NISM RA study kit
Chapter 3 of 15

Terms in the equity and debt markets

Worth 2 marks of 100Book pages 55 to 77About 45 minutes

The words analysts use to price a share, price a bond and price a commodity future.

Chapter mapFive parts. 3.1 and 3.2 have the numericals. Tap to jump.
IntroEquity or debt?Owner versus lender 3.1Equity wordsValues, market cap, EV, EPS, P/E, P/S, P/BV, DVR 3.2Debt wordsCoupon, maturity, yields, duration 3.3Types of bondsZero, floating, convertible, perpetual and more 3.4Commodity wordsSpot, basis, contango, cost of carry
Intro

Equity or debt?

A business that needs money can raise it in two ways. It can sell a part of itself (equity) or borrow (debt). Chapter 2 introduced both. Here is how they differ.

Owner versus lender
Equity investorDebt investor
RoleOwner of the businessLender to the business
Money staysAs long as the company needs itMust be repaid after a fixed time
ReturnNo fixed return. Gets the residual profit, whatever is leftFixed interest, plus principal back at maturity
Say in managementYesNo
RiskHigher. Long term, growth, volatileLower. Steady income, unless the company defaults
A company borrows at 12% and earns 14% on what it builds with the loan. The lender gets exactly 12%, as promised. The extra 2% goes to the owners. If the company earns only 10%, the lender still gets 12%, and the owners make up the gap from their share.

So the choice is a trade-off. Lower risk and a steady return: choose debt. A higher return: accept the extra risk of equity. Most investors split their money between the two.

3.1

Equity words

Five kinds of "value"

One share, five valuesEach answers a different question
Face value

The printed price

The nominal value of a share, such as Rs 10. Share capital = number of shares × face value.

Book value

What the books say

Net worth ÷ number of shares. What each share would get, in theory, if the company closed down.

Market value

What buyers pay today

The price on the stock exchange. Depends on expected performance, sentiment and liquidity.

Replacement value

Cost to rebuild

What a new company would pay today to set up the same plants and infrastructure.

Intrinsic value

What it is really worth

The present value of the cash the business will produce in future.

Face value

A share may be issued at face value, above it (at a premium) or below it (at a discount). Face value changes only when the company splits shares (face value goes down) or consolidates them (face value goes up).

Example: you hold 1 share of Rs 10. The company splits each share into 5. You now hold 5 shares of Rs 2 each.

A dividend stated as a percentage is a percentage of face value, not of market price. 30% dividend on a Rs 10 share = Rs 3. The same 30% on a Rs 2 share = Rs 0.60.

Book value

Book value per share = net worth (equity capital plus reserves) ÷ number of shares outstanding. Assets sit in the books at cost less depreciation. Their real selling value may be different, and is never known for sure.

Intrinsic value versus market price

Intrinsic value is the present value of the expected free cash flows from an asset. Warren Buffett calls it "the discounted value of the cash that can be taken out of a business during its remaining life". The discount rate used is usually the investor's required return, adjusted for the risks of the business. Later chapters show how.

Intrinsic value > market price

The share is undervalued. A buy candidate.

Intrinsic value < market price

The share is overvalued. A sell candidate.

This is hard to get right every time, because what is being priced is an unknown future. The book calls equity investing both an art and a science, shaped by human behaviour in groups.

Market capitalisation

Market cap = market price per share × number of shares outstanding

Example: 1 lakh shares at Rs 20 = market cap of Rs 20 lakh. It changes every time the price changes. "Outstanding" means issued, subscribed and fully paid up. Do not confuse it with authorised capital.

Large, mid and small capThe book's common rule of thumb, ranked by market cap
Large: top 50 to 100
Mid: next 200 to 500
Small: all the rest

Large caps have high liquidity and include most blue chips (long history, stable profits, market share). Small caps have little liquidity.

The book says there is no fixed size cut-off for large, mid and small cap. The ranking floats with the market, the period and the regulatory definition.

The ratio of a country's total market cap to its GDP is used to judge the size and importance of its stock market.

