Month: October 2022

Introduction

Investing in today’s world provides you with a plethora of options. 

People invest in stocks, gold bonds, provident funds, fixed deposits, invest in companies with stocks and shares, and much more. 

Investing in an Indian company or a foreign company is one of the most commonly used methods. 

A variety of investments are made by investors in India who are governed by certain sets of rules and regulations provided under the Securities and Exchange Board of India (SEBI) rules, Companies Act, 2013, and Company Act rules. 

Due to the difficulties faced by these rules, people tend to invest indirectly through investment institutions rather than investing themselves.

One of those investment institutions happens to be in QIB.

QIB full form means Qualified Institutional Buyers.

Let us dig more into the meaning of Qualified institutional investors and understand them in detail:

Regulated definition of Qualified institutional buyer (QIB) 

The definition of Qualified Institutional Buyer provided by the Securities and Exchange Board of India (SEBI) is as follows:

“Qualified Institutional Buyers are those institutional investors who generally seem to possess the expertise and the financial muscle to judge and invest in the capital markets.”

In terms of clause 2.2.2B (v) of DIP Guidelines, a ‘Qualified Institutional Buyer’ shall mean:

1. Public financial institutions as defined in section 4A of the Companies Act, 1956,
2. Scheduled commercial banks,
3. Mutual funds,
4. Foreign institutional investors registered with Securities and Exchange Board of India (SEBI),
5. Multilateral and bilateral development financial institutions,
6. Venture capital funds registered with Securities and Exchange Board of India (SEBI),
7. Foreign Venture capital investors registered with Securities and Exchange Board of India (SEBI),
8. State Industrial Development Corporations,
9. Insurance Companies registered with the Insurance Regulatory and Development Authority (IRDA),
10. Provident Funds with a minimum corpus of Rs.25 crores
11. Pension Funds with a minimum corpus of Rs. 25 crores.

Any entities falling under the categories specified above are considered as QIBs to participate in the primary issuance process; there is no specific requirement to be registered with the Securities and Exchange Board of India (SEBI) as QIBs. 

The insertion of the definition of “qualified institutional investor” enables the identification of a class of “qualified institutional investors”.

Qualified institutional investors (QIBs) make the payment on the allotment. This is an international practice. Once QIBs commit, they can’t go back on it.

What are Qualified institutional buyers (QIBs)?

The Securities and Exchange Board of India (Securities and Exchange Board of India (SEBI)) has introduced the concept of QIBs where Indian companies of varied sizes are looking to expand their operations faster. Qualified Institutional Buyers are those institutional investors who generally seem to possess the expertise and the financial muscle to judge and invest in the capital markets.

A qualified institutional buyer participates by investing in the appropriate institutional setting (QIP) of the issuing company. QIP is a system in which listed companies collect money on securities from corporate clients. 

Securities and Exchange Board of India (SEBI) registered bank dealer on behalf of the institution’s clients actively manages the allocation to QIP. 

Also, these bankers facilitate investments in compliance with the requirements set out in Chapter VIII of the Securities and Exchange Board of India (SEBI) (ICDR) Regulations, 2009.

Overview of rules and regulations governing Qualified institutional buyers (QIB) in India.

Typically, a qualified institutional buyer has less regulation and lower processing. However, some laws and regulations monitor how QIBs can operate. The following are some of the QIB rules –

• Any listed company that is eligible to raise funds in the domestic market can place its collateral on QIBs.

 However, the stocks of this listed company should be available for trading. Also, the minimum public shareholding pattern must also be complied with. Therefore, such entities may be able to raise funds through a channel of qualified institutional buyers. Also, these guidelines apply to securities in the form of shares equal to any other collateral other than guarantees. 

They can be converted or exchanged for equity shares at a later date (within six months of the allotment date). Therefore, these securities are known as ‘specified securities’. At the time of allotment, they are fully paid.

• These guidelines also specify the aggregate amount that companies can increase by QIB by the issuer. 

In a financial year, the accumulated value cannot exceed five times the total amount of the issuer at the end of its previous financial year. In addition, it has issued guidelines to control the prices of these said securities. 

The lower price of these quoted securities can be determined in the same way as GDR / FCCB issues. Any adjustments may be made through company actions such as bonus issues or pre-existing rights to existing shareholders.

• The Securities and Exchange Board of India (SEBI) guidelines also specify who can be investors or assigned to these securities. 

Securities and Exchange Board of India (SEBI) guidelines state that if the QIB registers them, then such institutional buyers may not be able to promote or relate to the provider’s developers directly or indirectly. 

In addition, all placements in QIBs are based on private placement. 

Other Regulations for Qualified Institutional Buyers (QIB) in India

• The Securities and Exchange Board of India (SEBI) gets merchant banks registered under its regulation and such merchant banks carry Qualified Institutional Placements (QIPs). 

They use integrity and it is mandatory to submit a certificate of due diligence to the stock market. This certificate ensures that all the provisions and requirements provided by Securities and Exchange Board of India (SEBI) are complied with.

• In the case of most of the stated securities, there must be a six-month gap between the two deposits. Also, the manufacturer and seller of the bank must submit all reports, documents, and obligations to obtain approval from the stock listing of these securities. 

However, for QIPs and special assignments, it is not mandatory to submit these documents. In addition, the issuing company may offer up to a 5% discount on QIPs, but this discount can only be granted after the approval of existing shareholders.

What are the advantages and disadvantages of Qualified institutional buyers (QIB)?

There are several merits and demerits to being a Qualified Institutional Buyers and they are as follows:

Pros of Qualified Institutional Buyers (QIB):

There are several benefits of investing through Qualified Institutional Buyers and they are as follows:

Takes lesser time

One of the most important advantages of Qualified Institutional investors is that it requires less time as there is no requirement of documentation approval by the Securities and Exchange Board of India (SEBI). The whole process can be completed in just 4 to 5 days.

Cost-effective way

This is a less costly process because it needs no appointment of bankers, advocates, auditors, and lawyers to obtain approval.

Large trading

QIBs can buy large stakes in a company when they have the benefit of going out and selling the stock at any time listed in the post.

Cons of QIB

But there is also a flip side to investing through QIB:

Qualified institutional buy allows institutional buyers to buy a major stake in the companies. As a result, it may result in the reduction of  the rights of the current shareholders of the companies. 

List of Qualified institutional buyers given by Securities and Exchange Board of India (SEBI)

The list provided by Securities and Exchange Board of India (SEBI) is as follows:

1. Public financial institutions as defined in section 4A of the Companies Act, 1956,
2. Scheduled commercial banks,
3. Mutual funds,
4. Foreign institutional investors registered with Securities and Exchange Board of India (SEBI),
5. Multilateral and bilateral development financial institutions,
6. Venture capital funds registered with Securities and Exchange Board of India (SEBI),
7. Foreign Venture capital investors registered with Securities and Exchange Board of India (SEBI),
8. State Industrial Development Corporations,
9. Insurance Companies registered with the Insurance Regulatory and Development            Authority (IRDA),
10. Provident Funds with a minimum corpus of Rs.25 crores
11. Pension Funds with a minimum corpus of Rs. 25 crores.

Conclusion

The idea of Qualified Institutional Buyers has become a common way of raising money in India.

Firstly, there is a benefit to the issuer as another, the time taken to complete the QIP is much shorter than the public shareholder as there is no need to wait long for document approval by the Securities and Exchange Board of India (SEBI) and the whole process can be completed promptly. 

It is less expensive as there is no need to hire a large team of bankers, lawyers, lawyers, and auditors to get permits. 

Introduction

The put-call ratio helps the traders to calculate the market mood before the market turns. Reading put-call ratio charts is vital since the changes it shows are well-defined predictors of future market action. Most traders utilise the put call ratio indicator as a generally accurate market direction indicator.

For F&O traders, the Put Call Ratio is a frequently utilised measure. It is most important to learn how to calculate the put-call ratio for stocks. So without any further ado, let’s deep dive into it.

