EBIT, EBT, EAT, FCF
Ad-hoc items	Not in FS but material	Contingent liabilities, legal cases, mgmt changes

Forecasting Revenue — Bottom-Up vs Top-Down

Bottom-Up (company-specific)

Units × price. E.g. 100 students × ₹100 = ₹10,000; next year 110 × ₹105 = ₹11,550. Best for small players / specific business units.

Top-Down (macro → micro)

GDP growth → sector's share of GDP → company's market share. Best for large / macro-sensitive firms (Maruti, HUL). Big firms use BOTH.

Revenue method	When to use
Historical data	Stable companies, consistent patterns
Management guidance	When the company gives growth guidance (e.g. Accenture 2–4%)
Analyst discretion	Cyclical / volatile firms where history is unreliable
Top-Down	Large, macro-sensitive businesses
Bottom-Up	Small companies, specific product lines

Forecasting Costs — COGS & SG&A

COGS = Sales × (1 - Gross Profit Margin)

COGS — % of sales

• Defensive (HUL/FMCG): margins stable (47–52%) → use historical average
• Cyclical (Tata Steel): P&L volatile → analyst discretion + research

HUL profits climb steadily; Tata Steel swings from +₹4.8L to −₹40k → unpredictable.

SG&A — mostly fixed

• Fixed SG&A (salaries, rent) → grow with inflation (~5%)
• Selling & distribution → model as % of sales (variable)
• Agent commission → % of revenue

Revenue doubles → staff salary does NOT double; it grows with inflation only.

The 5 Forecasting Methods + Convergence

Historical data

Project past trends — stable/defensive firms

Base rate & convergence

Abnormal growth reverts to the historical average

Management guidance

Non-recurring items, capex plans

Analyst discretion

Cyclical / volatile companies

Top-Down / Bottom-Up

Revenue forecasting (macro / micro)

Convergence (Muthoot): gold rose ~50%, profit grew 100% (EPS ₹132→₹263) — but next year won't repeat. Growth reverts to the historical ~11–12% (the analyst 2027 forecast implies only 11%). What happened historically eventually returns.

Balance-Sheet Forecasting

Fixed assets (capex)

• Maintenance capex = depreciation grown by inflation (dep ₹100 → ₹105). Depreciation = consumption of plant.
• Growth capex = ask management (new factories? expansion?) → add to maintenance.

Working capital

• Debtors → % of Sales
• Creditors → % of Purchases
• Inventory → % of COGS
• Debt & equity → historical leverage + mgmt guidance

Sales ₹100→₹150 (+50%), debtors stay 10% of sales → ₹10→₹15 (+50%).

Sensitivity & Scenario Analysis

Assumptions aren't precise, so you give a range, not a single number. Build three cases:

Base

Inflation 5%, CoE 15%

Optimistic

Inflation 4%, CoE 14%

Pessimistic

Inflation 7%, CoE 17%

Compare with the market-implied forecast

HDFC Bank ₹829.30 · trailing P/E 16.84× → E₀ = 829.30/16.84 = ₹49.24 · forward P/E 15.20× → E₁ = 829.30/15.20 = ₹54.55 → market-implied growth = (54.55−49.24)/49.24 = 10.8%.

If your forecast says 15% but the market implies 10.8% → either the market undervalues it, or your assumptions are too optimistic.

⚠ Exam Key Points

• Revenue is the only independently-forecast item; everything else is % of sales.
• Cyclical / volatile firm → analyst discretion (not history, not mgmt guidance).
• Capex → management guidance (only they know expansion plans).
• Summary item example → Free Cash Flow (calculated, not a driver).
• Forecast objects should be disclosed regularly (transparency) — not necessarily individual/discrete.
• Abnormal growth converges back to the historical average.
• Maintenance capex ≈ depreciation; growth capex from management.

🧮

Interactive Tools

Live Calculators

📈

Gordon Growth Model

P₀ = D₁r - g

Next Year's Dividend (D₁) — ₹

Required Rate of Return (r) — %

Growth Rate (g) — %

Intrinsic Value P₀

₹

⚠ INVALID

r must be > g for Gordon Growth to work!

🛑

Margin Call Price Calculator

P^* = P₀(1-IM)1-MM

Initial Stock Price (P₀) — ₹

Initial Margin (IM) — %

Maintenance Margin (MM) — %

Margin Call Triggers At

₹

Loan Amount: ₹

Your Equity: ₹

Price decline before call: %

•

Leverage & ROE Simulator

ROE = Asset Return × AssetEquity

Total Asset Value — ₹

Your Equity — ₹

Asset Return — %

Leverage Ratio

ROE

Debt: ₹
For every ₹1 equity → control ₹ of assets

📈

Two-Stage DDM Calculator

P₀ = Σ_t=1ⁿD_t(1+r)^t + P_n(1+r)ⁿ

Recent Dividend (D₀) — ₹

High Growth (g₁) — %

Years of High Growth (n)

Stable Growth (g₂) — %

Required Return (r) — %

Intrinsic Value P₀

₹

Terminal value at Year discounted to today + High-growth dividends discounted.