Enterprise value (EV)

EV is the value of the whole business, counting only the capital actually at work in it. So it adds the lenders' and preference holders' money to the shareholders', then takes out cash and non-core investments.

EV (standalone) = market value of equity + preferred capital + debt − cash and equivalents − non-operating financial investments

On a consolidated basis you also add non-controlling interest and the subsidiary's preferred capital and debt, and subtract the subsidiary's cash and investments too. Use fair market values. If a value is not available (unlisted bonds, bank loans), use the balance sheet value instead.

The book's EV exampleRs crore. 10 lakh shares trading at Rs 340.

Market cap

340 × 10 lakh = 34.0

+ Preferred

8.5 (book value)

+ Debt

6.4 (book value)

− Cash, investments

2.5 + 1.4

EV

Rs 45.0 crore

The balance sheet shows equity at 12.5. That is ignored: for listed equity, use market value.

Cash is subtracted in EV, not added. The book's sample question: market cap 10 lakh, debt 3 lakh, cash 4 lakh. EV = 10 + 3 − 4 = 9 lakh.

Earnings: which profit, which period?

Net profit
Profit left for the equity owners.
EBIT
Earnings before interest and taxes. To be shared among lenders, government and owners.
EBITDA
Earnings before interest, tax, depreciation and amortisation. First recovers the capital spent on assets, then is shared among lenders, government and owners.
Historical
Earnings of past years.
Trailing
The most recent period up to now, on a rolling basis. TTM = trailing twelve months. Also trailing 4 quarters. Useful when valuing a company in the middle of a year.
Forward
Earnings projected from future revenue and cost estimates.
Per-share numbers and price ratiosThe book's worked examples
EPS

Earnings per share

Net profit ÷ shares outstanding (strictly, the time-weighted average).

Rs 10 lakh ÷ 2 lakh shares = Rs 5

DPS

Dividend per share

Dividend % × face value, or dividend paid ÷ shares.

40% on Rs 10 face value = Rs 4

P/E

Price to earnings

Market price ÷ EPS. What the market pays for Rs 1 of earnings.

"12x" = twelve times earnings

P/S

Price to sales

Price ÷ sales per share, or market cap ÷ annual net sales.

Sales Rs 1 crore, 10 lakh shares, price Rs 40: 40 ÷ 10 = 4

P/BV

Price to book value

Market price ÷ book value per share.

(10 + 50 lakh) ÷ 6 lakh = BV Rs 10. Price Rs 20: 2x

Payout

Dividend payout ratio

DPS ÷ EPS. The share of profit paid out as dividend.

Reading the P/E

  • A P/E on past earnings has limited use. Prices move ahead of earnings, in anticipation of future profits.
  • If earnings are expected to grow, the market pays a higher multiple. So analysts look at the forward P/E. Example: a share at 20 times this year's earnings but only 15 times next year's. The same price is divided by bigger future earnings.
  • The P/E of the whole index is used to judge if the market is expensive or cheap. It rises when prices run ahead of earnings and falls when markets correct. A value investor may buy when the P/E is low.
  • A large, stable company usually has a higher P/E than a small, risky one. But this is not "gospel truth": a small company with high expected growth can have a higher P/E.

When P/S and P/BV are useful

P/S

Useful when a company is making losses for a while, so P/E means nothing. A lower P/S than peers may mean undervalued. A fall in revenue growth is a big risk for such shares.

P/BV

Useful when earnings are negative, and for banks and financial institutions, whose assets are mostly valued at market prices. Not relevant for services firms with few assets.

P/BV below 1 does not automatically mean a bargain. The company may have made poor investments that still have to be written down. Always ask why the market prices it below book value.

Differential voting rights (DVR)

A DVR share is like a normal share but carries less than one vote per share. The company raises money without giving away control. Investors who only want dividends and price gains do not mind. DVRs trade separately, usually at a discount to the normal share.

Under the Companies Act, 2013, to issue DVRs a company needs a dividend record of at least 10% over the preceding 3 years, and DVRs cannot exceed 25% of total post-issue paid-up capital. Examples from the book: Tata Motors and Pantaloons.