What is put call ratio – An explanation

A right to sell an asset at a fixed price is known as a “put”. The right to purchase an asset at a fixed price is known as a “call”. Investors frequently use the put-call ratio as a metric. PCR determines the market’s general attitude. 

A spike in negative sentiment indicates when traders are purchasing more puts than calls. They may expect a market crash if traders purchase more calls than puts.

Based on trading volumes, the put-call ratio helps traders and investors decide when to trade. It considers the present value of all open positions or the volume of options trading for a given period. 

Traders often purchase more calls than puts, resulting in a PCR ratio that is typically smaller than one. Put-call ratios can be calculated. Generally speaking, combining potential outcomes is a bad idea. Index options are the primary ones used during the PCR.

Individual traders often individually calculate gold, agricultural commodities, currencies, and other futures contracts’ put call ratios. One may attempt to filter his input. For example, the index put-call ratio should only contain index options traded on U.S. exchanges. The more heavily traded options contracts produce a more reliable PCR (equity options and index options are very liquid). It generates misleading results for some time.

Stock options, traders, and investors nearly always purchase more calls than puts. Because of this, the equity put-call ratio is often smaller than 1. Numbers of 1.00 or higher can appear on extremely bearish days. Typically, a ratio of 0.50 or 0.60 results from an ordinary day. However, index options result in significantly higher ratios. Several institutional and other investors ask for the index input that contains a reasonably compensated level of risk. As a result, companies buy much more index puts than equity puts.

Strike Cost

The strike price is also referred to as per strike. It is the most accurate way to determine the call and put options when trading illiquid assets and it is done by dividing the total open interest in put contracts at the same strike price and expiration date on a particular day by the total open interest in call options. It is the cost at which assets are bought and sold (put option) (call option). Retail traders utilise this metric because illiquid options typically have lower trading volumes.

The volume of Trading

To calculate the trading volumes for put and call options on a fixed asset, traders consider the strike price and expiration date. From a greater viewpoint, it is a significant signal for directional price fluctuations. Trading is predicated on what the majority of strike prices imply (bearish or bullish).

Active Interest

Open interest or outstanding contracts provide a clear picture of market behaviour. Investors can assess trade volume in the put and call options over a certain time frame by using it in connection with the PCR indicator. A rise in open interest indicates that the market is receiving money. Its drop suggests that money is leaving the market.

Interpretation of PCR

There are several ways to interpret the ratio once it has been established. All philosophies are of the contrarian variety. Therefore the general observations that high ratios are bullish and low ratios are bearish remain true. When defining precisely what is “high” and “low,” there is, nevertheless, some room for interpretation.

According to one school of thought, absolute ratios should be employed. For example, “if the 10-day moving average of the equities put-call ratio is greater than 0.65, that is a buy signal.” Unfortunately, there are times when using absolute numbers to compute any of the ratios might backfire. If the market continues to decline, more and more puts will be purchased, raising the ratio until it begins to fall back to normal levels. As a result, it is best to wait for the ratios to form a reasonable peak or low before sending a buy or sell signal. This interpretation is more dynamic, allowing buy and sell signals to arise at different absolute PCR levels.

1. Interpreting the Number

• A PCR formula below One (1): Investors who purchase more call options than put options speculate on an upcoming bullish trend.
• If the PCR formula is more than one (>1): It indicates that investors are betting on a future downward trend and are purchasing more put options than call options.
• Investors are probably purchasing the same number of put options as call options while the PCR is at one (=1), which indicates a neutral trend.
• Investors consider PCR below 0.7 strongly bullish, whereas they interpret PCR above 1 as strongly bearish. However, investors think no PCR is perfect.

2. Investment style

• PCR is seen differently depending on the investor’s investing strategy. Consider the following two investment strategies. 

• A momentum investor may view a high PCR as a negative indicator and a low PCR as a bullish signal.

• Because the PCR depends on the investor’s investing strategy, there is no correct way to understand it.

Limitation of Put Call Ratio

A non-average PCR indicator is quite volatile. It generates a lot of incorrect or inappropriate signals. Many of these signals may be filtered using an averaged Put/Call Ratio; the drawback of averaging is that trade indications appear later in the movement. Additionally, the acute levels are never settled. The Put/Call chart allowed traders to see which overbought levels historically led to reversals. Besides, traders must have faith that level will result in a similar outcome over a longer duration. For some traders, using complete PCR is the easiest option. However, traders must be aware of inherent biases and modify their extreme levels if employing the Equity or Index Put/Call Ratio separately.

Contrarian Indicators

A contrarian indicator indicates that the expert views things differently from the general view. For example, the market will rise if multiple financial advising companies make critical statements. Therefore, a contrarian indicator may be developed by monitoring the opinions of financial advisory services and taking opposite action when they reach a strong majority opinion. The reason for a successful signal indicates everyone who announces themselves to be bearish has likely already finished their selling before letting everyone know their view. Therefore, when virtually everyone is bearish, it indicates nearly everyone has completed selling. There are only buyers left, and markets frequently grow.

Investors frequently assess current ratio values against the long-term average to see whether sentiment has recently altered. Traders may take a rapid increase in the put-call ratio as a sudden spike in bearish attitudes and take appropriate action if the ratio has been changing in a small range.

How to use and calculate put call ratio

The put-call ratio means dividing the total number of put options traded by the total number of call options traded. The put-call ratio is the proportion of open interest or trading volumes for put-and-call options over a certain period. One denotes a neutral market, whereas one or less denotes a bullish market. More than one shows hedging emotion.

When the put call ratio is 1, there is the same number of call buyers as put purchasers. A ratio of one is not a good starting point for measuring market sentiment because there are typically more people purchasing calls than buying puts. As a result, the stock’s average put-call ratio of 0.7 is a perfect way to start when gauging mood.

• A rising put-call ratio indicates that equities traders are purchasing more puts than calls. 
• It also indicates that the market is becoming more hostile and bearish. In this situation, investors bet on a market drop or prepare their portfolios for a sell-off.
• A declining put-call ratio, especially anything less than 0.7 and nearing 0.5. indicates a positive indication. It demonstrates that traders purchase more calls than puts.
• Investors can assess market mood before market changes by using the put-call ratio. However, it’s crucial to consider both the denominator (the puts) and the numerator’s (demand) (the calls).
• The ratio’s denominator contains the number of call choices. As a result, a drop in the number of traded calls will increase the value of the PCR. This ratio number is critical because investors may increase the ratio by purchasing fewer calls rather than more puts.
• In other words, the ratio does not climb if a large proportion of puts are acquired.
• As a result, there are more bearish traders in the market, while bullish traders remain on the sidelines. Bullish traders may be anticipating what will happen before a significant event.
• The events can be an election, a Fed meeting, or the release of economic data, rather than signalling that the market is pessimistic.

Formula for Put Call Ratio

We have two techniques to compute the PCR formula, as described in the calculation section.

1. Put Call Ratio is calculated as follows: Put Volume divided by Call Volume. The ratio will be equal to 1000/2000, or 0.5, for instance, if the number of puts started in the market is in the range of 1000, and the number of calls initiated in the market is 2000.
2. Put Call Ratio is defined as the product of all open puts and all open calls. The put call ratio, in this scenario, will be 2.5/5 = 0.5 if the total open interest in puts is 2.5 and the total open interest in calls is 5.0. We will try to grasp what these values mean to you in part after this one. Or, to put it simply, the information you can get from the computations.

PCR and Implied Volatility Together (IV)

• If the PCR rises as the IV rises, it means that put activity is rising with a greater awareness of risk. That indicates a negative trend.
• If the PCR rises as the IV falls, it means that put activity is rising while the perception of risk is decreasing. This indicates a bullish trend and increased put writing.
• The unwinding of puts is reflected in the PCR and can be viewed as a hint that the markets may be bottoming out if the PCR falls along with a drop in IV.
• Puts are only being covered, and the markets will collapse once the covering is complete if the PCR declines with an increase in IV.

