Financial Intermediaries

From the time you access the market – let’s just say, to buy a stock till the time the stocks come and hit your DEMAT account, a bunch of corporate entities is actively involved in making this work for you. These entities play their role quietly behind the scene, always complying with the rules laid out by SEBI and ensure an effortless and smooth experience for your transactions in the stock market. These entities are generally referred to as the Financial Intermediaries.

Together, these financial intermediaries, interdependent of one another, create an ecosystem in which the financial markets exist. This chapter will help you get an overview of what these financial intermediaries are and the services they offer.

The Stock Broker

The stockbroker is probably one of the most important financial intermediaries that you need to know. A stockbroker is a corporate entity, registered as a trading member with the stock exchange and holds a stockbroking license. They operate under the guidelines prescribed by SEBI.

A stockbroker is your gateway to stock exchanges. To begin with, you need to open something called a ‘Trading Account’ with a broker who meets your requirements. Your requirement could be as simple as the proximity between the broker’s office and your house. At the same time, it can be as complicated as identifying a broker who can provide you a single platform using which you can transact across multiple exchanges across the world. At a later point we will discuss what these requirements could be and how to choose the right broker.

A trading account lets you carry financial transactions in the market. A trading account is an account with the broker which lets the investor buy/sell securities.

So assuming you have a trading account – whenever you want to transact in the markets you need to interact with your broker. There are a few standard ways through which you can interact with your broker.

1. You can go to the broker’s office and meet the dealer in the broker’s office and tell him what you wish to do. A dealer is an executive at the stock broker’s office who carries out these transactions on your behalf.
2. You can make a telephone call to your broker, identify yourself with your client code (account code) and place an order for your transaction. The dealer at the other end will execute the order for you and confirm the status of the same while you are still on the call.
3. Do it yourself – this is perhaps the most popular way of transacting in the markets. The broker gives you access to the market through software called ‘Trading Terminal’. After you log in to the trading terminal, you can view live price quotes from the market, and can also place orders yourself.

The basic services provided by the brokers includes…

1. Give you access to markets and letting you transact
2. Give you margins for trading – We will discuss this point at a later stage
3. Provide support – Dealing support if you have to call and trade. Software support if you have issues with the trading terminal
4. Issue contract notes for the transactions – A contract note is a written confirmation detailing the transactions you have carried out during the day
5. Facilitate the fund transfer between your trading and bank account
6. Provide you with a back office login – using which you can see the summary of your account
7. The broker charges a fee for the services that he provides called the ‘brokerage charge’ or just brokerage. The brokerage rates vary, and it’s upto you to find a broker who strikes a balance between the fee he collects versus the services he provides.

Depository and Depository Participants

When you buy a property the only way to identify and claim that you actually own the property is by producing the property papers. Hence it becomes extremely important to store the property papers in a safe and secure place.

Likewise when you buy a share (a share represents part ownership in a company) the only way to claim your ownership is by producing your share certificate. A share certificate is nothing but a piece of document entitling you as the owner of the shares in a company.

Before 1996 the share certificate was in paper format however post 1996, the share certificates were converted to digital form. The process of converting a paper format share certificate into a digital format share certificate is called “Dematerialization” often abbreviated as DEMAT.

The share certificate in DEMAT format has to be stored digitally. The storage place for the digital share certificate is the ‘DEMAT Account’. A Depository is a financial intermediary which offers the service of the Demat account. A DEMAT account in your name will have all the shares in the electronic format that you have bought. Think of the DEMAT account as a digital vault for your shares.

As you may have guessed, the trading account from your broker and the DEMAT account from the Depository are interlinked.

So for example if your idea is to buy Infosys shares then all you need to do is open your trading account, look for the prices of Infosys and buy it. Once the transaction is complete, the role of your trading account is done. After you buy, the shares of Infosys will automatically come and sit in your DEMAT account.

Likewise when you wish to sell Infosys shares, all you have to do is open your trading account and sell the stock. This takes care of the transaction part…however in the backend, the shares which are sitting in your DEMAT account will get debited, and the shares move out of your DEMAT account.

At present, there are only two depositaries offering you DEMAT account services. They are The National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited. There is virtually no difference between the two and both of them operate under strict SEBI regulations.

Just like the way you cannot walk into National Stock Exchange’s office to open a trading account, you cannot walk into a Depository to open a DEMAT account. To open a DEMAT account you need to liaison with a Depository Participant (DP). A DP helps you set up your DEMAT account with a Depository. A DP acts as an agent to the Depository. Needless to say, even the DP is governed by the regulations laid out by the SEBI.

Banks

Banks play a very straightforward role in the market ecosystem. They help in facilitating the fund transfer from your bank account to your trading account. You cannot transfer money from a bank account that is not in your name.

You can link multiple bank accounts to your trading through which you can transfer funds and trade. At Zerodha, you can add 1 primary bank account and up to 2 secondary bank accounts. You can use all the bank accounts to add funds but withdrawals are only processed to the primary bank account. Also, dividend payments, money from buybacks will be sent to the primary bank account. The primary bank account is connected not just to your trading account but also with the Depository and the Registrar and transfer agents (RTA).

Also, at this stage, you must have realized that the three financial intermediaries operate via three different accounts – trading account, DEMAT account and Bank account. All the three accounts operate electronically and are interlinked giving you a very seamless experience.