3.2

Debt words

A company that needs Rs 100 crore can take a bank loan, or issue bonds to many investors. If it issues 1 crore bonds of Rs 100 each, an investor putting in Rs 1,000 gets 10 bonds. Each investor's risk is limited to what they put in.

A bond is a contract. Its features are the principal, the coupon, the maturity, how often coupons are paid, and any collateral. With secured debt, the lender can have assets sold if the company defaults. With unsecured debt, they cannot. Debt can be privately placed with a few select investors or sold to the public. Debt sold in a public issue must be listed on a stock exchange. Unlisted debt is held to maturity or traded over the counter.

The three questions every loan answers
How much?

Face value (principal)

The loan amount per bond, also called par value. Rs 100, Rs 1,000 or any amount. This is what is repaid at maturity, whatever price you paid in the market.

At what rate?

Coupon rate

The fixed yearly payment, as a % of face value. Coupon amount = face value × coupon rate.

For how long?

Maturity (tenor)

From 91 days (T-bills) to 30 years or more. Some bonds never mature. It shrinks every day until the bond is redeemed.

Coupon, not "interest rate"The book advises calling it the coupon rate. "Interest rate" means the market-wide rate for borrowing and lending, which the central bank controls at its base.

Example. 8.24GS2018 means an 8.24% government security maturing in 2018. With face value Rs 1,000 it pays Rs 82.40 a year. G-secs pay twice a year, so the investor gets Rs 41.20 every 6 months. The last coupon comes with the principal on the maturity date.

Maturity is the single biggest factor behind changes in bond prices. Government T-bills are issued for 91, 182 and 364 days.

Market price moves opposite to interest rates

Once a bond trades, its price depends on market interest rates, inflation and default risk. A bond's value is its future cash flows, discounted at the market rate. So:

Market rates go up

Bond prices go down

Market rates go down

Bond prices go up

Your bond pays 10%. New bonds now pay 12%. Nobody will pay full price for your 10% bond when 12% is on offer. To sell it, you must cut the price until the buyer's return matches 12%.

Redemption: at maturity the issuer repays the principal and the final coupon. The bond then ceases to exist.

Bond calculatorFace value Rs 100, coupon paid once a year. Move the sliders.
price
current yield
Macaulay duration (years)
modified duration

Three ways to measure a bond's return

HPR, current yield, YTM, realised yieldFrom crude to complete
Holding period return

HPR

(Coupons + interest on reinvested coupons + price gain) ÷ purchase price.

Book: buy at 104, coupon 8 reinvested at 7%, sell at 110 after a year. (8 + 0.56 + 6) ÷ 104 = 14.00%

Crude. Ignores compounding. Do not compare with annualised returns.

Current yield

Coupon ÷ market price

8.24GS2018 at Rs 104: 8.24 ÷ 104 = 7.92%

Simple, but ignores future cash flows, its biggest drawback. Like a share's dividend yield.

Yield to maturity

YTM

The rate that makes the present value of all future cash flows (coupons, their reinvestment, redemption) equal to today's price. It is the bond's IRR. Found by trial and error or Excel's XIRR.

Realised yield

If you sell before maturity

Annualised, with compounding. Book: buy at 1,000, 12% coupons reinvested at 14%, sell at 1,050 after 5 years = about 13%.

Realised yield = [ (coupon × ((1 + reinvestment rate)years − 1) ÷ reinvestment rate + sale price) ÷ purchase price ]1/years − 1
YTM assumes two things: you hold the bond to maturity, and you reinvest every coupon at the same YTM. That means a flat yield curve that never changes, which is not realistic. It is still widely used because it is quick and simple.

Duration

Macaulay duration is the weighted average time in which you get your money back. The weights are the present values of each cash flow. It is usually less than the time to maturity.

Macaulay duration = Σ [ t × CFt ÷ (1 + y)t ] ÷ current price
Modified duration = Macaulay duration ÷ (1 + y)

Modified duration measures how sensitive the price is to interest rates. The higher it is, the more the price rises when rates fall, and the more it drops when rates rise.