⚠ Required return (r) must > stable growth (g₂)

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Reference

Formula Vault

📘 Equity Securities

Book Value

BV = Equity Capital + Retained Earnings

Price-to-Book Ratio

P/B = Market PriceBV per Share

Return on Equity

ROE = Net IncomeAverage BV

Average Book Value

Avg BV = Open BV + Close BV2

📗 DDM Family

Gordon Growth (Single-Stage)

P₀ = D₁r-g

Preferred Stock (g = 0)

P₀ = Dr

Sustainable Growth Rate

g = ROE × (1 - DPR)

Multi-Stage Terminal

P_n = D_n+1r-g

Single Period DCF

P₀ = D₁ + P₁1+r

📕 Relative Valuation

PE Ratio

PE = PriceEPS

Fundamental Leading PE

P₀E₁ = DPRr - g

Fundamental Trailing PE

P₀E₀ = DPR(1+g)r - g

Enterprise Value

EV = Mkt Equity + Mkt Debt - Cash

EV/EBITDA

EVEBITDA

Equity Value

Equity = EV - Debt + Cash

📙 NAV & Market Structure

Net Asset Value

NAV = Fair Value Assets - Liabilities

NAV per Share

NAV/Share = NAVShares

Leverage Ratio

LR = AssetEquity

ROE with Leverage

ROE = Asset Return % × LR

Margin Call Price

P^* = P₀(1-IM)1-MM

Short Selling Margin

Total w/Broker = Proceeds × (1 + Margin%)

📊 Indexes & Returns

Market Cap

MCap = Price × Outstanding Shares

Free Float MCap

FF MCap = MCap × Public Holding %

Stock Weight

w_i = MCap_iΣ MCap

Price Return

R_P = P₁ - P₀P₀

Total Return

R_T = P₁ + D - P₀P₀

⏱ Dates & Misc

Ex-Dividend Date

Ex-Div = Record Date - 1 Bus Day

Dividend Growth

D₁ = D₀ × (1+g)

Earnings Yield

EY = EarningsPrice = 1PE

Portfolio Value

V = Σ (Shares_i × Price_i)

🧠

Mastery Check

Complete Question Bank with Solutions

Q1: Advantage of Participating Preference Shares?▸

They receive EXTRA/SURPLUS dividend when company performs exceptionally well.

Q2: Benefit of Cumulative Voting?▸

Minority shareholders get proportional board seat / representation on the board.

Q3: Which is NOT a characteristic of Private Equity?▸

"Lower returns due to illiquidity" — INCORRECT. Private equity can give HIGHER returns.

Q4: GDR currency is always?▸

USD — even though listed outside US (e.g., London).

Q5: Which preference type carries MOST risk?▸

CALLABLE — capital gain capped by company.

Q6: Best describes Book Value of Equity?▸

Management should try to maximize it (through retained earnings / reinvestment).

Q7: Rise in ROE is most likely positive when?▸

Net Income rises FASTER than Book Value.

Q1: Analyst fair value = ₹45, CMP = ₹50▸

FV (₹45) < CMP (₹50) → OVERVALUED → DO NOT BUY. Conditions: followed by FEW analysts, confident in model.

Q2: Free Cash Flow to Equity model maps to?▸

(A) PRESENT VALUE MODEL — DCF method.
Multiplier→Relative; Asset-based→NAV; PV→DCF.

Q3: 50% stock dividend vs 3-for-2 split — which lower price?▸

90 shares × ₹150 = ₹13,500.
Both result in 135 shares × ₹100 = ₹13,500.
Answer: BOTH have the SAME effect.

Q4: First date buyer doesn't receive dividend?▸

Ex-Dividend Date. Stock trades WITHOUT dividend entitlement. Price drops by dividend amount.

Q5: Single Period DCF — D₁=$1.05, sell $13.45, r=13.2%▸

CF = 1.05 + 13.45 = $14.50. PV = 14.50/1.132 = $12.81

Q6: Multi Period DCF — D=$1.50 +8%/yr, sell $51 in 3 yrs, r=12%▸

Y3 CF = $1.8896 + $51 = $52.8896.
PV1=1.4464, PV2=1.3948, PV3=37.637.
Total = $40.48

Q7: Requirement of Gordon Growth Formula?▸

r > g — Required rate MUST exceed growth rate.

Q1: Preferred Stock Valuation (D=₹7, r=7.75%)▸

P₀ = 7 / 0.0775 = ₹90.32 → Option C

Q2: One-Year Holding (D₁=₹2, P₁=₹40, r=15%)▸

P₀ = (2 + 40)/1.15 = ₹36.52 → Option B

Q3: Gordon Growth (D₀=₹1, g=5%, r=10%)▸

D₁ = 1.05. P₀ = 1.05/(0.10−0.05) = ₹21 → Option B

Q4: Two-Stage (D₁=1.25, D₂=1.56, g_thereafter=5%, r=11%)▸

D₃=1.638. P₂=1.638/0.06=27.30. Y2 CF=1.56+27.30=28.86.
P₀ = 1.25/1.11 + 28.86/(1.11)² = 1.126+23.419 = ₹24.54 → Option C

Q5: Multi-Stage (D₀=1, g₁=25% for 2yrs, g₂=6%, r=10%)▸

D₁=1.25, D₂=1.5625, D₃=1.6563. P₂=41.4063.
Y2 CF=42.9688. P₀ = 1.25/1.10 + 42.9688/(1.10)² = 1.136+35.512 = ₹36.64 → Option C

Q6: Best Company for Constant Growth Model?▸

(A) Biotechnology (2 yrs old) ✗ Too new
(B) Automobile Manufacturer ✗ Cyclical
(C) Bread & Snack Producer (FMCG) ✓ — daily necessities, stable, defensive, growth near economy.

