HYDERABAD

APRIL 2010 - FUNDAMENTAL APPROACH TO EQUITIES

RAGHU IYER TRAINING

This program is designed to help you with the basic fundamentals of financial st
and understand what is written there
This will help you to buy shares with a fundamental understanding (profits, rese
growth, sales revenue) - this will create wealth in the long run

SECOND REASON
As time passes, clients will become more knowledgeable
Competition will become more knowledgeable
So in order to grow (or even survive) as an individual, you need to KNOW
This is knowledge economy
From Adam's days to 1800 - agricultural economy
From 1800 to 1975 - industrial economy
From 1975 till date - knowledge economy

AGENDA FOR TWO DAYS

1 What drives share prices
2 Fundamental approach to investing
3 Value versus Price
4 Importance of Value Multiples (PE, PBV, EV/EBIDTA)
5 Go thro United Phosphorous Research Report (afternoon)
6 Discuss your findings on the Report

TOM
1 Fair valuation of the Nifty (India)
2 Where is the market now and how do you invest in the current marke
Can we get a general understanding of markets for all tim
3 How can you invest to make money in the long run (creation of wealt
4 Derivatives - Combination Strategies - Bull Spread, Ratio Spreads, Bu
5 Option valuation - Intrinsic, Time value - how do you make money / lo
6 Indicators - Open Interest, Implied Volatility, Put Call Ratio

Very simple
Technicals is not part of the program
You don’t need to agree with me
If everybody agreed with everybody in the market place
If everyone believed that ITC is a good buy - what will happen?
Market will stop, BSE will close down
The basic foundation of markets is disagreement

WHAT DRIVES SHARE PRICES

Research study done in the UK, which identified three factors:
1 Liquidity
2 Sentiment
3 Fundamentals

1 Liquidity
Cash flow - is cash coming in or is cash flowing out?
Who creates cash flow in India?
a FIIs
b All others - mutual funds, insurance sector, HNIs, retail - q

In 2007, FIIs brought in around USD 16 bio (Rs 70,000 cr) - market zo
In 2008, FIIs took out around USD 17 bio (Rs 75,000 cr) - market fell
In 2009, FIIs brought in around USD 18 bio (Rs 80,000 cr) - market ro
Today, the FII community is the single largest cash flow provider and
to their tune

Indian Govt is definitely worried bcoz dependence on foreignors is ba

Foreignors are affected by global factors which we cannot control or

In the long run, we believe that (a) our domestic insurance sector wil
(b) our provident funds will start investing in the equity market
These will provide reasonable counter-balance to the FIIs

2 Sentiment
News flow - continuous news flow from global sources to Indian sourc
to company level sources
Stock markets react to news all the time, driven by sentiment (not by
In Nov 2009, we heard that Dubai is in trouble
Sensex crashed 300 / 400 points
 Now we heard that Greece is in trouble
Sensex crashed 250 points

Most human beings are emotional beings, not intellectual beings

We are 99% emotional and 1% intellectual

3 Fundamentals
We mean company's financial performance and financial prospects
How is it doing and how is it expected to do?
Sales, Operating Margins, EBIDTA, PAT, EPS, PE, RoE, RoCE, Debt - Eq
Capital Management - Sectoral issues, growth in the sector, custom
leadership, management quality, dividends, bonuses, investor frien

WHICH OF THESE FACTORS ARE MORE IMPORTANT THAN THE OTHERS

In the short term, markets are driven by liquidity and sentiment
In the long term, markets are driven by fundamentals

In the short term, fundamentals are useless

Most of the time, you will find that financial results are good, but share price ha

If Infosys over the last 15 years has gone from Rs 100 to Rs 20,000 - why?
Answer - great fundamental performance

If Infosys in the last 15 minutes has gone from Rs 2,421 to Rs 2,408 - why?
Answer - liquidity and sentiment
Someone wanted to sell very rapidly and he was happy to sell below

WHAT IS SHORT TERM AND WHAT IS LONG TERM

What was the largest investment by the Britishers in India?
Railways
What must have been their time horizon while making these investments? When
money back?
25 to 30 years

GMR runs Hyderabad Airport - they built Hyderabad Airport

How long do you think they will take to make money? How long will they run the
10 to 15 years payback period
Their concession agreement with the Govt runs for 60 years
What was Warren Buffet's largest investment last year (2009)?
Northern Railroad (railway in America) - Rs 85,000 cr
Very simple argument - US will grow (slowly) year on year - long term
Oil prices will rise (crude is short)
As oil prices increase, trucking will become expensive
More and more cargo will move to rail transport and railways will do well
US grows at 2% plus trucking move to rail - another 2%
Time horizon - 30 years
His age is 77 years

Planning Commission of India

Short term 5 years
Medium term 5 to 15 years
Long term More than 15 years

Sharekhan Hyderabad Branch - Derivatives Dealer

What is the time now?
Short term Next 10 minutes
Medium term Upto lunch time
Long term End of day 330 pm

He will be afraid to keep any position open at 330 pm - overnite risk

In the world of fundamental investing, you need long term thinking

Long term need not mean 30 years, 40 years
But you should have the vision for at least 3 years - if you want to make money
3 years), then maybe fundamental approach is not the best approach for you
Maybe trading could be tried

Research says that over a 12 year period, almost 90% of the movement in stock
fundamentals
If Infosys 12 years ago was Rs 500
Today it is 20000
Appreciation 19500

90%
 17550
Fundamental
Factors

If Him Fut 10 years ago was 2600

Today it is 11
Appreciation -2589

90%
-2330.1
Fundamental
Factors

INVESTING VERSUS TRADING

As stock brokers, your business model is trading oriented
You want fast traders as your clients
In the long run, investing can create wealth (trading may or may not)

If you allocate 10 - 15% of a good client's portfolio towards investing, that 10-15
in the long run
That can add to customer loyalty and goodwill and bring in a long term relations

FUNDAMENTAL APPROACH TO INVESTING

Basic beliefs and how do we make money from these beliefs:
1 Price is different from Value
2 Price is known every moment in the market
3 Value is unknown, unseen, unfelt - but it exists
4 If we can understand Value, we can make money
5 Price is generally wrong - the market is generally mispriced - overpri
6 Market moves based on liquidity and sentiment (over-excited or mise
7 Market is like a stopped clock - a stopped clock shows the right time
The market shows the right price rarely (price = value)
8 This equilibrium (price = value) is not sustained, soon there is chaos
9 If you buy when price < value, and wait wait wait for a situation whe
you can make money
10 We don’t know how long we will have to wait - we need patience bco
 equilibrium will happen (we believe it will happen sometime)

Sell

Buy

11 We are very happy that market is not logical, market is driven by sen
and this behaviour provides opportunity for us to make money

WHAT IS VALUE?
How is it computed / measured?