NSCCL and ICCL

NSCCL – National Security Clearing Corporation Ltd and Indian Clearing Corporation are wholly owned subsidiaries of National Stock Exchange and Bombay Stock Exchange respectively.

The job of the clearing corporation is to ensure guaranteed settlement of your trades/transactions. For example, if you were to buy 1 share of Biocon at Rs.446 per share there must be someone who has sold that 1 share to you at Rs.446 . For this transaction, you will be debited Rs.446 from your trading account and someone must be credited that Rs.446 toward the sale of Biocon. In a typical transaction like this the clearing corporation’s role is to ensure the following:

a) Identify the buyer and seller and match the debit and credit process

b) Ensure no defaults – The clearing corporation also ensures there are no defaults by either party. For instance the seller after selling the shares should not be in a position to back out thereby defaulting in his transaction.

For all practical purposes, its ok not to know much about NSCCL or ICCL simply because, you as a trader or investor would not be interacting with these agencies directly. You just need to be aware that there are certain professional institutions which are heavily regulated and they work towards smooth settlement, and efficient clearing activity.

Is Trade Always Better?

The East India Company (EIC) was formed for pursuing trade with the East Indies. English traders frequently engaged in hostilities with their Dutch and Portuguese counterparts in the Indian Ocean.

 

The Company decided to explore the feasibility of gaining a territorial foothold in mainland India, with official sanction of both countries, and requested that the Crown launch a diplomatic mission.

In 1612, James I instructed Sir Thomas Roe to visit the Mughal Emperor Nuruddin Salim Jahangir (r. 1605 – 1627) to arrange for a commercial treaty that would give the Company exclusive rights to reside and build factories in Surat and other areas. In return, the Company offered to provide the Emperor with goods and rarities from the European market. This mission was highly successful as Jahangir sent a letter to James through Sir Thomas Roe:

 

"Upon which assurance of your royal love I have given my general command to all the kingdoms and ports of my dominions to receive all the merchants of the English nation as the subjects of my friend; that in what place soever they choose to live, they may have free liberty without any restraint; and at what port soever they shall arrive, that neither Portugal nor any other shall dare to molest their quiet; and in what city soever they shall have residence, I have commanded all my governors and captains to give them freedom answerable to their own desires; to sell, buy, and to transport into their country at their pleasure. For confirmation of our love and friendship, I desire your Majesty to command your merchants to bring in their ships of all sorts of rarities and rich goods fit for my palace; ..."

 

So People respond to incentives in the same way as Jahangir did to get rare goods from East India Company.

 

During the period, 1780–1860, India changed from being an exporter of processed goods for which it received payment in bullion, to being an exporter of raw materials and a buyer of manufactured goods. More specifically, in the 1750s, mostly fine cotton and silk was exported from India to markets in Europe, Asia, and Africa; by the second quarter of the 19th century, raw materials, which chiefly consisted of raw cotton, opium, and indigo, accounted for most of India's exports.

• In 1800 India's share of the world manufactured product was four times that of Britain, and China's share was even higher. By 1900 India was fully under British control and the ratio was 8-1 in England's favour.
  
  
• Indian and Chinese rulers actually had before 1800 a good record of mitigating famines, and one British statistician suggested that whereas for the previous two millennia there was one major famine a century, under British rule there was one every four years." 

 

Based on such scholars as Bairroch, Parthsarathi, Gura and Pomeranz, Davis brings forth many facts that shore up his argument.

 

So we see that how India’s standard of living decreased immensely after its ability to produce goods and services decreased. Also we can say that the trade with East India Company made India worse off. So it's not always that Trade can make you better off.

Loan Appraisal Process

A bit lengthy message, but a must read for all

Do's and Don'ts of Loans

1) KYC - yes KYC is must. You must first identify the customer. It is better to approach the customer rather customer approaches you. Sometimes borrower is not selected properly he is either new customer or introduced by another stranger or middlemen. Never involve middlemen, talk to customers directly. Avoid giving multiple loans to single party/ family or a group, to minors, lunatics or insolvents. It is compulsory to complete all the KYC norms before even thinking of giving loan. For KYC the following things are to be taken care of-

a) Proof of Identity

b) Proof of residence

c) Proof of business address

d) PAN number

e) Photocopies of all these must be verified with original and also get them signed by the borrower and kept on record.

2) Understanding Credit Cycle - the credit cycle consist of credit opportunity -> Credit Creation -> Credit management -> Credit Completion -> Credit creation. Which ever branch you land at you will find loans in one stage or the other.

3) RBI’s Defaulter List - it must be confirmed from RBI’s Defaulter’s list, available on RBI’s website. Confirm that borrower/guarantors name do not appear in the defaulters list and confirmation of same must be put on record.

4) CIBIL reports – next step is to search the CIBIL reports of the borrower and guarantors in all loan cases and commercial CIBIL report in case of firms/ companies. CIBIL reports should be analyzed thoroughly viz. whether borrower/ guarantors availed loans from other banks or financial institutions is there any overdue amount. There should be documentary proof to satisfy these irregularities.

5) Search CERSAI or CIBIL Mortgage site - if mortgage of property is involved in the loan then before proceeding further search should be made on CERSAI or CIBIL Mortgage site to ascertain that there is no mortgage outstanding against the property in any other bank/ FI.

