IPO

While IPOs in their literal sense mean that the company is for the first time issuing its stock to the general public, in reality whichever company is coming out with an offer to sell its share to the general public is known to go the IPO route. So that also includes company who already have their stock trading in the stock market.

Generally the investing community is excited about IPOs because traditionally it was thought that during its first offer companies sell their stock to the general public at a discount to their intrinsic value. While this was true for the Indian markets a few years ago one look at the IPOs coming out today tells us that this is not true anymore. Many companies who do not even have a financial history of five years or so, come out with IPOs to take advantage of the booming financial markets and therefore are not only ‘not’ selling their stock at a discount but even at outrageous prices.

There can be two kinds of investors for IPOs the long term investors who have bought the stock because they believe in the company and think that by holding the stock of the company for a long period they will be able to make profits. The other kind is the short term investors who just buy into the IPO to sell during the initial few days or even hours of listing and make what are known as listing gains.

While investing in IPOs investors should be careful about the history of the company because a lot of companies these days are just listing their shares out because they think that they can take advantage of the general optimism which prevails today in the markets.

The operational history can be a good judge and along with the pedigree of the promoters these two parameters can be a very good indicator of whether to invest in a stock or not.

After analysing the past performance of the company and making sure that the IPO is not being issued by fly by night operators, an investor needs to look at the price at which the IPO is being issued at and decide whether it is a fair price or not. While there is no fixed indicator for this the P/E Multiple provides a good yardstick and you can see what P/E is being demanded by the issuing company and whether it compares with the P/E that prevails in the industry. An important and often unnoticed thing about the P/E Multiple of IPOs is that it is calculated on the current number of shares that the company has got. However as soon as the IPO takes place most of the times fresh shares are issued in the market which will automatically push the P/E Multiple higher by pushing the EPS lower. So whatever P/E you are looking at, keep in mind that you will have to increase that by a bit most of the times after issue of stock.

These are a few tips to be taken care of while investing in IPOs so that  you don’t end up burning your fingers.

When is the right time to sell?

Not long ago I had written about when is the right time to sell, at that time the market was peaking and there were quite a few stocks that were overvalued or were at least at a price that was "sellable". For investors who had sold stocks at that time, right now with the blood shed in the market there are quite a few good stocks which are trading at prices which are there all time lows and because fundamentally nothing has changed in these companies they can be bought at these prices. However if investors didn't sell at that time then there is still time for them to sell but this time unfortunately not for the reason of booking profits as was the case when I wrote the last piece but for the purpose of cutting losses.

The key at times such as this when there are heavy falls and investors end up losing a lot of money is to sit back and take stock of your portfolio. Essentially you would be able to categorize your stocks into three categories. First category stocks would be the ones that are fundamentally sound, nothing has changed in their business model and growth projections and are companies that have been in the business for years together, these are your standard blue chips. There is absolutely no sense in getting rid of these stocks in panic. These are companies that have lasted for years and are more than likely to bounce back. The second category are mid-caps and small-caps which have also done well in the past few years but don't have a stellar track record like the blue chips or haven't been long enough. If these have been bought by an investor at recent times and at very high prices (high P/E multiples relative to their growth rates) you may want to look at selling these stocks and cut your losses. These stocks have a tendency to be very volatile and may dent your portfolio in a matter of a few trading sessions. However if these are stocks which have been with you for a long period of time bought at decent prices, then you may want to hold on to them if nothing in their business or money making model has fundamentally changed. One such stock in my own portfolio is Dewan Housing Finance, not exactly a blue chip but a sound company which has done well over the years and which was bought at reasonable price about an year ago. I would hold on to this stock as nothing that would affect its earning ability has changed and the stock should bounce back as sanity is restored in the market. The third category is of stocks which had been bought purely on tips and the names of which you yourself had heard for the first time and which have no financial track record only promises. Get rid of them as soon as possible and cut your losses. Buying stocks without research and only on tips is the worst thing that any investor can do and better to learn from that mistake than to hold on to such stocks and make more losses.

There would however be sure to be a few investors who had sold stocks at that time and are sitting on some cash. They could buy some bargain picks which are going around in the market right now.

Growth in stocks is not linear

One interesting thing that I have learned in the last few days with the market boom is that growth of stocks is not linear like bonds or FDs. What that means is that while your fixed deposits will grow at a certain rate always and say will increase by 10% in six months and then another 10% in six months your stocks grow in a way which is not linear at all. Your stocks may remain stagnant for 11 months or even give negative return and then in the last month may grow by 30%.

I've wanted to write this post for a long time but I wanted to collect some data and present it before writing it. I figure if I wait to collect that data first then will never get around to writing this post. Anyone who wants to validate this though can go to www.nseindia.com and look up any stock and then see in which months it has risen by how much percentage and they will have their answer.

The point here is that many a times investors lose patience thinking that it's been over a year since they bought the stock and there have been no returns on it and maybe it’s a wrong decision etc. However if nothing has changed fundamentally then just this is not a good enough reason to sell your stock. There is absolutely no limit to how much a stock can grow in just a few days and which it does also but most of the times after you have already sold your shares.

This concept is very easy to understand however it is somehow not very easy to avoid the pitfalls that thinking along these lines brings to investors. That pitfall is holding a share for ages and then selling it just before it rises for the only reason that the stock didn't rise in all these days.

The key is to have patience and not sell only for the reason that it is not rising.

When is the right time to sell?

There is an adage in Dalal Street which goes "regret after selling and not after buying".

Many a times you would see investors who have sold stocks at profit however as soon as they sold their shares, the share went up another 10% in a matter of days. Hence the investor rather than basking in profits is brooding about the loss in profits that he could make if he had waited for a few more days.

Wisdom says this is better than buying a stock and then repenting because it goes down 10% after a few hours of your purchase, which incidentally occurs more number of times than is good for any honest tax paying citizen's metabolism.

With the market scaling all time highs and that too bouncing back in a really short time and being as volatile as it is today, one can rest assured that the stocks which have gone up will go down as well and its best to book profits at least to some extent so that if the market goes down your profits do not vanish away completely and at the same time if the market goes further up you are not just sitting on the sidelines and watching the value of the stock that you once owned go up.

For a long term investor it important not to rush while selling, and there isn't a need to book profits out of all stocks that you hold in your portfolio. If you have been patient enough and have bought and kept stocks for over a couple of years, chances are that at least one or two of them are bringing you excess of 100% returns.  In all probability one of these stocks would be overvalued as well, because of the general atmosphere that exists in a bull run, another great plus is that if you own stock for over one year it comes under a long term investment and no tax need to be paid for the capital gains from such appreciation.

Therefore a combination of these three factors 1. One of the stocks which are bringing in the greatest return in your portfolio, 2. Stock priced more than what you think should be the fair value and 3. Stock owned for over a year give a good yardstick to sell.

If you are holding a stock for a fairly long term you would have a good idea on what its worth is but as a general and quick guideline if the P/E exceeds the growth rate considerably then you can look at booking some profits in the stock.

There is no sure shot way of either predicting the bottom or the top when one is dealing with the markets the best one can do is over a long term stick to some sort of game-plan which brings more profits than would have accrued if the investor had just invested in fixed deposits or bonds.

Tax Benefits of Mutual Funds in India

Tax is a certainty when you go out to invest in any scheme. But one has to look at various aspects to avoid such taxes. Many people who invest in Mutual Funds look out for Tax-savings. The Government of India revised various Taxation schemes for providing tax-benefits to the investor.

Starting from, April 1, 2003, all dividends distributed to investors by debt-based mutual funds were exempted from taxes. However, Mutual Funds were required to pay a dividend distribution tax of 12.5% including surcharge on the dividends. Under Section 88 of Income Tax Act, 1961 ELSS-equity-linked savings schemes can benefit by a tax-rebate on investment up to Rs 10,000 under certain pre-stated conditions. Depending on whether mutual fund comes under short-term capital asset or a long-term one, the units are liable to taxes. The Section 2(42A) describes mutual fund as short-term capital asset if it is held for less than a year whereas if the units held for more than a year they come under long-term capital asset.

Section 10(38) of the Income Tax Act exempts long-term capital gains, occurring from reallocation of a unit of mutual fund, from taxes. The rule came into being after October 1,2004 so tax is exempted if the transaction took place after this date. This rule requires the securities transaction tax is paid to the appropriate authority.

The Section 111A of the Income Tax Act states that the short-term capital gains that crop up from transfer of a unit of mutual fund is taxable@ 10% plus applicable surcharge. This is applicable to all transactions that take place after October 1, 2004 and also the securities transaction tax is paid.

Under section 88E of Income Tax Act, the security transaction tax can be rebated if the transaction represents a business income.

Capital gains are calculated after considering cost of realization as adjusted by Cost Inflation Index stated by the central government.

The Section 112 of the Act states that capital gains that are not roofed by the exemption under Section 10(38) come under various categories of taxable long-term capital gains and charge rates of tax depending on the category. A resident individual and HUF is charged 20% (plus surcharge). All Indian companies and partnership firms are taxable at 20%( plus surcharge). Whereas the foreign Companies are liable to pay 20% tax (plus no surcharge).

The unit holders are liable to pay taxes. They pay a 10% tax plus applicable surcharge if they don’t opt for the cost inflation index benefit and if they take advantage of the cost inflation index benefit they are charged 20% tax with applicable surcharge.

Under Section 115AB of the Act, 1961, long-term capital gains considered as units acquired in foreign currency by an foreign financial organization kept for a period of more than one year will be taxed@ 10%(no surcharge). The gains don’t take into account cost of acquisition.

Under Section 2(EA) of the Wealth Tax Act, 1957, units held under Mutual Funds are not liable to Wealth tax, as they are not treated as assets. Moreover units of Mutual Fund can be given as gift, thus is not liable to gift tax i.e. no tax is payable by donor or donee.

Under Section 115E of the Act, for a non-resident Indian capital gains chargeable on reallocation or transfer of long-term capital assets are taxable. If they form an Investment income, they are charged @ 20% and long-term capital gains are taxed @ 10%.

Under Section 10(23D), income of any form received by the Mutual Fund is exempt from tax. However the Income distributed to a unit holder of a Mutual Fund is taxable under Section 115R. Income distributed to individual or HUF is taxable @ 12.5% and others are taxed @ 20.0%. This tax is excused for open-ended Equity Oriented Funds.

Purchase Redemption and Repurchase Price

Under various schemes offered by the Mutual Fund, the units of funds are purchased, redeemed, and repurchased. These prices vary according to the type of funds one deals in and the fund’s portfolio must be thoroughly studied before investing in y\the fund.

Purchase Price

Purchase price or sales price is the price paid to buy one unit of the fund. However, the fund can be loaded or it can be a No Load fund. In the former case when fund levies an entry load then the purchase price will be greater than net asset value of the fund. The price will depend upon the entry load levied on the fund. For a ‘No Load’ fund the purchase price is same as NAV. Generally, Funds charge an entry load between 1% and 2%. Exit loads range from 0.25% and 2.00%.

For e.g. Say an investor invests Rs 20,000/- and the current NAV is Rs.20/-. The entry load levied by the Mutual Fund is 1.00%; the price at which the investor invests is Rs.20.20 per unit. Units in a Mutual Fund are allotted to an investor depending upon the amount invested; it is not on thee basis of number of units purchased.

The investor receives 20000/20.20 = 990.099 units.

Now suppose the same investor decides to redeem his 990.099 units. The current NAV is Rs 25/- and the exit load is 1.25%. So the sale or redemption price per unit becomes Rs. 24.9875. The investor therefore gets 99.099 x 24.9875 = Rs.24762.3626.

So the purchase price here is Rs20.20 per unit as the investor has to pay the toll tax for entering the mutual fund bridge. Had it been a NO Load fund the purchase price would have been Rs 20.

Repurchase price

Generally, a Close-ended Fund has a fixed maturity period that range from 2 to 14 years. They sale only a fixed number of shares in the initial public offering after which the shares typically trade on a secondary market. The cost of closed-end fund shares that do business on a secondary market after their initial public offering is totally dependent on the market and doesn’t depend on the initial NAV. It may be more than or less than the share’s net asset value. Repurchase price is the price paid by a close-ended scheme to repurchase its units that are trading in the secondary market. The repurchase price can either be the NAV or it might have an exit load associated with it.

Redemption Price

Redemption price is the price received by the investor/customer on selling units of an open-ended scheme to the fund. In case of funds that does not levy an exit load the redemption price is same as the net asset value. However, in case the fund levies an exit load, the redemption price is lower than the net asset value. In that case the exit load percentage is subtracted from the NAV at the time of redemption of the fund.

Evaluation Criterion while buying a Mutual Fund

There are various aspects that should be looked into before putting your money into the Mutual Funds.

First of all the prospectus or the offer document must be studied in detail before investing. Various aspects covered must include:

Main features of the scheme followed: A Mutual Fund offers various schemes that are categorized according to investment objectives and Maturity period. Open-ended scheme doesn’t have a fixed maturity period and investors can buy or sell shares at any time based on NAV that is declared on daily basis. This scheme offers the highest liquidity. However, a closed-ended scheme has a fixed maturity period of 5-7 years. Based on investment objective, a scheme can be classified as growth scheme, income scheme, or balanced scheme. An investor, depending on his finances, risk-taking capacity, age etc, can take up any of the offered schemes.

Entry or Exit Loads: Some Mutual Funds offer a sales charge or load, which is to be paid when shares are bought or redeemed. There are some funds with no sales charge; these are called No Load Funds. Before investing the funds must be checked for the load they charge. However, it is meaningful to pay a load if fund gives a better investment than No-Load fund.

Risk factors involved in investment: Mutual Funds do not guarantee sure returns. These returns are related to the functioning of these funds. Mutual Funds invest in deposits, shares and debentures. There is some amount of risk associated with investment. The percentage may vary according to the working of the company or different companies may fail to pay the interest or principal amount on their securities. Government might change the rules regarding certain industries thus directly affecting the mutual bonds – this factor must be kept in mind while investing particularly in Sector funds.

Initial issue operating cost: One must check up with the offer document of the mutual fund for initial operating cost

Recurring Expenses that are to be charged: Again before investing all the expenses that are to be paid again and again must be kept in mind.

History of Mutual Funds: The Company’s profile, its profits, portfolio and competence must be the first thing to check up before taking up an issue. Moreover if you are investing in one scheme of he mutual fund the track record of performance in other schemes launched must be checked up.

Type of Securities that the fund invests in: One must see to the bonds, debentures and other stock options that the mutual funds invest in. The market value of these securities must be considered before investing.

Professional qualification of the person handling the funds: The financial handler of mutual funds must be a professional with good experience in the particular field. It is his duty – what to buy, when to buy, keeping a close watch and when to sell off. Handling this collective investment is a major issue and must be given in safe hands.

Penalties, if any, to be imposed: The offer document of Mutual Funds must be read carefully for any kind of penalties imposed under any circumstances. 

Different Schemes under Mutual funds

Tax Saving Schemes

These schemes give tax rebates to the investors under explicit requirements of the Income Tax Act, 1961 as well as saving in Capital Gains under section 54EA and 54EB, as the Government offers tax incentives for investment in particular avenues. Pension schemes offered by Mutual Funds, equity linked savings schemes are allowed as deduction under Section 88 of the Indian Income Tax Act, 1961. For example investing in diversified equity fund will never give you any tax benefits whereas investing in ELSS will show the tax benefits in the year of investment itself. The amount you invest in one financial year (April 1 to March 31) will be deducted from your taxable income that year. Tax-saving schemes mainly aim towards growth so they basically invest in equities. However, the risks associated with them are similar to any equity scheme.

Index Schemes

Under this scheme the mutual funds also called Index Funds imitate the performance of a specific index. The American index that is most commonly imitated is the S&P 500 by buying all 500 stocks using the same value as the index. BSE Sensex, the NSE S&P CNX 50 in India, NASDAQ 100, Russell 2000, MCSI-EAFE, Wilshire 5000 etc are the other popular stock indexes followed. These funds invest in a set of securities which moves according to a popular index used as a benchmark.and are called passive funds. The index determeines the choice of investments thus leaving the fund manager with no research on securities. However he only needs to adjust the funds i.e. buy and sell shares with change in Index. Thus the passive performance of funds is obvious causing a lower expense as compared to actively managed funds. The net asset value in Index schemes is directly proportional to the index they follow. However due to some factors such as tracking errors the percentage of change varies with each security. This variation is always mentioned in mutual fund document provided.Traditional Index schemes allow the change the share price only once a day. A new type of funds – Exchange-traded funds(ETFs) have a different approach. These index funds sell shares at a price that changes throughout the day, thus increasing the liquidity. Their practical approach have made them a hot cake financial tool with a bright future.

Sectoral Schemes

Sectoral Schemes are the ones that invest solely in particular sectors such as Fast Moving Consumer Goods (FMCG), Metal Industry, Information Technology, Petroleum Stocks, and Pharmaceuticals etc. The profits are dependent on the performance of particular industries. Unlike the equity schemes the portfolio of these schemes is limited to the particular sectors or industries. Therefore the risk factor associated with these schemes is usually high. A close watch on the rise and fall in the values of these securities is a must in order to avoid any unexpected results. Thus the user must exit from the scheme once there is a fear of losses in that particular sector else there is a risk of losing investment.

Why the market falls faster than it rises?

Almost everyone who has been in the market must have noticed that shares fall faster than they rise.  This article looks at a couple of reasons because of which this happens. 

One reason why this happens is because of traders buying shares on margin money. This happens as follows. Suppose you have shares worth Rs. 1 lakh, on these shares your broker will allow you to take positions of say up to Rs. 40000. What this simply means is that you can buy and sell shares worth Rs.40000 without actually having to cough up this amount. This is called playing on margin money. In the above example the margin is 40%, which means that you can play up to 40% of the shares that you own. Every time the margin decreases below 40% you have to either square off the position or you have to keep extra cash with your broker. Now assume that you have also entered into such a trade where you had shares of say HLL worth Rs.1 lakh and you have bought shares of Infosys for Rs.40000 with the margin hoping to sell them off later in the day and make a quick buck. Unfortunately for you however the market falls and the value of HLL now remains only Rs.90000 whereas you have bought Infosys worth Rs.40000. To maintain the margin of 40% your broker calls you to pay up additional margin money (called margin call in market parlance). You decide that its not worth it and sell the Infosys that you have, further creating downward pressure and lowering the price of Infosys. If you look at the bigger picture and see the market as a whole there certainly will be another person who was holding Infosys worth Rs. 1 lakh and HLL worth Rs.4000, because of your decision this person would need to sell his HLL now. This is a vicious cycle in which many traders will now get trapped and what started off as a correction would result in a big fall. This is one of the prime factors why markets fall off sharply in a single day, the fall being anywhere close to 300 to 800 points on the BSE. 

Another reason why the market falls rather sharply is what is known as “Panic Selling”. What this means is that small and new investors in the market see that the market is falling and they think that there is no end to the fall. Often these investors enter the market with the lure to make big money and know little about what companies they are buying and have little confidence in their investment decisions. Such investors tend to sell all of their holdings in such falls and bail out of the markets. In the process they tend to drive the prices of the shares that they hold further down and end up pushing the prices abysmally low. 

The above two reasons are quite common and can be witnessed in every big fall that the market has. Its for you to understand these reasons and the next time you enter a trade be aware of such reasons and play the market carefully. Anyone who has been in the market will tell you that it is almost impossible to avoid such losses. So maybe you will lose money on such transactions as well. Considering the way the market has risen these days it is probable that the situation confronts you in the near future. You must not completely shun away from the market after such a situation but must understand the reasons, learn from them and not repeat the mistake. 

Penny Stocks

Penny Stocks have long been the attraction of a lot of investors because of the tremendous returns that these stocks can generate in a short period of time. The reason that some of these stocks are able to generate such high returns which goes as high as five or even ten times the amount invested is the price and the volume of these stocks are low.

Because the volumes are low in such stocks when interest is generated in such stocks and people start investing the sudden spurt in volume leads to a large increase in price of such stocks.

And that is the danger that exists while investing in these stocks. Because one can raise the prices many folds just by investing a few lakhs. Many a time these stocks are the target of Promoter manipulation.

The modus operandi is quite simple. A few promoters group together and generate artificial interest in a particular penny stock. Suppose there are two promoters who hold majority of the stock in their company where the volumes in the markets are low. Now one promoter will start selling his stock in the open market and the other promoter will keep on buying this stock at progressively higher prices. Since the volume is low the promoters are easily able to jack the prices by doing this. At the same time they also engage in spreading rumors about the company and create interest among the ordinary investors. They are easily able to prop up the prices from a low of say Rs.5 to a high of Rs. 20.

You can think of the two promoters as husband and wife and think that the husband has sold off all his shares to the wife and the wife has paid for the stocks. The net effect remains the same as the stocks of the couple remain with them and so does the money. Although in the real world the trade is more complex this analogy helps us to understand what exactly is going on in this transaction.

Now at the same time there is “real” demand for the stocks of the company in the market by investors other than the wife and it is at this time that the “wife” starts selling off chunks of her shares to the public at these propped up higher prices. Now because there is a genuine demand for those stocks in the market the prices do not fall as suddenly as they went up and this gives a good opportunity for the wife to get out of the stocks at a higher price than what they had originally had the shares for.

This is a neat way promoters have come up of making money in the penny stocks but at the same time other investors who are not well informed about the stock market become victims and lose their money in the deal.

This is not to say that all penny stocks will end up in losses, only to exercise caution while investing in the same and do some basic research before jumping into such penny stocks, which promise to triple in a month just because they have doubled in the last month. You need to look into why is it that they have doubled in the last month and get a sense of the safety that they offer before buying into it.

Mutual Fund Types

Any investor when making financial investments can follow only three important and distinctive objectives:

1. keeping the value of the invested money (investing in a monetary system that is stable to protect the income in under-evolved economies)
2. gaining a profit from the invested money (most typical example are the bank deposits that regulate pay out income under the name of interest)
3. increasing the value of the invested money (when investments are made in stocks or land/buildings) 

To satisfy the diversified objectives of the investors, the mutual funds administrators created three big fund types that have as a purpose meeting the respective objectives through different placement politics. Technically speaking the three types are: 

Ø Monetary Funds The monetary funds have as an investing objective keeping the value of the invested money. These types of funds are generally addressed to investors that, because of aversion towards risk or other motives (like needing the invested money in a short time), don’t want the value of their investment to decrease. Until now, in the USA, there has never been a monetary fund that ever signalized a decrease in the title value. 

The monetary funds can be successfully used to efficiently evaluate and sustain the current bank accounts (of individuals or companies). There are countries where payments can be made right out of the monetary fund, because sometimes these funds act just like a current bank account. Monetary funds invest usually in stocks that generate income and the variation in profit is very low. Their main investment areas are: national/state bonds, bank deposits, commerce effects emitted by commercial banks or commercial companies with an average withdraw limit of 90 days (they only choose low withdraw limits). 

Ø Income Funds  These funds have as an investing objective gaining a profit from the invested money or generating stable income. They are addressed to those that need supplementary stable income in addition to their current income. Since the majority of the incomes made by the fund are distributed to investors, the stock value doesn’t suffer significant variation. Still, because of the structure of the portfolio, there is a risk that the stock value would decrease.

Generally, investors in income funds are retired persons, young families or families that have to pay for their children’s studies. The investors can opt for cashing the distributed incomes or for reinvesting them automatically in the fund. The income funds will invest mostly in stocks that generate high incomes, but because of the long periods before withdrawal it is possible that they become exposed to value variations. The main investment fields are: bonds, asset mortgages, preferential stocks, common stocks emitted by very good companies with a rule of distributing consistent dividends. 

Ø Growth Funds Growth funds have as a primary objective increasing the value of the invested money (the value of the stocks). They mostly address those investors who wish for their investment to grow over time. The stock value will grow or decrease depending on the evolution of the stock market and the abilities of the investor.

The main categories that invest in growth funds are mature families that have already satisfied their basic material necessities (a house, a car and other assets) and they can afford to risk some of their current incomes with an investment that has a higher risk factor. Of course, in these kinds of funds the investors can also be persons with an appetite for risk. Within the category of growth funds we distinguish a different subcategory, named accumulation funds. These funds are the fund in which the investor, with the help of a contract sighed, has the responsibility to regularly invest in stocks (monthly, quarterly). Also they may sound like they belong to a different type, they are nevertheless growth funds.

A growth fund will invest in stocks whose value is considerably variable over time, any types of stocks, convertible bonds, options and futures contracts.

There are many other funds classifications, by the geographical zones they invest in, by the risk factor of the portfolio, etc., but, leaving these details aside, any fund will fit into one of the three categories presented above.

Common Mistakes made by Investors

The individual investor often makes certain typical mistakes that will eventually cause him to give up or to lose everything.

Believing every investment you make is 100% safe
Any investment implies a certain risk factor that is determined by a multitude of factors. Disregarding these factors leads to wrongly evaluating the wining possibilities. 

Great expectations
Those investors that neglect risks also have great expectations regarding the general profits. In this case disappointment will occur, maybe even sadness or desperation when they lose the final investment also. 

Not doing your homework
You must be as informed as possible about your investment, about its risks and the credibility of the brokers and company administrators. 

Not diversifying the portfolio
When we say investment portfolio, we mean all the investment a certain person has made.
Through diversification the investor will attempt to cover through profits some companies that might register losses. Regarding the optimal rapport between winning and security, a portfolio will have a pyramidal distribution of the stock types. The biggest investment will be done in companies with minimum risk and maximum security like governmental bonds. Climbing the risk stair the number of investments will decrease. Investments in extremely risky companies will represent a low percentage of the portfolio. 

Being greedy and/or being afraid
Greed never pushes to safe investment. Through greed you will only make investments that don’t stand a chance. Fear will determine a rather calm and secure behavior that won’t bring you losses but will cause you to flip over great opportunities. 

Investing because of a “tip”
An investment has to be done accordingly to the needs and risk tolerance of every individual. These two elements are unique and like fingerprints are always different, the same way there can’t be two persons with identical needs and risk tolerance. So, if an investment is an opportunity for the one that who told you the tip, it doesn’t mean it is for you too. 

Not giving up on time
This is a mistake that can be hardly eliminated. It’s hard because the market fluctuates anyway and investors can’t say when it’s just a normal day or if the stock price is really going down. Many people won’t admit they made a financial mistake and don’t want to give up their stocks. It has been statistically proven that in these cases things go from bad to worse.
Avoiding such situations is difficult even for a pro who usually has more information that the individual investor. 

Investing only short term
Avoiding, or reducing this risk can be achieved by investing long term in profitable stable companies. In these cases, bad yearly evolutions can be recovered through better years. 

Thinking you are the smartest
Every investor bases his decisions on information he knows at a certain moment. Not wanting to hear advice or to hear new things, does not make you smarter, it brings you a great disadvantage and you will only put on hazard with your investments. 

Fundamental Analysis

This type of looking at the problem consists of selecting the stocks based on information regarding the financial situations of the company, its area of activity, and also on comparing the price with other similar ones from the market. The fundamental analysis is useful when investing in stocks for a long period of time (at least a year). Those who use this type of analysis have themselves different objectives of evolution and profit, using mostly certain criteria.

Buying stocks – based on the fundamental analysis

Certain criteria are to be taken into consideration. There are three important categories that can be used alone or in combination.

1. Value investing: Some long term investors are determine the value of the business they are placing their money in, searching to buy the stock at the greatest discount possible compared to the calculated value. In other words, the question here is how much do the companies’ goods will be worth if they were to be sold? An estimated answer can be given evaluating active elements they posses (such as lands, fixed transportation means, floating actives) at a correct market price, adding to that the funds the company has. Investors who use this criterion think that the respective business has a future in efficiency if the stock holders are to be chanced, if the economic environment is changed and improved or any other major alteration, at which moment the company would value at least three times as much as in the beginning.

2. Growth Stocks are used by the investors preoccupied with identifying companies belonging to areas that tend to increase and to expand. They are focusing on the rhythm of evolution of the business figure and profit, determining the growth rate in real terms. This can be forecasted upon the future, but it is necessary to also identity the economic and legislative risk factors that could appear and alter the graph. Also investors reflect upon the quality of that company and their advantage or disadvantage compared to concurrent companies. Usually, growing companies don’t give dividends, the profit remaining just the difference between the buying price and the selling price of a stock. These companies are the most risky ones, especially because of the lack of dividends, which could’ve added some stability.

3. Income Stocks: Income stocks are dividend stocks. Investors prefer these stocks because they give them some stability and a clear benefit. These stocks are recommended if the stock price is lower than the estimated dividend price, and if they belong to mature companies. Usually, when investing in such stocks you are making a long-term investment.

Selling stocks – based on the fundamental analysis

A stock has to be sold if analyzing the situation fundamentally when the answer to the question Why am I buying this stock? is not true anymore. The following situations can also be reasons to sell:

– a newsflash about a company or about the entire economic area modifies initial expectations

– the price for the stock has been over evaluated

– over evaluation can be determined by comparing it with the ones from other companies

How Quibi could have succeeded

It’s rare for a company to become a punchline before it even launches, but then again very few startups receive the kind of pre-launch hype that Quibi had. By the time its app officially debuted in April, it had raised $1.75 billion in investment, a figure almost unheard of for brand new ventures.

What’s more, its founder Jeffrey Katzenberg had already given dozens of interviews to top-tier media outlets in which he claimed his app that delivered Netflix-quality shows in 10-minute bites would shift the paradigm for how we consume video on our phones. “Five years from now, we want to come back on this stage and if we were successful, there will have been the era of movies, the era of television and the era of Quibi,” he said in 2019. “What Google is to search, Quibi will be to short-form video.”

To be fair to Katzenberg, he had the kind of resume to earn him the benefit of the doubt. As an executive at Disney during the 80s and 90s, he oversaw some of the most lucrative film franchises in the company’s history, and he later went on to found Dreamworks. But despite these credentials, Hollywood veterans expressed doubt that a 69-year-old media mogul and his 64-year-old CEO had their fingers on the pulse of the mobile-viewing generation. Quibi’s slate of announced shows and films didn’t inspire much confidence, and months before the app even launched, the business press treated it as an over-hyped startup funded by “dumb money.”

We’re now a little over six months post-launch, and a lot of those critics probably feel pretty vindicated. After debuting near the top of the iOS and Android app stores, Quibi quickly fell in the rankings. Within a month it was no longer among the top 100 most-downloaded apps, and a month after that it slipped out of the top 1,000. Most of its shows garnered mediocre reviews, and only 8% of its users reportedly converted into paying subscribers after their 90-day free trial expired.

By late summer, even Quibi’s executives were acknowledging it had underperformed expectations. It lowered its first-year projections from 7.4 million users to 2 million, and it sought $200 million in additional funding just so it could stay afloat. Its blue chip advertisers are renegotiating their rates in light of disappointing viewership numbers, and in September The Wall Street Journal reported that its executives were exploring a sale of the company. And then just this week The Information broke the news that Katzenberg had tried to offload Quibi’s content onto Facebook and NBCUniversal, and, failing that, was considering shutting down the company completely. While it’s too soon to call Quibi a complete and utter failure, the paradigm for video consumption remains unshifted. (UPDATE: Apparently it wasn’t too soon to call Quibi a complete failure)   

Some would argue that Quibi’s underlying premise -- that a market exists for super premium short form video -- was doomed from the start, but I don’t agree with that assessment. Billions of people consume short videos across YouTube, TikTok, and other platforms every month, and Quibi would only have to convert a relatively tiny percentage of them, 30 million or so, to be considered successful.

Instead, I think Quibi’s failures can be mainly attributed to flawed executions in its technology building, marketing, and content acquisition. Basically, in attempting to create a juggernaut video app, Katzenberg and his cohorts failed to incorporate many of the strategies that other streaming giants pioneered. Here are four ways I would have approached Quibi’s development and launch differently:

Devoted half my content budget to YouTubers

One of Quibi’s biggest strategic blunders, in my mind, was that it tried to build a streaming destination geared toward Millennials and Gen Z without leveraging the creative brilliance and marketing reach of the very creators that excel at attracting those viewers: YouTubers. 

Instead Katzenberg devoted the vast majority of his considerable budget to traditional Hollywood projects that cast older A-list stars like John Travolta and Kiefer Sutherland -- celebrities more likely to appeal to Boomers and Gen-X. "The reason why we went with stars, and celebrities, and known talent is because it's brand new, and we needed to clearly define for the consumer, for people that would subscribe to this, why is it different?" he explained. He also bragged that Quibi content would cost him up to $100,000 per minute to acquire.

Yes, Quibi did greenlight some programming from online influencers. In late 2019 The New York Times reported that YouTube stars like Shan Boodram and Liza Koshy had sold shows to the platform, and its executives regularly took pitch meetings with YouTubers.

But they also placed an exceedingly high bar for influencer pitches, rejecting many of their ideas and pushing them into formats that seemed more designed for traditional TV than online viewing. According to Business Insider, Katzenberg was known to say, “If it can be on YouTube, it can't be on Quibi.” Anonymous talent agents told the publication that Katzenberg and crew were often dismissive of really creative show concepts. “It was super frustrating because we thought that we had a few good ideas and they were automatically shut down because they were quote unquote 'YouTuber ideas,' which I thought was very strange," one said.  

It’s clear from reading interviews with Katzenberg that he fundamentally looked down at the craft perfected by YouTubers and online influencers. “If there are good actors and good talent on YouTube who can transition to that, then we’re happy to have them,” he said in early 2020. “But it’s highly differentiated…we’re not trying to do a high-end version of what they’re doing. We’re actually trying to bring the ecosystem of broadcast, cable, streaming, television and television storytelling and bringing that to this world.”

If I were in Katzenberg’s position, I would have allocated a much larger portion of my budget toward YouTubers, TikTok stars, and other influencers -- as much as 50%. I also would have given them much more creative leeway in pitching show concepts. There would be several benefits to the strategy.

For one, it would have been much more economically efficient. I sincerely doubt that any YouTubers would have pitched ideas that require $100,000 per minute to produce, which means Quibi could have spread its budget across hundreds of niches and influencers while also expanding its content library considerably.

This approach would also have had built-in marketing benefits. The top YouTubers collectively have tens of millions of passionate fans who spend considerable amounts of money on everything from merchandise to live events. They could have provided a massive and organic push to get their followers to sign up for free trials to Quibi. Even if they required additional marketing budget to do so, the spend would generate much higher ROI than traditional advertising channels.

By having a mix of YouTuber content and more traditional Hollywood fare, Quibi could have better bridged the divide between high-end subscription services like HBO and the user-generated videos found on platforms like YouTube and Facebook. Instead, it just took traditional Hollywood content and chopped it up into 10-minute bites. 

Published to all devices

Regardless of the quality of Quibi content, the company faced a steep uphill battle in driving user adoption, essentially requiring millions of people to incorporate it into their media consumption habits. So why on earth did it place draconian restrictions on how its shows and movies could be viewed?

On launch day, Quibi could only be watched through mobile devices. There were no connected-TV apps on Roku, Amazon Fire, or Apple TV. You couldn’t even view them on your laptop browser. This was intentional on Katzenberg’s part. “Mobile video is the white space,” he said in 2019. His vision of the average Quibi user was someone who would fire up the app while waiting in line at the bank or commuting to work on a city bus, and so he designed it so as not to allow literally any other use case.

This is a great example of how Quibi’s leaders failed to simply observe the competitive landscape. When it comes to mobile video views, no other platform is more successful than YouTube, yet a sizable portion of YouTube watching occurs on laptop and desktop computers. And its connected-TV viewing is growing quickly, counting at least 100 million monthly users.

Quibi executives realized their mistake almost immediately. Within days, they announced development for connected TV apps, but it’ll be months still before they become available. The company now allows users to “cast” their mobile screens to their TVs if they have Chromecast, but this option isn’t accessible for the vast majority of streaming video users.

Even if Quibi gets up and running on platforms like Roku by the end of the year, it’ll have lost crucial runway in onboarding and converting users, especially the millions of those who already let their 90-day free trials expire.

Released the first season of every show on free platforms like YouTube

This is admittedly the most radical of all my suggestions, but I think it would have driven viral, organic conversion to the Quibi app.

Think of just about every successful streaming service in existence. They all started with significant back catalogues of licensed IP -- shows and movies with already existing fan bases. Netflix was able to drive so much viewership to House of Cards because it already had thousands of hours of linear TV content from shows like Friends and Breaking Bad. The Mandalorian wouldn’t have pulled down the significant audience numbers it had if Disney+ didn’t also include hundreds of classic movies and TV shows stretching back decades.

Quibi launched with almost entirely new IP, and though it offers a free trial for new users, they still need to download and visit a new app, a process that generates quite a bit of friction. Any app marketer will tell you that getting users to download a new app is only half the battle; it’s just as difficult to get them to open it on a regular basis.

Imagine if Quibi had decided to inject the first season of all its serialized shows directly into the channels that billions of people are already using: YouTube, Facebook Watch, IGTV. It could have leveraged their reach to build massive fan bases that could then be driven to downloading the app.

Instead, Quibi placed draconian restrictions on its IP. The most mind-boggling decision involved blocking people from utilizing their phone’s screen capture functionality when watching shows. Users were shocked to learn they couldn’t easily create memes and other commentary that they could then share to their social media accounts. Again, all Quibi executives needed to do was observe the competitive landscape to know that social media discussion is the life blood for driving viewership to new shows.

To be fair, Quibi has gotten better about distributing content on free channels. Its YouTube account publishes lots of free clips and, in some cases, entire episodes of its shows. But most of the full-episode content comes from its lower-production reality and news shows. Getting users hooked on a high-production serialized show would drive much stronger adoption.

Bought the content outright instead of licensing it

Most people view Netflix’s move into original show production as a strategy to differentiate its content slate from competing services, but perhaps its biggest positive impact was in how it insulated Netflix from the ever-rising content licensing fees that threatened its longterm health. It can continue to expose millions of users to episodes of, say, Stranger Things without paying much in additional costs, whereas shows like The Office and Friends were always subject to competitive bidding wars and could be yanked off Netflix entirely.

According to reporting in Hollywood trade press, Quibi structured its content deals so the rights revert back to the creators of the shows after a two-year period. This makes it hard for the company to increase its residual value over time with evergreen content. This means that a sizable portion of its annual budget will be directed toward license renewals instead of new projects. As a result, its content library won’t expand nearly as quickly as it could have otherwise.

Quibi executives certainly acknowledge that the company isn’t meeting growth expectations, but it blames this fact on a single culprit. "I attribute everything that has gone wrong to coronavirus," he told The New York Times. 

While you can’t discount Covid-19 as a significant factor that’s driving the economic decisions for millions of American consumers, I think there’s no denying that Quibi made some huge missteps that hobbled its growth in those early months. And though it seems clear that the company is correcting for at least some of those mistakes, it may have lost out on the crucial momentum that could have allowed it to stand out in an incredibly competitive field. With such large rivals each spending billions of dollars every year on premium video, you only get so many bites at the apple before you join the mountain of media startups that failed to break through.

Re-investing when terrified

LET’S PLAY A SIMPLE GAME. At the start of the game you are given $20 and told the following: The game will last 20 rounds. At the start of each round you will be asked if you would like to invest. If you say yes, the cost will be $1. A fair coin will then be flipped. If it comes up heads you will receive $2.50. If it comes up tails, you will lose your $1.

Now there are two things we know about this game. First—and perhaps most obvious—it is in your best interest to invest in all rounds due to the asymmetric nature of the payoff. That is to say, you stand to make more than you lose in each round; the expected value per round is $1.25, giving a total expected value to the game of $25. In fact, there is only a 13 percent chance that you’d end up with total earnings of less than $20, which is what you’d have if you chose not to invest at all and just kept the initial endowment. The second thing we know is that the outcome in a prior round shouldn’t impact your decision to invest in the next round—after all, the coin has no memory.

However, when experimenters studied this game they found some very unusual behavior.8 They asked three different groups to play the game. The first group was very unusual; they had a very specific form of brain damage—these individuals couldn’t feel fear. The second group of players were people like you and me—ostensibly without any evidence of brain damage. The third group consisted of people who had brain damage but in parts of their brains unrelated to the processing of emotion (and hence fear).

Who do you think fared best? Not surprisingly, it was the group with the inability to feel fear. They invested in 84 percent of rounds, whereas the so-called normals invested in 58 percent of rounds, and the group with non- fear- related brain damage invested 61 percent of the time.

The group who couldn’t feel fear displayed their real edge after rounds in which they had lost money. Following such rounds, they invested more than 85 percent of the time—pretty optimal behavior. This was a huge contrast with the other two groups, who displayed seriously sub-optimal behavior. In fact, so bad was the pain/fear of losing even $1 that these groups invested less than 40 percent of the time after a round in which they had suffered a loss.

You might think that, as time went on, people would learn from their mistakes and hence get better at this game. Unfortunately, the evidence suggests a very different picture. When the experimenters broke the 20 rounds down into four groups of five games, they found that those who couldn’t feel fear invested a similar percentage of the time across all four groups. However, the normals started off by investing in about 70 percent of the rounds in the first five games, but ended up investing in less than 50 percent of the final five games. The longer the game went on, the worse their decisionmaking became.

You may be wondering why I am telling you this story—well, it naturally parallels the behaviors investors exhibit during bear markets. The evidence above suggests that fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision- making appears to become.

Of course, this game is designed so that taking risk yields good results. If the game were reversed and taking risk ended in poor outcomes, the normals would outperform the players who can’t feel fear. However, the version of the game outlined above is a good analogy to bear markets with cheap valuations, where future returns are likely to be good.

Cost of Capital

The basic principle for weighting equity and debt in cost of capital is that weights should always be market value numbers as opposed to book value numbers. Most companies and Valuers still often use book value weights for estimating cost of capital due to the following specious reasons:

 

1.      Book Value seems more reliable than market value since book values are not as volatile as market value. While this is true, this is only because book value is estimated only every quarter or every year. The fact that something does not move does not make it more reliable.

 

2.      Taking book value is a more conservative approach. However, this reasoning does not withstand any logical scrutiny. Book value weights are usually less conservative than market value weights and it gives a lower cost of capital. Book value weights tend to weigh debt more (not taking in account the improved or existing repayment capacity of the company and weigh equity less (not taking in account the going concern value of the company). The cost of debt is usually lower than cost of equity, thereby giving a lower cost of capital.

 

3.      The return on capital, i.e. the accounting return on capital, is based on book value. While this is true, the cost of capital has no relation with the return on capital. The cost of capital is the cost at which new funding can be raised from the market today. The book value is completely irrelevant when estimating cost of capital.

 

Hence, for computing cost of capital, we need market value of equity and market value of debt.

 

For a publicly traded company, the market value of equity is relatively simple. The market value of equity is simply the market capitalization of the company. The market value of debt is somewhat trickier as many publicly traded companies have debt that is not rated. So most Valuers and analysts use the book value of debt as a proxy for market value of debt while using market value of equity to compute cost of capital. This is highly inconsistent.

 

The market value of debt can be computed very simply. The inputs we require are (i) the book value of debt, (ii) interest expense, (iii) tenure of the debt. Having these 3 parameters, we can compute the present value of the debt by discounting the cashflow to present terms at the cost of debt. This gives the cost of debt for the company. We can make the same calculation for the company’s lease commitments to estimate the total market value of debt for the company. Some Valuers argue the logic behind converting lease commitments into debt. However, in case of businesses like retailers or restaurants, a bulk of debt takes the form of lease commitments. This changes the cost of capital for the company and the value of the operating assets of the company.

 

So when we’re valuing a company, we take the market value of equity, estimate the market value of debt, and now with the cost of equity and cost of debt, we’re in a position to compute the cost of capital.

 

Some people ask whether to use cost of equity or the cost of capital as the hurdle rate or discounting rate. The answer depends on how we compute returns. If returns mean the returns to equity investors, i.e. cashflows leftover after debt payments, then the appropriate discount rate will be the cost of equity. If returns are measured to the entire business, i.e. return on capital using pre-debt earnings, the appropriate hurdle rate is cost of capital. This goes back to the basic principle of discount rates, i.e. the discount rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.

Approaches to Valuation

Before we begin, let us burst a few general myths about Valuation

 

Myth 1: A Valuation is an objective search for “true value”

Truth: All valuations are biased. The only questions are how much and in which direction.

 

Myth 2: A good Valuation provides a precise estimate of value

Truth: There are no precise valuations. In fact, the payoff to valuation is greatest when valuation is least precise.

 

Myth 3: The more quantitative the model, the better the Value

Truth: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Simpler valuation models do much better than complex ones.

 

With that behind us, there are broadly 2 approaches to Valuation of Securities

 

1.      Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.

2.      Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.

 

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon:

 

1.      a perception that markets are inefficient  and make mistakes in assessing value

2.      an assumption about how and when  these inefficiencies will get corrected

 

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

 

Discounted Cash Flow Valuation

 

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. To use discounted cash flow valuation, you need

1.      to estimate the life of the asset

2.      to estimate the cash flows  during the life of the asset

3.      to estimate the discount rate  to apply to these cash flows to get present value

 

Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets. Since DCF valuation, done right, is based upon an asset's fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

 

Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for (1) equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector and (2) equity portfolio managers, who have to be fully (or close to fully) invested in equities

 

This approach is designed for use for assets (firms) that derive their value from their capacity to generate cash flows in the future. It does make your job easier, if the company has a history that can be used in estimating future cash flows. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to "true" value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm.

 

Relative Valuation

 

The value of any asset can be estimated by looking at how the market prices "similar" or 'comparable" assets. The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics). To do a relative valuation, you need

1.      an identical asset, or a group of comparable or similar assets 

2.      a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value)

3.      and if the assets are not perfectly comparable, variables to control for the  differences 

 

Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO) and investing on "momentum" based strategies. With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).

 

A portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts' judgments are right. It is just less overvalued than other securities in the market. Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail. Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

 

This approach is easiest to use when there are a large number of assets comparable to the one being valued, these assets are priced in a market, and there exists some common variable that can be used to standardize the price. This approach tends to work best for investors who have relatively short time horizons, are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.), and can take actions that can take advantage of the relative mispricing; for instance, a hedge fund can buy the under valued and sell the over valued assets.

 

Contingent Claim (Option) Valuation

 Options have several features

1.      They derive their value from an underlying asset, which has value

2.      The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.

3.      They have a fixed life

Any security that shares these features can be valued as an option.

 

Direct Examples of Options

1.      Listed options, which are options on traded assets, that are issued by, listed on and traded on an option exchange.

2.      Warrants, which are call options on traded stocks, that are issued by the company. The proceeds from the warrant issue go to the company, and the warrants are often traded on the market.

3.      Contingent Value Rights, which are put options on traded stocks, that are also issued by the firm. The proceeds from the CVR issue also go to the company

4.      Scores and LEAPs, are long term call options on traded stocks, which are traded on the exchanges.

 

Indirect Examples of Options

1.      Equity in a deeply troubled firm - a firm with negative earnings and high leverage - can be viewed as an option to liquidate that is held by the stockholders of the firm. Viewed as such, it is a call option on the assets of the firm.

2.      The reserves owned by natural resource firms  can be viewed as call options on the underlying resource, since the firm can decide whether and how much of the resource to extract from the reserve,

3.      The patent owned by a firm or an exclusive license  issued to a firm can be viewed as an option on the underlying product (project). The firm owns this option for the duration of the patent.

4.      The rights possessed by a firm to expand an existing investment into new markets or new products.

 

Advantages of Using Option Pricing Models

Option pricing models allow us to value assets that we otherwise would not be able to value. For instance, equity in deeply troubled firms and the stock of a small, bio-technology firm (with no revenues and profits) are difficult to value using discounted cash flow approaches or with multiples. They can be valued using option pricing.

Option pricing models provide us fresh insights into the drivers of value. In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it.

 

Disadvantages of Option Pricing Models

When real options (which includes the natural resource options and the product patents) are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task.

The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you first need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

Finally, there is the danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash flow valuation for a pharmaceutical firm because it has valuable patents would be double counting the patents if he values the patents as options and adds them on to his discounted cash flow value.