Example
There is a shop in Vijaywada - price of the shop is Rs
You have some surplus cash, you want to buy this shop and let it out on rent for
After 5 years, you plan to sell the shop
You want to know what is the "value" of the shop

Reasonable rental for the shop per month Rs

Reasonable increment in rental every year
Reasonable appreciation in property value annual
What is your return on other possible investments

Valuation can be done on Discounted Cash Flow basis as follows:

Year Rental Property Total Present

Value
Factor
1.000
1 60.00 60.00 0.926
2 69.00 69.00 0.857
 3 79.35 79.35 0.794
4 91.25 91.25 0.735
5 104.94 2,415.77 2,520.71 0.681
Value
Price
Value > Price - good buy

If Interest rates rise to 12%, the shop becomes unattractive (not a good buy)
If Interest rates fall to 1%, the shop becomes very very attractive

Valuation is not only dependent on shop related data but also your cost of borro
of other investments

DCF valuation of companies is difficult - bcoz you need lots of data

Short cut is multiples

PE multiple (Price / Earnings)

What is the PE of the shop?
Price 1,500
Earnings in year one 60
PE 25 times

For every one rupee of earning, the price is Rs 25

Most popular multiple in retail stock market is the PE

When we see the figure of 25, we should be able to understand whether this is t
attractive ?

Company PE = CMP / EPS

EPS - Earnings per Share = PAT / No of Equity Shares

Share capital Rs 200 cr

PAT Rs 300 cr
Share price Rs 450 per share

You need information on Face Value per share

If Face Value per share is Rs 10
No of Shares 200 10 20
EPS = PAT / No of Shares
300 20 15.00
PE = CMP / EPS
450 15.00 30.00

For every one rupee of earnings, the price is Rs 30

PE of the shop was 25 times
Which is cheaper?
Shop is cheaper than this share

What is the PE of the Post Office?

Price is Rs 100
Earnings are Rs 8
PE 12.5 times

Comparative PE
Company 30.00 Most expensive
Shop 25.00
Post Office 12.50 Cheapest

PE tells us what is cheap and what is expensive

Infosys price is Rs 2,600

Satyam price is Rs 97
Which is cheaper?
Price Earnings
Infosys 2600 106
Satyam 97 1

EPS / PE
Trailing Based on past 4 quarters profits
Forward Based on future projected profits (could be FY 11, 12)

Basic Number of shares as of today

Diluted Number of shares that will be issued in future
Past 4 quarters profit is Rs 250
FY 11 estimated profit is Rs 325
Current No of Shares 20
Additional shares to be issued 3
Future No of Shares 23
CMP 160.00
EPS Rs PE x
Trailing / Basic 12.50 12.80
Trailing / Diluted 10.87 14.72
Forward / Basic 16.25 9.85
Forward / Diluted 14.13 11.32

As an investor, which one is the most relevant definition?

The investor is very keen on forward earnings and he should be concerned with

Future number of shares are those shares which the company is legally obligate
These are not mere plans
Examples:
1 Convertible Debentures
2 FCCBs - Foreign Currency Convertible Bonds
3 Convertible Preference Shares
4 Warrants
5 ESOPs

UNITED PHOSPHOROUS RESEARCH REPORT

1 P&L
2 Bal Sheet
3 Ratios as given
4 Valuation multiples as given

1 P&L
Net Sales 2,449.8 Core Income
Operating Costs 1,882.7 Raw Materials, Labour, Mfg, Adm
Operating Profit 567.1
Other Income 21.2 Interest, Dividends, Capital Gain
EBIDTA 588.3 Earnings Before Interest, Depn,
Depreciation & Amort 165.6
EBIT 422.7
Interest 104.6
PBT 318.1 Before Exceptional Items
Exceptional Item 7.6
PBT 310.5 After Exceptional Items
Tax 52.5
PAT 258.0
Adjusted PAT 265.6 Regular PAT plus Exceptional Ite

Exceptional items could be VRS, loss due to floods, strikes (non-routi

PAT is also called Net Profit
Adjusted PAT is the realistic PAT as estimated by the analyst. In this
added back Exceptional Items. In other cases, he may make other a

Amortization is Depreciation of Intangible Assets (Goodwill, Patents,

Depreciation is applied for Tangible Assets (Buildings, Plant, Machine

If you buy a car for Rs 8 lakhs and it has a life of 10 years, the annua
and this will be called as Depreciation
If you buy a patent for Rs 8 lakhs and it has a life of 10 years, the an
and this will be called as Amortization

RPAT - Reported PAT - Reported as per the Company's P&L in their A

This profit would be Profit After Tax before Minority Interest

UPL has many subsidiaries (children) - where UPL holds more than 50
If UPL holds a company in Europe where its shareholding is 60% and
UPL Europe makes a profit of Rs 100 cr
How much of that belongs to UPL India?
Rs 60 cr
Rs 40 cr belongs to who?
Tony Blair
Tony Blair is the minority shareholder in UPL Europe

In my P&L, first I will add the entire Rs 100 cr in my PAT

Then I will deduct Rs 40 cr as Minority Interest
Then I will show Rs 60 cr as PAT after Minority Interest