Significance of put call ratio

The put-call ratio is a unique financial method that analyses options trading volumes to determine the mood of the market.

Call options trading volume is expected to grow before market price rallies. Simultaneously, trade activity in put options is anticipated to grow before the market price falls.

Trading signals for the put-call ratio typically conflict with recent market trends. As a result, investors who aggressively trade against the market might create positions that the market as a whole might not be aware of.

A new wave of put options on a company, for instance, may appear in response to a weak corporate earnings report. As a result, the PCR ratio may increase and send the market bearish trading signals.

Bottom line

An excellent gauge of market mood is the put call ratio. The chance that the market will perceive a substantial price event in the future of the security increases with the put-call ratio’s distance from parity. A put-call ratio is a great tool for discovering and categorising potentially successful transactions since day traders are continuously searching for securities that have the potential for sudden abrupt price swings. 

The put-call ratio is best utilised as a component of a larger set of market mood indicators because it is relatively unclear and open to many different interpretations of metrics. Additionally, a deeper investigation of each possible transaction is necessary since market sentiment in general is insufficient on its own to find lucrative deals. 

The put call ratio indicator is not particularly useful in sideways markets. It is useful at market peaks, but occasionally with some delay. Like many other indicators, the PCR is not entirely reliable on its own. When combined with volume, volatility (VIX), support/resistance levels, trendlines, moving averages, and other technical indicators, the PCR may provide useful insights about market mood and when a reversal may be imminent.

Introduction

To run a company is an expensive job; before it can earn any revenue, it has to pay many expenses incurred. One such expense is an operating expense. Operating expenses help keep the business running. It is also vital for analysing a company’s operational performance. Some examples of operating expenses include payroll, inventory costs, insurance, travelling expenses, rent, bank charges, and legal fees. These expenses are listed in an Income Statement under Selling, General & Admin Costs (SG&A), and Cost of Goods Sold (COGS). 

These expenses are not directly linked with the production of goods or services. If a company can control its operating expenses without ruining its product, then it can retain more cash in its business.  

What is an Operating Expense?

Let’s discuss operating expenses meaning. A company incurs a cost for performing its operational activities known as an operating expense or OMEX.  The operational activities of a company are its key commercial activities for generating revenue. An operating expense is an unavoidable expense. Since this expense does not directly link with the production of goods or services, they do not directly impact the product’s price or quality. You can find operating expenses in the company’s Income Statement. You can review the general ledger for expenses that do not directly affect the cost of creating a product or service. 

Operating expenses are different for every industry. They are listed under Selling, General & Admin Expenses (SG&A). Some operating expenses are office supplies, salaries & wages, maintenance & repairs, advertising & marketing, etc. 

Operating expense examples

What is a Company’s Operating Activity?

The operating activities are revenue-producing and cover a company’s core business activities. Operating activities include both operating revenues and operating expenses. They also provide a good portion of cash flow and determine whether a company is profitable or not. However, they are different from investing or financing (issuance of bonds) activities of a company that helps it optimally function over the long term. An operating activity differs from industry to industry. 

For example, Buying a building may be an investing activity for any industry. However, purchasing a building for resale is an operating activity for a real estate company. 

Importance of Operating Expenses

• Vital for analysing the operational performance of a company. 
• It helps firms reduce operating expenses to increase earnings and gain a competitive advantage.
• It helps identify the company’s recurring expenses that are not important for business operations so that the necessary adjustments can be made. 
• It helps to measure cost and stock management efficiency. 
• Analysis of financial records where revenues and costs are recorded most precisely is beneficial for management. They can identify and modify unjust spending and make decisions accordingly. 

Calculation of operating expenses

A company calculates operating expenses or OMEX to identify recurring costs other than raw materials and direct labour used in the manufacturing process. Adding all the expenses together, you get the company’s operating expenses for an accounting period. Once you know your operating expense, you can calculate the operating expense ratio (OER). The OER helps directly compare income with expenses; therefore, you can compare your business with others. Operating expenses calculation can be done by a simple formula. 

Operating expense formula or operating expense ratio (OER): COGS+OPEX/Revenues

Operating expense calculation (OER) = $50000+$60000/$250000 = 0.44

Compare your OER to the industry benchmark to analyse if it’s good or bad. An increasing OER signals a decline in the operating efficiency of the business. So, watch out for the operating expense ratio from time to time. You can calculate total operating expenses by this formula:

Operating expense= Salaries & wages + Insurance Expense + Rent + Repairs & Maintenance + Travel + utilities + Supplies 

Operating ratio vs Operating expense ratio

It’s easy to get confused between the two. The operating expense ratio is for the real estate industry, and it measures the cost of the property against the income it generates. It helps to compare expenses of similar kinds of properties. 

The operating ratio compares the company’s total expenses against revenues or net sales generated. The operating ratio helps to analyse companies in different industries. 

What is preferred, CAPEX or OPEX?

From an income-tax perspective, companies typically favour OPEX over CAPEX. For example, rather than buy computers and laptops directly for $800 apiece, a company may choose to lease them from a vendor for $300 apiece for three years. This is because buying a piece of equipment is referred to as a capital expense. Now, even though the company pays $600 for the equipment, it can only deduct $250 as an expense in that year.

On the other hand, the total amount of $300 paid for leasing to the vendor is an operating expense because it was incurred as part of the daily business operations. The business can, therefore, deduct the cash it spent that year.

The benefit of deducting expenses is that it lowers income tax, which is levied on net income. Another benefit is the time value of money, i.e., assuming that the cost of capital is 5%, then saving $100 in taxes this year is better than saving $104 in taxes next year.

However, tax may not be the only consideration. If a public company wishes to boost its book value and earnings, it may choose to make a capital expense and only deduct a small part of it as an expense. This will result in a higher asset value on its balance sheet and a higher net income that it can report to investors. 

How to cut operating expenses

Here are some ways for small business owners to reduce their operating expenses.

• Take advantage of discounts by paying invoices early. 
• Work from home or find a less costly place to reduce utility and rent costs. 
• Cancel all unused subscriptions.
• Reduce travel costs by finding a cheaper alternative like video conferencing. 
• Automate or outsource tasks like bookkeeping, human resources, and payroll for extra efficiency.
• Find a freelancer for infrequent demands. 
• Benefit from internship program to lower operating costs. 
• Setup a bidding method for projects and compare who is willing to work for you at the lowest price. 

What is the operating margin?

An operating margin or return on sales (ROS) represents how much profit a company makes through its core operations. It is calculated by dividing operating income by net sales. The higher the ratio, the better a company is in illustrating that it is efficient at turning sales into a profit. It tells that a part of the revenue can cover the non-operating expense. The company’s past operating margins can tell investors and lenders if the company’s performance is getting better or not. 

However, it can be improved through efficient use of resources, better management control, effective marketing, and improved pricing. 

Operating Margin = Operating Earnings ​​/ Revenue 

Types of Operating Expenses

There are various types of operating expenses. Operating expenses fall under Selling, General & Admin Expenses, and COGS. Let’s discuss all of them in detail. 

• Operating expenses under SG&A

Traveling expenses

These are charged in Profit & Loss as Travelling expenses. When the staff travels for an event, supplies, or to meet clients, the company pays travelling expenses or reimburses them for conveyance. 

Utility expenses

These are charged in the Profit & Loss account of the company. All the utility bills like water and electricity used for daily operating activities are considered utility expenses. 

Telephone expenses

Charged under the P&L account, these expenses are incurred on mobile phones, internet, and landlines. Companies also reimburse employees for telephone expenses. 

Office supplies

These are day-to-day expenses incurred on purchasing office supplies like pens, papers, folders, files, clips, etc. 

Property tax

Companies have to pay property tax on their properties. It is also an operating expense. 

Bank charges

Banks charge fees for the general transactions that happen in the business, such as transaction charges for cheques, etc. 

Research expenses

A company does a lot of research on new products, and the expenses incurred on the research are treated as research expenses. They are recorded under the P&L account. 