What pushes duration (and rate risk) upWith everything else the same

Longer maturity

Higher duration

Lower coupon

Higher duration

Lower yield

Higher duration

Duration shrinks as a bond nears maturity, so the bond gets less risky with time.

Duration is like a seesaw. A long plank (long maturity, small coupons) swings a lot when someone sits at the far end. A short plank barely moves. The "someone" is a change in interest rates.
3.3

Types of bonds

Every bond is built from three parts: principal, maturity and coupon. Change one of them and you get a new type of bond. Chapter 2 already covered convertible types (FCD, PCD, OCD, NCD) and the foreign, euro and masala naming rules. Here is what is new.

Eight types of bondsWhich part is changed, and who it helps
Coupon removed

Zero coupon bond

No coupon. Issued at a discount, redeemed at par. The return is the gap. Higher duration, so more rate risk, than a coupon bond of the same maturity. The issuer keeps its cash until one "bullet" repayment.

Coupon floats

Floating rate bond

Coupon reset to a benchmark (inflation, inter-bank or call rates), typically every 6 months. Lower rate risk. Good when rates are rising. Limits: cap (maximum) and floor (minimum). Inverse floaters move opposite to the benchmark.

Principal becomes shares

Convertible bond

Debt that can turn into equity. Lower coupon than plain debt. Issuer need not repay. But existing owners are diluted and EPS falls.

Principal protected

Principal protected note (PPN)

Part goes into debt that grows back to the principal. The rest goes into equity, derivatives or commodities for upside. A synthetic product. Still carries the issuer's credit risk.

Linked to inflation

Inflation protected securities

Principal and coupon adjusted for inflation, so the real return is protected. Helps retired investors most.

Different currency

Foreign currency bond

Issued in a currency other than the issuer's home currency, such as USD. Lower rates, but the issuer carries currency risk.

Sold abroad

External (Euro) bond

Currency differs from the currency of the country where it is sold. INR bonds sold abroad are masala bonds; the investor carries currency risk.

No maturity

Perpetual bond

No maturity date. Issuer never has to redeem. May be "callable": the issuer can buy it back when it chooses.

Zero coupon bonds in practice

  • Money market instruments are short-term zeroes, under 1 year: T-bills (government), commercial paper (companies), certificates of deposit (banks and financial institutions).
  • Very long zeroes issued at a steep discount are deep discount bonds. Examples: an old IDBI issue, and Kisan Vikas Patra.
  • The book's example: in October 2009, ETHL Communications Holdings (an Essar Group company) raised Rs 4,280 crore in zero coupon bonds. Series 1 was issued at Rs 85.80 (implied rate 9.15%), Series 2 at Rs 82.55 (9.25%). Both repaid Rs 100 in 2011.
For the same rupee return, a zero coupon bond has more interest rate risk than a coupon bond of the same maturity, because its duration is higher. A floating rate bond has less.

Convertible bonds: the terms fixed at issue

The conversion date (on or before which to convert), the conversion ratio (shares per bond), the conversion price (usually at a discount to market price), and the portion that converts. Conversion can be compulsory or optional, full or partial. After conversion, debt leaves the balance sheet and equity capital rises.

Principal protected notes

Several NBFCs have issued PPNs as Equity Linked Bonds (ELBs) and Commodity Linked Bonds (CLBs). Some are listed.

"Principal protected" does not mean "no credit risk". If the issuer fails, the protection fails too.

Inflation protection in India

Inflation Indexed Bonds (IIB)

Government securities issued by the RBI. A fixed real coupon is applied to the inflation-adjusted principal. At maturity you get the higher of face value or adjusted principal. Index: WPI. Index ratio = reference index on settlement date ÷ reference index on issue date.

Inflation Indexed National Saving Securities, Cumulative 2013

For retail investors (individuals, minors, HUFs, charities). 10 years. Interest = fixed 1.5% + inflation based on CPI. Compounded every 6 months and paid at maturity. The fixed rate is a floor, paid even in deflation. Taxable.

The two use different indices, as per the book: IIB uses WPI; the 2013 retail securities use CPI.