RPAT 282.1
Minority Interest must be 24.2
PAT after Minority Interest 257.9

EPS = PAT / No of Shares

RPAT 282.1
Share Capital 37.5
Face value per Share (Rs) 2.0
No of Shares 18.75
EPS 15.0

Fully Diluted EPS (given) 15.0

This depends on CD, FCCB, CPF, W, ESOPs

BV - Book Value
BV = Shareholders Funds / No of Shares
Shareholders Funds means funds provided by shareholders (owners)
Shareholders Funds = Capital + Reserves
Reserves means past accumulated profits + Share Premium if any

Shareholders Funds 1,495.4

No of Shares 18.75
Book Value per Share Rs 79.8

Book Value indicates the amount invested by shareholders historical

If you compare this book value with the CMP, you get the PBV (Price

Price 163.0
BV 79.8
PBV 2.0
The actual PBV is 4.1
There was a bonus issue in FY 09 of 1:1
So the price of 163 of today would have been double before FY 09
If you want the PBV of FY 07, then the price should be adjusted (doub

Adjusted Price 2 326.0

 BV 79.8
PBV 4.1

PBV tells you the quantum of wealth created by the company

If PBV > 1, it indicates that wealth has been created
If PBV < 1, it indicates that wealth has been destroyed

Accounting Goodwill
Arises only on "acquisitions"
If UPL acquires a Spanish company for Rs 200 cr but gets assets of only Rs 175
is recognized as Goodwill

Net Current Assets

Also called "Working Capital"
Current Assets minus Current Liabilities
Current Assets include
Inventories
Receivables
Cash and Bank Balances
Loans and Advances and Deposits

Current Liabilities include

Vendors Payable
Bills Payable
Expenses Outstanding

Working capital indicates the amount blocked in day to day running of the busin

Simple Debt Equity Ratio

Debt 1959.3
Shareholders Funds 1495.4
Debt Equity 1.3

Net Debt = Debt minus Cash Balance

Cash Balance we don’t know, but we can easily find out

Net Debt Equity 1.0

Equity 1,495.4
Therefore Net Debt will be 1,495.4
Gross Debt is 1,959.3
Cash Balance must be 463.9

RoCE - Return on Capital Employed = EBIT / CE

EBIT 422.7
CE - Total of Bal Sheet 3,533.9
RoCE 12.0%

This capital employed includes funds provided by shareholders as well as funds

RoNW - Return on Net Worth (also called RoE - Return on Equity)

Net Worth = Shareholders Funds = Equity
RoE = PAT / NW
RPAT 282.1
Shareholders Funds 1,495.4
RoNW 18.9%

Business
CE
EBIT

Bankers Govt
Interest Inc Tax

For the Owner to generate a healthy RoE, the business should generate a health

KEY RATIOS
1 Check the ratios for FY 09, FY 10, FY 11
2 Valuation ratios PE, PBV for same 3 years
3 From the P&L, check the EPS for same 3 years
4 Read the Research Report carefully
Key ratios for FY 09
FY 09 FY09 FY 09
OPM 944.9 4,931.7 19.2%
EBIDTAM 986.7 4,931.7 20.0%
PATM 475.2 4,931.7 9.6%
Net Debt : Equity 1,562.8 2,604.6 0.6
RoCE (EBIT/CE) 794.0 4,794.4 16.6%
RoNW 485.1 2,604.6 18.6%

EBIDTA 986.7
Depreciation 192.7
EBIT 794.0

Debt Equity Ratio means Debt / Equity

Net Debt means Gross Debt (Borrowings) minus Cash on Hand
Net Debt Equity Ratio is given
We know Equity (Shareholders Funds)
We know the Gross Debt
We know the Ratio
So we can get the Cash Balance

Net Debt Equity Ratio = Gross Debt - Cash

Equity

In the year FY 09:

0.6 = 2072.3 - Cash
2604.6

1562.76 = 2072.3 - Cash

Cash = 509.54

Valuation Ratios
FY 09
PE Multiple 163.0 11.0 14.8
Book Value 2,604.6 44.0 59.3
PBV 163.0 59.3 2.7
EPS 485.1 44.0 11.0

Reading the Report and summarizing the contents

Page One
Summary
1 Diversified product portfolio - many products
2 India sales are 20% of total sales, Sales abroad are 80%, various geo
3 Patent protection is going off in many products, UPL is a generic play
4 India demand is likely to be strong and growing
5 Revenue growth was 37% per annum (2005 - 2009) - CAGR
6 Future revenue growth will slow down to 13% (2009 - 2011) - lower s
7 OPM will improve by 0.80% (lower raw mat cost and Cerexagri)
8 Production will shift from India from Australia and Argentina
9 PAT will grow at 28% CAGR (2009 - 11)
10 Historically, UPL share price has quoted at 9.4 x EV/EBIDTA multiple
is trading at a discount - 7.9 x FY 10 and 6.4 x FY 11
11 He has not considered seed business profits
12 Target price is Rs 225 - derived as 8.5 x FY 2011 EV/EBIDTA

Poor man's multiple is PE - retail

PE = Price / EPS
Rich man's multiple is EV/EBIDTA - if Vijay Mallya wants to buy Deccan Airways,
If Raghu Iyer wants to buy 2 shares of Deccan Airlines, he will look at PE

What is EV? EV stands for Enterprise Value (value of the enterprise)

Market Cap No of Shares x CMP
+ Debt
- Cash

What does it mean?