Office admin expenses

It includes daily expenses like stationery, cleaning charges, petty cash, transport, etc. 

Direct material cost

The direct material used to make the product is treated as direct material cost. It is a direct, unavoidable cost that is paid regularly. 

Advertising expenses

Advertising expenses help increase sales as it promotes and advertises the product. However, this operating expense does not include a company’s trade discount to its customers. 

Repair & Maintenance Expenses

The asset that is used for production undergoes regular repair and maintenance. Such operating expense is treated as repair and maintenance expense. It includes repair of vehicles or machinery, etc. 

Sales expenses

These are costs incurred for selling the product and increasing the sales like a discount on sales, sales commission, etc. 

• Operating expenses under Cost of Goods Sold (COGS)

The cost of goods sold is the cost that is incurred for products or goods sold by the company during a specific period. 

Depreciation expenses

A tangible asset is prone to wear and tear. Such a reduction in the cost of an asset is treated as a depreciation expense and falls under COGS. 

Product cost

Product costs are incurred to make the product to sell it to the customers. It includes direct material, direct overhead, and direct labour. 

Freight in & Freight out Cost

The shipping cost for the purchase of merchandise is the freight-in cost. It is considered a part of the merchandise cost. However, if the merchandise is not sold, it is considered in the inventory. 

The cost of the transportation is the Freight-out cost. It includes delivery of the goods from suppliers to customers. 

Rental cost

The properties that provide support for the production are eligible for rental costs — for example, salaries, wages, other benefits given to staff for producing goods, etc. 

• Compensation-based operating expenses

House rent allowance

It is an allowance given to the employee by an employer for staying in a rented house. It is a part of the CTC and can be claimed. 

Salaries

It is one of a company’s key fixed expenses to pay its employees’ salaries. It also includes provident fund, pension, gratuity, etc. 

Operating vs Non-Operating expense

Now that we have discussed operating expenses, we also need to about its counterpart, i.e., non-operating expenses. It is important to understand how operating and non-operating expenses differ. 

Conclusion

Analysing operating expenses gives an accurate picture of the company’s financial position and provides a better comparison with competitors. A low OER, i.e., Operating expense ratio, allows a company to expand in the future. Generally, when a company is new, its OPEX will be quite high since they have to spend on human resources, infrastructure, and marketing expenses heavily. However, this ratio tends to shrink when the company starts generating significant revenues. Similarly, at the time of liquidity, OPEX plays a crucial role in decision-making. The departments that incur higher OPEX possibly shut down while the departments with lower OPEX continue.  

Introduction

The paths you can take to invest in your future are endless. There are many publicly traded stocks to choose from, several types of investment options, and plenty of opportunities to invest on your own or with the assistance of a financial advisor. In short, investors should follow no set formula or path to achieve their expected numbers except for one: investing for the long term.

Investors who attempt to time the market or do short-term day trading cannot take advantage of the advantages of long-term investing. Here we will understand how long-term stock investments help us gain long-term profits.

What are long-term investments?

Long-term investments can be defined as an investment that an investor holds for more than 12 months. These can also be in investment in shares. Unlike short-term investments, where investments are most likely to be sold in a short period, long-term investments will not be sold for at least one year from the date of investment. In some cases, investors may also choose never to sell them. 

How do long-term investments work? 

Investors generally choose long-term investments when they have excess capital that they can afford to keep invested for a long time. Investing in stocks for the long term also requires a lot of patience as the holding period can extend to decades.

Long-term investments do have the potential to generate excellent returns due to the power of compounding. The longer an investor stays invested in the stock, the higher returns the stock will be able to generate. Retirement planning is one of the key reasons most individuals have an investment portfolio.

If started early, individuals would have enough time until retirement to assemble a significant pre-retirement portfolio. This is due to the folding force.

Market fluctuations and other market-related risks such as inflation and downturns generally get offset by the rupee compounding over the long term. This will allow investors to generate an overall higher return in the end.

Advantages of Long-term investing in stocks

• The data shows that you will almost always be right

Historically, if you align your portfolio over the long term, you are more likely to make money. Although the stock has a roughly 50-50 chance of going up or down if we go by just the probability of happening two events, the stock can only go down to Rs. 0, but it can go up indefinitely. If you let your winner stocks go as high as they can, there’s a good chance you’ll see your portfolio grow in value over the long term, especially if you focus on investing in stocks of high-quality businesses.

• Compounding works in your favour

Staying invested in stocks for the long term allows you to take advantage of compounding or the ability to reinvest your profits (e.g. dividends) over time to create even greater profit potential. Time is your best friend as an investor, and being able to reinvest a 3% dividend can make all the difference to your wealth after retirement. For example, simply pocketing a 3% yield will double your money approximately every 33 years, assuming no growth in dividends or stock prices. If you reinvested back into multiple shares of the same stock, your investment would double in almost 10 years!

• It is easy for everyone

One of the greatest aspects of long-term investing is that anyone can do it. It doesn’t take Rakesh Jhunjunvala to pick a well-run business portfolio and hold onto it for 10, 20, or 50 years. Sure, you won’t always be right, but don’t worry, even the greatest investors are wrong a third of the time – or more. But with long-term investing, there is no difficulty in learning different trading styles or platforms because you will not be an “active trader”.

• You will sleep better at night

One of the most beneficiary things about being a long-term investor is that being long-term investor helps you sleep better at night. You won’t have to wake up every day at the opening bell and check whether your portfolio has sunk or exploded overnight. It is likely that the companies you want to invest in for the long term are high-quality companies and, therefore, will have a relatively low propensity for volatility. Finding dividend-paying stocks that other long-term income investors are looking for is usually a good way to keep portfolio volatility low and stress levels minimal.

• It’s easy to fix your investment mistakes

Remember the point above about everyone making mistakes at some point in the stock market? One important aspect of long-term investing is that it allows you to correct some or all of your mistakes. That doesn’t mean you should be picking up any stock you come across in the hope that your losing stock is heading higher. It means continuing to stick with companies that have demonstrated strong growth and perhaps joining companies whose business models are still intact but have fallen temporarily facing hard times. Riding the winners over the long term tends to correct many, if not all, of the “investing mistakes”.

• Commissions are an afterthought

When you are an active trader, commission costs can play a big role in your trading strategy. It’s not uncommon for intra-day traders to burn through thousands of rupees in commissions each year. As a long-term investor, you don’t have to worry about commission every day, or even a few dozen times a year when you add to your positions or maybe sell a stock once in a while. Commissions are a complete afterthought for the long-term investor, as their profits, in the long run, can easily offset the commissions paid.

Taxation of gains on the sale of long-term stocks

Long-term capital gains (LTCG) on the sale of listed shares became taxable from April 1, 2018. In the case of investing in shares, long-term means a holding period of more than one year from the date of purchase. Long-term capital gains are gains from the sale of listed shares.

Before the Union Budget 2018 amendment, LTCG earned on the sale of shares in the hands of investors was exempt from tax. These shares were already subject to Securities Transaction Tax (STT).

Only short-term capital gains were taxed at 15%. The objective of exempting LTCG from tax was to increase investors’ participation in India’s stock markets. Thanks to the exemption, investors began to see stocks as a profitable investment tool. However, LTCG on equity funds is taxable after the Union Budget 2018.

Long-term capital gains (LTCG) above Rs 1 lakh from listed shares in a financial year are taxed at 10% without the benefit of indexation.

How to Invest in the best long-term stocks? 

Investors are often advised to invest in stocks for the long term to reap the benefits of compound growth. The power of compounding is an important concept to understand and truly get the benefits of long-term investing. Compounding is similar to the multiplier effect, as the interest that is earned on the initial capital also earns interest, and the value of the investment grows at a multiplicative rather than an additive rate. The higher the rate of return, the steeper the growth and wealth creation curve. To give an example, an investment of just ₹ 1 lakh in year 1 at 10%, invested for 20 years, can compound to ₹ 6.72 lakh, giving a phenomenal return on capital of 672%.

Companies operate with the primary goal of making a profit and strive to continuously increase this profit. However, the various strategies and decisions they make shape their growth path in the process. This factor distinguishes good companies from bad, profitable from unprofitable. Profitable ones generate significant returns for their shareholders.

Company growth comes not only with scale but with operational efficiency, and that is a gradual process. The strategies adopted by the management make or break the growth path, and as investors, we must always study the company’s business model. It is also essential to have a macro perspective when managing a business and keep in mind various factors such as government policy, interest rates, and stakeholder claims (including debt and equity holders), among others.

The next part includes an assessment of the industry in which the company operates. An investor should assess how the industry will shape up to analyse whether there will be sufficient demand for the company’s growth in the future. For example, the dominant theme that has seen phenomenal growth is the FMCG sector. India is a developing country with strong growth prospects driven mainly by infrastructure and human capital development along with urbanisation in the country. As the country experienced growth in disposable income, the share of processed food consumption rose, and companies like Britannia benefited. If an investor had invested in Britannia at ₹196 per share in 2010, he would have made a 1940% return over 10 years. That’s the power of compounding.

So if an industry is expected to grow, a company in that sector with strong fundamentals will also prosper if all cards fall on the table. The company continues to grow on its capabilities and effective profitability as India continues to flourish in this theme.

Another growth success story is HDFC Bank. The financial sector has seen strong growth in India with banking penetration. As banking grew and formalised, banking stocks saw strong inflows and rose exponentially. HDFC Bank was part of this rally with an uptrend in its charts. Its revenues moved from ₹16,314 crores in 2010 to ₹1,22,189 crore in 2020, a growth of about 25% CAGR, while the stock moved from ₹210 per share to ₹1,385 per share, a rise of 6060% during the year, excluding dividends paid by the company.

These are examples of a company gradually growing to generate strong returns for its shareholders, and as an investor, you need to patiently be a part of this entire rally regardless of minor ups and downs. So when a company establishes its business and grows, the value of its stock increases, thus rewarding shareholders who stick with the company longer.

Factors to be considered before investing for long-term in any stock. 

• Evaluate the sector/industry segment of the company

An investor must first look at the sector in which the company currently operates. This is crucial to understand because a sector that has strong growth potential can offer higher growth in value to the investor in the long run. Strong growth potential can come from the ability to expand or penetrate further into the market, or both. If the industry also provides more room for price increases over time as it expands, this will only further benefit companies. An investor should also assess the number of participants in the sector and the intensity of competition to determine the growth opportunities and threats it may face in the future.

Some industries have low barriers to entry where it is easy to start a business and compete. If the sheer size of the industry has high growth potential, a larger number of players can coexist profitably. An example of this is the FMCG industry, where there are a large number of competitors offering a wide range of products, but the scale of penetration and expansion is large enough for multiple companies to coexist profitably. On the other hand, in a mature, low-growth industry, even a small number of players can have a huge impact on the profitability of their competitors.

• The industry’s potential to deliver value

Companies in highly competitive industries will experience greater pressure on their profit margins. Therefore, it is more beneficial to look for such companies that are climbing the ladder to become one of the top players in the given sector, can navigate the sector well, and secure strong finances despite the competition. Also, look for companies for which there is growth potential in the form of moving up the value chain in a low-growth sector.

For example, Telecom companies moving from voice offerings to data and related services not only created a new revenue stream but also expanded the entire sector and various other opportunities. Look for companies that can build sustainable competitive advantages against other industry players. Companies in high-growth industries tend to have better prospects than companies in mature industries. Finally, it should be considered that an industry with great opportunities is also likely to attract more competition. To determine the opportunity available, the balance between the two opposing factors of industry potential and competitive intensity must be assessed.

• Level of regulations

Investors need to check the level of regulation that goes into the sector. The primary reason for regulation is to protect consumer and government interests over corporate interests. This results in an erosion of value as the benefits that would have accrued to the company are transferred to consumers and the government, leaving very little for the company’s shareholders. An example of this is the coal industry in India. The industry was under strict regulation regarding mining and pricing and was monopolistic, with mining rights granted only to Coal India.

Another example is government-regulated energy companies. These companies cannot earn excess returns beyond the specified limits. Industries such as consumer goods, automobiles, paints, and electrical items can be easily manufactured and sold in India without any significant government regulation. The higher the regulatory handle, the higher the regulatory risk because the revenues and profits of such businesses are to some extent under the control of the government and can adversely affect value creation and growth.

• Dependence on the economic cycle

Any country’s economy moves in cumulative cycles with all other industrial cycles. As GDP grows, so do production, employment, and consumer incomes, increasing demand for products. Similarly, when GDP growth slows or declines, output, employment, and income fall. Sectors like airlines, cement, metals, infrastructure, housing, banking, and finance are examples of cyclical industries.

Industries such as consumer staples, information technology, and pharmaceuticals are relatively immune to economic cycles and therefore survive the stress of a down cycle for industry. Because of their relative resilience to economic cycles, these sectors are relatively more stable financial performers, and investors are typically willing to assign premium valuations to these firms because of their stability. Lower dependence on economic cycles also means that companies do not get stressed when the economy faces a downturn, providing some portfolio protection against these downturns.

• Quality of management

Among the most critical factors in evaluating a company is the quality of its management. Effective management teams see and overcome the industry’s various challenges and transform their business models towards more attractive industries and higher growth in enterprise value. Assess whether the board of directors and management are different from each other because the BOD is responsible for larger company decisions while management is involved in day-to-day operations. Thus, the corporate governance process involves balancing the relationships and interests between the board of directors, founders, management, minority shareholders, auditors, and other stakeholders.

Effective handling of this balance demonstrates the strength of corporate governance. The higher and better the company’s corporate governance standards, the better the company’s minority shareholders are protected and the more certain that management will act in the shareholders’ interest. This can be found by going through the annual report.

While there are many other factors that investors need to consider, the above are key factors to assess and find long-term wealth builders.

What are the limitations of trading in long-term stocks?

There is a flip side to investing in long-term stocks. The drawbacks of investing in long-term stocks are as follows:

• Blockage of the principal amount

Blockage of the principal amount leads to heavy distress for investors during the spell of contingencies. Withdrawal of principal amount untimely might cause significant losses. Hence it is not that feasible to invest, especially for the ones who are investing without any liquid funds in hand. Here, capital gets tied up.

• Due to the longer period, investors lose patience and panic

Impassive planning and short-patience investors find long-term investment to be ridiculous because of redundancy and unfaithfulness in market prices.

• Lack of liquidity

Since a lack of liquidity is created, investors find it concrete to survive because of an insatiable mindset, and these investments cannot be liquidated shortly, or else an ample amount of loss may be incurred on it.

Final Thoughts

While purchasing stocks in the long term, the company does not guarantee the return and marginal profits. It depends upon the market as to how the market reacts to the stock trade. If you have some money saved up, investing in long-term stocks can be one of the best ways to manage your risk and magnify your portfolio. 

If you find these long-term stocks expensive, finding some penny stocks with a high yield potential of around 100% or more would add the same to your pocket.

Investing here can be a great idea since the risk factor is low, and new investors focus on the same. However, investors should focus on stocks of small and mid-cap only if they have experience in that particular portfolio and are ready to bear some risk.

Thus, patience and money to invest are the two factors to yield a stable return from your investment.

Introduction

In India, equity shares are the most attractive investment option. When individuals invest in equity shares of a company, they accept the utmost profit or development associated with that business venture. When an investor decides to invest in stocks, bonds, stocks, or any other type of capital asset, including real estate, they do so with the expectation of making a profit. When the asset’s sale price exceeds its acquisition price, the sale results in a capital gain.

Capital gains are of two types: long-term capital gains on shares and short-term capital gains on shares. Here you will get a full explanation of LTCG, how to calculate it, and the tax implication in gains.

What are long-term capital gains?