6) Loan safety - safety of your loan is directly related on the basis on which decision to was taken, type and quantum of credit to be given and terms and conditions of the loan. But practically no loan is safe as we can’t see what is going on in the borrowers mind. Loans with all proper documentation and all due diligence paid also goes NPA. But still you can wisely apply points mentioned in article and save a going to be NPA loan.

7) Pre sanction Visit - next step is to visit the residence place of borrower, place of unit and property to be mortgaged. Pre sanction visit is basically to determine the “bank-ability” and access related riskiness of the proposal. Identification of borrower and site must be ascertained beyond doubt by inquiring from neighbors and other surrounding people. The whole observations must be noted down and to be placed on the record.

8) Assets and liabilities Reports - assets and liabilities statements of all borrowers/ guarantors must be prepared on prescribed format mentioning full detail of assets & liabilities duly signed by borrower/ guarantor and accountant/ manager. You should also take necessary proof of asset and liabilities be taken.

9) Balance Sheets – in case of working capital limits 3 years balance sheets of the unit along with income tax/ Sale tax returns etc.( for higher amount get audited balance sheets) projected balance sheets of next 2 years in cases of working capital limits and for the period of loan in case of term loan is mandatory. The balance sheets must be thoroughly analyzed and sanction-able limits be assessed. You should analyze the following points in balance sheet-

a) How capital or fund is raised?

b) How capital or fund is utilized?

c) Financial stability of firm.

d) Profitability?

e) Repayment capacity.

f) Expenditure analysis.

g) Sales achieved.

h) Existing loans and liabilities.

10) Project report - project report ( for the proposed project if term lending is required) containing details of the machinery to be acquired, price, name of suppliers, capacity utilization assumed, production , sales, projected profit and loss and balance sheets for the next 7-8 years till the proposed loan is to be paid. Project report should be analyzed and feasibility be ascertained.

11) Credit Rating - credit rating must be done in all the loan cases as per bank’s guidelines. Retail loans like Housing Loan, auto loan, and education loan should be done as per bank norms. Rate of interest should be fixed as per credit rating. In agriculture loans there is no need of credit rating. Credit rating should be done judiciously based on analyzing balance sheets. Always avoid sanctioning loan credit rating below 3.

12) Legal opinion - verification of title deed of property to be mortgaged is utmost necessary. It must be ascertained that it is original not fake, scanned copy or duplicate one. In Legal opinion revenue authority should personally verify that title deed to be mortgaged tally with the one kept with revenue records. Must get certified copy of the title deed and tally it with original Title deed. Also take certificate from advocate that certified copy tallies with the original one. Thoroughly read the legal opinion given by the advocate and observe that there is no objectionable which goes against the bank’s interest. Also obtain all the documents mentioned in the legal opinion. Here it is also important to personally verify that submitted title deed belongs to the property you visited earlier. Also make sure that SARFAESI act 2002 is applicable on the property. Certificate of change of land must be took in case unit to be financed is to be built on agriculture land.

13) Any additional limit sanctioned against same securities already charged to the bank ensure-

a) To extend charge to such limits too.

b) All concerned should be kept informed.

c) Acknowledge debt / balance conformation with the borrower.

14) Valuation - valuation of property to be mortgaged is to be done from valuer on banks panel. Considered value is earlier circle rate or realizable value which ever is lower. After that realizable value can be considered. For agriculture land circle rate fixed by the collector revenue for the area/ Circle. Land revenue Authority/ Tehsildar/ DM/ or any other authority for determining the valuation of land should be considered. Valuation report of the valuer must be thoroughly analyzed that it should not contain any comment which may harm the bank’s interest on later stage. The title deed, revenue numbers, area of the land must tally with deed/ legal opinion and valuation report.

15) Filling of Appraisal note - after verifying all the documents the appraisal note should be filled. Care should be taken that full detail should be filled and it should be complete in all respects. Appraisal should reveal whether proposal is fair banking risk. documentation forms the basis for legal relationship between bank and borrower. Following points should be taken care off:

a) Information of the borrower: name, full address, phone numbers, PAN no., date of birth and net worth and constitution should be given.

b) While processing credit processing figure out both positive and negative points on a piece of paper.

c) Now compare the proposal with circular of the bank. All circulars have checklist. Tick point by point and figure out gaps if any. *Also jot the measures that you or the party needs to take to fill those gaps.

d) Get confidential reports from other bank and FI.

e) Amount of loan and purpose of loan should be given in full.

f) Constitution of account- whether account is individual/ joint/ co- borrower/ proprietorship/ partnership/ pvt ltd. Co/ ltd co.

g) Full details of his accounts with other banks, branches should be given in full detail.

h) Information of guarantors should be given in detail viz. name. address, PAN number, Date Of Birth, Phone no. , net worth etc.

i) Detail of Primary security should be given in full as related to the case e.g. if it is mortgage of property full address as mentioned in the legal opinion should be given along with date of legal opinion and valuation report and values viz. market value , realizable value and accountant/ manager with date. If hypothecation of vehicle – its RC no, date, engines no. value, date of insurance etc.

j) Similarly for additional security full detail should be given as the case may be.

k) Balance sheet figures should be given in full, preferable consisting of last 2 years audited figures, current year’s provisional figures and projected figures of next 2 years. Ratios like current ratio, debt-equity ratio etc. must be calculated and filled. Observation about balance sheet must be mentioned in the note.

l) Credit rating must be mentioned in the note and based on it rate of interest should be mentioned by quoting circular no on which it is based.