If I buy the whole company, what will it cost me

If I spend that much EV, what do I earn

You earn EBIDTA
So what is the relationship between EV and EBIDTA - that becomes the multiple

Enterprise Value of United Phosphorous Ltd - FY 10

Market Cap 44.0 163

Debt

Less : Cash Balance

Enterprise Value
EBIDTA
EV / EBIDTA Multiple

Historically, UPL has traded at a multiple of 9.4

Now it is trading at a discount

Let us apply a discount of 10% 0.9

A reasonable multiple could be 8.5
EBIDTA of FY 11 1,330.5
Target EV 11,256.0
Estimated Net Debt 2,072.3 540.0 1,532.3
Estimated Market Cap 9,723.73
No of Shares 44.0
Target Share Price 221.2

CAGR
Fundamental analysis is all about long term - patience
In the long term, growth is very important
Growing companies will get good multiples (high multiples)
What is growth? How do we measure growth?

YoY, QoQ, Sequential, CAGR - all these are growth

FY 08-09 FY 08-09 FY 08-09 FY 08-09
Q1 Q2 Q3 Q4
Sales 150 222 201 181
Sequential
QoQ 48% -9% -10%
CumuSales 754
YoY
Qtly YoY

All these are short term growth measurements which are not useful for long term
These growth metrics create "noise"

Short term data by itself can be highly volatile and therefore misleading

Practical applications
Examples
Price of a bus ticket many years ago
Price of the same bus ticket today

CAGR 15th root of 20 times 1.22 0.22

Price of house in Guntur

Price of a similar house today

CAGR 1.14 0.14

Price of land in Vijaywada

Price of similar land today

CAGR 1.64 0.64

Price of chai - Blue Sea Hotel in Hyderabad

Price of chai today

CAGR 1.39 0.39

Sensex many many years ago
Sensex today

CAGR 1.18 0.18

UPL Sales 2007 - 2011

UPL Sales 2007 - 2011

CAGR 1.27 0.27

UPL RPAT 2007 - 2011

UPL RPAT 2007 - 2011

CAGR 1.3 0.3

 ndamentals of financial statements, research reports

nderstanding (profits, reserves, book value, capital,

e long run

you need to KNOW

/EBIDTA)
ort (afternoon)

nvest in the current market

ding of markets for all times
long run (creation of wealth)
Spread, Ratio Spreads, Butterflies, etc
w do you make money / lose on Time Value
y, Put Call Ratio
 happen?

factors:

wing out?

nce sector, HNIs, retail - quite quite small

(Rs 70,000 cr) - market zoomed up

s 75,000 cr) - market fell 60%
(Rs 80,000 cr) - market rose 100%
est cash flow provider and the Indian market dances

ndence on foreignors is bad strategy

hich we cannot control or even understand

mestic insurance sector will become huge and

n the equity market
nce to the FIIs

bal sources to Indian sources to sectoral sources

riven by sentiment (not by logic)

not intellectual beings

and financial prospects

S, PE, RoE, RoCE, Debt - Equity ratio, Working

owth in the sector, customer demand, technological
ds, bonuses, investor friendly

NT THAN THE OTHERS

sentiment

e good, but share price has dropped

to Rs 20,000 - why?

21 to Rs 2,408 - why?

e was happy to sell below Rs 2,421 also

ers in India?

these investments? When would they have got their

bad Airport
How long will they run the airport?
st year (2009)?

year - long term

ailways will do well

- overnite risk

term thinking

you want to make money in the shorter run (less than

he best approach for you

of the movement in stock prices can be related to

10%
 1950
Liquidity and Sentiment

10%
-258.9
Liquidity and Sentiment

may or may not)

wards investing, that 10-15% may create good wealth

ng in a long term relationship

nerally mispriced - overpriced or underpriced

ment (over-excited or miserable)
lock shows the right time twice a day
ice = value)
ained, soon there is chaos
it wait for a situation when price = value, price > value,

ait - we need patience bcoz we don’t know when

happen sometime)

Price
Value

al, market is driven by sentiment and liquidity

r us to make money

15 lakhs
p and let it out on rent for 5 years

5000
15% 115%
10% 110% 15
8% 108%

as follows:

DCF

55.56
59.16
 62.99
67.07
1,715.55
1,960.33
1,500.00
e > Price - good buy

active (not a good buy)

y attractive

but also your cost of borrowings / opportunity cost

d lots of data

nderstand whether this is too high, too low, interesting,

cr
 times

expensive

PE
24.53 Cheaper
97.00 Expensive

s (could be FY 11, 12)

sued in future
 cr
cr
cr
cr
cr

should be concerned with dilution of equity

ompany is legally obligated to issue

Materials, Labour, Mfg, Admin, Selling

st, Dividends, Capital Gains (Non Core Income)

ngs Before Interest, Depn, Tax and Amortization
e Exceptional Items

Exceptional Items

ar PAT plus Exceptional Item added back

o floods, strikes (non-routine items, unusual items)

ed by the analyst. In this case, he has merely

ases, he may make other adjustments.

Assets (Goodwill, Patents, IPR)

(Buildings, Plant, Machinery)

life of 10 years, the annual expense will be Rs 80,000

s a life of 10 years, the annual expense will be Rs 80,000

Company's P&L in their Annual Report

Minority Interest

re UPL holds more than 50% shareholding

shareholding is 60% and Tony Blair holds 40%

PL Europe

cr in my PAT
 rity Interest

This you cannot calculate (company will provide)

by shareholders (owners)

+ Share Premium if any

by shareholders historically into the company

MP, you get the PBV (Price to Book Value)

Times
Why?

en double before FY 09
e should be adjusted (double)
ed by the company
n created
n destroyed

ets assets of only Rs 175 cr, the extra amount paid

o day running of the business

reholders as well as funds provided by banks

Return on Equity)

RoCE

Owners
Equity
PAT RoE

s should generate a healthy RoCE

 He has considered Adjusted PAT for this purpose
Gross Debt 2,072.3 Diff is Cash 509.5

He has considered RPAT

on Hand
 The analyst has considered simple EPS and not diluted EPS

road are 80%, various geographies

ucts, UPL is a generic player

5 - 2009) - CAGR
3% (2009 - 2011) - lower selling prices
cost and Cerexagri)
lia and Argentina

