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Archive for August, 2009

Have the markets gone a little too far with this rally?

August 29th, 2009 Ash No comments

Many analysts, including myself feel that this rally is overdone. It was just in March that the Dow hit the 6500 levels and the Sensex fell to the early 8000s. The economic situation in USA (the largest economy of the world) has improved to some extent as we can see in consumer spending, new jobless claims, housing starts and to some extent, housing prices. However, the situation in UK remains grim. Japan has officially emerged from recession and Germany too seems to be doing ok so far. However, does this justify a roughly 50% rally in the Dow or a 100% rally in the Sensex ? I personally think that the markets have gone a little too ahead of themselves and need to correct.

1) The Shanghai Composite too has been heading south of late due to monetary policy concerns, weak earnings and concerns about the economy(Premier Wen Jiabao’s comments).

2) If the world markets see a correction, I am fairly certain that Indian markets will follow suit as has been the case over the last few months; global cues have been playing a significant role in the performance of the Indian markets for a while.

3) The improvement in corporate earnings in USA and India have been largely due to cost-cutting measures and not due to improvement in sales volume or economies of scale. Thus, the optimism about earnings, in my opinion, is too much and too soon.

4) Optimism about economic reform,political stablitlity and disinvestment in India is probably not worth a 17% jump in 2 days(post election euphoria- Sensex).

Therefore, I am selling about 25-30% of my holdings and booking profits.

Question
Why sell only 25-30% and not the whole amount if you think that the markets will see a correction?

Answer
1. I have been saying since June that the rally has been overdone. But we didnt see a significant correction till now.(I dont count one-off 700 point drops as significant corrections.) The Sensex seems upward sticky at the 14500-15000 levels(Technical Analysts call that support). Therefore, these positions are my hedge against rising markets.

2. I am very bullish over the long run and feel that we will hit the 30,000 levels over the next 3-5 years. Therefore, these positions will serve as long term holds.

Categories: Misc Tags:

The fruits of a diversified, high beta, blue chip portfolio.

August 25th, 2009 Ash No comments

I opened a set of positions worth about 1.16 lakh Indian Rupees (about 2300 USD) last Monday.I chose blue chips from different sectors.The total return from my portfolio over the last week was INR 8,232 i.e. 7.09%. Such is the world of equities. Bank deposits, in comparison, pay about 7.5 -8 % per year in India.

Remember, equities is a big, bad world. You can lose as much money as you make and more ! Let us delve into my portfolio composition and the steps I took to minimize the probability of losses.

1. I diversified across sectors – By investing sizable chunks of my portfolio in different sectors such as Banking, Energy, Telecom and Metals, I reduced the risk of all components of my portfolio falling in price at the same time, thus reducing the probable volatility of the overall portfolio. Mathematically speaking, I chose stocks whose returns are not well correlated with each other, thereby reducing the overall variance of the portfolio.

2. I picked stocks which had taken a beating in the short run – I personally believe that some amount of mean reversion occurs in the case of most stocks, discounting long term trends. Therefore, I picked stocks like Reliance Industries and Reliance Communications which did not appreciate much despite the fact that the Benchmark Index (Sensex) appreciated substantially in the same time period. They were far away from their 52-week highs. Of course, this by itself doesn’t guarantee that they wont fall further but it is my observation that stocks tend to overreact to news and correct to reflect their fundamentals over time. Thus, in my opinion, it is more likely that a stock which has climbed significantly over the short run for “flimsy” fundamental reasons is more likely to be overvalued than one that hasn’t.

3.I included stocks with  high betas – Since I was bullish on the Indian markets for the short run, I chose stocks with high betas such as ICICI Bank and Tata Steel . In other words, I chose stocks which are more likely to follow the general market. Incidentally, high beta stocks tend to be volatile and give above average returns.

4. I chose stocks on whom I was bullish in the long run – I am extremely bullish on all the stocks I chose as far as the long run is concerned. Thus, even if they fell in value temporarily, I could hold on to them for long run and have sold them when they appreciated in value. Of course, I had to set stop losses in order to manage my risk, but that is a different story.

5. I chose blue chip stocks – I chose profitable companies that are leaders in their field, with plenty of cash and ample liquidity to meet short term obligations. I also made sure that I chose companies with high growth rates. Such blue chips are less volatile than mid-caps and small caps. They are also more likely to survive hard times than others.

6.I was mentally prepared to lose money in the short run - Equities is a high-risk and high reward business. I only invest the money that I dont currently need and am ok with losing some money in the short run. This is what lets me sleep peacefully at night.