Any profit generated from the sale of a qualified investment is considered a long-term capital gain. The period of long time capital gain is more than a year from the time of sale. It is calculated by subtracting the purchase price of assets owned for more than a year from the market price.

This profit represents the net profit made by investors when they sell their assets. Listed equity shares are acceptable investment options when it is held for more than a year after producing LTCG on shares. Privately held equity shares must be owned for at least 24 to 36 months to classify as a long-term capital asset.

Most investors choose to invest in long-term assets to maximise their return on investment. Because they provide tax benefits over earnings from short-term capital assets and enable long-term capital gains on equity shares.

Long-term capital gains tax rate

An individual who makes a profit from selling a capital asset that isn’t an inventory item is subject to capital gains tax. The sale of securities such as stocks, bonds, precious metals, real estate, and personal property typically results in capital gains. Not every country levies a capital gains tax. The majority of nations have distinct tax rates for both individuals and companies.

There are two sorts of capital gains taxes: long-term capital gains tax and short-term capital gains tax. Any asset kept for less than 36 months is considered a short-term asset for purposes of the short-term capital gains tax. Property cannot be sold or transferred within 24 months.

A long-term asset has been kept for longer than 36 months. Profits realised from the sale of these assets would be considered long-term capital gains and subject to tax as a result.

Assets like preference shares, stocks, UTI units, securities, equity-based mutual funds, and zero-coupon bonds are also categorised as long-term capital assets if they are kept for more than a year. According to the Income Tax Act of India, transactions involving any such capital asset are subject to taxation, as well as any additional surcharges that could be imposed on the sale.

Previously, the LTCG on equity shares was free from taxation under Section 10(38) of the Income Tax Act of 1961. To establish the tax ramifications of LTCG on the sale of equity shares, Section 10 (38) would be repealed and replaced by Section 112A, according to the Annual Budget of 2018. The long-term capital gains (LTCG) on shares are taxed at a special rate of 10% for gains beyond Rs. 1 lakh. In this instance, the sum does not take into account the benefits of indexation or the formula used to determine foreign currency capital gains for non-residents. Long-term capital gains are a considerably better investment choice than profits from short-term capital assets, which are taxed at a rate of 15%.

Long-term capital gains exemption

The basic exemption limit defines the amount of income below which an individual can avoid paying any tax. It also indicates that there will be no tax due if the taxpayer’s income is below the basic exemption limit. For the fiscal year 2021–2022, a person may only get the following basic exemptions:

• An Indian citizen who is 80 years of age or older and whose annual income is less than Rs. 5,00,000 is exempt from this tax.
• An Indian citizen aged 60 to 80 who earns no more than Rs. 3,00,000 annually is exempt from long-term capital gains tax.
• For people 60 years of age or younger, the yearly exempt amount from long-term capital gain tax is Rs. 2,50,000.
• These tax benefits are available to Hindu Undivided Families in India who make less than Rs. 2,50,000 annually. 
• Regardless of age, non-resident Indians (NRIs) are only exempt up to a total of Rs. 2,50,000 from long-term capital gain tax.

Imagine that the taxpayer could change the standard exemption amount for long-term capital gains. How does that operate? The steps are described below.

Only a resident individual or resident HUF may request a change to the long-term capital gain exemption limit. As a result, a non-resident person or HUF could not change the exemption ceiling for long-term capital gains. The short-term capital gain adjustment can only be made by a resident person or HUF after the other income has been modified. According to the Finance Act of 2020’s amendments, income other than long-term capital gains would be subtracted from the exemption limit before the residual limit could be subtracted from long-term capital gain rate.

Saving Tax on Long-term Capital Gains

The following tactics can help you pay less in taxes on long-term capital gains period. You may investigate all of your options, find out about specific programmes, invest in residential real estate, and purchase bonds.

The Capital Gain Account Strategy

Through the capital gain account scheme, an investor can obtain tax benefits without buying a residence. The only withdrawals from this account that the Indian government permits are for the purchase of homes and plots; all other withdrawals must be utilised within three years of the first withdrawal. Any residual profit will be subject to taxation at the applicable long-term capital gain rates.

Investing in residential real estate

To avoid paying taxes on long-term capital gains, one might alternatively buy brand-new residential property. Sections 54 and 54F are related to these exclusions. If a person or Hindu Undivided Family sells a built-up residence and uses the capital gain to purchase or construct a new residential property, they are unquestionably free under Section 54 from paying long-term capital gains tax.

The “fresh” or new property must be acquired either a year before or two years after the “existing” or current property is sold. The seller must finish building the new property within three years after selling the previous one.

Acquiring bonds

If you wish to save money on taxes, you can use Section 54EC to lower long-term capital gains tax by moving the full value to bonds issued by NHAI and RECL. You may see a list of these bonds on the Income Tax Department of India’s official website.

Special rates for long-term capital gain tax

There is some special and exceptional capital gain rate on some assets.

Collectables

Gains on art, antiques, jewellery, old cars, precious metals, stamp collections, coins, and other collectables are taxed at a rate of 12% to 28% in India, regardless of your income.

QSB or Qualified Small Business stock

A qualifying small business stock’s (QSB) tax status is determined by the stock’s acquisition date, holder, and holding period. The stock must have been purchased from a QSB after August 10, 1993. The investor must be a non-corporate entity that owned the shares for at least five years to be eligible for this exemption.

A domestic C company that has never had its total gross assets surpass $50 million since August 10, 1993, is commonly referred to as a qualified small business stock. Cash held by the business and the adjusted bases of all other assets it owns are both included in aggregate gross assets. The QSB must also submit all mandatory reports.

Certain types of businesses fall within the QSB category. Companies in the technology, retail, wholesale, and manufacturing sectors are eligible to be QSBs, while those in the hotel, personal services, banking, agriculture, and mining sectors are not.

Under this exemption, the taxpayer may initially exclude 50% of any gain. It has been done from the sale of the shares of the small business that qualifies. Later it increased to 100% for QSB shares acquired after September 27, 2010, and to 75% for shares purchased between February 18, 2009, and September 27, 2010. 11. The maximum gain subject to this treatment shall not exceed $10 million or ten times the adjusted basis of the shares, whichever is greater.

Possessed Real Estate

If you sell your principal residence, you can take advantage of a special capital gains arrangement. In India, the first Rs. 250,000 of an individual’s capital gains on the sale of their primary residence are excluded from taxable income if the seller has owned and has to pay 5% tax if they have 2.5 lakh to 5 lakh. This loss is not considered if you sold your home for less than you bought it since capital losses from the sale of personal property, such as your home, are not deductible.

Real estate for investment

According to the degradation of their properties, real estate owners typically qualifies for deductions from their total taxable income. This decrease, which lowers the original purchase price of the property, is meant to symbolise how the property would gradually deteriorate as it ages.

Your taxable capital gain will increase as a result of the property’s sale.

Exceptions in Investment

The net investment income tax is another capital gains tax to which high-income persons may be liable. This law imposes an additional percentage tax on your investment income.

Calculating capital gains

Before understanding how to calculate long-term capital gains on shares by long-term capital gains tax calculator or LTCG calculator, it is essential to be familiar with several key phrases. These include

• Sales price
• Acquisition costs
• Costs associated with the selling or transfer
• Indexing
• Holding time.

Sales price

The sale value is the amount that is due or received when a capital asset is sold. For shares, it is determined by the asset’s gross selling price minus Securities Transaction Tax (STT) and brokerage fees.

Acquisition Cost 

The following processes are used to determine the cost of acquisition for equity shares bought before 1 February 2018:

1. To calculate an investment’s fair market value, the number of bought shares is multiplied by their highest price as of January 31st, 2018.
2. The investment’s value is chosen to be less than the difference between its fair market value and its actual sale price.
3. The greatest value is then chosen, and it is contrasted with the share’s purchase price. This value includes the cost of purchasing the asset. On January 31, 2018, no shares were traded; instead, the highest price from the previous trading day was used.

Expenditure Related to Sales or Transfers

These costs cover things like brokerage fees, registration fees, and other costs related to selling an item. When calculating long-term capital gains on equity shares, the Securities Transaction Tax (STT) costs that are levied on sale transactions are not allowed to be subtracted.

Indexation

To guarantee that the gains are calculated using the current worth of money, indexation helps to integrate the time value of money (with an adjustment for inflation) in the calculation of LTCG on shares. The base year for the indexation is 1.4.2001, and the index used is the Cost Inflation Index (CII).

Holding period

The number of months that the assessee owned the equity shares is used to calculate the holding period. This period starts the day an asset is purchased and concludes the day before an equity share is transferred.

Long term vs short term capital gain

These are the primary sources of income; thus, both short-term and long-term capital gains are subject to taxation. On the other hand, the proper exemptions for persons are laid forth in the Income Tax Act.

The table below illustrates how long-term and short-term capital gains compare to one another. The primary distinctions between these two capital gains are in the holding period, profit, and risk.

Conclusion

Capital gains may be taxed in India depending on the asset type and the duration of the investment holding period. On realised profits surpassing Rs. 1,000,000 in a fiscal year, there is a 10% long-term capital gains tax if you have owned shares for longer than a year.

Introduction

Valuation is linked to the investment in some way or other because valuation is the way to determine whether you are paying the right price for stocks or shares. Before investing, it is also essential to check a company’s finances and future growth potential. 

True worth can be challenging, especially for a private company. Still, it’s as simple as multiplying the number of shares outstanding by the current share price, and you will be able to determine the market value of publicly-traded or listed companies.

To accurately perform a valuation, you must consider several factors such as past growth, future growth potential, current earnings, future earnings projections, and much more. But how do you find out if the stock of the company you are thinking of investing in or your favourite stock is overvalued or undervalued, or at par?

One of the best ways to assess this is through the process of valuation of a company, which involves taking into account several different factors like industry trends, the strength of the management team and competitors, and future growth prospects before deciding on the actual price you’re willing to pay for your stock.

Here’s how to perform a valuation on any given company, from start to finish.

What Is a Company Valuation?

Although calculating company valuation seems complicated at first, there are several simple formulas that you can use to estimate a company’s worth. The formula used depends on what metrics you’re willing to use. Other valuation methods include Price-to-Earnings Ratio, Price-to-Book Ratio and Price/Sales Ratio. Still, these are best for understanding how a public company performs compared with similar companies (more on public companies below). This guide will focus on three major types of valuations: EBITDA Multiples, Enterprise Value and Discounted Cash Flow Analysis. Keep in mind that these methods assume that the business is operating at its full potential—that there aren’t any hidden issues or problems slowing it down.

A company valuation measures all its assets, liabilities and profits to determine its actual value. Calculating a company valuation will allow you to determine if the business is worth more than others think. It can also show you how valuable a startup is compared with other companies operating within the industry or in a similar business line. Finally, these calculations can give insight into where you might want to take a startup as it continues to grow—showing where a company may be underperforming or thriving.

As stated above, you can use several different types of calculations regarding company valuation. Your choice depends on your information and how conservative or accurate you want your estimation to be. To determine EBITDA Multiples, you’ll need basic financial statements that show revenue, gross profits and net profit margins. On top of that, each type requires its specific steps to get an accurate valuation. The process may also seem daunting because it is fairly detailed and involves using formulas with many different variables—but as long as you follow these instructions step by step, we promise it will be a breeze!

Data used to determine valuations

There are several methods you can use for company valuation. Two standard methods are discounted cash flow (DCF) and comparable companies (multiples). The latter uses multiples for valuation, which are ratios that compare one company’s or one segment’s current size or financial performance with another company’s.

For example, if company A is twice as large as company B in terms of revenues, we can say that it is valued at twice as much by investors (or its valuation multiple would be 2). Remember that there is no established rule on what values companies should give through their multiples, so they differ across industries and geographies.

It would help if you researched when determining multiples for your target industry or area. Multiples used most often include:

• Price-to-earnings (P/E).
• Price-to-book value (P/BV).
• Price-to-cash-flow (P/CF).
• Enterprise value over EBITDA.
• Others.

Another way to look at valuation is based on metrics like operating margin or return on equity, but remember that these metrics don’t consider future growth potential.

How to evaluate a company

This first method of valuation—known as asset-based valuation because it’s based on assets such as buildings, equipment and inventories—is simple. The value is simply equal to total assets minus total liabilities. Assuming that all assets are liquid (quickly sold) and there are no hidden liabilities, we can calculate the liquidation value. To do so, we add up all current assets and subtract any current liabilities; then, we subtract another layer of non-current (long-term) liabilities.

It varies from company to company which method would be right to determine that company’s valuation. Maybe you’re looking at pre-revenue companies or performing the valuation by looking at a similar company. We have mentioned the in-depth guide for all kinds of the company’s valuation process, but first, let’s start with valuation methods.

Methods of Valuation

There are several methods used in valuing companies. One of them is the DCF (discounted cash flow) method, which requires evaluating future cash flows generated by the company and discounting them by accounting for risk. The second method is relative valuation, where comparisons are made with similar firms acquired or merged into other companies.

A third method is transaction analysis, where historical transactions involving similar firms are analyzed to determine their value. And finally, peer analysis consists of data from comparable publicly traded peers as a benchmark for performance metrics like earnings growth rate and P/E ratio. But how would you know which method to use while determining the valuation of a company? For this, we have covered the list of scenarios that you can use to see the valuation.  

• Methods for post-revenue companies

It can be challenging to figure out how much a company is worth. While you can use plenty of methods, you have a few choices when deciding which approach is best for business. Pre-revenue valuation methods usually involve projecting a company’s future earnings, which means they’ll tend to be fairly conservative and often less accurate than post-revenue approaches. The good news is that all valuations have limitations—there’s no correct answer or one method that’s perfect every time.

One standard pre-revenue valuation method is comparable companies, which involves taking data from publicly traded companies with a similar size and growth stage as a business. For example, let’s say you wanted to know how much investors might pay for a software development company valued at $1 million. You can start by comparing a company’s metrics (like its revenue) with those of comparable businesses that are publicly traded. The biggest pitfall with using another company’s metrics is that two companies don’t necessarily need to be alike in every way for their metrics to be useful for comparison. This method can produce overly optimistic or pessimistic results if it only relies on one or two metrics.

When determining whether or not a company is overvalued, undervalued or at par with its peers, consider several factors such as customer retention rates, customer acquisition costs; cash flow; future opportunities; and return on investment. This will help give you a clear picture of where the business stands within its industry. And remember, just because one method shows that a company is undervalued doesn’t mean it’s time to sell—it’s still important to consider several different valuation methods when deciding whether or not now is the right time for an exit strategy. 

• Methods for pre-revenue companies

For pre-revenue companies, most investors use the multiples method for valuation. This is when you determine what multiple businesses will trade at by comparing it to comparable companies in size, sector and stage of growth. If a company is  generating low revenues but is growing quickly, many investors compare it to other businesses in the virtual space. 

For example, if XYZ Ltd. launched an app to help people rent their homes on the weekends, you could look at Magicbricks (and its 33% estimated EBITDA margin) or Nobroker. You could also try looking at similar real estate startups like Flatchat or Nestaway.

Valuation of a Company by Comps

When you start looking at business valuations in earnest, you’ll see three ways to value businesses. The first is ratios and metrics that use historical financial data, such as price-to-earnings or enterprise value-to-EBITDA. The second approach uses multiples, like price-to-sales or enterprise value divided by revenue. The third way is via discounted cash flow (DCF) analysis, which takes your future expectations for profit and cash flow and discounts them back to today’s dollars.

We have given a beginner’s guide on DCF further in this article. But if you’re just getting started with valuation, focus on comparing similar companies based on their fundamentals—that’s what we call comps. If your company has 100 crores in annual sales and 10 crores in net income, compare its valuation to other companies with 100 crores in sales and 10 crore in net income. This gives you a clear picture of how much investors think those earnings are worth. We’ll show you how below.