16) Repayment - detail of repayment mentioning amount of EMI, duration in months must be mentioned. If moratorium period allowed then it must be mentioned and also mention date of first installment.

17) Disbursement - in case of term loan, disbursement should be as per schedule approved by the bank. In case of housing loans disbursement should be related to actual progress in implementation of project. For that you should visit the site periodically. For any delay in project you should seek the borrower’s arguments. Also monitor costs being incurred and scrutinize receipts being produce by the borrower.

18) Role of periodic inspections - periodical inspections enables bank to keep check on the stocks hypothecated to bank. Now what you should do in periodical inspections? 

a) Obtain basic info on the functioning of unit.

b) Do physical verification of the stock.

c) Match the stock with the stock statement given.

d) Do rough valuation of stock on MRP or market price.

e) Quality of stock hypothecated to bank. It should not be of inferior quality what is charged to bank or obsolete or rejected stock which is of no market value.

f) The bank’s name should be prominently displayed onsite the unit where goods are hypothecated to bank. E.g. *“OUR BANK , SBI bank* Board like this should be displayed outside.

g) In case of pledge- ensure that storage area is properly maintained, earthquake and flood resistant, goods are stored in a proper manner, stock audit is regularly conducted and a proper register is maintained.

h) Also note that the stocks or securities that are offered should be adequately insureand that too on continuous basis.

i) Branch should maintain a inspection register where all the findings at the site should be noted. It is a good idea to take 2-3 snapshots and paste them on register with signature of visiting officials.

j) Inspection should be done vigorously and not pre-informing the borrower and telling him to prepare tea/snack(on a lighter note). Inspection should be done without even making borrower know that you are going to visit and which date or time. Just caught the borrower red handed only then you will come to know how he behaves and looks in real life.

k) In case if housing loans, visit office of sub registrar or revenue office to verify charge of bank on the mortgaged property.

19) CERSAI - after disbursing the mortgage related cases the mortgage must be registered with the CERSAI within one month of mortgage. It is mandatory and registered number must be mentioned in the loan file.

20) Post sanction appraisal - post sanction appraisal generally deals with documentation of the facility and after care follow up. One must carefully view the transactions on the loan/ CC facility given. Non payment of interest on due date should be immediately followed up with the borrower. In case of CC frequent overdrafts should not be allowed. Also transactions with sister concerns should be monitored. Scrutinize the stock statements which are periodically submitted. Physically verify the securities and books of accounts of the borrower.

21) ROC - in case of pvt and public ltd. Companies, the banks charge on assets of the company must be registered with ROC within 30 days of creation of charge. The search report of this charge must be on the record.

22) Review of borrower’s account - periodical review of borrower’s account is necessary for-

a) NPA control- if you can identify some odds during initial stages of account the you can easily minimize your future NPA.

b) Taking preventive measures for improvement in cash flow slippage into substandard/ doubtful category.

c) Necessary to ascertain if business is doing good or bad. If bad then take preventive measures.

23) Vetting - the executed documents of loans of larger amounts must be got vetted from advocate on the banks panel and certificate should be put on the record. In case of larger loans the documents must be got vetted second time from another advocate on the banks panel and certificate be put on record.

24) Post sanction follow up  – for post sanction follow up ensure terms and conditions of sanction is intimated to borrower well in advance also ensure borrower advised the same. Ensure receipt of acceptance of terms and conditions and kept on record and are fulfilled before disbursement.

25) Post lending visit - this visit is very important to verify the end use of funds. Assets to be created by the loan sanctioned must be verified physically and facts noted in the visit report.

26) Renewal or revival - renewal or revival of accounts must be done on due date on basis of latest financial documents.

The checklist is only indicative and not exhaustive. The guidelines may vary. But It will help people dealing in advances portfolio to take judicious and prompt decisions dealing loan proposals. The mantra for good credit is simple –

“Good system of appraisal/ assessment of credit Needs and Effective supervision and follow up post sanction”

Liquidation as a Going Concern

IBBI vide notification dt. 25 Jul 2019 inserted Regulation 32A in the Liquidation Regulations whereby the Liquidator may sell the Corporate Debtor, or the business thereof, as a going concern. This was supposed to be a welcome move, as it is generally known that the economic value of a going concern business is higher than the value of assets. Hence, this move was supposed to increase the economic worth of national assets under Liquidation.

However, it has been repeatedly mentioned in the Regulation that under such a mechanism, the “assets and liabilities” of the business will be sold as a going concern, which opens a Pandora ’s Box for the buyers under such a scheme.

As per the data published by IBBI[i], as of 30 Jun 2020, 957 cases had resulted in liquidation with a total liquidation value of Rs. 40 kCr. Against this, the total claims were Rs. 5.46 lac Cr, i.e. the total liquidation value of the 957 cases in liquidation was a mere 7% of the total claim amount. If these companies were to be sold as going concerns, what would happen to the remaining 93% of the claims being Rs. 5.07 lac Cr? Does the company as a going concern get sold with all those liabilities? Assuming the proceeds of this liquidation value are distributed among the creditors in the Waterfall mechanism of Section 53 of the IBC, what action would the creditors take to recover these remaining dues, which have been sold to a new buyer? Are we staring at another round of CIRP for these remaining dues?