Categories: Misc Tags:

A very interesting set of ETFs

August 23rd, 2009 Ash No comments

I was looking into ways of diversifying my portfolio and came across a set of exchange traded funds that seem to fit my needs perfectly.

Nifty Benchmark Exchange Traded Fund(NiftyBees)
This ETF tracks the S&P CNX Nifty, an index that tracks the performance of 50 of the biggest and most liquid stocks traded on the National Stock Exchange (India).  This ETF is perfect for investors who seek diversification within the large capitalization universe.  This ETF should be considered a passive investment. The advantages of this ETF are low costs(typically about 1% – management fee and 0 entry/exit load) and diversification benefits.
Link

Nifty Junior Benchmark Exchange Traded Fund(JuniorBees)
This ETF tracks the CNX Nifty Junior Index , an index that tracks the performance of 50 fairly liquid midcap stocks traded on the National Stock Exchange. I feel that this ETF is right for those investors who seek exposure to mid-cap stocks but are too risk averse to invest in individual midcaps. It too should be considered a passive investment.The advantages of this ETF too are low costs(typically about 1% – management fee and 0 entry/exit load) and diversification benefits .
Link

Gold Exchange Traded Fund(GoldBees)
This ETF tracks the Gold Spot price in Indian Rupees. Thus, it provides investors with a convenient way to gain exposure to gold (commodities). I particularly like this ETF as it makes life easy for those commodity investors who find collateralized futures positions cumbersome (me) and restrictive.
Link

Disclosures

  1. I am not paid by Benchmark funds or third parties to advertise/blog about these ETFs.
  2. I do invest in these ETFs or am planning to invest in future. At the time of writing, I own 22 shares of NiftyBees, 0 shares of JuniorBees and 0 shares of GoldBees.
Categories: Misc Tags:

My latest equity portfolio

August 23rd, 2009 Ash No comments

Current Portfolio

Company – Reliance Industries
Sector -Refining and Petrochemicals
Portfolio Weight -39%
Horizon -Long term

Company -Tata Steel
Sector -Steel
Portfolio Weight -22%
Horizon -Long term

Company -Reliance Communications
Portfolio Weight -22%
Sector -Telecommunications
Horizon -Long term

Company -ICICI Bank
Portfolio Weight -13%
Sector -Banking and Finance
Horizon -Long term

ETF -Nifty Benchmark Exchange Traded Fund
Portfolio Weight -4%
Sector -Index
Horizon -Long term

Stocks that I am eying and planning to buy on dips

Company – DLF
Investment – 30,000 INR
Sector – Real Estate
Horizon -Long term

Company -Tata Consultancy Services
Investment – 30,000 INR
Sector – IT
Horizon -Long term

Categories: Misc Tags:

The Basics of Taxation for investors

August 15th, 2009 Ash No comments

Income earned as a result of investments may be taxable. The impact of taxes on investment returns can be substantial and can potentially play a significant role in investment strategy. It is possible to minimize the impact of taxes through tax-planning. Thus, all investors should understand the basics of taxation and the tax laws that apply to them.

Marginal Tax Rate
The tax rate applicable to every additional dollar of income earned is called the marginal tax rate. If a country’s tax rates are as follows:

Tax3

The marginal tax rate applicable to a person whose income is $68,000 is 10%.

Tax on Dividends and Interest
Income earned as dividends from stocks or interest payments from bonds, bank deposits etc is usually subject to taxation. The tax rate applicable depends on the tax structure of the country of which the investor is a resident. Some governments tax dividends and/or interest at a lower rate than other types of income, thereby giving investors the incentive to own stocks and/or interest bearing securities.

For example, dividends are taxed at 15% p.a. in USA for most investors while dividends are not taxed at all in Hong Kong!

Capital Gains Tax
A capital gain is total increase in the value of an asset. If a stock is purchased at $10 and its value increases to $15 over the course of 1 year, the total capital gain is $5.
If the investor sells this stock, the capital gain is considered a realized capital gain. If the investor continues to hold the stock at the end of the year, the capital gain is considered an unrealized capital gain.The tax payable on capital gains is called capital gains tax. Most countries tax capital gains at lower rates than other types of income.

Realized and unrealized capital gains are usually taxed at different rates by most countries. Most countries also tax long term capital gains at a lower rate than short term capital gains.

