Stock Valuation, Market Mechanics, and Risk Management
Understanding Stock Valuation
A stock is worth the present value of its expected future income. Using the dividend growth model, that future income is primarily future dividends. The formula is: Stock Value = Present Value of Future Dividends.
Calculating Total Return
A stock provides returns in two ways:
- Dividend Yield: Cash paid by the company while you own the stock.
- Capital Gains Yield: Profit earned if the stock price increases.
Total Return = Dividend Yield + Capital Gains Yield
Example: If the beginning
Read MoreFinancial Derivatives: Functions, Risks, and Pricing
Derivatives are financial contracts whose value is derived from an underlying asset such as shares, commodities, currencies, or indices. Common derivatives include futures, forwards, options, and swaps.
Economic Significance of Derivatives
- Risk Management (Hedging): Derivatives help investors and companies protect themselves from price fluctuations and reduce financial risk.
- Price Discovery: They help determine future expected prices of securities through market demand and supply.
- Increase Market Efficiency:
Essential Trading Terms and Financial Market Concepts
Core Market Terminology
- Spot Price: The current market price at which an asset (stock, currency, commodity) can be bought or sold for immediate delivery/settlement. Also called the “cash price.”
- Bid Price: The highest price a buyer is willing to pay for a security at a given moment.
- Ask Price (Offer Price): The lowest price a seller is willing to accept for a security. Bid-Ask Spread = Ask − Bid.
- Lot Size: The minimum number of units/shares in one futures or options contract. In India, lot size is
Financial Markets, Intermediaries, and Fixed Income Assets
Markets, Intermediaries & Financing Instruments
Money Markets vs. Capital Markets
| Feature | Money Market | Capital Market |
|---|---|---|
| Maturity | < 1 year | > 1 year |
| Instruments | Promissory notes, treasury bills, credit lines, commercial discounts | Bonds, stocks, fixed-term loans |
| Purpose | Finance working capital | Finance fixed asset investments & expansion |
| Liquidity | High | Lower |
| Credit Risk | Relatively low | Higher |
The 3 Channels of Market Operation
- Organised institutions: NYSE, regional exchanges, regulated markets
- OTC market: Brokers
Capital Budgeting and Bond Valuation Formulas
Capital Budgeting Metrics
- NPV: NPV = -C₀ + CF₁/(1+r)¹ + CF₂/(1+r)² + … + CFₙ/(1+r)ⁿ. Accept if NPV > 0.
- IRR: The discount rate where NPV = 0. Accept if IRR > r.
- Payback: Years to recover initial investment. Discounted Payback uses discounted cash flows.
- PI: PI = PV(future CFs) / Initial Investment. Accept if PI > 1.
- MIRR: Solves PV(outflows) × (1+MIRR)ⁿ = FV(inflows).
Decision Rules and Conflicts
- NPV vs IRR: Use NPV for mutually exclusive projects or differences in scale/timing.
Financial Decision Making and Capital Optimization
Capital Structure and Share Valuation
First, I check the shares mentioned.
| Debt Ratio | Asset | Debt | Equity | NS Shares |
|---|---|---|---|---|
| % Provided | $ Finance Your Company | Ratio x Asset | Asset – Debt | Equity / Shares |
Earnings and Return Metrics
| Interest | Interest Expense | EPS | Expected EPS | Expected Return |
|---|---|---|---|---|
% Provided. Examples:
| Interest x Debt | NPAT / N Shares | Same as EPS | % Provided |
Risk and Variance Calculations
| Price per Share | Standard Deviation | Coefficient of Variation |
|---|---|---|
| EPS / Expected Return | EPS |