When comparing similar companies, you’re mainly looking at two different sets of numbers. The first is valuation multiples—like price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA). These multiples tell you how much investors are willing to pay for a dollar of profit or EBITDA generated by your business. For example, if a company is trading at a P/E ratio of 20 and your firm is trading at 25, it tells you that investors think your business has more growth potential than its peers. And that might make sense given where you’re located and what types of clients and projects you attract.

Valuation based on income

One of these most common methods is using comparable companies’ sales and earnings multiples for your calculations. If you are looking at an Internet stock, for example, you can look at how much Amazon is selling versus how much it earns. What multiple does it get? Is it better or worse than other similar stocks in its industry? Be sure you know the methodologies used in these comparisons when coming up with your valuation multiples. This way, you’ll understand if they are being heavily influenced by one particular company—especially if that company tends to have a very large market share or impact on competitors within its industry.

Valuation based on asset

One common valuation technique involves using comparable companies. The idea is that, while every company is unique, some sectors are very similar in terms of operations, costs and revenues. In theory, if you know what other companies in your sector have been sold for (or valued at), you can use their multiples to come up with an estimate for your own company. There are several caveats with valuing by comps—especially when dealing with private companies—but it’s still a widely used tool. Other valuation methods include price-to-earnings ratios, price-to-book ratios and discounted cash flow analysis.

Net asset value

Also known as net worth, net asset value estimates a company’s assets based on its book value. The goal of performing a valuation is to arrive at an unbiased assessment of your company’s intrinsic worth and compare it to what investors believe your company is worth. This can provide valuable insight into whether you should sell or hold onto your stock for long-term profit potential.

Discounted Cash Flow Valuation

The discounted cash flow (DCF) method is one of two primary techniques for valuing a company. It’s used in private and public company valuation but is more applicable for smaller businesses and startups. The DCF method is based on how much value you’ll get from all future cash flows from owning a piece of the company. To do that, you need to forecast your growth rate and how long you expect those future cash flows to last (or how long your return will continue).

By plugging known financial information into an equation, you can figure out what your share of those future cash flows is worth today. While many other valuation methods have their unique strengths and weaknesses, none really outperform DCF as far as accuracy goes. That said, it’s important to remember that many judgment calls go into performing any type of valuation—and they often vary depending on whom you ask. For example, companies with high uncertainty or risk often require higher rates of return because investors don’t want to commit money without knowing if they’ll get paid back.

Market Capitalization Approach 

This approach values a company by multiplying its current market price by its total number of outstanding shares. Market capitalization is also known as market value, market cap, or simply value.

The other elements are used while calculating the valuation of a stock or company.

• PE ratio

The price-to-earnings ratio, or PE ratio, is one of the most commonly used ratios in determining if a company is overvalued or undervalued. It’s calculated by dividing the current stock price by annual earnings per share. This can be compared to other companies in your industry and historical averages for your industry. A higher PE means that the stock is more expensive than other similar stocks, which can mean it’s overvalued; conversely, a lower PE means it’s undervalued.

• Price to earning per stocks

There are no hard and fast rules for valuing a company. However, some generally accepted guidelines include earning per stock (P/E). Earning per share (EPS) is determined by dividing net income by the weighted average number of shares outstanding. A stock trading at Rs 30 per share with an EPS of Rs 1 would have a P/E ratio of 20x earnings. This means that investors, in the aggregate, are willing to pay 20 times its current annual earnings for ownership in that company.

• Price to sales ratios

The price-to-sales ratio (PSR) is one of several multiples used to value a company. It’s calculated by dividing a company’s share price by its sales per share. The higher a PSR, the more expensive a stock is relative to its sales level. A PSR greater than 1 indicates that you would pay more for each dollar in sales than you would if it were lower.

• PBV Ratio= Stock Price / Book Value of the stock

This ratio is one of the easiest and simplest ways to arrive at a valuation number. Book value is generally considered to be net worth minus intangible assets. For example, if a company has 100 lakh in net worth but owns 10 lakh in patents that can’t be sold separately, its book value would be 90 lakh.

• EBITDA

This acronym stands for earnings before interest, taxes, depreciation and amortization. EBITDA is often used in company valuation and may also be referred to as earnings before interest and taxes. EBITDA measures a company’s pre-tax profitability by taking into account revenues minus all operating expenses (including depreciation). 

Determining if a company is over or undervalued

You’ll need to calculate its valuation to determine if a company is over or undervalued. The valuation formula follows: Market Capitalization + Debt – Cash = Enterprise Value. For example, if TCS. has a market capitalization of 500 lakhs and 120 lakhs in debt with 250 lakhs in cash, then its enterprise value would be 370 lakhs (Market Cap + Debt – Cash). Next, compare that number to similar companies in your industry. For better clarity, let’s understand the example of both over and undervalued companies.

Examples of overvalued companies

When making decisions on stocks, it’s important to remember that every company is subject to its own valuation. While some stocks may be considered undervalued or fairly valued, others are highly overvalued. Paytm and Zomato are two prominent companies that have been plagued by overvaluation—in fact, Zomato has depreciated more than 50% and Paytm has lost more than 60.26% valuation since the IPO. That said, high market value isn’t always an indicator of high worth, meaning you should always consult other metrics when attempting a company valuation analysis. For example, if you believe Paytm is truly worth 19 billion dollars, then you might want to consider the current valuation, which is less than $1 billion.

Examples of undervalued companies

By using company valuation analysis, you can find out which companies are undervalued so that one can invest in them. Some examples of undervalued companies include Deepak Nitrite and IOL Chemicals and Pharmaceuticals. Starting from Deepak Nitrite, one of the leading chemical intermediates companies, you look at the company’s price chart in the last 1 year. You will see a CAGR of 166.5% and a PEG ratio of 0.26; not only this company has shown approximately 62% over the last 3 years. 

Similarly, IOL Chemicals and Pharmaceuticals is among the few leading companies in bulk drugs; the company is also the largest producer of Ibuprofen, with more than 35% market share. When you look at the CAGR of 3 years, you will find the 43.6% return in the price chart of this company; the company has shown a sales growth of 39% and 326% profit growth in the past 3 years.

Present Value of a Growing Perpetuity Formula

Present value is one of several ways analysts look at a company’s valuation. It looks at how much money it would take today to equal Rs. 1 tomorrow, based on its expected earnings and growth rate. To determine the present value, you can use an online calculator or formula that uses variables like periods, interest rates and future cash flows (also known as discounted cash flow).

This basic equation calculates present value by plugging in estimated growth rates: Present Value = (E / r)^(1/t) + Cash Flow N. The E/r part refers to your expected rate of return on your investment. Use 15 per cent if you’re estimating an IPO with minimal risk; 10 percent for a mid-range startup; and 5 percent for mature companies with stable earnings. 

The N represents your total number of years. Plug in 1 if you want to know what it takes to be worth Rs. 1 right now, 2 for two years from now, etc. The Cash Flow section represents all your estimated income over those periods. If you don’t have actual numbers yet, just estimate them—you’ll get more accurate once you have real data from real customers paying real dollars into your business bank account!

Future Growth Potential

One easy way to evaluate is by looking at how much money an investor thinks that company will make in five years. That investment logic is called future growth potential, worth 35% of your company’s value. To figure out what investors think your company’s value should be, add up how much they think you’ll earn in five years and divide that number by 1 minus your cost of capital (which we’ll explain below).

The result will tell you roughly what your business is worth right now. For example, if investors think you’ll have $100 million in sales in five years and your cost of capital is 10%, then they’re saying your business is worth $1 million today. 

Conclusion

Valuation is an important topic in finance and accounting. It refers to determining the worth of an asset or company, which ultimately helps financial experts determine whether an investment is too risky or not. In real life, valuation isn’t often as straightforward as many experts make it out to be because we must take into account all of these variables over time. However, these techniques are simplified for students taking business and finance classes to learn how valuations work in theory before applying them in practice later.