Q7: Deferred Dividend (D₄=0.82, g=5%, r=10%)▸

P₃ = 0.82/0.05 = ₹16.40. P₀ = 16.40/(1.10)³ = ₹12.32

Q1: Least likely characteristic of price multiples?▸

"They are insensitive to inputs" — INCORRECT. Multiples ARE sensitive to inputs. Change the multiple → valuation changes.

Q2: Fundamental PE (DPR=60%, g=7%, r=15%)▸

PE = 0.60/(0.15−0.07) = 0.60/0.08 = 7.5x

Q3: Meaning of Enterprise Value?▸

Market Value of Equity + Market Value of Debt − Cash & Short-term Investments

Q4: Most appropriate for Asset-Based Valuation (NAV)?▸

(A) Company in financial distress ✓ CORRECT
(B) High inflation ✗ NAV not used during hyperinflation
(C) Software companies ✗ Intangible assets — not suitable for asset-based valuation

🃏

Active Recall

Flashcard Trainer

Equity Investments

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🎓 The Complete Equity Investments Topic — Conquered!

Eleven chapters, four live calculators, the formula vault and the full question bank — everything you need for exam day, in one self-contained page.

— जय हिंद! —

Overview of Equity Securities

Types of Equity Securities

1. Common Shares (Equity)

2. Preference Shares (Preferred Stock)

Sub-Types of Preference Shares

Voting Power — Statutory vs Cumulative

1. Statutory (Straight) Voting

2. Cumulative Voting Good Governance

Dual Class Equity Structures

Public vs Private Equity

Foreign Equity Investments — ADR, GDR, Global Registered Shares

Sponsored vs Unsponsored ADR/GDR

Book Value vs Market Value

ROE vs Required Rate of Return

Role of Equity in Financing — Uses of Equity Capital

Equity Valuation — Concepts & Methods

Market Price vs Intrinsic (Fair) Value

Methods of Equity Valuation

1. Relative Valuation

2. Absolute Valuation

When to Use NAV vs DCF (Real Examples)

Types of Dividends & Corporate Actions

1. Regular Cash Dividend Sticky

2. Special Dividend One-time

Stock Split, Bonus Shares, Reverse Split — Essentially the Same Concept

Summary — Corporate Action Effects

Dividend Payment Chronology — Timeline

Discounted Cash Flow (DCF) — Numericals

Dividend Discount Models (Single & Multi-Stage)

The Gordon Growth Model

ITC Practical Valuation Example

Preferred Stock Valuation (g = 0)

Sustainable Growth Rate Calculation

Two-Stage Dividend Discount Model

Deferred Dividend Problem

When to Use Which Valuation Model?

Relative Valuation & EV/EBITDA

Method of Comparable (Comparable Company Analysis)

PE Ratio — Logic and Calculation

Other Multiples (When Earnings Negative)

Method of Fundamental (Fundamental PE)

EV/EBITDA Multiple

House Analogy — EV vs Net Worth

Real Example — Hindustan Unilever (HUL) Valuation

EV/EBITDA — Detailed Calculation Example

Net Asset Value (NAV) Method

NAV Calculation — Worked Example

Master Decision Table — When to Use Which Method

Advantages & Disadvantages of All Methods

Market Efficiency & Behavioral Finance

Meaning of Market Efficiency

Active vs Passive Investing

Market Value vs Intrinsic (Fundamental) Value

Six Factors Promoting Market Efficiency

Four Forms of Market Efficiency (Master Table)

Exam Question Patterns

Anomalies in Market Efficiency

Behavioral Finance — Investor Behaviors

Key MCQ Solutions

Security Market Indexes

What Are Indexes?

Two Types of Returns

Five Weight Systems (Most Important Topic)

1. Price Weighted

2. Equal Weighted

3. Market Cap Weighted

4. Free Float Market Cap Weighted NIFTY 50 uses this

5. Fundamental Weighted

Summary Table — All Weight Systems

Weight Systems — Worked Numerical Examples 🧮

Indexes 101 — What They Measure & Return Types

Index Construction — 4 Decisions

Reconstitution in Practice

Practical Indexes in India

Rebalancing vs Reconstitution

Rebalancing during Reconstitution — funding the gap

5 Uses of Security Market Indexes

Equity Index Types — Style & Multi-Market

Fixed Income (Bond) Indexes

Alternative Investment Indexes