9.4 x EV/EBIDTA multiple - at the moment it

6.4 x FY 11

2011 EV/EBIDTA

ts to buy Deccan Airways, he will study EV/EBIDTA

, he will look at PE

he enterprise)
hat becomes the multiple

FY11
7,163.9 7,163.9
2,472.3 2,072.3
9,636.2 9,236.2
577.0 Back calculated 540.0
9,059.2 8,696.2
1,139.9 1,330.5
7.9 Given 6.5

times

FY 09-10 FY 09-10 FY 09-10 FY 09-10

Q1 Q2 Q3 Q4
200 212 183 234

10% 6% -14% 28%

 829
10%
33% -5% -9% 29%

are not useful for long term investing

erefore misleading

0.50 1995
10.00 2010
20 15
times years
22%

2.50 1998
12.00 2010
4.8 12
times years
14%

2.50 2003
80.00 2010
32 7
times years
64%

0.50 2002
7.00 2010
14 8
times years
39%
 100 1979
18,000.00 2010
180 31
times years
18%

2,449.8 2007
6,335.7 2011
2.59 4
times years
27%

282.1 2007
807.4 2011
2.86 4
times years
30%
Day Two

Valuation in more detail

History of the PE in India
High and low levels that we have seen in our past - learnings from them
Current PE level in India
PEG (Price Earnings to Growth)
Valuation of the Nifty based on DCF
Reasonability of the PE based on statistics

You can understand the Nifty level at any time (too high, too low, reasonable ba

Future of India
How to make money from the market
Systematic Investing

What should you see in any Research Report

Are there good and bad levels of some ratios that we should be caref

Importance of PE
What is the PE of India today?
India PE means Sensex PE or Nifty PE
PE is "number of times"
For every one rupee that I am earning, what is the price
The Nifty PE on 9th April, 2010 was 23.21 times
For every one rupee that the Indian corporate is earnings, we are pa

Is this valuation of 23.21 times too high / too low ?

What is the PE of the Post Office?
Price 100
Earning 8
PE 12.5

History of the PE
Sensex started in 1979
Early 1980s 7 times
Mid 1980s 8 - 9 times
Late 1980s 9 - 11 times
Early 1990s Over 70 times
Mid 1990s 10 - 14 times
Late 1990s, Early 2000 28 times
Early 2000 - mid 2003 10 - 14 times
Mid 2003 to Jan 2008 10 - 28 times
Jan 2008 - Sept 2008 28 - 10 times
Sept 2008 - March 2010 10 - 23 times

21000 Sensex (Jan 2008) is lower than 4600 Sensex (Sept 1994)
Sensex PE in Jan 2008 was 28 times, while the PE in Sept 1994 was 72 times

If you compute the average PE over the last five to ten years, it will give you a g
Also study the max PE and the min in this period
We buy when Price < Value and sell when Price > Value
When PE rises too much, that means Price is rising too fast and vice versa

Average PE 18.92 Last five years

Average PE 17.68 Last ten years

Max PE 28.29 Last five years

Max PE 28.29 Last ten years

Min PE 10.68 Last five years

Min PE 10.68 Last ten years

If PE goes above 28 times, the market looks overpriced and you should be sellin
If PE goes below 11 times, the market looks underpriced and you should be buy

Standard deviation concept

I want to know the heights of adult males in Hyderabad
The population of Hyderabad is 80 lakhs, of which 25 lakhs are adult males
I can take a sample of 30 people and estimate the heights of the entire populati

Data of 30 people
Average of these people
Standard deviation of this data
1 sigma
 2 sigma
3 sigma

Standard deviation
Distance from the average
Square of this distance
Sum of the squares of 30 observations
Square root of this sum

Statistical Model - Normal Distribution - Gaussian Distribution

66% of the observations will fall within +/- 1 sigma
95% of the observations will fall within +/- 2 sigma
99% of the observations will fall within +/- 3 sigma

66% of adult males in Hyderbad will fall between

95% of adult males in Hyderbad will fall between
99% of adult males in Hyderbad will fall between

PE - Standard Deviation
5 years 3.46 18.92 3.46 6.93
10 years 3.46 17.68 3.46 6.92

5 year Prob
Less than 3 sigma 8.53 0.50%
3 sigma to 2 sigma 8.53 11.99 2.00%
2 sigma to 1 sigma 11.99 15.45 14.50%
1 sigma to Average 15.45 18.92 33.00%
Average to 1 sigma 18.92 22.38 33.00%
1 sigma to 2 sigma 22.38 25.84 14.50%
2 sigma to 3 sigma 25.84 29.31 2.00%
Above 3 sigma 29.31 0.50%
Portfolio rebalancing based on statistical modeling of PE

NIFTY BEES is India, Nifty BeeS is Nifty, Nifty is India

10 year Prob
Less than 3 sigma 7.29 0.50%
3 sigma to 2 sigma 7.29 10.75 2.00%
2 sigma to 1 sigma 10.75 14.21 14.50%
1 sigma to Average 14.21 17.68 33.00%
Average to 1 sigma 17.68 21.14 33.00%
1 sigma to 2 sigma 21.14 24.60 14.50%
2 sigma to 3 sigma 24.60 28.06 2.00%
Above 3 sigma 28.06 0.50%

Concept of PEG
Price Earnings to Growth
What should be the right PE level?
The PE multiple should be equal to Growth expected in the EPS

If you expect your EPS to grow by 14%, then your PE should be 14 times
Companies whose earnings are expected to grow fast can enjoy a higher PE

If we expect Indian corporate earnings to grow by 20% per annum, then the Ind

If the PE is more than the growth rate, market is overpriced (good sell)
If the PE is less than the growth rate, market is underpriced (good buy)

PE Growth % PEG Market

14 14 1.00 Fairly priced
14 20 0.70 Under priced
14 10 1.40 Over priced

PEG was formulated by Peter Lynch

Peter Lynch was a Fund Manager for Fidelity from 1977 to 1990
He ran a fund Magellan Fund
In 1977, the corpus of the fund was USD 20 mio (Rs 90 cr)
In 1990, the corpus was USD 13 bio (Rs 58,500 cr)
Peter Lynch says that this is a good approximate measure (not an accurate mea

Infosys in early 2000 was quoting at Rs 13,800 (Ketan Parekh scan time)
PE of Infosys was 160 times
Experts used to justify this PE (Infosys earnings are growing at 160%, so PE is ok
They used the concept of PEG to justify the Infosys price
Once the scam broke, all shares collapsed including Infosys (all fell to less than

The mistake is understanding and defining growth

160% was the actual growth of Infosys earnings
But is 160% sustainable over the long term?