Wealth Tax
Wealth tax is the tax imposed by some governments on the net assets of its citizens. Taxable wealth may include property, houses, stocks, bonds and other securities. The laws pertaining to wealth tax vary widely from county to country. Fortunately, wealth tax rates are generally much lower than income tax rates and are typically in the order of about 1% p.a. For example, the maximum wealth tax applicable in Switzerland is about 1.5% of net assets p.a.

Tax Drag
Tax drag is the decrease in possible income due to taxes. An example would best illustrate the concept of tax drag.

Illustration-Tax Drag
Assume that a mutual fund yields 8% annually and that the income from the investment is re-invested in the same fund. Ashish Mishra invests $100,000 in this mutual fund. Assuming that no taxes are applicable, his investment would be worth $215,892 in 10 years.

Calculation
((1.08) ^ 10) X 100,000 = 215,892

Suppose the income from mutual funds is taxed at 20%, Ashish would have a post-tax income of $6,400 at the end of the first year and thus would only be able to re-invest the said amount at the end of the first year( As opposed to $8000 assuming no taxes). This results in a reduction in the 2nd year’s income. The income lost is not only the tax paid but the potential interest that could be earned on the tax.

The following table shows the income, tax paid and the future value of the investment in the scenario where there is no tax and in the scenario where there is a 20% tax payable every year.

Tax1

Tax2

Note that the total potential income lost due to taxes, i.e. tax drag is $29,934, which is more than the total tax paid ($21,490).

Tax Planning Strategies
It is possible to minimize the impact of taxes through careful planning. The following simple strategies can go a long way in minimizing tax drag:

  • If unrealized capital gains are not taxed, delay selling your asset and realizing the capital gain for as long as possible. Do also consider the risk of the fall in market price before making your decision.
  • Consider using a tax-deferred account such as a retirement account (available in some countries)
  • Always use after-tax returns while making decisions about investments.
  • In the event that long-term capital gains are tax exempt (e.g. India), consider holding stocks for long periods to avoid capital gains tax.
  • Also consider tax-exempt bonds issued by your local government (e.g. some RBI bonds in India, certain Municipal bonds in USA)
Categories: The Basics Tags:

The Basics of Investing: Asset Allocation and Diversification

August 14th, 2009 Ash No comments

Asset Allocation
Asset Allocation is the process by which the total investble capital is distributed across different asset classes. As discussed in the previous article, asset classes are sets of assets that behave similarly and have similar characteristics, e.g. Stocks, Fixed Income Securities, Commodities and Cash (Cash Equivalents).

Investors typically do not invest all their money in one asset class or one single security. The reasons for this will become obvious as we continue through this article. Asset allocation depends heavily on the individual needs of investors, their risk profiles and unique constraints. Young investors with a high disposable income tend to invest heavily in stocks while middle aged investors tend to invest in balanced portfolios consisting of both stocks and fixed income securities. Retirees tend to invest heavily in high grade debt securities (bonds etc).

As discussed in the previous article, tax structures influence asset allocation. Equities are preferred in countries with high tax rates as taxes typically apply only to dividend income and realized capital gains. The tax drag can be minimized by deferring the realization of capital gains. We will discuss different tax structures and tax drag in a separate article.

A study found that up to 90% of the return of portfolios can be explained simply by asset allocation (as opposed to market timing or other factors). Thus, in my opinion, asset allocation is the single most important part of portfolio management.

Diversification
Diversification is the process of reducing the overall risk of the portfolio by investing in several securities (typically across different asset classes) instead of investing in a single security.

Benefits of diversification
The main benefit over diversification is the reduction of risk (volatility of returns).As we discussed in the previous article; risk is the volatility of returns. Every fund manager would like to have the highest possible return with the lowest possible risk.

Example of the benefits of diversification
Suppose there exist two companies, IcecreamLand and BlanketWorld which manufacture and sell ice-creams and blankets respectively. On hot days, IcecreamLand has high sales and makes a profit of $1 per share while BlanketWorld has low sales and no profits. On cold days, BlanketWorld has high sales and makes a profit of $1 per share while IcecreamLand has very low sales and no profit.

An investor with $2000 to invest could choose to invest in IcecreamLand and/or BlanketWorld. Suppose Mark Alphonso invests $2000 and buys 2 shares of IcecreamLand, George Santino invests $2000 and buys 2 shares of BlanketWorld and Bill Yang too invests $2000 and buys 1 share of IcecreamLand and 1 share of BlanketWorld.