Foreign currency and external bonds

Foreign currency bond example: Delhi International Airport Limited (a GMR company) issued USD bonds in February 2020. Euro bond example: a USD bond sold in Kuwait. Hedging the currency risk can wipe out the interest saving. See Chapter 2 for the naming rules and the first masala bond.

AT1 perpetual bonds

Many Indian banks issued perpetual bonds as Additional Tier 1 (AT1) capital under Basel III. They are riskier than normal bonds:

  1. No fixed maturity date.
  2. Rank below deposits, loans from other banks and all other bonds.
  3. Coupon can be paid only from distributable profits.
  4. Coupon is non-cumulative: a missed coupon is not made up later.
  5. Can be converted into equity by the issuer if a pre-set trigger event happens.
3.4

Commodity words

Spot price
Price for immediate delivery, set by supply and demand. Exchanges publish it daily. It is the basis for futures and for the Final Settlement Price (FSP), which matters for cash settlement or when a seller defaults on delivery.
Basis
Spot price − futures price.
Contango
Futures price above spot. Traders may expect the spot price to rise.
Backwardation
Futures price below spot. Traders may expect the spot price to fall.
Cost of carry
Cost of holding the commodity from purchase until futures delivery: storage, insurance, transport, financing and other costs.
Delivery
Commodity futures are deliverable: on expiry the actual goods change hands between buyer and seller.
Basis is spot minus futures, not the other way round. So in contango (futures above spot) the basis is negative. In backwardation it is positive.
Futures fair value calculatorFair value = spot + spot × carry rate × months ÷ 12. Book example: gold at Rs 1,02,000, 8%, 3 months.
carry cost
futures fair value
basis (spot − futures)
market state

All exam traps in this chapter

  1. Dividend % is on face value. 30% on Rs 2 face value = Rs 0.60.
  2. Split lowers face value; consolidation raises it. 1 share of Rs 10 split into 5 = 5 shares of Rs 2.
  3. Intrinsic value above market price = undervalued. Below = overvalued.
  4. No fixed cut-off for large, mid and small cap. Book's rule of thumb: top 50 to 100 large, next 200 to 500 mid.
  5. EV subtracts cash and non-operating investments. Use market value of listed equity, not its book value.
  6. TTM = trailing twelve months. Forward earnings = projected.
  7. Forward P/E is lower than current P/E when earnings are expected to grow.
  8. P/S suits loss-making firms. P/BV suits banks and financial firms, not services firms.
  9. P/BV below 1 is not automatically a bargain.
  10. DVR: fewer than 1 vote per share; 10% dividend over 3 years; at most 25% of post-issue paid-up capital; trades at a discount.
  11. Coupon amount = face value × coupon rate. G-secs pay half-yearly.
  12. Rates up, bond prices down. A bond with a coupon below market yield trades below face value.
  13. Current yield = coupon ÷ market price. Ignores future cash flows.
  14. YTM = IRR of the bond. Assumes holding to maturity and reinvesting at the same rate.
  15. HPR ignores compounding; realised yield is annualised.
  16. Higher duration with longer maturity, lower coupon, lower yield. Modified duration = Macaulay ÷ (1 + y).
  17. Zero coupon: issued at discount, higher rate risk. Floating: lower rate risk, cap and floor.
  18. Convertibles have lower coupons and dilute EPS on conversion.
  19. PPN still has credit risk.
  20. IIB uses WPI. The 2013 retail inflation securities use CPI with a 1.5% fixed rate.
  21. Foreign currency bond: issuer bears currency risk. Masala bond: investor bears it.
  22. AT1 perpetual coupons are non-cumulative and paid only from distributable profits.
  23. Basis = spot − futures. Contango: futures above spot. Backwardation: futures below spot.

For the group discussion

  1. Pick a listed company you know. Find its price, EPS and book value. Work out its P/E and P/BV. Is it cheap?
  2. Why might a bank trade below book value? What would you check before calling it a bargain?
  3. Would you buy a floating rate bond or a zero coupon bond if you expected rates to rise? Why?
  4. Why would a promoter family issue DVRs instead of normal shares?
  5. Gold futures trade below spot. What might traders be expecting?