Your office boy's salary went up from Rs 3,000 to Rs 5,000

Growth in salary 67% 167%
If the office boy assumed that this growth will sustain for the long term:
Year Salary
0 3,000
1 5,000
2 8,333
3 13,889
4 23,148
5 38,580
6 64,300
7 107,167
8 178,612
9 297,687
10 496,145
11 826,909
12 1,378,181
13 2,296,968
14 3,828,280
15 6,380,467
16 10,634,112
17 17,723,521
18 29,539,201
19 49,232,002
20 82,053,337
21 136,755,561
If actual growth rates are very high (more than 30%), please don’t pay a PE of m
Please don’t follow PEG model, bcoz such high growth rates are not sustainable

For example, UPL earnings growth rate as we saw yesterday was very high
RPAT growth of 30% over 2007-11
We don’t necessarily pay a PE of 30 times to UPL - why?
Bcoz the growth is not sustainable

PEG model will prevent you from paying high PE

Shoppers Stop is quoting at 80 PE
You should question whether Shoppers Stop earnings can grow at 80% per annu

Warren Buffet says

You pay a high price for a cheery consensus

INDIA GROWTH STORY

What is the GDP growth expected in India?
I think minimum growth will be at least 6.50%
Real growth vis-à-vis Nominal growth
Real is before inflation (without inflation) and Nominal is after inflation
Last year This year Growth
Steel tons 100 105 5%
Price per ton 20 22 10%
Sales Revenue 2000 2310 16%

Economic forecast is on Real growth. India will grow at 6.5% in Real terms.

Real growth is 6.50%

Inflation 6.00%
Nominal growth will be 12.50%

Sector Real Inflation Nominal

Agri 2.00% 6.00% 8.00% Is not listed on the stock exc
Industry 7.50% 6.00% 13.50% Listed
Services 8.00% 6.00% 14.00% Listed
India 6.50% 6.00% 12.50%
Corporate India Sales will grow at 13.5 to 14% over the long term
Corporate Profits may rise faster - say 14 to 16% over the long term

Long term means what?

Goldman Sachs (the world's best investment bank) produced the BRIC report
By 2026, India will beat all countries in GDP other than US and China (India will
In 2046, India will beat the US (and become No 2)
India will grow annually at the rate of at least 5.5% GDP till 2050

In 2046, India's population will be at least 8 times the US population

So, if your GDP = US GDP, your per capita GDP is one-eighth of US per capita

Where will the Sensex be after 30 years

100,000
80,000
50,000

18000 14% 114% 30 917,103

18000 15% 115% 30 1,191,812
18000 16% 116% 30 1,545,298
18000 180 3,240,000
18000 18% 118% 30 2,580,671

Sensex over the long term

Buy

Buy

Sell
18000
 2010

Systematic Investing
Nifty SIP from Jan 1, 1999 to April 9, 2010 generates 36% return per annum
Even if you started on a bad day (Ketan Parekh scam height), you still earn 37%
If you started on Ketan Parekh height and stopped on 27th Oct, 2008, you still e

RESEARCH REPORT KEY POINTS

1 Sales growth CAGR Annual
2 PAT growth CAGR Annual
3 PE level Current
4 PEG (PE / Growth)
5 Industry PE level

6 Debt Equity Ratio If this is high say more than 2 times, be c

Infra sector can borrow upto 4 times, all
7 RoE Should be more than 15%
8 RoCE Should be more than 13%
s from them

low, reasonable band) - buy / hold / sell

we should be careful about

earnings, we are paying a price of Rs 23.21

times
 Harshad Mehta period

Ketan Parekh period

94 was 72 times

, it will give you a good sense of valuation

nd vice versa

you should be selling and getting out

you should be buying buying buying

re adult males
the entire population using statistics

165 cms
15 cms
15 cms
 30 cms
45 cms

168 165 3
9
xx
yyy

ribution
n +/- 1 sigma
n +/- 2 sigma
n +/- 3 sigma

all between 150 180

all between 135 195
all between 120 210

10.39
10.38

Equity Debt
Very very low priced 100% 0%
90% 10%
75% 25%
60% 40%
40% 60%
25% 75%
10% 90%
Very very high priced 0% 100%
 Equity Debt
Very very low priced 100% 0%
90% 10%
75% 25%
60% 40%
40% 60%
25% 75%
10% 90%
Very very high priced 0% 100%

be 14 times
njoy a higher PE

nnum, then the India PE can be 20 times

(good sell)
(good buy)

Action
Nothing / Hold
Buy
Sell
ot an accurate measure, don’t rely on it entirely)

h scan time)

at 160%, so PE is okay)

(all fell to less than 30%)

long term:
 don’t pay a PE of more than 30 times
are not sustainable over the long term

was very high

ow at 80% per annum over the next ten years

r inflation

Real

Nominal

in Real terms.

ed on the stock exchange

ng term

d the BRIC report

nd China (India will be No 3)

pulation
of US per capita

ng term
1000000

Sell
 2040

urn per annum

, you still earn 37% per annum
Oct, 2008, you still earn 11% per annum

e than 2 times, be careful

w upto 4 times, all others should be lower
One Up on Wall Street - By Peter Lynch
Beating the Street - By Peter Lynch
Buffetology - By Mary Buffet
www.investopedia.com
www.moneychimp.com
www.motleyfool.com
SNMJ

NIFTY - APRIL 9, 2010 1. Go long April Futures and go short April 54

NIFTY INDEX 5362
NIFTY APRIL FUTURES 5367 2. Go long April Futures and go long April 49
Calls Puts
LTP Strike LTP 3. Long April Futures, Long April 4900 Put, S
467.00 4900 6.45
372.50 5000 10.90 4. Long April Futures, Short April 5400 Call a
282.00 5100 18.00
193.35 5200 32.00 5. Go long April 5200 Call and go short April
116.95 5300 53.80
58.45 5400 92.40 6. Go long April 5400 Call and April 5000 Put
22.90 5500 157.00
6.80 5600 239.00 7. Go short on the same as 6 above

8. Go short April 5000 Put and go long April 4

9. Go long April Fut and short May Fut

Combinations - Strategies
Valuation
Indicators

Six positions possible

1 Long Futures
2 Short Futures
3 Long Calls
4 Short Calls
5 Long Puts
6 Short Puts

Six Graphs

Long Futures
Gains
33
 5367 5400 Nifty Price

Losses Bullish position is a p

from upward movem

Short Futures

5367

5400 Call
Long Calls

Strike
5400

-58.45
Premium The graph will chang
5458.45
BEP

Short Calls

58.45
Premium
Strike
5400

BEP for both long an

 5200 Strike
Long Put

Strike
5200
-32
Premium

5168
BEP

Short Put

32

5200

COMBINATION OF LONG FUTURES AND SHORT 5400 CALL

EXERCISE ONE

Covered Call

91

5309 5400
The upside risk on the Short Call is "covered" by Long Futures upside reward

2. Go long April Futures and go long April 4900 Put

Downside Reward

Downside Risk -473

By paying Rs 6 premium, I have limited my downside risk

Max Loss is Rs 473 - downside
Max Gain is unlimited - upside

3. Long April Futures, Long April 4900 Put, Short 5400 Call

UpRew DoRew
85

DoRisk UpRisk 4900

-415

Limited Gains
Limited Losses
View : Bullish Very popular in forex markets
Upside Reward
Downside Risk
4. Long April Futures, Short April 5400 Call and April 5500 Call

114

5400

Nifty 5367 5367-58-23

View : Moderately Bullish 5286
I believe that Nifty will move up, but it will not move up beyond 561
High risk startegy - both sides, losses are unlimited

5. Go long April 5200 Call and go short April 5400 Call

Bull Spread
Gains limited
65 Losses limited
View : Bullish
5200 5400 Upside reward
Downside risk
-135
5335

5. Go long April 5400 Call and go short April 5500 Call

Bull Spread
 65 Gains limited
Losses limited
View : Bullish
5400 5500 Upside reward
Downside risk
-35
5435

Success Ratio = 65:35

6. Go long April 5400 Call and April 5000 Put

Long Strangle

5000 5400
-69

4931 5469

This strategy is useful for "events". A big event is about to happen - Budget, Ele
Election Results, RBI policy, Quarterly Results, Major announcements, Major Co

7. Go short on the same as 6 above

Short Strangle

69

5000 5400
8. Go short April 5000 Put and go long April 4900 Put

Spread using Puts

4900 5000

-95
4995

9. Go long April Fut and short May Fut - Calendar Spread Strategy
April Futures 5367
May Futures - suppose 5380
Spread 13

After 4 days:
April 5391
May 5401
Spread 10

If you square up:

April 24
May -21
Net Net 3
NIFTY - APRIL 9, 2010
NIFTY INDEX 5362
NIFTY APRIL FUTURES 5367
Calls Puts Call Very Very
LTP Strike LTP BEP Bullish Bullish
5900 RoI
467.00 4900 6.45 5,367.00 533.00 114%
372.50 5000 10.90 5,372.50 527.50 142%
282.00 5100 18.00 5,382.00 518.00 184%
193.35 5200 32.00 5,393.35 506.65 262%
116.95 5300 53.80 5,416.95 483.05 413%
58.45 5400 92.40 5,458.45 441.55 755%
22.90 5500 157.00 5,522.90 377.10 1647%
6.80 5600 239.00 5,606.80 293.20 4312%

If you are very bullish, the Out of the Money Calls (5400, 5500, 5600) are good

Calls Puts Call Moderately

LTP Strike LTP BEP Bullish Bullish
5432 RoI
467.00 4900 6.45 5,367.00 65.00 14%
372.50 5000 10.90 5,372.50 59.50 16%
282.00 5100 18.00 5,382.00 50.00 18%
193.35 5200 32.00 5,393.35 38.65 20%
116.95 5300 53.80 5,416.95 15.05 13%
58.45 5400 92.40 5,458.45 (26.45) -45%
22.90 5500 157.00 5,522.90 (22.90) -100%
6.80 5600 239.00 5,606.80 (6.80) -100%

If you are moderately bullish, the In The Money Calls are good (4900 to 5200)

The maximum liquidity is at the ATM

If you are a fast trader, then ATM is good bcoz the bid-ask difference will be nar

In general, selling options is high risk (unlimited losses)

Options industry is like the Insurance industry
How many people buy insurance?
Crores of people
How many people sell insurance?
15 companies
Where is the intellect? Who prices the policies?
Sell side
Buy side knows nothing - buy side is all retail simple people who are afraid of de
Companies are betting mathematically that mortality will remain at reasonable
too many people will not die too soon

In Options Industry, there are millions of buyers of options

But there are very few sellers
Sellers are experts, they price the options, they control the market, they unders
mathematics, they understand Delta, Gamma, Vega, Theta and are constantly
their positions
Buyers think their losses are limited (so they are comfortable)
Sellers know that their losses are unlimited (they are very uncomfortable and ar
monitoring their positions, delta and rehedging)

One selling desk may have a position of Rs 500 cr

OPTION VALUATION
Stock price Known
Strike price Known
Volatility Suspense Can be back-calculated
Time to expiry Known
Interest Zero

Price Known

That back-calculated volatility is known as "Implied Volatility" IV

IV comes from the price of the option as seen in the market
 Historical Volatility
What has been the Nifty volatility in the past?
Standard deviation of daily returns

Nifty CloseDaily Ch Daily Ret Daily Vol Annual Vol

5,246 16
5,263 17 0.32%
5,205 (58) -1.09%
5,225 20 0.39%
5,260 35 0.67%
5,282 22 0.41%
5,303 21 0.39%
5,262 (40) -0.76%
5,249 (13) -0.25%
5,291 41 0.79%
5,368 78 1.47% 0.75% 12.1%
5,366 (2) -0.04% 0.76% 12.1%
5,375 9 0.16% 0.61% 9.8%
5,304 (70) -1.31% 0.80% 12.7%
5,362 57 1.08% 0.84% 13.4%

We can convert Daily Volatility into Annual Volatility (we multiply by 16)

Our Historical Volatility is 13.4%

The Implied Volatilty is 15.5%

Nifty Volatility over the past 5 years has been in the range of 15% to 45% most
Higher vol means higher Option prices (both Calls and Puts)
Example - during Budget, during Elections, options will become very expensive

In range bound situations, volatility will be low

In dull markets, volatility will be low
In slow bullish markets, volatility will be low
In nervous markets, volatility will be high
In bearish markets, volatility will be high
In panicky markets, volatility will be v v v high
During events, volatilty will be high
If volatility shoots up during bullish markets, that is a sign of nervousness (Jan 2

Historical Implied Markets

Volatility Volatility
Past Future
Low Low Dull, Range Bound, Slow Bullish
High High Nervous, Panic, Crash, Bearish
High Low Expectation is dull markets
Low High Expectation is high vol, crash

I am assuming you are a Buyer

When Imp Vol is low, buying options may be a good strategy
When Imp Vol is high (above 40%), options are very expensive and hence stayin
be better

The calculator is very useful for understanding when you will make mo
Nifty is at 5367
You are bullish
You bott the 5400 Call for Rs 58
After 4 days, Nifty goes to 5381
Will you make money on the Call?
Call value will increase bcoz Nifty went up
Call value will fall bcoz time has passed

OPEN INTEREST
The number of open positions in any instrument

5400 Calls of Nifty

You Buyer 2 Seller 1 Seller 2
Day 1 2 -2
Day 2 3 1 -4
5 -1 -4
Day 3 -4 20 1 0
1 20 0 -4
If Open Interest is rising, that means traders are taking fresh positions
If Open Interest is falling, that means traders are squaring up (they are going aw
booking profits or booking losses)

One Example
Nifty is at 5367 today
5400 Call Open Interest is 10 lakh units
Tom, Nifty moves up to 5391
Open Int of 5400 Call reduces to 8 lakh units and Open Int of 5500 Call increase
units
What does this mean?

Traders are squaring up 5400 Calls and moving to 5500 Calls

Why? What does this mean?
It means traders (sellers) are nervous - why? They are afraid that Nifty may cros
5400 may not be a strong resistance for the Nifty

Example Two
Nifty is at 5367 today
5400 Call Open Interest is 10 lakh units
Tom, Nifty moves up to 5391
Open Int of 5400 Calls rises to 11 lakh units
What does this mean?

Traders are quite confident (sellers) that 5400 will be a strong resistance
It is not likely to be broken
 go short April 5400 Call

go long April 4900 Put

April 4900 Put, Short 5400 Call

April 5400 Call and April 5500 Call

nd go short April 5400 Call

nd April 5000 Put

6 above

nd go long April 4900 Put

rt May Fut

Unlimited gains
Unlimited losses
View : Bullish
 Upside Reward
Downside Risk

sh position is a position that seeks to gain

m upward movement

Unlimited gains
Unlimited losses
View : Bearish
Upside Risk
Downside Reward

Unlimited gains
Limited losses
View : Bullish
Upside Reward
Downside Risk (Low)

graph will change its direction at the strike price

Limited gains
Unlimited losses
View : Bearish
Upside Risk
Downside Reward

for both long and short positions is the same

Unlimited gains
Limited losses
View : Bearish
Upside Risk (Low)
Downside Reward

Limited gains
Unlimited losses
View : Bullish
Upside Reward
Downside Risk
upside reward

Put Insurance

4900

5373

Collar

5400

5367+6-58
5315

forex markets
 5614

5500

7-58-23

e up beyond 5614

ns limited
es limited
w : Bullish
de reward
nside risk
ns limited
es limited
w : Bullish
de reward
nside risk

Unlimited Gains
Limited Losses
View : Volatile
Both sides : Gains
Mid range : Losses

pen - Budget, Elections,

ements, Major Court Case hearings

Limited Gains
Unlimited Losses
View : Range bound
Both sides : Losses
Mid range : Gains

High risk strategy

 5362

Strategy

You believe that the spread

will fall
5600) are good

(4900 to 5200)
rence will be narrow

o are afraid of death

n at reasonable levels

ket, they understand

d are constantly rehedging

mfortable and are constantly

5367
5400
15.50%
18
0%

58.45

Volatility" IV
market
ual Vol

ly by 16)

5% to 45% most of the time

very expensive
rvousness (Jan 2008)

nd, Slow Bullish

Crash, Bearish
ull markets
igh vol, crash

and hence staying away may

u will make money

Seller 3 Open Int

2

5
-17
-17 21
hey are going away, they are

500 Call increases by 2.5 lakh

at Nifty may cross 5400

esistance
Call Call Put Put
Bid Offer Bid Offer
467.20 470.95 6.45 6.50
372.00 375.45 10.80 10.90
279.55 282.00 17.85 18.00
193.50 194.15 32.00 32.25
116.90 116.95 53.55 54.00
59.00 59.20 92.40 92.45
22.75 22.90 156.05 157.50
6.90 7.00 235.50 239.50