Their returns would be as follows:
returns

Note that all three investors earn the same return i.e. $360 over the entire year, an impressive 18% p.a. However, the important point to note here is that the variance in the total income is different for different investors. Mark Alphonso and George Santino experience huge volatility in their incomes, a semi-annual standard deviation of $255 as opposed to Bill Yang whose semi-annual standard deviation is 0. All three investors got the same return (18%p.a) but Bill Yang’s portfolio was far less volatile and thus far less risky. Thus, Bill’s diversified portfolio outperformed the other two portfolios as it achieved the same return as the other two portfolios despite being much less risky.

The lesson to be taken away from here is that diversification reduces the overall risk of the portfolio. The larger the number of securities, the lower the variance and thus, the lower the risk of the portfolio (assuming a correlation of less than 1 between the stocks).

The importance of correlation
Correlation is a statistical measure that characterizes the linear relationship between two variables. The correlation coefficient measures the strength and nature of that relationship. From a qualitative perspective, the returns of two stocks are positively correlated if the return of one stock increases as the other increases; and are negatively correlated if one increases as the other decreases.

Illustration
Series A: 1, 3, 4,5,6,8

Series B: 3, 4, 6, 8, 6, 9

Series C: -5,-, 3, 1-, 7-, 12,-14

Series A and Series B are highly correlated (correlation coefficient of 0.9) while Series A and Series C are negatively correlated (correlation coefficient of -0.7).

We will cover the quantitative aspects of correlation in a different article. For now it will suffice to understand that the overall volatility (risk) of the portfolio decreases as the correlation between the different in the portfolio decreases.

Monitoring, Rebalancing and Optimization
It is essential for investors to monitor the performance of their portfolios over time and make adjustments as the need arises. Rebalancing is the process of restoring portfolio component weights to their target weights when they change significantly.

Example of rebalancing
Suppose Bob Enslow decides that his portfolio will comprise 60% of equities and 40% of commodities. In August 2008, he invests $6000 in a mutual fund tracking the Dow Jones Industrial Average and $4000 in a commodity mutual fund tracking the Rogers International Commodity Index. Suppose in August 2009, he finds that his equity mutual fund holdings are valued at $10000 and that his commodity mutual fund holdings are valued at $4500. His portfolio now consists of 69% equities and 31% commodities.

In order to restore his portfolio to its original asset weights, he would sell $1300 worth of his equity holdings and invest the returns in a commodity mutual fund. His new portfolio would consist of $8700 worth of equities and $5800 worth of commodities.

Portfolio Management Best Practices

  • Come up with a written plan detailing you investment objectives and constraints.
  • Diversify across asset classes.
  • Diversify your portfolio across different securities within an asset class.
  • Don’t trade too often as brokerage and transaction costs may dampen your return.
  • Think long term.
  • Understand business cycles and their impact on the economy.

The Basics of Investing: Portfolio Management

August 12th, 2009 Ash No comments

Assets and Asset Classes
An asset is anything that is expected to provide positive cashflow in the future. This is a rather broad definition and thus encompasses securities (e.g. stocks, bonds), real estate (e.g. land, houses), intellectual property (e.g. copyrights, patents) etc.

Asset classes are assets that have similar features and behave similarly. The main asset classes are – Equity (stocks), Fixed Income Securities (bonds etc), Commodities (gold, silver, oil, wheat etc), Cash Equivalents (short term deposits, money market instruments) and real estate.

Portfolio
A portfolio is the set of assets held by an individual or an institution. Typically, these assets consist of securities such as stocks, bonds, deposits, bills etc. These individuals/institutions hold these assets, expecting that they will appreciate in value (resulting in a capital gain) and/or provide income throughout their life (e.g. dividends, coupon payments etc).

Portfolio Management
Portfolio Management entails the management of the composition of the portfolio such that it meets the needs of the individual/institution holding it. This typically involves the following steps:
• Assessing the needs of the investor
• Understanding the unique constraints that apply to the investor
• Asset Allocation (deciding how much is invested in each asset class)
• Security Selection (deciding which securities to invest in)
• Portfolio Monitoring
• Adjusting the portfolio to meet changing needs/ market conditions

Understanding investor needs and constraints
Investors have different needs. These needs often stem from the goals of different investors, the unique constraints that they face, their risk profiles, tax environment and their individual natures. For example, a young professional is likely to want to grow his portfolio to meet a specific goal later on, such as an MBA degree, purchase of a home, marriage etc while a wealthy retiree is more likely to be interested in maintaining her standard of living and combating the effects of inflation.