The Corporate Debtor in liquidation is already one which has gone through the process of insolvency and has failed to find a resolution. If the Corporate Debtor is left again in the economic playing field with 93% of its liabilities, it is highly unlikely that it’ll survive and won’t fall into the trap of insolvency again.

 

Our view is that once the liquidation process is initiated and completed, either by sale of assets or sale of business or sale as going concern, and the proceeds have been distributed to the claimants as per Section 53 of the IBC, the Liquidator cannot take responsibility for any pending claims. The liabilities of the Corporate Debtor are already converted to claims under the CIRP and Liquidation processes. The liabilities, if unclaimed or unsettled, cannot turn live again because their claims had not been submitted in the insolvency or liquidation processes.

 

But more important than that, the sale of liabilities under liquidation as a going concern is in complete violence to Section 53 itself, which speaks of settlement of claims under liquidation. If the liabilities were to come live once again even after receiving proceeds from liquidation, then the liquidation process itself is deemed to have been failed. However, one may still argue that in case of liquidation as a going concern, Section 53 of the IBC does not apply and the proceeds of liquidation shall simply be used to reduce the liabilities rather than to settle them completely.

It should also be understood that at certain times, the assets are inherently linked to certain liabilities and their separation is not possible for a going concern. Examples include long-term supply contracts where the goods are to be called off over a period as required, certain infrastructure contracts which require submission of performance guarantees, indemnification obligations etc. These are pecuniary liabilities which are essential for the operations of the going concern. Such liabilities cannot be settled under Section 53 of the IBC if the Corporate Debtor is to be sold as a going concern.

In conclusion, the transfer of liabilities in liquidation as a going concern does not do justice to the spirit of the IBC. However, there is a need of clarity from the IBBI whether the liabilities are necessary to be required to be transferred during sale as a going concern. Meanwhile, all eyes will be on the future course of legal proceedings on this issue. The Adjudicating Authority may take a view that is contrary to ours, which it has the right to do and settle the matter. However, the same Adjudicating Authority may make use of its generic powers under Section 60(5) of the IBC to clear the matter and bring a unique opportunity of liquidation as going concern giving a real resolution to the strained Corporate Debtor.

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[i] https://www.ibbi.gov.in/uploads/whatsnew/a98a313021b1250be5ca3b9301626f25.pdf

Buffet Indicator

The Buffet Indicator (BI) is an approach which hinges on the assumption that the stock market is the barometer of the economy. Holding this assumption to be true, we can assume that in the long run, the markets should only rise (or fall) as much as the economic activity in any nation. How true is that? Let’s find out.

Before we analyze the Buffet Indicator, let us first understand WHAT it is. The Buffet Indicator is simply the ratio of the prominent market index of the economy (such as NIFTY, SENSEX, NIFTY 500, Dow Jones, Hang Seng, NASDAQ etc.) and the GDP of the country. While the market index is a fairly simple number daily updated on the stock exchange, the GDP is a little more tricky.

 

The most widely published numbers for GDP in any economy are the GDP growth rate reported on a quarterly and annual basis with YoY growth (or decline) in constant currency terms. This immediately poses 4 problems

1. GDP is not reported as a number but as a growth rate
2. Which GDP to take? GDP or GDP per capita or GDP (PPP) or some other variant of economic activity
3. The growth rate is not in terms of the immediately preceding quarter but the quarter in the year before
4. The GDP indicator is in real terms while the market index is in nominal terms

The first two problems can be resolved fairly easily. Along with the GDP growth rate, the GDP can also be easily found with some searching. However, we prefer a method wherein we take any arbitrary number for GDP at a certain point in time, and taking the growth rates from there. This is very similar to NIFTY being initiated at a value of 1,000 on 22 Apr 2016. As we’re only interested in the Market-to-GDP ratio, the initial figures are meaningless and we’re only interested in the ratio. In fact, we can use the growth rate of any indicator of economic activity and use the ratio against it. If GDP seems to be an unfair method, we can use any other measure like total funding by banks or total exports by a country or total number of internet users in a country. But by far, we find GDP to be the truest measure of economic activity in a country.

 

The third problem can be tackled by adjusting the GDP growth rate for the annual figures published by the Government or any authentic source such as the World Bank. Another way to approach the problem would involve some mathematical working to take YoY growth figures for every quarter for the market values. We prefer the former method of working.

 

The fourth problem can be dealt in two ways. We can either add the inflation figures to the GDP growth rate, or we can choose to find and use the nominal GDP growth rates. Less prudent investors may still choose a third approach – ignoring inflation. This holds true for an economy where the inflation is static. However, inflation has been very volatile in the past in India. Still, taking a value of inflation opens another pandora’s box which is beyond the scope of this article. For the purposes of this article, we have ignored inflation and assumed the inflation to be consistent in the long run.

 

BI assumes that the measure of economic activity taken is consistent in the long run. However, every decade or so there are fundamental changes in the way GDP is calculated and reported. While one Government may want to highlight nominal GDP figures, another may choose to focus on GDP per capita and the news reports will follow. Consistency is key in long term valuation studies. Another assumption taken by the BI is that the market is a meaningful measure of economic activity and while the same may not seem to be true looking at everyday variations in the stock market, the same does hold true in the long run as evidenced from the graph below.

As seen in the graph, the 5 year average of the Buffet Indicator is a fairly stagnant ratio. Assuming there are no big variations in the GDP growth rate in the short-term, we can assume most of the variation in the Buffet Indicator is attributable to the variation in the market. The assumption is confirmed by the fact that the Buffet Indicator moves in tandem with the market. Whenever a big difference with the average arises, the market sees a sharp movement in the opposite direction (but don’t hold us to this). At the time of writing this article, the CY 2020 Q2 GDP figures have recently been published and the Buffet Indicator is 9% higher than its 5 year average. Are we looking at a sharp correction soon?

A Note on Nominal & Real Cash-Flows

A problem most people face while dealing with valuations is the adjustment in inflation. Inflation being a volatile number in India, most valuers tend to ignore it. In usual practice we see valuers using nominal interest rates and real cash flows without adjusting for inflation at all. This assumption holds true when prices are very inelastic and inflation is zero. However, most products do not follow this rule.

 

So before we delve into what is the correct way to value cashflows, let us first understand the culprits in the situation – nominal & real interest rates and nominal & real cash flows.

 

Nominal interest rates are interest rates quoted by the agency. For example, if the Indian Government is issuing 3.15% T-Bills on 19 Aug 2020, then the nominal rate of interest offered by the Indian Government on those T-Bills is 3.15%. The Real Interest Rate is given by

 

Real Interest Rate = Nominal Interest Rate – Inflation

 

We will get back to inflation in a moment. Regarding cash flows, the basic model remains as

 

Revenue = Capacity * Capacity Utilization * Sale Price

Or Revenue = Past Revenue * Growth

 

Without really caring about where this growth is coming from. As long as the growth is consistent with the past growth, we are comfortable with our valuation. However, it is very imperative to know whether the growth is a result of increase in sale prices, or increase in scale of operations, or the more likely scenario – both! If the growth is on account of increase in sale prices only, then it is not a “real” growth but only in nominal terms. However, if we do not consider the growth in sale prices, then it would be unfair to discount the cash flows at nominal interest rates.

 

The principle that emerges is – Real Cash-Flows must be discounted at Real Interest Rates and Nominal Cash-Flows must be discounted at Nominal Interest Rates.

 

Let’s say we have a cash-flow where we’re using nominal rates. The discount rate is the same as quoted by the market in terms of nominal rates of risk free rates and market premiums. Whereas the cash-flows are being increased in accordance with inflation year-on-year. If we were to convert the same cash-flow to real rates, we would have to reduce the discount rates by inflation and the increase in cash-flows would be reduced to the extent of inflation. The net value of the cash-flows should remain the same. Which makes sense as there should be no effect of inflation on the Valuation Date. It should only affect future cash-flows which are being valued in the discounting model.

 

Next we address the elephant in the room. What should be the inflation rate. Take 10 different sources and they will all give you a different rate of inflation. Broadly, there’re two major measures of inflation – the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). In the long run, both these rates have displayed similar characteristics. Some might even take the long-term increase in gold-prices to be a measure of inflation. However, all these measures are backward-looking and discounting of cash-flows has to be done on a forward-looking basis. The issue remains unresolved at the moment and the closest estimate often taken is a 4% inflation rate given the RBI’s present inflation target.

 

Even as the issue for the measure of inflation remains unresolved, it is prudent to be aware that the discounting of cash-flows must be consistent with the interest rates taken. Otherwise we remain unaware of our own shortcomings while estimating valuations under the discounted cash-flow approach.

Equity Value per Share

When we value a business using FCFF or FCFE, we are able to calculate the value of operating assets generating cash flows. We need to go several steps further to arrive at the value of equity per share. Some of such steps are adjustments for cash and cross holdings. We might want to simply add them to our arrived valuation and let that be. However, this isn’t appropriate in all circumstances. Next, we need to subtract the debt (in case of FCFF) to arrive at the value of equity. This value of equity has two classes of claimholders. Managers and investors may have claim on the company if they’ve been given options. These options need to be netted out before we can arrive at the value per share.

 

Consider a company which earns a return on capital (RoC) just its cost of capital (CoC). It does not create value for the shareholders, but neither does it destroy any value. For companies such as this, cash is a neutral asset. The value of cash on its books can be called as the fair value of the cash. Taking the argument further, consider a company that does not earn its CoC. This means this company has made some bad investments. Cash in the books of a company by itself does not hurt an investor. What does hurt the investor is what the managers do with that cash. If a company is unable to earn its CoC, then the cash will be wasted with the company. In such a scenario, the investor must discount the cash. The management of such a business wastes cash rather than pay it out to the investors as dividend. Conversely, if a company earns more than its CoC, the cash on its books should be valued at a premium. But that is only applicable if the company does not have adequate access to capital markets. With access to capital markets, there’s no need for a company to retain large cash balances. So a premium to cash may be appropriate for emerging market companies, but not for those in developed markets. Further, during times of volatility for such companies, they can use the cash to survive till the economy picks up again, as well as use it to acquire assets from other companies not faring well in the economic downturn.

 

The second point of contention are cross holdings as there’s no reliable mechanism of accounting for cross-holdings. To estimate cross-holdings effectively, we need to know how they’re accounted for in the financial statements. Often they’re valued at book values. In a perfect world, we’d value the parent company on a standalone basis and then value each cross-holding separately. This allows us to treat each company with its own cash flows, growth, and risk rather than apply one CoC and growth rate across the board. However, to do this we need the full financials of each cross-holding company, which is often tough to come by. So there’re 2 compromise solutions. (a) If the cross-holding is in a public traded company, we already have a market price. This is cheating since the idea behind intrinsic valuation is that markets can be wrong and we’re trying to estimate value on our own. But that gets complicated with investments in too many companies. (b) If the cross holdings are in private companies, then we can use the PB ratio from listed companies in the same sector. We use the PB ratio as the record of investment in the cross-holding company is at book value.

 

Next, we need to look at unutilized assets – assets that do not form a part of the operations but are under the ownership of the company. We can either count the value of the cash flows from the asset or the value of the asset, but not both. That’s double counting. Unutilized assets are those who do not contribute to the cash flows in our FCF models. We prepare a collection of such assets and estimate a market value for them. Sometimes companies have real-estate holdings worth more than the rent they generate. So we can have an option to either value the company as a going concern based on its cash flows or we can value it as a collection of real estate holdings, but we can’t add the two up.

 

Last stop is the equity options to the management or investors. The companies that give a lot of options to their employees tend to be young high-growth risky companies. Long term options on risky companies may be valuable pieces of equity. Often, analysts value options based on exercise value, i.e. what is the option worth if it were exercised as on the valuation date. Sometimes they dilute the number of shares to value the options. That undermines how much equity gets given away as such values can be low even for options with significant economic value. So such claims should be valued as options in an option-pricing model. This is the value that needs to be subtracted from the value of the equity to arrive at the value of equity per share outstanding. Similar mechanism may be used for future option values. Companies use options to compensate employees. Since we treat the rest of the compensation as operating expenses, we must treat options in the same light. If we issued these options to the market and used the cash to pay the employees, it’d be cash compensation. So equity options are compensation. Future options are just such compensation exercised in the future.

 

In summary, getting from the value of the operating assets to value of equity per share can be problematic because people try to take shortcuts. If we don’t take shortcuts and work one step at a time, there’s nothing intensely difficult about this process.

Pricing Jet

Aviation in a tough industry. Globally we have seen time & again that the industry is prone to bankruptcy. A significant amount of capital expenditure is required upfront & then there are very high fixed costs. This means that unless we get a high degree of customer stickiness, it becomes very difficult to make a profit. This is a factor we’ve seen play out in India where a lot of airlines have gone bankrupt despite the fact that there is tremendous growth in traffic & the projected growth is also very high. As a result, there’re a lot of airlines investing in growing capacity because they want to cater to this growing market. As they invest in growing capacity they also have to ensure that the capacity gets utilized. That builds a pressure on the airlines to keep pricing at a level where more customers join the band of flyers. This has been a big pain for Indian airlines despite the huge growth margins. India has the lowest airfares in the world[i]. Because the airfares are so low, the airlines are unable to make profits while operating. It is often said that oil is a big factor in aviation but oil has been volatile for over 6 years now. Despite that, the global aviation industry has returned a profit consistently for the last 10 years. It is expected that the industry will hit a profit of $ 36B in 2019[ii]. Looking just at the APAC, the profitability is expected to be $ 10B[iii]. These numbers show that airlines have been on a positive growth trajectory for the last 10 years.

Despite this backdrop, the Jet fallout did happen. The airline industry in India is suffering from very high ATF prices. The tax imposed by the central & state governments on ATF in India make it a very expensive fuel in comparison to their international peers. Further, ATF is not a part of the GST. Hence, airlines are unable to take the set-off of the GST that they pay. Also, there’re a lot of congestions are airports which adds to the operating costs of airlines. Apart from the infrastructure issues, there’s a pursuit for growth & market share resulting in lack of discipline in pricing.

In a distressed situation, the first question asked during valuation is the possibility of a turnaround, i.e. the steps to be taken to make sure that the airline can operate at margins that are remunerative. There has been a history of turnarounds in the airline industry globally as well as in India. Spicejet was almost grounded about 5 years ago & today is one of the best aviation stocks in the world[iv]. Any incoming investor looks at the possibility of a turnaround when they are evaluating a distressed business & try to figure out what is the best they can do with the business. They would always put a higher degree of risk in to the future cashflows of the company because they’re not sure whether they’ll be able to achieve those projected cashflows. One of the most valued assets for any airline is parking slots, which guides an airline’s ability to land at a certain airport. Jet’s parking slots are only available to it till June. If the airline is not revived till then the slots will be up for auction and then the airline will have no value left. Another factor the investors will look at is the flexibility of the lenders in taking a haircut. The equity value of a business is the total value of the business minus the total debt of the business. If the value of the business is less than the value of the debt, then theoretically there is no value to equity. Then an investor would not bother coming in. The only reason an investor would come in is if the lenders are willing to bring their value down to a reasonable number.

From a lender’s perspective, it’s important for them to maximize their recovery. In order to maximize recovery, tough questions need to be faced. If they invest some more money one may argue that it is putting good money after bad. Another argument is that by making a relatively small investment, the lenders may be able to recover a significantly higher sum later. When this starts to play out, the lenders need to have a lot of comfort with the new investor and their business plan. If the lenders have that confidence, things may work out for the airlines.

It remains to be seen if any new investor will perceive value in the airline. However, as the age old adage goes, at the right price, everything is a good asset.

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[i] https://www.telegraph.co.uk/travel/news/revealed-cheapest-countries-for-flights/

[ii] https://www.travelagentcentral.com/running-your-business/stats-airline-profits-to-hit-35-5-billion-next-year

[iii] https://www.iata.org/pressroom/pr/Pages/2018-12-12-01.aspx

[iv] https://www.livemint.com/Companies/T2BOBSwziSYSnEDPMJ2xEM/The-SpiceJet-turnaround-story-and-how-it-became-worlds-best.html

Relative Valuation

Relative Valuation is an approach where an asset is valued not based on of its fundamentals (cash-flows, growth, and risk) but on the basis of what other people are paying for assets just like it. Hence, it is also called “pricing”. It is the way for how 90% of the valuations are done. Relative Valuation has 3 steps.

1. Finding companies just like the subject company
2. Standardizing prices. We cannot compare price per share because it is an arbitrary number. If the stock were to split, the price per share would halve. So we use a multiple. Dividing price by earnings or by book value, we obtain a standardized price.
3. Controlling for those differences. The target company might still be different from other companies in terms of growth and risk in cash-flows which need to be adjusted for.

 Any relative valuation considers a multiple comprising of a numerator and a denominator. In the numerator, we see one of 3 numbers – market value of equity (market cap), market value of the firm (market cap + market value of debt), or enterprise value (market cap + market value of debt – cash). The numerator always takes some measure of market value. With the denominator, we can divide the market value number by revenue or any of the drivers of revenue. There are several advantages of using revenue, it being a positive number helping us to always being able to calculate the multiple. The drivers of revenue may be number of clients for subscription businesses, and such. We may also use a measure of earnings such as net income or operating income for equity and firm respectively. Similarly, we may use the cash-flows in the denominator, using FCFE or FCFF. We can also use the book value in the denominator, using book value of equity or of the firm. Using a multiple involves a 4-step process.

1.  Defining the multiple. The first check on a multiple is the consistency of its definition, i.e. if the numerator of the multiple is an equity value, the denominator has to be an equity value as well. Same goes for firm / enterprise values. The second check should be on the uniformity of estimation of the multiple. If we are using multiple values of 15 firms, we need to be measuring the same thing. A common multiple used is the price-to-earnings ratio. However, the “earnings” portion of that multiple is an accounting number and we know the same accounting standards may result in different degrees of fidelity to those standards. The PE may use the earnings from the most recent financial year or the trailing twelve months. The earnings could be before or after the extraordinary items. The earnings may be primary, partially diluted, or fully diluted. What analysts use is simply the story they’re trying to sell. Similar problems persist with other widely used ratios such as EV/EBITDA. Accounting numbers pose a threat that companies with conservative estimates of earnings look expensive and aggressive ones look cheap.
   
   
2. Describing the multiple. This is an analysis where we find the basic statistical data like average and standard deviation. Most multiple data is asymmetrical. Most ratios such as PE, EV/EBITDA are positive for healthy companies. So the minimum is pegged to zero. But PE ratios may be as high as 100 or even 300 for some companies due to which the averages get pulled out by large positive outliers. Hence the median makes more sense while talking about a multiple. Also, when such ratios are negative, we need to drop the companies from our data-set. As of 30 Nov 2018, 21% of Indian listed companies had a negative PE ratio. That’s losing a lot of data. Also, we are creating a bias in the sample by ignoring the smallest, riskiest, and most troubled companies.
   
   
3. Drivers of multiple. The questions we’re trying to answer here are (a) what are the variables that determine this multiple and (b) how does the change in those variables change the multiple. Again taking PE ratios as an example. We know that high growth companies have high PE ratios. So what is the change in PE for a 1% change in growth? If we can’t answer this question, then we cannot scale our multiples for our specific companies. The simplest way to do that is to use a stable growth dividend discount model for determining the price, and then substitute the mathematical term for the price in the relative valuation multiple.
   
   
4. Apply the multiple. To apply the multiple we need to find out the comparable companies. The lazy way of doing this is to compare companies in the same sector. Reliance is a refinery but is there any refinery company that is remotely close to Reliance? From a valuation perspective, a comparable company is one with similar cash flows, similar growth, and similar growth. There is no need to consider a sector. However, no matter how careful are, there will be differences between the target company and sample companies. We need to find creative ways of controlling for those differences. For example, since high growth companies have high growth rates, we may divide the PE ratio by the growth rate which is called the PEG ratio.

 So one needs to be creative about Relative Valuation. Don’t just compare multiples with the average for the sector. We need to consider the data, look across the sector, and not throw away information. Some statistical analysis enables us to make better judgments about why differences in companies translate into differences in multiples. If we’re able to do that, multiples are excellent tools to have in the arsenal.