Risk Profiles
Some investors are in a better position to take risks or are more willing to take risks than others. The distinction between the two is important since a willingness to take risk does not necessarily mean an ability to do so. Risk profiles are influenced primarily by age, financial situations and intrinsic natures. For example, young investors with decades of working life left are generally in a better position to make risky investments than older investors who are scheduled to retire in a short while. A young, unmarried IT professional is in a better position to make a risky investment than a single mother who has to provide for her daughter’s education and upkeep.

Thus, understanding your own risk profile before making investments is very important.

Tax Environment
Different countries have different tax structures. Some countries like Singapore have a light tax regime, exempting capital gains from tax, providing generous standard deductions and taxing income at a maximum rate of 15-20%. Countries like Sweden have marginal tax rates as high as 60%. Investors in countries with a high rate of income tax and low capital gains tax would prefer that their investments appreciate in value rather than pay regular dividends while investors in countries with a uniformly light tax structure would be indifferent to the manner in which their investment income presents itself. These are important factors in asset allocation and security selection.

Understanding the tax-liabilities resulting from your investments is critical. Do not ignore it.

We will cover Asset Allocation, Security Selection, Portfolio monitoring and adjustment in the next article.

The Basics of Investing: Risk,Reward and Time Horizons

August 8th, 2009 Ash No comments

A position
In trader parlance, one takes a “long position” in an asset if he/she buys that asset and takes a “short position” if he/she borrows that asset and sells it.

The difference between investing and trading
Investors are people who buy assets (in this case, stocks) in anticipation of long term appreciation in their value. Traders are people who buy (or short sell) assets, expecting to profit from short term appreciation (or decline) in their value.

So can be observed, investing and trading are two totally different activities.

Long term and short term investing
Investors buy assets (in this case, stocks) for the long run, typically for periods in excess of 5 years. Medium term investors invest with time horizons of 1-3 years while short term investors invest with time horizons of les than 1 year. Traders and speculators hold positions for short periods lasting less than 1 year. Day traders hold positions for less than 1 day at a time.

Returns to be expected from investing
Before one starts investing/trading, it is important to have a rough idea of the kind of return to be expected. Returns from investing in broad-based developed market indices over long periods (30 years +) tend to be about 10-12 % p.a. Returns from emerging market indices tend to be higher than those from developed market indices. Investing in individual stocks is more risky than investing in diversified portfolios and often yields more than investing in broad based indices.

Returns to be expected from trading
Returns from trading stocks vary significantly and could theoretically range from negative infinity to positive infinity. Speculative investments in stocks have often yielded over 100% in a single day, just as they have also resulted in returns of minus 90% over a few hours. This kind of volatility is especially present in penny stocks and stocks of companies in emerging markets. Trading is risky business and therefore should be approached with caution by beginners.

Risk
Risk here, is defined as the volatility of returns. For the sake of quantification, risk is taken as the standard deviation of the returns earned from an investment.
Assume that Stock A’s monthly returns are 5%,-6%,10%,1%,-8% and that Stock B’s returns are 1%,0.2%,0%,-0.2%0.2% .Stock A is considered more risky than Stock B since its standard deviation of returns is 7.5% while that of Stock B is 0.45 %. That is despite the fact that Stock A has a higher average return than Stock B.

Risk and Reward
In the world of investing, the reward that an investor gets depends heavily on the risk that he/she is willing to take on. Government bonds are the least risky and could yield anywhere between 1% and 5% p.a. depending on the maturity of the bond, the issuing government, the currency of issue and the prevailing interest rates. Bonds of robust companies with fairly certain cashflows yield more than government bonds while bonds of companies with poor credit ratings yield even more. Stocks and real estate typically have the highest average return as well as the highest risk(volatility of returns) among all asset classes.

If one desires a high return, she must be willing to take on a higher amount of risk. It is improbable that one will consistently be able to find investments with low risk and high return.

Further Reading

I would recommend  the book,“A Random Walk Down Wall Street” to those interested in reading more about the basics of investing.

The Basics of Investing through Stockbrokers

August 6th, 2009 Ash No comments

Buying/Selling stocks
Stocks are traded on stock exchanges. Individual investors generally need to make use of the services of a stock broker to buy/sell shares. Stock brokers carry out transactions on the behalf of clients for a commission. Individuals who want to transact in shares should open an account with a stock broker.

Bid-Ask Spread
Stock brokers charge clients a commission for executing their trades. They also earn money from the bid-ask spread. Example – If you ask a broker for a quote for 1 share of Citi and receive the following price: “3.10, 3.20”, it means that the broker is willing to buy(from you) 1 share of Citi for $3.10 and sell(to you) 1 share of Citi for $3.20.

Here, the bid price is $3.10 and the ask price is $3.20.Notice that if the broker buys 1 share at $ 3.10 and sells it at $3.20, she will make a profit of $0.10 . This difference in the ask price and the bid price is known as the bid-ask spread.

Brokers
Cost is a very important consideration in choosing a broker as commissions and spreads can add up to a substantial sum especially for active traders. Most brokers allow clients to place orders online or via telephone. Deep Discount brokers charge very low commissions and can provide reasonable execution. Most brokers also offer access to global markets. Therefore, it should be possible for a trader based in Singapore to buy stocks traded on the NYSE through his broker in Singapore.

Costs
Commissions typically amount to about 0.25% of the value of the trade. The catch here is that most brokerages charge a “minimum commission”. That would imply that the client could end up paying $20 as commission for buying a stock worth $1. Minimum commissions vary across countries. They typically stand at around US$10 in USA, SGD 25 in Singapore and INR 25-50 in India.* Some brokers offer very good “per-trade” rates subject to a minimum number of trades every month.

The broker not only executes trades on the client’s behalf but can also provide research reports that help clients make better trading decisions. Different levels of service are available for different fees. These usually pertain to trade execution and research reports. In my opinion, beginners need not lose sleep over these details.

Some Brokers
USA:  Charles Schwab, E-Trade
Singapore: Kim Eng Securities, CIMB
India: HDFC Securities, ICICI Securities

* Clients should contact their brokers for detailed information in this regard.

Categories: Stocks, The Basics Tags: , ,

The Basics of Investing in Stocks

August 5th, 2009 Ash No comments

Definition
Equity Shares, commonly known as stocks are small parts of a company (corporation). Stocks represent ownership of the issuing company and typically entitle the holder to voting rights when major corporate decisions of the issuing company are put to vote.

Rights of the shareholder
Shareholders collectively also appoint the board of directors of the issuing company and typically approve/reject major decisions taken by the board such as the issue of new shares, mergers and acquisitions etc. In case of bankruptcy of the issuing company, shareholders also have a claim on the assets of the company, though their claim is subordinate to that of bondholders.

Trading of Shares
Shares are most often traded on stock exchanges. In order for a company to enable its shares to be traded on an exchange, it has to list its shares on the exchange. The issuance of shares by a company and their subsequent listing on a stock exchange for the very first time is termed an Initial Public Offering (IPO).

Dividends
Investors expect to be compensated for investing in the shares of a company. To compensate investors, companies typically pay their shareholders a part of their income every year. This payment is known as a dividend payment.It is not legally binding on a company to pay dividends. In fact, several companies do not pay dividends for several years together, preferring to re-invest their earnings in the company’s operations.

Capital Gains
Increases in the price of shares result in capital gains. If the market value of a share is greater than its purchase price, the difference between the market value and the purchase price is the unrealized capital gain. If a stock is sold at a price greater than its purchase price, the profit is known as the realized capital gain.

Total Return
The total return to the shareholder consists of the dividend income and the capital gain on the share.
Total Return = Total Dividends received + Capital Gains


Types
There are two main types of stocks – Common stock and Preferred stock.
Common stocks give their holders ownership in a company and claim on the assets of the company in case of bankruptcy. In addition, they also give holders voting rights when important corporate decisions are put to vote at shareholder meetings. Common stockholders typically receive a dividend from the issuing company at its discretion.

Preferred stocks are hybrids between debt and equity instruments that give their holders a higher priority claim over the assets of the company than common stocks. Preferred stock holders receive fairly certain fixed dividend payments every year but typically do not have voting rights. The scope for capital gains on preferred stock is rather limited.


Valuation of shares
Shares can be valued in several different ways. Analysts use complex models to value shares of different companies. These models fall into two categories:

  1. Discounted cashflow models
  2. Multiple models

Discounted cashflow models discount the cashflow that is expected to be received from the stock, typically in the form of dividends, using a discount rate that is reflective of the risk associated with the investment.

Multiple models use a market-based multiple of a fundamental parameter of the company to value the stock of that company. For example, the earnings multiple model values a stock as a given multiple of its earnings per share. Therefore, if the appropriate earnings multiplier is 15 and the earnings per share of a company are $1 per share, the value of each share of that company is $15.

We will cover different valuation methods in detail in another article.

Categories: Stocks, The Basics Tags: