portfolio construction using fundamental analysis

Portfolio Construction Using Fundamental Analysis

Alliance Business Academy 1

1. INTRODUCTION

1.1THEORETICAL BACKGROUND

The foundation of Modern Portfolio Theory was laid by Markowitz in 1951. He began

with the simple premise that since almost all investors invest in multiple securities rather

than one, there must be some benefit in investing in a portfolio of securities. He measured

riskiness of a portfolio through variability of returns and showed that investment in

several securities reduced this risk. His work won him the Nobel Prize for Economics in

1990. Markowitz‘s work was extended by Sharpe in 1964, Lintner in1965 and Mossin in

1966. Sharpe shared the Nobel Prize for Economics in 1990 with Markowitz and Miller

for his contribution to the Capital Asset Pricing Model (CAPM). This model breaks up

the riskiness of each security into two components - the market related risk which cannot

be diversified called systematic risk measured by the beta coefficient and another

component which can be eliminated through diversification called unsystematic risk.

The Markowitz model is extremely demanding in its data needs for generating the desired

efficient portfolio. It requires N (N+3)/2 estimates (N expected returns + N variances of

returns + N*(N-1 )/2 unique covariance‘s of returns). Because of this limitation the single

index model with less input data requirements has emerged. The Single index model

requires 3N+2 estimates (estimates of alpha for each stock, estimates of beta for each

stock, estimates of variance σei2 for each stock, estimate for expected return on market

index and an estimate of the variance of returns on the market index σm2) to use the

Markowitz optimization framework. The single index model assumes that co-movement

between stocks is due to movement in the index. The basic equation underlying the single

index model is:

Ri = ai + βi*Rm where

Ri = Return on the ith stock

ai = component of security i‘s that is independent of market performance



βi= coefficient that measures expected change in Ri given a change in Rm

Rm = rate of return on market index

The term ai in the above equation is usually broken down into two elements ai which is

the expected value of ai and ei which is the random element of ai. The single index model

equation, therefore, becomes:

Ri = αi + βi*Rm + ei

Single index model has been criticized because of its assumption that stock prices move

together only because of common co-movement with the market. Many researchers have

found that there are influences beyond the market, like industry-related factors, that cause

securities to move together.

1.2 FUNDAMENTAL ANALYSIS

Fundamental analysis of a business involves analyzing its income statement, financial

statements, its management, competitive advantages, its competitors and markets. The

analysis is performed on historical and present data, with the goal to make financial

projections. One of the primary assumptions of fundamental analysis is that the price on

the stock market does not fully reflect a stock‘s ―real‖ value.

Intrinsic value is defined to be the present value of all future net cash flows to the

company. The intrinsic value of an equity share depends on a multitude of factors. The

earnings of the company, the growth rate and risk exposure of the company have a direct

bearing on the price of the share. These factors in turn rely on the host of other factors

like economic environment in which they function, the industry which they belong to,

and finally companies‘ own performance. The fundamental school of thought appraised

the intrinsic value of shares through:

Economic Analysis

Industry Analysis



Company Analysis

1.2.1 Economic Analysis

The level of economic activity has an impact on investment in many ways. If the

economy grows rapidly, the industry can also be expected to show rapid growth and vice-

versa. When the level of economic activity is low, stock prices are low, and when the

level of economic activity is high, stock prices are high reflecting the prosperous outlook

for sales and profits of the firms. The analysis of macroeconomic environment is essential

to understand the behavior of the stock prices. The commonly analyzed macro-economic

factors are as follows:

A. Gross Domestic Product:

GDP indicates the rate of growth of the economy. GDP represents the aggregate

value of the goods and services produced in the economy. GDP consists of

personal consumption expenditure, gross private domestic investment and

government expenditure on goods and services and net export of goods and

services. The growth rate of economy points out the prospects for the industrial

sector and return investors can expect from investment in shares. The higher

growth rate is more favorable to the stock market.

B. Savings and investment:

It is obvious that growth requires investment which in turn requires substantial

amount of domestic savings. Stock market is a channel through which the savings

of the investors are made available to corporate bodies. Savings are distributed

over various assets like equity shares, deposits, mutual fund units, real estate and

bullion. The saving and investment patterns of the public affect the stock to a

great extent.



C. Inflation:

Along with the growth of GDP, if inflation also increases, then the real rate of

growth would be very little. The demand in the consumer product industry is

significantly affected. If there is a mid level of inflation, it is good to the stock

market but high rate of inflation is harmful to the stock market.

D. Interest rates:

The interest rate affects the cost of financing to the firms. A decrease in interest

rate implies lower cost of finance for firms and more profitability. More money is

available at a lower interest rate for the brokers who are doing business with

borrowed money. Availability of cheap fund encourages speculation and rise in

price of shares.

E. Budget:

The budget draft provides an elaborate account of the government revenues and

expenditures. A deficit budget may lead to high rate of inflation and adversely

affect the cost of production. Surplus budget may result in deflation. Hence,

balanced budget is highly favorable to the stock market.

F. The tax structure:

Concessions and incentives given to a certain industry encourage investment in

that particular industry. Tax relief given to savings encourages savings. The type

of tax exemption has an impact on the profitability of the industries.

G. The Balance of payment:

The balance of payment is the record of a country‘s money receipts from and

payments abroad. The difference between receipts and payments may be surplus

or deficit. BOP is the measure of the strength of rupee on external account. If the

deficit increases, the rupee may depreciate against other currencies, thereby,



affecting the cost of imports. The volatility of the foreign exchange rate affects

the investment of the foreign institutional investors in the Indian Stock Market. A

favorable balance of payment renders a positive effect on the stock market.

H. Monsoon and Agriculture:

Agriculture is directly and indirectly linked with the industries. A good monsoon

leads to higher demand for input and results in bumper crop. This would lead to

buoyancy in the stock market. When the monsoon is bad , Agriculture and

hydroelectric production would suffer. They cast a shadow on the share market.

I. Infrastructure facilities:

Infrastructure facilities are essential for the growth of industrial and agricultural

sector. A wide network of communication system is a must for the growth of the

economy. Regular supply of power without any power cut would boost the

production. Banking and financial sectors should also be sound enough to provide

adequate support to industry and agriculture.

J. Demographic factors:

The demographic data provides details about the population by age, occupation,

literacy and geographic location. This is needed to forecast the demand for the

consumer goods. The population by age indicates the availability of able work

force. Population, by providing labor and demand for products, affects the

industry and stock market.

1.2.2 Industry Analysis

Industry analysis is a type of investment research that begins by focusing on the status of

an industry or an industrial sector. Each industry has differences in terms of its customer

base, market share among firms, industry-wide growth, competition, regulation and

business cycles. Learning about how the industry works will give an investor a deeper



understanding of a company's financial health. The Industry life cycle analysis and

Porter‘s 5 forces model for competitive advantage are common valuation techniques.

A. Industry Life Cycle Model:

This model is a useful tool for analyzing the effects of an industry's evolution on

competitive forces. Using the industry life cycle model, we can identify five

industry environments, each linked to a distinct stage of an industry's evolution.

a. Pioneering development: - During this start up stage, the industry experiences

modest sales growth and very small or negative profit margins and profits. The

market for the industry‘s product or service during this time period is small, and

the firms involved incur major development costs.

b. Rapid accelerating growth: - During this rapid growth stage, a market develops

for the product or service and demand becomes substantial. The profit margins are

very high. The industry builds its productive capacity as sales grow at an

increasing rate as the industry attempts to meet excess demands.

c. Mature stage: - The success in stage2 has satisfied most of the demands of the

industry goods and services. Thus, further sales growth may be above normal but

it no longer accelerates. The rapid growth of sales and the high profit margins

attract competitors to the industry, which causes an increase in supply and lower

price, which the profit margin begin to decline to normal levels.

d. Stabilization and market maturity: - During this stage which is probably the

longest stage, the industry growth rate declines to the growth rate of aggregate

economy or its industry segment. Competition produces tight profit margins, and

the rate of return on capital eventually becomes below the competitive level.

e. Deceleration of growth and decline: - At this stage of maturity, the industries

sales growth declines because of shifts in demand or growth in substitutes. Profit



margins continue to be squeezed, and some firms experiences low profits or even

losses.

B. Porter’s Five Forces Model

This model identifies five competitive forces that shape every single industry and

market. These forces help us to analyze everything from the intensity of

competition to the profitability and attractiveness of an industry.

a. Threat of New Entrants: - The easier it is for new companies to enter the

industry, the more cutthroat competition there will be. Factors that can limit the

threat of new entrants such as high fixed cost, existing loyalty to major brands,

government regulations etc act as barriers to entry.

b. Power of Suppliers: - This is how much pressure suppliers can place on a

business. If one supplier has a large enough impact to affect a company's margins

and volumes, then they hold substantial power. When there are very few suppliers

of a particular product or there are no substitutes or switching to another

(competitive) product is very costly, the supplier is powerful and vice versa.

c. Power of Buyers: - This is how much pressure customers can place on a

business. Some companies serve only a handful of customers, while others serve

millions. In general, it's a red flag (a negative) if a business relies on a small

number of customers for a large portion of its sales because the loss of each

customer could dramatically affect revenues. If one customer has a large enough

impact to affect a company's margins and volumes, then they hold substantial

power.

d. Availability of Substitutes: - What is the likelihood that someone will switch to

a competitive product or service? If the cost of switching is low, then this poses to

be a serious threat. The main issue is the similarity of substitutes. If substitutes are

similar, then it can be viewed in the same light as a new entrant, which is a threat

to the company.



e. Competitive Rivalry: - This describes the intensity of competition between

existing firms in an industry. A highly competitive market might result from:

Many players of about the same size, no dominant firm.

Little differentiation between competitor‘s products and services.

A mature industry with very little growth. Companies can only grow by

stealing customers away from competitors.

1.2.3 Company Analysis

In the company analysis the investor assimilates the several bit of information related to

the company and evaluates the present and future value of stock. The risk and return

associated with the purchase of the stock is analyzed to take better investment decision.

The present and future are affected by a number of factors. They are:-

A. Competitive advantage of the company:

Competitive advantage (CA) is a position that a firm occupies in its competitive

landscape. A company's long-term success is driven largely by its ability to

maintain a competitive advantage - and keep it. Competitive advantages vary

from situation to situation and from time to time. Some basic examples of CAs

can be divided in 4 main global areas:

Cost - Low cost operations

Quality - High quality and consistent quality

Time - delivery speed, on time delivery and development speed

Flexibility - customization, volume flexibility and variety



B. Earnings of the company:

Sales alone do not increase the earnings but the costs and expenses of the

company also influence the earnings of the company. Further, earnings do not

always increase with the increase in sales. The company‘s sales might have

increased but its earnings may decline due to the rise in costs.

C. Capital structure:

The equity holders‘ return can be increased manifold with the help of financial

leverage, i.e. using debt financing along with equity financing. The effect of

financial leverage is measured by computing leverage ratios. The debt may be in

the form of debentures and term loans from financial institutions.

D. Management:

Good and capable management generates profit to the investors. The management

of the firm should efficiently plan, organize, actuate and control the activities of

the company. The basic objective of management is to attain the stated objectives

of the company for the good of the equity share holders, the public and the

employers. Good management depends on the quality of the manager. Some

believe that management is the most important aspect for investing in a company.

It makes sense - even the best business model is doomed if the leaders of the

company fail to properly execute the plan.

E. Operating efficiency:

The operating efficiency of a company directly affects the earnings of a company.

An expanding company that maintains high operating efficiency with a low

break-even point earns more than the company with high break-even points. If a

firm has stable operating ratio, the revenue will also be stable. Efficient use of

fixed assets with a raw materials, labor and management would lead to more

income from sales. This leads to internal fund generation for the expansion of the



firm. A growing company should have low operating ratio to meet the growing

demand for its product.

F. Business Model:

Even before an investor looks at a company's financial statements or does any

research, one of the most important questions that should be asked is: What

exactly does the company do? This is referred to as a company's business model –

it's how a company makes money. You can get a good overview of a company's

business model by checking out its website. Unless you understand a company's

business model, you don't know what the drivers are for future growth, and you

leave yourself vulnerable to being blindsided.

G. Corporate Governance:

Corporate governance describes the policies in place within an organization

denoting the relationships and responsibilities between management, directors and

stakeholders. These policies are defined and determined in the company charter

and its bylaws, along with corporate laws and regulations. The purpose of

corporate governance policies is to ensure that proper checks and balances are in

place, making it more difficult for anyone to conduct unethical and illegal

activities Good corporate governance is a situation in which a company complies

with all of its governance policies and applicable government regulations in order

to look out for the interests of the company's investors and other stakeholders.

H. Financial analysis:

The best source of financial information about a company is its own financial

statements. This is a primary source of information for evaluating the investments

prospects in the particular company‘s stock. Financial statement analysis is the

study of a company‘s financial statement from various viewpoints. The statement

gives the historical and current information about the company‘s operations.

Historical financial statements help to predict the future. The current information



aids to analyze the present status of the company. The two main statements used

in analysis are:-

Balance sheet

Profit and loss account

1.2.4 Strengths Of Fundamental Analysis

A. Long-term trends:

Fundamental analysis is good for long-term investments based on long-term

trends, very long-term. And also the ability to identify and predict long-term

economic, demographic, technological or consumer trends can benefit patient

investors who pick the right industry groups or companies.

B. Value Spotting:

Sound fundamental analysis will help identify companies that represent good

value. Some of the most legendary investors think long-term and value.

Fundamental analysis can help uncover companies with valuable assets, a strong

balance sheet, stable earnings and staying power.

C. Business Acumen:

One of the most obvious, but less tangible, rewards of fundamental analysis is the

development of a thorough understanding of the business. After such painstaking

research and analysis, an investor will be familiar with the key revenue and profit

drivers behind a company. Earnings and earnings expectations can be potent

drivers of equity prices. Even some technicians will agree to that. A good

understanding can help investors avoid companies that are prone to shortfalls and

identify those that continue to deliver.



1.2.5 Weakness Of Fundamental Analysis

A. Time Constraints:

Fundamental analysis may offer excellent insights, but it can be extraordinarily

time consuming. Time consuming models often produce valuations that are

contradictory to the current price prevailing on Wall Street. When this happens,

the analyst basically claims that the whole street has got it wrong. This is not to

say that there are not misunderstood companies out there, but it is quite brash to

imply that the market price, and hence Wall Street, is wrong.

B. Industry/Company Specific:

Valuation techniques vary depending on the industry group and specifics of each

company. For this reason, a different technique and model is required for different

industries and different companies. This can get quite time consuming and limit

the amount of research that can be performed.

C. Subjectivity:

Fair value is based on assumptions. Any changes to growth or multiplier

assumptions can greatly alter the ultimate valuation. Fundamental analysts are

generally aware of this and use sensitivity analysis to present a base-case

valuation, a best-case valuation and a worst-case valuation. However, even on a

worst case, most models are almost always bullish, the only question is how much

so.

1.2.6 Obstacles in the way of a successful Fundamental Analysis:

A. Inadequacies or incorrectness of data:

An analyst has to often wrestle with inadequate or incorrect data. While deliberate

falsification of data may be rare, subtle misrepresentation and concealment are

common. Often, an experienced and skilled analyst may be able to detect such



ploys and cope with them. However, in some instances, he too is likely to be

misled by them into drawing wrong conclusions.

B. Future uncertainties:

Future change are largely unpredictable more so when the economic and business

environment is buffeted by frequent winds of change. In an environment

characterized by discontinuities, the past record is a poor guide to future

performance.

C. Irrational market behavior:

The market itself presents a major obstacle to the analyst. On account of neglect

or prejudice , under valuations may persist for extended periods; likewise

overvaluations arising from unjustified optimism and misplaced enthusiasm may

endure for unreasonable lengths of time. The slow correction of under or

overvaluation poses a threat to the analyst. Before the market eventually reflects

the values established by the analyst, new forces may emerge. As Benjamin

Graham put it; ―The particulars danger to analyst is that, because of such delay,

new determining factors may supervene before the market price adjusts itself to

the value as he found it‖

1.2.7 Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two groups:

proponents of ―technical analysis‖ and believers of ―efficient market hypothesis‖. Put

simply, technical analysts base their investments (or, more precisely, their trades) solely

on the price and volume movements of securities. Using charts and a number of other

tools, they trade on momentum, not caring about the fundamentals. While it is possible to

use both techniques in combination, one of the basic tenets of technical analysis is that

the market discounts everything. Accordingly, all news about a company already is

priced into a stock, and therefore a stock‘s price movements give more insight than the

underlying fundamental factors of the business itself.



Followers of the efficient market hypothesis, however, are usually in disagreement with

both fundamental and technical analysts. The efficient market hypothesis contends that it

is essentially impossible to produce market-beating returns in the long run, through either

fundamental or technical analysis. The rationale for this argument is that, since the

market efficiently prices all stocks on an ongoing basis, any opportunities for excess

returns derived from fundamental (or technical) analysis would be almost immediately

whittled away by the market‘s many participants, making it impossible for anyone to

meaningfully outperform the market over the long term.

1.2.8 Conclusion

Fundamental analysis can be valuable, but it should be approached with caution. We all

have personal biases and every analyst has some sort of bias. There is nothing wrong with

this and the research can still be of great value. Corporate statements and press releases

offer good information, but should be read with a healthy degree of skepticism to

separate the facts from the spin. Press releases don't happen by accident and are an

important PR tool for companies. Investors should become skilled readers to weed out the

important information and ignore the hype.

1.3 VALUATION

In selecting stocks that trade for less than their intrinsic value, value investors actively

seek stocks of companies with sound financial statements that they believe the market has

undervalued. They believe the market always overreacts to good and bad news, causing

stock price movements that do not correspond with their long-term fundamentals. The

result is an opportunity for value investors to profit by taking a position on an

inflated/deflated price and getting out when the price is later corrected by the market.



1.3.1 Valuation Approaches

Discounted cash flow valuation:

This approach has its foundation in the ―present value‖ rule, where the value of

any asset is the present value of expected future cash flows on it. The discount

rate will be a function of the riskiness of the estimated cash flows, with higher

rates for riskier assets and lower rates for safer projects.

Relative valuation:

Estimates the value of an asset by looking at the pricing of 'comparable' assets

relative to a common variable like earnings, cash flows, book value or sales.

Contingent claim valuation:

A contingent claim or option is an asset that pays off only under certain

contingencies, if the value of the underlying asset exceeds a prescribed value for a

call option or is less than the prescribed value for a put option. Option pricing

models are used to measure the value of assets that share option characteristics.

A) Discounted Cash Flow Valuation

In discounted cash flow valuation, the value of an asset is the present value of the

expected cash flows on the asset. It is based on the philosophy that every asset has an

intrinsic value that can be estimated, based upon its characteristics in terms of cash flows,

growth and risk.

The 4 step DCF valuation Technique

Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the

expected cash flow for the company based on assumptions regarding the company's

revenue growth rate, net operating profit margin, income tax rate, fixed investment

requirement, and incremental working capital requirement.



Step 2—Estimate the Discount Rate: the next order of business is to estimate the

company's weighted average cost of capital (WACC), which is the discount rate that's

used in the valuation process

Step 3—calculate the Value of the Corporation: the company's WACC is then used to

discount the expected cash flows during the Excess Return Period to get the corporation's

Cash Flow from Operations. We also use the WACC to calculate the company's Residual

Value. To that we add the value of Short-Term Assets on hand to get the Corporate

Value.

Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's

liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common

Equity, divide that amount by the amount of stock outstanding to get the per share

intrinsic stock value

Advantages of DCF Valuation

Since DCF valuation, done right, is based upon an asset‘s fundamentals, it should

be less exposed to market moods and perceptions.

If good investors buy businesses, rather than stocks (the Warren Buffet adage),

discounted cash flow valuation is the right way to think about what you are

getting when you buy an asset.

DCF valuation forces you to think about the underlying characteristics of the firm,

and understand its business. If nothing else, it brings you face to face with the

assumptions you are making when you pay a given price for an asset.

Disadvantages of DCF valuation

Since it is an attempt to estimate intrinsic value, it requires far more inputs and

information than other valuation approaches. These inputs and information are not

only noisy (and difficult to estimate), but can be manipulated by the savvy analyst

to provide the conclusion he or she wants.



In an intrinsic valuation model, there is no guarantee that anything will emerge as

under or overvalued. Thus, it is possible in a DCF valuation model, to find every

stock in a market to be overvalued.

B) Free cash flow to firm (FCFF)

A Firm is composed of all its claimholders and includes, in addition to equity investors,

bondholders and preferred stockholders. The cash flows to the firm are therefore the

accumulated cash flows to all these claimholders.

Estimating Cash flows to the Firm

The cash flows to the firm are those cash flows left over after meeting operating expenses

and taxes but before making payments to any claimholders. There are two ways in which

these cash flows can be calculated. One way is to accumulate the cash flows to different

claimholders to the firm.

FCFF = Free cash flows to equity + interest expense (1- tax rate) + Principal Repayments

– New Debt Issues + Preferred Dividends.

The other approach, which should yield an equivalent number, starts with the earnings

before interest and taxes.

FCFF = EBIT (1-tax rate) + Depreciation – Capital Expenditures – Working Capital

Needs

A firm with free cash flows to the firm growing at a stable growth rate can be valued

using the following model:

Value of firm = FCFF1 / (WACC - gn)

Where,

FCFF= Expected free cash flow to firm for next year

WACC= Weighted average cost of capital



gn= Growth rate in FCFF (forever)

1.4 CAPM- CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically

appropriate required rate of return (and thus the price if expected cash flows can be

estimated) of an asset, if that asset is to be added to an already well-diversified portfolio,

given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's

sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often

represented by the quantity beta (β) in the financial industry, as well as the expected

return of the market and the expected return of a theoretical risk-free asset.

A. Assumptions of CAPM

All investors have rational expectations.

There are no arbitrage opportunities.

Returns are distributed normally.

Fixed quantity of assets.

Perfectly efficient capital markets.

Investors are solely concerned with level and uncertainty of future wealth

Separation of financial and production sectors.

Thus, production plans are fixed.

Risk-free rates exist with limitless borrowing capacity and universal access.

The Risk-free borrowing and lending rates are equal.

No inflation and no change in the level of interest rate exist.



Perfect information, hence all investors have the same expectations about

security returns for any given time period.

B. Formula

E (Ri) = Rf + [E (Rm) – Rf ]βi

Where,

E(Ri) – Expected return of security i

Rf – Risk Free Return

Rm – Market return

βi – Beta of the security

C. The Risk Free Asset

The risk-free asset is the (hypothetical) asset which pays a risk-free rate. It is

usually proxied by an investment in short-dated Government securities. The risk-

free asset has zero variance in returns (hence is risk-free); it is also uncorrelated

with any other asset (by definition: since its variance is zero).

D. Market Return

The expected market rate of return is usually measured by looking at the

arithmetic average of the historical returns on a market portfolio (ex- S&P 500)

E. Risk and Diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable

risk, and unsystematic risk which is also known as idiosyncratic risk or

diversifiable risk. Systematic risk refers to the risk common to all securities - i.e.

market risk. Unsystematic risk is the risk associated with individual assets.

Unsystematic risk can be diversified away to smaller levels by including a greater



number of assets in the portfolio (specific risks "average out"). A rational investor

should not take on any diversifiable risk, as only non-diversifiable risks are

rewarded within the scope of this model. Therefore, the required return on an

asset, that is, the return that compensates for risk taken, must be linked to its

riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness -

as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is

represented by higher variance i.e. less predictability. In other words the beta of

the portfolio is the defining factor in rewarding the systematic exposure taken by

an investor

1.5 MEANINGS OF VARIOUS PERFORMANCE MEASURES

A. Sharpe Ratio:

This ratio was developed by William Forsyth Sharpe in 1966.Sharpe originally

called it the "reward-to-variability" ratio in before it began being called the

Sharpe Ratio by later academics and financial professionals. The Sharpe ratio or

Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the

excess return (or Risk Premium) per unit of risk in an investment asset or a

trading strategy. The Sharpe ratio is used to characterize how well the return of an

asset compensates the investor for the risk taken. When comparing two assets

each with the expected return E[R] against the same benchmark with return Rf, the

asset with the higher Sharpe ratio gives more return for the same risk. Investors

are often advised to pick investments with high Sharpe ratios.

Sharpe measure = (Average rate of return on portfolio p – Average rate of return

on a risk – free investment) / Standard deviation of return of portfolio p

B. Treynor Ratio:

The Treynor ratio (sometimes called reward-to-volatility ratio) relates excess

return over the risk-free rate to the additional risk taken; however systematic risk

instead of total risk is used. Higher the Treynor ratio, better the performance



under analysis. As systematic risk is measure of risk, the Treynor measure

implicitly assumes that the portfolio is well diversified.

Treynors measure = (Average rate of return on portfolio p – Average rate of

return on a risk- free investment)/ Beta of portfolio p

C. Jensen Measure:

In finance, Jensen's alpha (or Jensen's Performance Index, ex-post alpha) is used

to determine the excess return of a stock, other security, or portfolio over the

security's required rate of return as determined by the Capital Asset Pricing

Model. This model is used to adjust for the level of beta risk, so that riskier

securities are expected to have higher returns. The measure was first used in the

evaluation of mutual fund managers by Michael Jensen in the 1970's.

To calculate alpha, the following inputs are needed:

The realized return (on the portfolio),

The market return,

The risk-free rate of return, and

The beta of the portfolio.

Jensen's alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta * (Market

Return - Risk Free Rate))

Alpha is still widely used to evaluate mutual fund and portfolio manager

performance, often in conjunction with the Sharpe ratio and the Treynor ratio.

D. Fama’s measure:

Fama proposed a measure of net selectivity based on the total risk of the portfolio.

His measure is:



[Return earned on portfolio + Standard deviation of portfolio/ standard deviation

of market return*(Market return – Risk free return)]

Fama measure of net selectivity reflects the difference between the return earned

on the portfolio and the return posited by the capital market line.



2.1 INTRODUCTION

The foundation of Modern Portfolio Theory was laid by Markowitz in 1951. He began

with the simple premise that since almost all investors invest in multiple securities rather

than one, there must be some benefit in investing in a portfolio of securities. He measured

riskiness of a portfolio through variability of returns and showed that investment in

several securities reduced this risk. His work won him the Nobel Prize for Economics in

1990. Markowitz‘s work was extended by Sharpe in 1964, Lintner in1965 and Mossin in

1966. Sharpe shared the Nobel Prize for Economics in 1990 with Markowitz and Miller

for his contribution to the Capital Asset Pricing Model (CAPM). This model breaks up

the riskiness of each security into two components - the market related risk which cannot

be diversified called systematic risk measured by the beta coefficient and another

component which can be eliminated through diversification called unsystematic risk.

The Markowitz model is extremely demanding in its data needs for generating the desired

efficient portfolio. It requires N(N+3)/2 estimates(N expected returns + N variances of

returns + N*(N-1 )/2 unique covariance‘s of returns). Because of this limitation the single

index model with less input data requirements has emerged. The Single index model

requires 3N+2 estimates (estimates of alpha for each stock, estimates of beta for each

stock, estimates of variance σei2 for each stock, estimate for expected return on market

index and an estimate of the variance of returns on the market index σm2) to use the

Markowitz optimization framework. The single index model assumes that co-movement

between stocks is due to movement in the index.

Single index model has been criticized because of its assumption that stock prices move

together only because of common co-movement with the market. Many researchers have

found that there are influences beyond the market, like industry-related factors, that cause

securities to move together.



2.2 REVIEW OF LITERATURE:

Elton, Edwin J, et al., (1977), are among the prominent researchers, who have worked on

Sharpe's Single Index Model. They presented a new method for selecting optimal

portfolios when upper bound constraints on investments in individual stocks were present

and when the variance-covariance matrix of returns possessed a special structure such as

that implied by standard single index model. Extending their previous work, more

commonly called as EPG approach to portfolio optimization, it was shown that upper

bounds could be dealt within a more complex fashion that shares many of the features of

ranking procedures of standard single index model.

Bawa, Vijay S, et al., (1979), showed that the construction of optimal portfolio could be

simplified by using simple ranking procedures when returns followed a stable distribution

and the dependence structure had any of several standard forms. The ranking procedures

simplified the computations necessary to determine an optimum portfolio.

Faaland, Bruce H. and jacob, Nancy l, (1981), examined alternative solution procedure to

achieve the objective of chossing 'n' securities from a universe of 'm' securities in order to

maximise the portfolio's excess-return-to Beta ratio. The paper concluded with

computational experience on problems with 'n' ranging from 10 to 200 and 'm' from 500

to 1245.

Mulvey, John M, et al., (2003), observed that a multiperiod portfolio model provides

significant advantages over traditional single-period approaches-especially for long-term

investors. Such a framework can enhance risk adjusted performance and help investors

evaluate the probability of reaching financial goals by linking asset and liability policies.

2.3 STATEMENT OF PROBLEM

Investors generally hold a portfolio of securities to take advantage of diversification,

while individual return and risks are important, what matters finally is the return and risk

of the portfolio. In constructing a portfolio fundamental analysis can be used to select



securities or Sharpe single index model can be used to construct an optimal portfolio. In

many cases it is seen that securities trade above their intrinsic value especially in the

recent times because of boom in stock market, as a result investors pay more to purchase

them and the returns are not up to the mark. Hence the study entitled:-―Portfolio

construction using fundamental analysis‖

2.4 OBJECTIVES OF THE STUDY

To undertake study of banking sector.

To identify stocks in banking sector which trade for less than their intrinsic value.

To construct a portfolio of banking stocks which are undervalued.

To construct a portfolio of banking stocks using Sharpe single index model.

To find if there is a significant difference in mean returns of portfolio constructed

using fundamental and optimization approach.

2.5 SCOPE OF THE STUDY

Scope of the research is confined to valuation of selected Banking stocks, construction of

portfolio based on the analysis and to check the significant difference between returns of

the portfolios.

2.6 OPERATIONAL DEFINITION OF CONCEPTS

Fundamental Analysis:

A method of evaluating a stock by attempting to measure its intrinsic value.

Fundamental analysts study everything from the overall economy and industry

conditions, to the financial conditions and management of companies.



Intrinsic value:

The economic value of a company or its common stock based on internally-

generated cash returns. Intrinsic value can be thought of as the discounted stream

of net cash flows from an asset

Beta:

A statistical measure of the relative volatility of a stock, fund, or other security in

comparison with the market as a whole. The beta for the market is 1.00. Stocks

with betas above 1.0 are more responsive to the market, but are also more risky

investments. Stocks with a beta below 1.0 tend to move in the opposite direction

of the market. It is measure of systematic risk of a stock

Free cash flow to Firm:

The cash flows to the firm are those cash flows left over after meeting operating

expenses and taxes but before making payments to any claimholders.

FCFF = EBIT (1-tax rate) + Depreciation – Capital Expenditures –

Working Capital Needs

Weighted Average Cost Of Capital:

A calculation of a firm's cost of capital that weights each category of capital

proportionately. WACC is calculated by multiplying the cost of each capital

component by its proportional weighting and then summing.

Single index model:

A model of stock returns that decomposes influences on returns into a systematic

factor, as measured by the return on the broad market index, and firm specific

factors.



2.7 RESEARCH METHODOLOGY

Type of Study:

The research conducted is a Analytical study. It may involve relating the

interaction of two or more variables. In this project a study is conducted to

determine the level of significance in portfolio mean returns constructed through

fundamental analysis and Sharpe single index model.

Type of Data:

Data required for this study was secondary data which was collected from various

secondary sources like capital line Database, NSE India , BSE , Ministry of

Bankings, Investopedia, Economy watch, Money.rediffmail etc.

Method of Sampling:

The sampling technique followed for the study is non-probabilistic judgmental

sampling. The samples were collected based on certain criteria which suited the

research objective

Sample Size:

The sample consists of 10 companies of the banking industry selected on the basis

of the research objective

Techniques of Analysis:

The Value growth FCFF model is used to find the intrinsic value of the selected

banking stocks, then as portfolio is constructed using these undervalued stocks.

This is followed by selecting stocks to construct an optimum portfolio using past

share price data through the Sharpe‘s optimization model. The return and risk

aspects were then compared between the two portfolios. Then the level of

significance between the return of portfolios constructed through fundamental



analysis and through Sharpe‘s optimization model was determined. The following

test is used to check the hypothesis

Test for equality /difference of mean portfolio returns

Ho : There is no significant difference between the returns of the two

Portfolios.

H1 : There is significant difference between the returns of the two portfolios.

The test statistics is

)( yxSE

yxtcal

The independent sample and dependent sample t-test do not apply in this case as

the portfolios have the same underlying securities.

The standard error (S.E.) in the difference in the portfolios‘ mean returns is found

to be

n

Covyxyxsiyx

yxSE

k

i

ijjjiiii

1

22 ))()(()(

)(

Using this for sample formula for standard error (S.E.), a test of equality

/difference of portfolio mean returns is constructed.

2.8 LIMITATIONS OF THE STUDY

The FCFF valuation model, like all Value-growth models, is sensitive to

assumptions about the expected growth rate.



The practical limitations are selecting an appropriate discount rate and estimating

the future cash flow.

2.9 OVERVIEW OF CHAPTER SCHEME

Chapter 1: Theoretical Background

This chapter covers the Theoretical background of the study. It gives a brief

introduction to fundamental analysis, factors to be considered for economy,

industry and company analysis, the strengths and weaknesses of fundamental

analysis. A brief note on the valuation approaches, free cash flow to firm method,

Capital Asset Pricing Model and some definitions of various performance

measures is given.

Chapter 2: Research Design

This chapter includes the statement of problem, objectives of the study, scope of

the research, methodology of research, the sources and tools of data collection,

sampling type and size, techniques of analysis, test for equality/ difference of mean

portfolio returns, limitations of the study, operational definitions and an overview

of the chapter scheme.

Chapter 3: Industry Analysis

This chapter covers the industry profile. It gives a brief introduction of the

Banking industry. This chapter includes history of Banking, riches of Indian

Banking, Indian Banking industry overview, Investment in Indian Banking

industry.

Chapter 4: Data Analysis

This chapter includes all the relevant calculations for valuation of banking stocks.

It also includes the methodology for portfolio construction based on Sharpe‘s

optimization model and the test for equality/ difference of mean portfolio returns.



Chapter 5: Summary of findings , Conclusions and Suggestions

This chapter gives the summary of findings of the study, conclusions and

suggestions.



3.1 THE INDIAN ECONOMY

3.1.1 Macroeconomic And Monetary Developments In 2008-09

The highlights of macroeconomic and monetary developments during 2008-09 are:

A. Overview

The Indian economy, after exhibiting strong growth during the second quarter of 2008-

09, has experienced moderation in the wake of the global economic slowdown. Although

agricultural outlook remains satisfactory, industrial growth has decelerated sharply and

services sector is slowing. The economic slowdown, during the second quarter vis-à-vis

the first quarter of 2008-09, was primarily driven by a moderation of consumption growth

and widening of trade deficit, offset partially by an acceleration in investment demand.

The balance of payments (BoP) for the first half of 2008-09 reflected a widening of the

current account deficit and moderation in capital flows. Net capital inflows reduced

sharply and remained volatile during 2008-09 with foreign direct investment inflows

showing an increase, while portfolio investments recording a substantial outflow.

The growth of non-food credit remained high during 2008-09, so far, albeit with some

moderation in recent months. Continued high growth in time deposits enabled the

banking system to sustain the credit expansion while the non-banking sources of funds to

the commercial sector declined.

The total flow of resources from banks and other sources to the commercial sector during

2008-09, so far, has been somewhat lower than the comparable period of 2007-08.

Financial markets in India, which, by and large, remained orderly from April 2008 to

mid-September 2008, witnessed heightened volatility subsequently reflecting the knock-

on effects of the disruptions in the international financial markets and the uncertainty that

followed. This necessitated the Reserve Bank to undertake a series of measures to inject



rupee and foreign exchange liquidity from mid-September 2008 onwards. Liquidity

conditions turned around and became comfortable from mid-November 2008.

Headline inflation has declined in major economies since July/August 2008. In India,

inflation measured as year-on-year variation in the wholesale price index (WPI) has

declined sharply since August 2008 and was at 5.6 per cent as of January 10, 2009.

On the macroeconomic front, the downside risks for economic growth emanate from

global economic slowdown, deterioration in global financial markets and slowing down

in domestic demand. On the positive side, factors include expected increase in

consumption demand mainly reflecting rise in basic exemption limits and tax slabs, Sixth

Pay Commission awards, debt waiver for farmers and pre-election expenditure. The

easing of international oil prices and commodity prices may help in softening the

inflationary pressure.

B. Output

According to estimates released by the Central Statistical Organisation (CSO) in

November 2008, the real GDP growth was placed at 7.6 per cent during the second

quarter of 2008-09 as compared with 9.3 per cent during the corresponding quarter of

2007-08, reflecting deceleration in growth of industry and services.

The Ministry of Agriculture has set a target for foodgrains production for 2008-09 at

233.0 million tonnes. According to the First Advance Estimates, the kharif foodgrains

production during 2008-09 was placed at 115.3 million tonnes (Fourth Advance

Estimates) as compared with that of 121.0 million tonnes during the previous year.

The index of industrial production during April-November 2008-09 recorded year-on-

year expansion of 3.9 per cent as compared with 9.2 per cent during April-November

2007-08. The manufacturing sector recorded growth of 4.0 per cent during April-

November 2008-09 (9.8 per cent during April-November 2007-08) and the electricity

sector recorded growth of 2.9 per cent (7.0 per cent during April-November 2007-08).



Available information on the leading indicators of services sector activity during April-

October 2008-09 indicate some acceleration in growth in respect of several indicators

such as railway revenue earning and freight traffic and export cargo handled by civil

aviation as compared with the corresponding period of 2007-08. On the other hand,

growth decelerated in respect of cargo handled at major ports and other indicators of civil

aviation excluding export cargo, commercial vehicles, cement and steel.

C. Aggregate Demand

Aggregate demand in the Indian economy is primarily domestically driven, though

exports have been gaining progressively higher importance in recent years. The economic

slowdown, during the second quarter vis-à-vis the first quarter of 2008-09, was primarily

driven by a moderation of consumption growth and widening of trade deficit, offset

partially by an acceleration in investment demand. On the other hand, the government

consumption expenditure accelerated during the same period.

According to the latest information on Central Government finances for 2008-09 (April-

November), the revenue deficit and fiscal deficit were placed higher than those in April-

November 2007 both in absolute terms and as per cent of budget estimates (BE) primarily

on account of higher revenue expenditure.

Tax revenue as per cent of BE was lower than a year ago on account of lower growth in

income tax, corporation tax and customs duties owing to economic slowdown. Aggregate

expenditure as per cent of BE, was higher than a year ago on account of higher revenue

expenditure, particularly, subsidies, defence, other economic services, social services and

plan grants to States/Union Territories.

While expenditure is slated to increase on account of the fiscal stimulus measures

undertaken by the Government to address the problem of economic slowdown, growth of

tax revenue is likely to decelerate in the coming months of 2008-09 due to moderation in

economic activity. The net cash outgo on account of the two supplementary demand for



grants is placed at Rs. 1,48,093 crore. This, in turn, will be reflected in the non-

attainability of the deficit targets for 2008-09 as envisaged in the Union Budget 2008-09.

During 2008-09 (up to January 13, 2009), special bonds amounting to Rs.44,000 crore

and Rs.14,000 crore have been issued to oil marketing companies and fertiliser

companies, respectively.

Sales performance of select non-Government non-financial public limited companies in

the private corporate sector during the first two quarters of 2008-09 was impressive;

however, profits performance was subdued as compared with 2007-08. Higher increase in

expenditure in relation to sales growth was primarily on account of rising input costs,

interest expenses and large provisioning towards mark to market (MTM) losses on

foreign exchange related transactions which exerted pressure on profits.

D. The External Economy

India‘s balance of payments position during the first half of 2008-09 (April-September)

reflected a widening of trade deficit resulting in large current account deficit, and

moderation in capital flows. Merchandise trade deficit recorded a sharp increase during

April-November 2008 on account of higher crude oil prices for most of the period and

loss of momentum in exports since September 2008. Net surplus under invisibles

remained buoyant, led by increase in software exports and private transfers. Net capital

inflows reduced sharply and have remained volatile during 2008-09 so far.

The large increase in merchandise trade deficit during April-September 2008 led to a

significant increase in the current account deficit over its level during April-September

2007. The widening of trade deficit during April-September 2008 could be attributed to

higher import payments reflecting high international commodity prices, particularly crude

oil prices.

The surplus in the capital account moderated during April-September 2008 reflecting

increased gross capital outflows on the back of global financial turmoil. While the net

inward FDI (net direct investment by foreign investors) remained buoyant reflecting



relatively strong fundamentals of the Indian economy and continuing liberalisation

measures to attract FDI, net outward FDI (net direct investment by Indian investors

abroad) also remained high during April-September 2008. The gross capital inflows were

higher on account of higher FDI inflows and NRI deposits during the period.

In terms of residual maturity, the revised short-term debt (below one year) comprising

sovereign debt, commercial borrowings, NRI deposits, short-term trade credit and others

maturing up to March 2009, was estimated at around US $ 85 billion as at end-March

2008.

According to the provisional data released by DGCI&S, India‘s merchandise exports

during April-November 2008 increased by 18.7 per cent while imports recorded a higher

growth of 32.5 per cent, largely due to the rise in petroleum, oil and lubricants (POL)

imports. The rise in oil imports was primarily due to the elevated international crude oil

prices, while the volume of oil imports moderated. Merchandise trade deficit during

April-November 2008 widened to US $ 84.4 billion from US $ 53.2 billion a year ago.

As of January 16, 2009, foreign exchange reserves at US $ 252.2 billion declined by US

$ 57.5 billion over the level at end-March 2008, including changes due to valuation

losses.

E. Monetary Conditions

Monetary and liquidity aggregates that expanded at a strong pace during the first half of

2008-09 showed some moderation during the third quarter reflecting the decline in capital

flows and consequent foreign exchange intervention by the Reserve Bank.

Growth in broad money (M3), year-on-year (y-o-y), was 19.6 per cent (Rs. 7,36,777

crore) on January 2, 2009 lower than 22.6 per cent (Rs. 6,91,768 crore) a year ago.

Aggregate deposits of banks, y-o-y, expanded 20.2 per cent (Rs.6,49,152 crore) on

January 2, 2009 as compared with 24.0 per cent (Rs. 6,21,944 crore) a year ago.



The growth in bank credit continued to remain high. Non-food credit by scheduled

commercial banks (SCBs) was 23.9 per cent (Rs.5,01,645 crore), y-o-y, as on January 2,

2009 from 22.0 per cent (Rs.3,79,655 crore) a year ago.

The intensification of global financial turmoil and its knock-on effect on the domestic

financial market, and downturn in headline inflation, necessitated the Reserve Bank to

ease its monetary policy since mid-September 2008.

Reserve money growth at 6.6 per cent, y-o-y, as on January 16, 2009 was much lower

than that of 30.6 per cent a year ago. Adjusted for the first round effect of the changes in

CRR, reserve money growth was 18.0 per cent as compared with 21.6 per cent a year

ago.

F. Financial Markets

The crisis in global financial markets deepened since mid-September 2008, triggered by

the collapse of Lehman Brothers followed by the failure of a number of other financial

firms across countries. The pressure on financial markets mounted with the credit spreads

widening to record levels and equity prices crashing to historic lows leading to

widespread volatility across the market spectrum. The turmoil transcended from credit

and money markets to the global financial system more broadly. The contagion also

spilled over to the emerging markets, which saw broad-based asset price declines amidst

depressed levels of risk appetite.

Added to this, there was a significant deterioration in the global economic outlook. As a

result, authorities in several countries embarked upon an unprecedented wave of policy

initiatives to contain systemic risk, arrest the plunge in asset prices and shore up the

confidence in the international banking system. While these initiatives did help in

restoring some level of stability, the financial market conditions remained far from

normal during the period October-December 2008.

Liquidity conditions tightened significantly in India between mid-September and October

2008 emanating from adverse international developments and some domestic



factors.Financial markets in India came under pressure since mid-September 2008,

reflecting the knock-on effects of the disruptions in the international financial markets.

This necessitated the Reserve Bank to undertake a series of measures to inject rupee and

foreign exchange liquidity from mid-September 2008 onwards.

Accordingly, money markets in India came under some pressure mirroring the impact of

capital outflows and redemption pressures faced by mutual funds and other investors. The

pressure on money markets was reflected in call rates breaching the upper bound of

Liquidity Adjustment Facility (LAF) corridor but settling back within the corridor by

November 2008. Interest rates in the collateralised segments of the money market moved

in tandem with but remained below the call rate during the third quarter of 2008-09.

In the credit market, lending rates of scheduled commercial banks, which had increased

initially, started declining in December 2008. Yields in the government securities market

also came to soften during the third quarter 2008-09.

In the foreign exchange market, Indian rupee generally depreciated against major

currencies. Indian equity markets witnessed downswings quite in line with trends in

major international equity markets.

The Reserve Bank swiftly initiated a series of measures, which helped to assuage

liquidity conditions, while reassuring the market that the Indian banking system

continued to be safe and sound, well capitalised and well regulated.

G. Price Situation

The accommodative monetary policy, which was pursued by most central banks since

September 2008, aimed at mitigating the adverse implications of the recent financial

market crisis on economic growth and employment.

Headline inflation moderated in major economies since July/August 2008 on account of

the marked decline in international energy and commodity prices as well as slowdown in



aggregate demand emerging from the persistence of financial market turmoil following

the US sub-prime crisis.

After remaining at elevated levels for an extended period, global commodity prices

declined sharply since the second quarter of 2008-09 led by decline in the prices of crude

oil, metals and food. The WTI crude oil prices have eased from its historical high of US $

145.3 a barrel level on July 3, 2008 to around US $ 42.3 a barrel as on January 22, 2009

reflecting falling demand in the Organisation for Economic Co-operation and

Development (OECD) countries as well as some developing countries, notably in Asia,

following the economic slowdown. Metal prices eased further during the third quarter of

2008-09, reflecting weak construction demand in OECD countries and some

improvement in supply, especially in China.

In India inflation, based on the year-on-year changes in wholesale price index (WPI),

declined sharply from an intra-year peak of 12.9 per cent on August 2, 2008 to 5.6 per

cent as on January 10, 2009. The recent decline in WPI inflation was driven by decline in

prices of minerals oil, iron and steel, oilseeds, edible oils, oil cakes, raw cotton.

Amongst major groups, primary articles inflation, year-on-year, increased to 11.6 per

cent on January 10, 2009 from 4.5 per cent a year ago and (it was 9.7 per cent at end-

March 2008). This mainly reflected increase in the prices of food articles, especially of

wheat, fruits, milk, and eggs, fish and meat as well as non-food articles such as oilseeds

and raw cotton. The fuel group inflation turned negative (-1.3 per cent) as on January 10,

2009 as compared to an intra-year peak of 18.0 per cent on August 2, 2008. This reflected

the reduction in the price of petrol by Rs. 5 per litre and diesel by Rs. 2 per litre effective

December 6, 2008 as well as decline in the prices of freely priced petroleum products in

the range of 30-65 per cent since August 2008.

Manufactured products inflation, year-on-year, also moderated to 5.9 per cent on January

10, 2009 as compared with the peak of 11.9 per cent in mid-August 2008 but remained

higher than 4.6 per cent a year ago. The year-on-year increase in manufactured products



prices was mainly driven by sugar, edible oils/oil cakes, textiles, chemicals, iron and steel

and machinery and machine tools.

Inflation, based on year-on-year variation in consumer price indices (CPIs), increased

further during November/December 2008 mainly due to increase in the prices of food,

fuel and services (represented by the ‗miscellaneous‘ group). Various measures of

consumer price inflation were placed in the range of 10.4-11.1 per cent during

November/December 2008 as compared with 7.3-8.8 per cent in June 2008 and 5.1-6.2

per cent in November 2007.

H. Macroeconomic Outlook

The various business expectations surveys released recently reflect less than optimistic

sentiments prevailing in the economy. The results of Professional Forecasters‘ Survey

conducted by the Reserve Bank in December 2008 also suggested further moderation in

economic activity for 2008-09.

According to the Reserve Bank‘s Industrial Outlook Survey of manufacturing companies

in the private sector, the business expectations indices based on assessment for October-

December 2008 and on expectations for January-March 2009 declined by 2.6 per cent

and 5.9 per cent, respectively, over the corresponding previous quarters.

The global economic outlook has deteriorated sharply since September 2008 with several

countries, notably the US, the UK, the Euro area and Japan experiencing recession. In

India too, there is evidence of a slowing down of economic activity. Unlike in the

advanced countries where the contagion of crisis spread from the financial to the real

sector, in India the slowdown in the real sector is affecting the financial sector, which in

turn, has a second-order impact on the real sector.

On the positive side factors include expected increase in consumption demand mainly

reflecting rise in basic exemption limits and tax slabs, Sixth Pay Commission awards,

debt waiver for farmers and pre-election expenditure.



WPI inflation has fallen sharply driven by falling international commodity prices

especially those of crude oil, steel and selected food items, although, some contribution

has also come from the slowing domestic demand. Going forward, the outlook on

international commodity prices indicate further softening of domestic prices.

3.2 INDIAN BANKING INDUSTRY PROFILE

3.2.1 Introduction

Financial sector reforms were initiated as part of overall economic reforms in the country

and wide ranging reforms covering industry, trade, taxation, external sector, banking and

financial markets have been carried out since mid 1991. A decade of economic and

financial sector reforms has strengthened the fundamentals of the Indian economy and

transformed the operating environment for banks and financial institutions in the country.

The sustained and gradual pace of reforms has helped avoid any crisis and has actually

fuelled growth. As pointed out in the RBI Annual Report 2001-02, GDP growth in the 10

years after reforms i.e. 1992-93 to 2001-02 averaged 6.0% against 5.8% recorded during

1980-81 to 1989-90 in the pre-reform period.

The most significant achievement of the financial sector reforms has been the marked

improvement in the financial health of commercial banks in terms of capital adequacy,

profitability and asset quality as also greater attention to risk management. Further,

deregulation has opened up new opportunities for banks to increase revenues by

diversifying into investment banking, insurance, credit cards, depository services,

mortgage financing, securitisation, etc. At the same time, liberalisation has brought

greater competition among banks, both domestic and foreign, as well as competition from

mutual funds, NBFCs, post office, etc. Post-WTO, competition will only get intensified,

as large global players emerge on the scene. Increasing competition is squeezing

profitability and forcing banks to work efficiently on shrinking spreads. A positive fallout

of competition is the greater choice available to consumers, and the increased level of

sophistication and technology in banks. As banks benchmark themselves against global



standards, there has been a marked increase in disclosures and transparency in bank

balance sheets as also greater focus on corporate governance.

3.2.2 Definition of Banking

Financial institutions may be defined as economic agents specialising in the activities of

buying and selling at the same time financial contracts and securities. Banks may be seen

as a subset of the financial institutions, which are retailers of financial securities: they

buy the securities issued by borrowers and they sell them to lenders. A bank is an

institution whose current operations consist in granting loans and receiving deposits from

the public.

Definition of "Banking" as per the Banking Regulation Act, 1949 says-"banking" means

the accepting, for the purpose of lending or investment, of deposits of money from the

public, repayable on demand or otherwise, and withdraw able by cheque, draft, order or

otherwise". The Act defined the functions that a commercial bank can undertake and

restricted their sphere of activities

Dr. Paget in Law of Banking states, ―No one and no body, corporate or otherwise, can be

a banker who does not:

i. Conduct Current Accounts

ii. Pays cheques drawn on himself

iii. Collects cheques for his customers

A bank is therefore ―Any company that transacts the business of banking in India‖.

Negotiable Instrument Act.

Banker:

Banker is ―Any person acting as a banker‖ Negotiable Instrument Act.

A bank is a business which provides financial services, usually for profit. The name bank

derives from the Italian word banco, desk, used during the Renaissance by Florentines

bankers, who used to make their transactions above a desk covered by a green tablecloth.



A commercial bank accepts deposits from customers and in turn makes loans based on

those deposits. Traditional banking services include receiving deposits of money,

lending money and processing transactions. Some banks (called Banks of issue) issue

banknotes as legal tender. Many banks offer ancillary financial services to make

additional profit; for example: selling insurance products, investment products or stock

broking.

Currently in most jurisdictions commercial banks are regulated and require permission to

operate. Operational authority is granted by bank regulatory authorities and provides

rights to conduct the most fundamental banking services such as accepting deposits and

making loans. A commercial bank is usually defined as an institution that both accepts

deposits and makes loans; there are also financial institutions that provide selected

banking services without meeting the legal definition of a bank.

Banks have a long history, and have influenced economies and politics for centuries. In

history, the primary purpose of a bank was to provide liquidity to trading companies.

Banks advanced funds to allow businesses to purchase inventory, and collected those

funds back with interest when the goods were sold. For centuries, the banking industry

only dealt with businesses, not consumers. Commercial lending today is a very intense

activity, with banks carefully analysing the financial condition of its business clients to

determine the level of risk in each loan transaction. Banking services have expanded to

include services directed at individuals and risks in these much smaller transactions are

pooled.

A bank generates a profit from the differential between what level of interest it pays for

deposits and other sources of funds, and what level of interest it charges in its lending

activities. This difference is referred to as the spread between the cost of funds and the

loan interest rate. Historically, profitability from lending activities has been cyclic and

dependent on the needs and strengths of loan customers. In recent history, investors have

demanded a more stable revenue stream and banks have therefore placed more emphasis

on transaction fees, primarily loan fees but also including service charges on array of



deposit activities and ancillary services (international banking, foreign exchange,

insurance, investments, wire transfers, etc.). However, lending activities still provide the

bulk of a commercial bank's income.

3.2.3 Initial Phase of Nationalisation

When the country attained independence Indian Banking was exclusively in the private

sector. In addition to the Imperial Bank, there were five big banks each holding public

deposits aggregating Rs.100 Crores and more, viz. the Central Bank of India Ltd., the

Punjab National Bank Ltd., the Bank of India Ltd., the Bank of Baroda Ltd. and the

United Commercial Bank Ltd. Rest of the banks were exclusively regional in character

holding deposits of less than Rs.50 Crores.

Government first implemented the exercise of nationalisation of a significant part of the

Indian Banking system in the year 1955, when Imperial Bank of India was Nationalized

in that year for the stated objective of "extension of banking facilities on a large scale,

more particularly in the rural and semi-urban areas, and for diverse other public

purposes" to form State Bank of India. SBI was to act as the principal agent of the RBI

and handle banking transactions of the Union & State Governments throughout India.

The step was in fact in furtherance of the objectives of supporting a powerful rural credit

cooperative movement in India and as recommended by the "The All-India Rural Credit

Survey Committee Report, 1954". State Bank of India was obliged to open an accepted

number of branches within 5 years in unbanked centers. Government subsidised the bank

for opening unremunerative branches in non-urban centres. The seven banks now

forming subsidiaries of SBI were nationalised in the year 1960. This brought one-third of

the banking segment under the direct control of the Government of India.

But the major process of nationalisation was carried out on 19th July 1969, when the then

Prime Minister of India, Mrs.Indira Gandhi announced the nationalisation of 14 major

commercial banks in the country. One more phase of nationalisation was carried out in

the year 1980, when seven more banks were nationalised. This brought 80% of the



banking segment in India under Government ownership. The country entered the second

phase, i.e. the phase of Nationalised Banking with emphasis on Social Banking in

1969/70.

Chronology of Salient steps by the Government after Independence to Regulate Banking

Institutions in the Country

1949 : Enactment of Banking Regulation Act.

1955(Phase I) : Nationalisation of State Bank of India

1959(Phase II) : Nationalisation of SBI subsidiaries

1961 : Insurance cover extended to deposits

1969(Phase III) : Nationalisation of 14 major banks

1971 : Creation of credit guarantee corporation

1975 : Creation of regional rural banks

1980(Phase IV) : Nationalisation of seven banks with deposits over 200 crores.

3.2.4 Regulatory and Legal Environment

The advent of liberalization and globalization has seen a lot of changes in the focus of

Reserve Bank of India as a regulator of the banking industry. De-regulation of interest

rates and moving away from issuing operational prescriptions have been important

changes. The focus has clearly shifted from micro monitoring to macro management.

Supervisory role is also shifting more towards off-site surveillance rather than on-site

inspections. The focus of inspection is also shifting from transaction-based exercise to

risk-based supervision. In a totally de-regulated and globalised banking scenario, a

strong regulatory framework would be needed. The role of regulator would be critical

for:

Ensuring soundness of the system by fixing benchmark standards for capital



adequacy and prudential norms for key performance parameters.

Adoption of best practices especially in areas like risk-management, provisioning,

disclosures, credit delivery, etc.

Adoption of good corporate governance practices.

Creation of an institutional framework to protect the interest of depositors.

Regulating the entry and exit of banks including cross-border institutions.

A. The Need for Regulation

Banking is one of the most heavily regulated businesses since it is a very highly

leveraged (high debt-equity ratio or low capital-assets ratio) industry. In fact, it is an

irony that banks, which constantly judge their borrowers on debt-equity ratio, have

themselves a debt-equity ratio far too adverse than their borrowers! In simple words, they

earn by taking risk on their creditors‘ money rather than shareholders‘ money. And since

it is not their money (shareholders‘ stake) on the block, their appetite for risk needs to be

controlled.

B. Bank Failures and Systemic Risk

The wonder of banking (a financial innovation that seems to create money out of nothing)

has had its inglorious moments beginning from the times of John Law and his Banque

Royale in 1720 right upto the recent failures of co-operative banks in Gujarat and

Maharashtra in India.

`A bank fails economically when the market value of its assets declines below the market

value of its liabilities, so that the market value of its capital (net worth) becomes

negative. At such times, the bank cannot expect to pay all of its depositors in full and on

time.’ (George G. Kaufman, Bank Failures, Systemic Risk, and Bank Regulation, 1995)

There is a risk that the failure of one bank may spill over to other banks and possibly

even beyond the banking system to the financial system as a whole, to the domestic

macro economy, and to other countries. Banks indulge in continuous lending and



borrowing, to and from each other, and need to pay other banks for third-party transfers,

and therefore, tend to be very tightly financially interconnected with each other. This is

recognized as systemic risk. Thus, banks are particularly susceptible to systemic risk, and

shocks at any one bank are viewed as likely to be quickly transmitted to other banks,

which in turn can transmit the shock to the corresponding chain of banks.

C. Settlement Risk

At the granular level, it is settlement risk that propagates bank defaults. Settlement risk

could possibly result from defaults in the payments clearing process, especially when the

payment and receipt of funds are not simultaneous i.e. when funds are disbursed before

they are received. As a result, credit is extended by one bank to another. If final

settlement of net outstanding balances at each participating bank is made only at the day-

end (net settlement) there is a possibility of an intra-day or daylight overdraft which

might lead to default by some banks if their anticipated funds position at the end of the

day is not realized.

This risk is being addressed by the Real Time Gross Settlement (RTGS) where large

value domestic transactions and Continuous Linked Settlement (CLS) for foreign

exchange transactions worldwide in major currencies are settled on a one to one basis.

The central idea is to complete both legs of any large transaction simultaneously --- in

domestic currency and foreign exchange transactions --- to avoid settlement exposures.

For transactions in securities, it is delivery versus payment; in other transactions, it is

payment versus payment. The essence is to eliminate time lag between the two legs of a

transaction, whether on account of net settlement procedures or difference in time zones.

3.2.5 Goals And Tools For Bank Regulation And Supervision

The main goal of all regulators is the stability of the banking system. However, regulators

cannot be concerned solely with the safety of the banking system, for if that was the only

purpose, it would impose a narrow banking system, in which checkable deposits are fully

backed by absolutely safe assets – in the extreme, currency. Coexistent with this primary



concern is the need to ensure that the financial system operates efficiently. As we have

seen, banks need to take risks to be in business despite a probability of failure. In fact,

Alan Greenspan puts it very succinctly, `providing institutions with the flexibility that

may lead to failure is as important as permitting them the opportunity to succeed‘.

The twin supervisory or regulatory goals of stability and efficiency of the financial

system often seem to pull in opposite directions and there is much debate raging on the

nature and extent of the trade-off between the two. Though very interesting, it is outside

the scope of this report to elaborate upon. Instead, let us take a look at the list of some

tools that regulators employ:

Restrictions on bank activities and banking-commerce links: To avoid

conflicts of interest that may arise when banks engage in diverse activities such as

securities underwriting, insurance underwriting, and real estate investment.

Restrictions on domestic and foreign bank entry: The assumption here is that

effective screening of bank entry can promote stability.

Capital Adequacy: Capital serves as a buffer against losses and hence also

against failure. Capital adequacy is deemed to control risk appetite of the bank by

aligning the incentives of bank owners with depositors and other creditors.

Deposit Insurance: Deposit insurance schemes are to prevent widespread bank

runs and to protect small depositors but can create moral hazard (which means in

simple terms the propensity of both firms and individuals to take more risks when

insured).

Information disclosure & private sector monitoring: Includes certified audits

and/or ratings from international rating agencies. Involves directing banks to

produce accurate, comprehensive and consolidated information on the full range

of their activities and risk management procedures.



Government Ownership: The assumption here is that governments have

adequate information and incentives to promote socially desirable investments

and in extreme cases can transfer the depositors‘ loss to tax payers! Government

ownership can, at times, promote financing of politically attractive projects and

not the economically efficient ones.

Mandated liquidity reserves: To control credit expansion and to ensure that

banks have a reasonable amount of liquid assets to meet their liabilities.

Loan classification, provisioning standards & diversification guidelines:

These are controls to manage credit risk.

Further, the expected integration of various intermediaries in the financial system would

add a new dimension to the role of regulators. Also as the co-operative banks are

expected to come under the direct regulatory control of RBI as against the dual control

system in vogue, regulation and supervision of these institutions will get a new direction.

Some of these issues are addressed in the recent amendment Bill to the Banking

Regulation Act introduced in the Parliament.

The integration of various financial services would need a number of legislative changes

to be brought about for the system to remain contemporary and competitive. The need

for changes in the legislative framework has been felt in several areas and steps have

been taken in respect of many of these issues, such as,

Abolition of SICA / BIFR setup and formation of a National Company Law

Tribunal to take up industrial re-construction.

Enabling legislation for sharing of credit information about borrowers among

lending institutions.

Integration of the financial system would change the way we look at banking functions.

The present definition of banking under Banking Regulation Act would require changes,



if banking institutions and non-banking entities are to merge into a unified financial

system

While the recent enactments like amendments to Debt Recovery Tribunal (DRT)

procedures and passage of Securitisation and Reconstruction of Financial Assets and

Enforcement of Security Interest Act, 2002 (SARFAESI Act) have helped to improve the

climate for recovery of bank dues, their impact is yet to be felt at the ground level. It

would be necessary to give further teeth to the legislations, to ensure that recovery of

dues by creditors is possible within a reasonable time. The procedure for winding up of

companies and sale of assets will also have to be streamlined.

In the recent past, Corporate Debt Restructuring has evolved as an effective voluntary

mechanism. This has helped the banking system to take timely corrective actions when

borrowing corporates face difficulties. With the borrowers gaining confidence in the

mechanism, it is expected that CDR setup would gain more prominence making NPA

management somewhat easier. It is expected that the issue of giving statutory backing

for CDR system will be debated in times to come.

In the emerging banking and financial environment there would be an increased need for

self-regulation. This is all the more relevant in the context of the stated policy of RBI to

move away from micro-management issues. Development of best practices in various

areas of banks‘ working would evolve through self-regulation rather than based on

regulatory prescriptions.

Role of Indian Banks‘ Association would become more pronounced as a self regulatory

body. Development of benchmarks on risk management, corporate governance,

disclosures, accounting practices, valuation of assets, customer charter, Lenders‘

Liability, etc. would be areas where IBA would be required to play a more proactive role.

The Association would also be required to act as a lobbyist for getting necessary

legislative enactments and changes in regulatory guidelines.

HR practices and training needs of the banking personnel would assume greater

importance in the coming days. Here again, common benchmarks could be evolved.



Talking about shared services, creation of common database and conducting research on

contemporary issues to assess anticipated changes in the business profile and market

conditions would be areas where organizations like Indian Banks‘ Association are

expected to play a greater role.

Evolution of Corporate Governance being adopted by banks, particularly those who have

gone public, will have to meet global standards over a period of time. In future, Corporate

Governance will guide the way Banks are to be run. Good Corporate Governance is not a

straight jacketed formula or process; there are many ways of achieving it as international

comparisons demonstrate, provided the following three basic principles are followed:-

Management should be free to drive the enterprise forward with the minimum

interference and maximum motivation.

Management should be accountable for the effective and efficient use of this

freedom. There are two levels of accountability – of management to the Board

and of the Board to the Shareholders. The main task is to ensure the continued

competence of management, for without adequate and effective drive, any

business is doomed to decline. As stated by J.Wolfensohn, President, World Bank

– ―Corporate governance is about promoting corporate fairness, transparency and

accountability‖.

In order to enlist the confidence of the global investors and international market

players, the banks will have to adopt the best global practices of financial

accounting and reporting. This would essentially involve adoption of judgmental

factors in the classification of assets, based on Banks‘ estimation of the future

cash flows and existing environmental factors, besides strengthening the capital

base accordingly.

When we talk about adoption of International accounting practices and reporting formats

it is relevant to look at where we stand and the way ahead. Accounting practices being

followed in India are as per Accounting Standards set by the Institute of Chartered



Accountants of India (ICAI). Companies are required to follow disclosure norms set

under the Companies Act and SEBI guidelines relating to listed entities. Both in respect

of Accounting Practices and disclosures, banks in India are guided by the Reserve bank

of India guidelines issued from time to time. Now these are, by and large, in line with the

Accounting Standards of ICAI and other regulatory bodies. It is pertinent to note that

Accounting Standards of ICAI are based on International Accounting Standards (IAS)

being followed in a large number of countries. Considering that US forms 40% of the

financial markets in the world compliance with USGAAP has assumed greater

importance in recent times. Many Indian banks desirous of raising resources in the US

market have adopted accounting practices under USGAAP and we expect more and more

Indian Financial entities to move in this direction in the coming years.

There are certain areas of differences in the approach under the two main international

accounting standards being followed globally. Of late, there have been moves for

convergence of accounting standards under IAS and USGAAP and this requires the

standard setters to agree on a single, high-quality answer.

In the Indian context, one issue which is likely to be discussed in the coming years is the

need for a common accounting standard for financial entities. While a separate standard

is available for financial entities under IAS, ICAI has not so far come out with an Indian

version in view of the fact that banks, etc. are governed by RBI guidelines. It is

understood that ICAI is seized of the matter. It is expected that banks would migrate to

global accounting standards smoothly in the light of these developments, although it

would mean greater disclosure and tighter norms.

3.2.6 Risk Management

Risk is inherent in any commercial activity and banking is no exception to this rule.

Rising global competition, increasing deregulation, introduction of innovative products

and delivery channels have pushed risk management to the forefront of today‘s financial

landscape. Ability to gauge the risks and take appropriate position will be the key to



success. It can be said that risk takers will survive, effective risk managers will prosper

and risk averse are likely to perish. In the regulated banking environment, banks had to

primarily deal with credit or default risk. As we move into a perfect market economy, we

have to deal with a whole range of market related risks like exchange risks, interest rate

risk, etc. Operational risk, which had always existed in the system, would become more

pronounced in the coming days as we have technology as a new factor in today‘s

banking. Traditional risk management techniques become obsolete with the growth of

derivatives and off-balance sheet operations, coupled with diversifications. The

expansion in E-banking will lead to continuous vigilance and revisions of regulations.

Building up a proper risk management structure would be crucial for the banks in the

future. Banks would find the need to develop technology based risk management tools.

The complex mathematical models programmed into risk engines would provide the

foundation of limit management, risk analysis, computation of risk-adjusted return on

capital and active management of banks‘ risk portfolio. Measurement of risk exposure is

essential for implementing hedging strategies.

Under Basel II accord, capital allocation will be based on the risk inherent in the asset.

The implementation of Basel II accord will also strengthen the regulatory review process

and, with passage of time, the review process will be more and more sophisticated.

Besides regulatory requirements, capital allocation would also be determined by the

market forces. External users of financial information will demand better inputs to make

investment decisions. More detailed and more frequent reporting of risk positions to

banks‘ shareholders will be the order of the day. There will be an increase in the growth

of consulting services such as data providers, risk advisory bureaus and risk reviewers.

These reviews will be intended to provide comfort to the bank managements and

regulators as to the soundness of internal risk management systems.

Risk management functions will be fully centralized and independent from the business

profit centres. The risk management process will be fully integrated into the business

process. Risk return will be assessed for new business opportunities and incorporated



into the designs of the new products. All risks – credit, market and operational and so on

will be combined, reported and managed on an integrated basis. The demand for Risk

Adjusted Returns on Capital (RAROC) based performance measures will increase.

RAROC will be used to drive pricing, performance measurement, portfolio management

and capital management.

Risk management has to trickle down from the Corporate Office to branches or operating

units. As the audit and supervision shifts to a risk based approach rather than transaction

orientation, the risk awareness levels of line functionaries also will have to increase.

Technology related risks will be another area where the operating staff will have to be

more vigilant in the coming days.

Banks will also have to deal with issues relating to Reputational Risk as they will need to

maintain a high degree of public confidence for raising capital and other resources. Risks

to reputation could arise on account of operational lapses, opaqueness in operations and

shortcomings in services. Systems and internal controls would be crucial to ensure that

this risk is managed well.

The legal environment is likely to be more complex in the years to come. Innovative

financial products implemented on computers, new risk management software, user

interfaces etc., may become patentable. For some banks, this could offer the potential for

realizing commercial gains through licensing.

Advances in risk management (risk measurement) will lead to transformation in capital

and balance sheet management. Dynamic economic capital management will be a

powerful competitive weapon. The challenge will be to put all these capabilities together

to create, sustain and maximise shareholders‘ wealth. The bank of the future has to be a

total-risk-enabled enterprise, which addresses the concerns of various stakeholders‘

effectively.

Risk management is an area the banks can gain by cooperation and sharing of experience

among themselves. Common facilities could be considered for development of risk



measurement and mitigation tools and also for training of staff at various levels.

Needless to add, with the establishment of best risk management systems and

implementation of prudential norms of accounting and asset classification, the quality of

assets in commercial banks will improve on the one hand and at the same time, there will

be adequate cover through provisioning for impaired loans. As a result, the NPA levels

are expected to come down significantly.

3.2.7 Types of Banks

There are various types of banks which operate in our country to meet the financial

requirements of different categories of people engaged in agriculture, business,

profession, etc. On the basis of functions, the banking institutions in India may be divided

into the following types:

Central Bank

(RBI, in India)

Development Banks

Specialized Banks

(EXIM Bank SIDBI,

NABARD)

Types of Banks

Commercial Banks

a) Public Sector Banks

b) Private Sector Banks

c) Foreign Banks

Co-operative Banks

a) Primary Credit Societies

b) Central Co-operative Banks

c) State Co-operative Banks



A. Central Bank

A bank which is entrusted with the functions of guiding and regulating the banking

system of a country is known as its Central bank. Such a bank does not deal with the

general public. It acts essentially as Government‘s banker; maintain deposit accounts of

all other banks and advances money to other banks, when needed. The Central Bank

provides guidance to other banks whenever they face any problem. It is therefore known

as the banker‘s bank.

The Reserve Bank of India is the central bank of our country. The Central Bank

maintains record of Government revenue and expenditure under various heads. It also

advises the Government on monetary and credit policies and decides on the interest rates

for bank deposits and bank loans. In addition, foreign exchange rates are also determined

by the central bank. Another important function of the Central Bank is the issuance of

currency notes, regulating their circulation in the country by different methods. No other

bank than the Central Bank can issue currency.

B. Commercial Banks

Commercial Banks are banking institutions that accept deposits and grant short-term

loans and advances to their customers. In addition to giving short-term loans, commercial

banks also give medium-term and long-term loan to business enterprises. Now-a-days

some of the commercial banks are also providing housing loan on a long-term basis to

individuals. There are also many other functions of commercial banks, which are

discussed later in this lesson.

According to Bank of India Act, 1934 a scheduled bank, is entitled to facilities of

refinance from RBI, subject to fulfillment of the following conditions laid down in

Section 42 (6) of the Act, as follows:

It must have paid-up capital and reserves of an aggregate value of not less than an

amount specified from time to time; and



It must satisfy RBI that its affairs are not being conducted in a manner detrimental

to the interests of its depositors.

The classification of commercial banks into scheduled and nonscheduled categories that

was introduced at the time of establishment of RBI in 1935 has been extended during the

last two or three decades to include state cooperative banks, primary urban cooperative

banks, and RRBs. RBI is authorized to exclude the name of any bank from the Second

Schedule if the bank, having been given suitable opportunity to increase the value of

paid-up capital and improve deficiencies, goes into liquidation or ceases to carry on

banking activities

Types of Commercial banks:

a) Public Sector Banks:

These are banks where majority stake is held by the Government of India or

Reserve Bank of India. Examples of public sector banks are: State Bank of India,

Corporation Bank, Bank of Baroda and Dena Bank etc.

b) Private Sectors Banks:

In case of private sector banks majority of share capital of the bank is held by

private individuals. These banks are registered as companies with limited liability.

For example: The Jammu and Kashmir Bank Ltd., ICICI Bank, HDFC Bank,

Development Credit Bank Ltd, ING Vysya Bank, etc.

c) Foreign Banks:

These banks are registered and have their headquarters in a foreign country but

operate their branches in our country. Some of the foreign banks operating in our

country are Hong Kong and Shanghai Banking Corporation (HSBC), Citibank,

American Express Bank, Standard & Chartered Bank etc. The number of foreign

banks operating in our country has increased since the financial sector reforms of

1991.



C. Development Banks

Business often requires medium and long-term capital for purchase of machinery and

equipment, for using latest technology, or for expansion and modernization. Such

financial assistance is provided by Development Banks. They also undertake other

development measures like subscribing to the shares and debentures issued by

companies, in case of under subscription of the issue by the public. Industrial Finance

Corporation of India (IFCI) and State Financial Corporations (SFCs) are examples of

development banks in India.

D. Co-operative Banks

People who come together to jointly serve their common interest often form a co-

operative society under the Co-operative Societies Act. When a co-operative society

engages itself in banking business it is called a Co-operative Bank. The society has to

obtain a license from the Reserve Bank of India before starting banking business. Any

co-operative bank as a society is to function under the overall supervision of the

Registrar, Co-operative Societies of the State. As regards banking business, the society

must follow the guidelines set and issued by the Reserve Bank of India.

Types of Co-operative Banks

There are three types of co-operative banks operating in our country. They are primary

credit societies, central co-operative banks and state co-operative banks. These banks are

organized at three levels, village or town level, district level and state level.

a) Primary Credit Societies: These are formed at the village or town level with

borrower and non-borrower members residing in one locality. The operations of

each society are restricted to a small area so that the members know each other

and are able to watch over the activities of all members to prevent frauds.

b) Central Co-operative Banks: These banks operate at the district level having

some of the primary credit societies belonging to the same district as their



members. These banks provide loans to their members (i.e., primary credit

societies) and function as a link between the primary credit societies and state co-

operative banks.

c) State Co-operative Banks: These are the apex (highest level) co-operative banks

in all the states of the country. They mobilize funds and help in its proper

channelisation among various sectors. The money reaches the individual

borrowers from the state co-operative banks through the central co-operative

banks and the primary credit societies.

E. Specialized Banks

There are some banks, which cater to the requirements and provide overall support for

setting up business in specific areas of activity. EXIM Bank, SIDBI and NABARD are

examples of such banks. They engage themselves in some specific area or activity and

thus, are called specialized banks.

a) Export Import Bank of India (EXIM Bank): If you want to set up a business

for exporting products abroad or importing products from foreign countries for

sale in our country, EXIM bank can provide you the required support and

assistance. The bank grants loans to exporters and importers and also provides

information about the international market. It gives guidance about the

opportunities for export or import, the risks involved in it and the competition to

be faced, etc.

b) Small Industries Development Bank of India (SIDBI): If you want to establish

a small-scale business unit or industry, loan on easy terms can be available

through SIDBI. It also finances modernization of small-scale industrial units, use

of new technology and market activities. The aim and focus of SIDBI is to

promote, finance and develop small-scale industries.

c) National Bank for Agricultural and Rural Development (NABARD): It is a

central or apex institution for financing agricultural and rural sectors. If a person



is engaged in agriculture or other activities like handloom weaving, fishing, etc.

NABARD can provide credit, both short-term and long-term, through regional

rural banks. It provides financial assistance, especially, to co-operative credit, in

the field of agriculture, small-scale industries, cottage and village industries

handicrafts and allied economic activities in rural areas.

3.2.8 Functions Of Commercial Banks

The functions of commercial banks are of two types.

Primary functions

Secondary functions

A. Primary functions

The primary functions of a commercial bank include:

Accepting deposits

Granting loans and advances

a) Accepting deposits

The most important activity of a commercial bank is to mobilize deposits from the

public. People who have surplus income and savings find it convenient to deposit the

amounts with banks. Depending upon the nature of deposits, funds deposited with

bank also earn interest. Thus, deposits with the bank grow along with the interest

earned. If the rate of interest is higher, public are motivated to deposit more funds

with the bank. There is also safety of funds deposited with the bank.

b) Grant of loans and advances

The second important function of a commercial bank is to grant loans and advances.

Such loans and advances are given to members of the public and to the business

community at a higher rate of interest than allowed by banks on various deposit



accounts. The rate of interest charged on loans and advances varies according to the

purpose and period of loan and also the mode of repayment.

B. Secondary functions

In addition to the primary functions of accepting deposits and lending money, banks

perform a number of other functions, which are called secondary functions. These are as

follows,

Issuing letters of credit, traveler‘s cheque, etc.

Undertaking safe custody of valuables, important document and securities by

providing safe deposit vaults or lockers.

Providing customers with facilities of foreign exchange dealings.

Transferring money from one account to another; and from one branch to another

branch of the bank through cheque, pay order, demand draft.

Standing guarantee on behalf of its customers, for making payment for purchase

of goods, machinery, vehicles etc.

Collecting and supplying business information.

Providing reports on the credit worthiness of customers.

Providing consumer finance for individuals by way of loans on easy terms for

purchase of consumer durables like televisions, refrigerators, etc.

Educational loans to students at reasonable rate of interest for higher studies,

especially for professional courses.



3.2.9 Indian Banking Sector Reforms

The transformation of the banking sector in India needs to be viewed in light of the

overall economic reforms process along with the rapid changes that have been taking

place in the global environment within which banks operate. The global forces of change

include technological innovation, the deregulation of financial services internationally,

our own increasing exposure to international competition and, equally important, changes

in corporate behavior such as growing disinter mediation and increasing emphasis on

shareholder value. Recent banking crises in Asia, Latin America and elsewhere have

accentuated these pressures.

India embarked on a strategy of economic reforms in the wake of a serious balance-of-

payments crisis in 1991; a central plank of the reforms was reform in the financial sector

and, with banks being the mainstay of financial intermediation, the banking sector. The

objective of the banking sector reforms was to promote a diversified, efficient and

competitive financial system with the ultimate objective of improving the efficiency of

resources through operational flexibility, improved financial viability and institutional

strengthening.

As you are aware, the financial system in India by the late 1980s was characterized by

dominant government ownership of banks and financial institutions, widespread use of

administered and variegated interest rates, and financial repression through forced

financing of government fiscal deficits by banks and through monetization. Thus,

although a great degree of financial deepening had indeed taken place and financial

savings had increased continuously, financial markets were not really functioning, and

there was little price discovery in terms of the cost of money, i.e., interest rates. The

efficiency and productivity enhancing function of the financial system was severely

handicapped. Hence, a widespread financial sector reform effort has been underway since

1991.



Chart No: 3.1

Chart showing of Transformation Initiatives Needed for Banks

3.2.10 Major Reform Initiatives

Some of the major reform initiatives in the last decade that have changed the face of the

Indian banking and financial sector are:

Interest rate deregulation. Interest rates on deposits and lending have been

deregulated with banks enjoying greater freedom to determine their rates.

Adoption of prudential norms in terms of capital adequacy, asset classification,

income recognition, provisioning, exposure limits, investment fluctuation reserve,

etc.

Reduction in pre-emptions – lowering of reserve requirements (SLR and CRR),

thus releasing more lendable resources which banks can deploy profitably.

Government equity in banks has been reduced and strong banks have been

allowed to access the capital market for raising additional capital.



Banks now enjoy greater operational freedom in terms of opening and swapping

of branches, and banks with a good track record of profitability have greater

flexibility in recruitment.

New private sector banks have been set up and foreign banks permitted to expand

their operations in India including through subsidiaries. Banks have also been

allowed to set up Offshore Banking Units in Special Economic Zones.

New areas have been opened up for bank financing: insurance, credit cards,

infrastructure financing, leasing, gold banking, besides of course investment

banking, asset management, factoring, etc.

New instruments have been introduced for greater flexibility and better risk

management: e.g. interest rate swaps, forward rate agreements, cross currency

forward contracts, forward cover to hedge inflows under foreign direct

investment, liquidity adjustment facility for meeting day-to-day liquidity

mismatch.

Several new institutions have been set up including the National Securities

Depositories Ltd., Central Depositories Services Ltd., Clearing Corporation of

India Ltd., Credit Information Bureau India Ltd.

Limits for investment in overseas markets by banks, mutual funds and corporates

have been liberalized. The overseas investment limit for corporate has been raised

to 100% of net worth and the ceiling of $100 million on prepayment of external

commercial borrowings has been removed. MFs and corporates can now

undertake FRAs with banks.

Indians allowed to maintain resident foreign currency (domestic) accounts. Full

convertibility for deposit schemes of NRIs introduced.



Universal Banking has been introduced. With banks permitted to diversify into

long-term finance and DFIs into working capital, guidelines have been put in

place for the evolution of universal banks in an orderly fashion.

Technology infrastructure for the payments and settlement system in the country

has been strengthened with electronic funds transfer, Centralized Funds

Management System, Structured Financial Messaging Solution, Negotiated

Dealing System and move towards Real Time Gross Settlement.

Adoption of global standards. Prudential norms for capital adequacy, asset

classification, income recognition and provisioning are now close to global

standards. RBI has introduced Risk Based Supervision of banks (against the

traditional transaction based approach). Best international practices in accounting

systems, corporate governance, payment and settlement systems, etc. are being

adopted.

Credit delivery mechanism has been reinforced to increase the flow of credit to

priority sectors through focus on micro credit and Self Help Groups. The

definition of priority sector has been widened to include food processing and cold

storage, software upto Rs 1 crore, housing above Rs 10 lakh, selected lending

through NBFCs, etc.

RBI guidelines have been issued for putting in place risk management systems in

banks. Risk Management Committees in banks address credit risk, market risk

and operational risk. Banks have specialized committees to measure and monitor

various risks and have been upgrading their risk management skills and systems.

The limit for foreign direct investment in private banks has been increased from

49% to 74% and the 10% cap on voting rights has been removed. In addition, the

limit for foreign institutional investment in private banks is 49%.



Wide ranging reforms have been carried out in the area of capital markets. Fresh

investment in CPs, CDs are allowed only in dematerialized form. SEBI has

reduced the settlement cycle from T+3 to T+2 from April 1, 2003 i.e. settlement

of stock deals will be completed in two trading days after the trade is executed,

taking the Indian stock trading system ahead of some of the developed equity

markets. Stock exchanges will set up trade guarantee funds. Retail trading in

Government securities has been introduced on NSE and BSE from January 16,

2003. A Serious Frauds Office is proposed to be set up. Fungibility of ADRs and

GDRs allowed.

3.2.11 Value Added Services By Banks

A. E-banking (Electronic Banking)

With advancement in information and communication technology, banking

services are also made available through computer. Now, in most of the branches

you see computers being used to record banking transactions. Information about

the balance in your deposit account can be known through computers. In most

banks now a day‘s human or manual teller counter is being replaced by the

Automated Teller Machine (ATM). Banking activity carried on through

computers and other electronic means of communication is called ‗electronic

banking‘ or ‗e-banking‘. Let us now discuss about some of these modern trends in

banking in India.

B. Automated Teller Machine

Banks have now installed their own Automated Teller Machine (ATM)

throughout the country at convenient locations. By using this, customers can

deposit or withdraw money from their own account any time.

C. Debit Card

Banks are now providing Debit Cards to their customers having saving or current

account in the banks. The customers can use this card for purchasing goods and



services at different places in lieu of cash. The amount paid through debit card is

automatically debited (deducted) from the customers‘ account.

D. Credit Card

Credit cards are issued by the bank to persons who may or may not have an

account in the bank. Just like debit cards, credit cards are used to make payments

for purchase, so that the individual does not have to carry cash. Banks allow

certain credit period to the credit cardholder to make payment of the credit

amount. Interest is charged if a cardholder is not able to pay back the credit

extended to him within a stipulated period. This interest rate is generally quite

high.

E. Net Banking

With the extensive use of computer and Internet, banks have now started

transactions over Internet. The customer having an account in the bank can log

into the bank‘s website and access his bank account. He can make payments for

bills; give instructions for money transfers, fixed deposits and collection of bill,

etc.

F. Phone Banking

In case of phone banking, a customer of the bank having an account can get

information of his account; make banking transactions like, fixed deposits, money

transfers, demand draft, collection and payment of bills, etc. by using telephone.

As more and more people are now using mobile phones, phone banking is

possible through mobile phones. In mobile phone a customer can receive and send

messages (SMS) from and to the bank in addition to all the functions possible

through phone banking.



3.2.12 Challenges Ahead

The banking industry in India is undergoing a major transformation due to changes in

economic conditions and continuous deregulation. These multiple changes happening one

after other has a ripple effect on a bank (Refer fig.) trying to graduate from completely

regulated sellers market to completed deregulated customers market.

Chart No. 3.2

Chart showing of challenges facing Indian Banking Industry

A. Improving profitability:

The most direct result of the above changes is increasing competition and

narrowing of spreads and its impact on the profitability of banks. The challenge

for banks is how to manage with thinning margins while at the same time

working to improve productivity which remains low in relation to global

standards. This is particularly important because with dilution in banks‘ equity,



analysts and shareholders now closely track their performance. Thus, with falling

spreads, rising provision for NPAs and falling interest rates, greater attention will

need to be paid to reducing transaction costs. This will require tremendous

efforts in the area of technology and for banks to build capabilities to handle

much bigger volumes.

B. Reinforcing technology:

Technology has thus become a strategic and integral part of banking, driving

banks to acquire and implement world class systems that enable them to provide

products and services in large volumes at a competitive cost with better risk

management practices. The pressure to undertake extensive computerization is

very real as banks that adopt the latest in technology have an edge over others.

Customers have become very demanding and banks have to deliver customized

products through multiple channels, allowing customers access to the bank round

the clock.

C. Risk management:

The deregulated environment brings in its wake risks along with profitable

opportunities, and technology plays a crucial role in managing these risks. In

addition to being exposed to credit risk, market risk and operational risk, the

business of banks would be susceptible to country risk, which will be heightened

as controls on the movement of capital are eased. In this context, banks are

upgrading their credit assessment and risk management skills and retraining

staff, developing a cadre of specialists and introducing technology driven

management information systems.

D. Sharpening skills:

The far-reaching changes in the banking and financial sector entail a fundamental

shift in the set of skills required in banking. To meet increased competition and



manage risks, the demand for specialized banking functions, using IT as a

competitive tool is set to go up. Special skills in retail banking, treasury, risk

management, foreign exchange, development banking, etc., will need to be

carefully nurtured and built. Thus, the twin pillars of the banking sector i.e.

human resources and IT will have to be strengthened.

E. Greater customer orientation:

In today‘s competitive environment, banks will have to strive to attract and retain

customers by introducing innovative products, enhancing the quality of customer

service and marketing a variety of products through diverse channels targeted at

specific customer groups.

F. Corporate governance:

Besides using their strengths and strategic initiatives for creating shareholder

value, banks have to be conscious of their responsibilities towards corporate

governance. Following financial liberalisation, as the ownership of banks gets

broad based the importance of institutional and individual shareholders will

increase. In such a scenario, banks will need to put in place a code for corporate

governance for benefiting all stakeholders of a corporate entity.

G. International standards:

Introducing internationally followed best practices and observing universally

acceptable standards and codes is necessary for strengthening the domestic

financial architecture. This includes best practices in the area of corporate

governance along with full transparency in disclosures. In today‘s globalised

world, focusing on the observance of standards will help smooth integration with

world financial markets.



H. Deregulation:

This continuous deregulation has made the Banking market extremely

competitive with greater autonomy, operational flexibility, and decontrolled

interest rate and liberalized norms for foreign exchange. The deregulation of the

industry coupled with decontrol in interest rates has led to entry of a number of

players in the banking industry. At the same time reduced corporate credit off

take thanks to sluggish economy has resulted in large number of competitors

battling for the same pie.

I. New rules:

As a result, the market place has been redefined with new rules of the game.

Banks are transforming to universal banking, adding new channels with lucrative

pricing and freebees to offer. Natural fall out of this has led to a series of

innovative product offerings catering to various customer segments, specifically

retail credit.

J. Efficiency:

This in turn has made it necessary to look for efficiencies in the business. Banks

need to access low cost funds and simultaneously improve the efficiency. The

banks are facing pricing pressure, squeeze on spread and have to give thrust on

retail assets

K. Diffused Customer loyalty:

This will definitely impact Customer preferences, as they are bound to react to

the value added offerings. Customers have become demanding and the loyalties

are diffused. There are multiple choices; the wallet share is reduced per bank

with demand on flexibility and customisation. Given the relatively low switching

costs; customer retention calls for customized service and hassle free, flawless

service delivery.



L. Misaligned mindset:

These changes are creating challenges, as employees are made to adapt to

changing conditions. There is resistance to change from employees and the Seller

market mindset is yet to be changed coupled with fear of uncertainty and Control

orientation. Acceptance of technology is slowly creeping in but the utilization is

not maximised.

M. Competency Gap:

Placing the right skill at the right place will determine success. The competency

gap needs to be addressed simultaneously otherwise there will be missed

opportunities. The focus of people will be on doing work but not providing

solutions, on escalating problems rather than solving them and on disposing

customers instead of using the opportunity to cross sell.

3.2.13 Strategic Options With Banks To Cope With The Challenges

Leading players in the industry have embarked on a series of strategic and tactical

initiatives to sustain leadership. The major initiatives include:

Investing in state of the art technology as the back bone of to ensure reliable

service delivery

Leveraging the branch network and sales structure to mobilize low cost current

and savings deposits

Making aggressive forays in the retail advances segment of home and personal

loans

Implementing organization wide initiatives involving people, process and

technology to reduce the fixed costs and the cost per transaction

Focusing on fee based income to compensate for squeezed spread, (e.g.CMS,

trade services)



Innovating Products to capture customer ‗mind share‘ to begin with and later the

wallet share

3.2.14 Conclusion

The face of banking is changing rapidly. Competition is going to be tough and with

financial liberalisation under the WTO, banks in India will have to benchmark

themselves against the best in the world. For a strong and resilient banking and financial

system, therefore, banks need to go beyond peripheral issues and tackle significant issues

like improvements in profitability, efficiency and technology, while achieving economies

of scale through consolidation and exploring available cost-effective solutions. These are

some of the issues that need to be addressed if banks are to succeed, not just survive, in

the changing environment.



4. DATA ANALYSIS & INTERPRETATION

The Two growth FCFF model is used to find the intrinsic value of the selected Banking

stocks. This is followed by selecting stocks to construct an optimum portfolio using past

share price data through the Sharpe‘s optimization model. The return and risk aspects are

then compared between the two portfolios. Then the level of significance between the

return of portfolio constructed through fundamental analysis and portfolio constructed

through Sharpe‘s optimization model is determined.

The Two Stage growths Free Cash Flow to Firm Model is used for valuating the

following companies.

1) Allahabad Bank

2) Andhra Bank

3) Bank of Baroda

4) Bank of India

5) Bank of Maharashtra

6) Corporation Bank

7) IDBI Bank

8) Indian Bank

9) Indian Overseas Bank

10) Oriental Bank of Commerce



The Two-stage FCFF Model

The two stage FCFF model is designed to value a firm which is expected to grow much

faster than a stable firm in the initial period and at a stable rate after that.

The Model

The value of any stock is the present value of the FCFE per year for the extraordinary

growth period plus the present value of the terminal price at the end of the period.

Value = PV of FCFE + PV of terminal price

The terminal price is generally calculated using the infinite growth rate model,

Pn =FCFF n+1/r-gn

Where,

gn = Growth rate after the terminal year forever

4.1 EVALUATION OF IDBI BANK LTD

A Development Financial Institution (DFI) transformed into a full-service commercial

bank and named as Industrial Development Bank of India Ltd (IDBI). It was incorporated

as a wholly owned subsidiary of Reserve Bank of India (RBI) in the year of 1964. The

bank helping to build a modern and industrially buoyant India and supporting the dreams

of Corporate India to its fruition in every possible way for over 44 years and bank

reaching out over a broader operating canvas as a new generation full service commercial

bank IDBI focusing on industrial and economic development of the country and inclusive

banking, pervasive growth and unbounded prosperity and Bank has been actively

engaged in providing a major thrust to financing of Small & Medium Enterprises

(SMEs). In 1976 IDBI came under the holding of Government of India (GOI) by the way

of RBI's transfer. RBI surrendered its 100% stake to GOI . The Bank made its Initial

Public Offer (IPO) in July, 1995, it brought down GOI holding to 72% and the post-



capital restructuring to 58.1%. IDBI transferred its International Finance Division to

Export-Import Bank of India in the year 1982.

The Bank won the coveted "Outstanding Achiever of the Year Award-2006" under both

Corporate and Individual categories at the Indian Banks' Association (IBA) Awards 2006

organized by IBA and Trade Fares & Conferences International (TFCI) . It was also

awarded the Special Award for "Best Internet Bank for Corporate Customers" and for the

"IT Team of the Year" by Institute For Development and Research in Banking

Technology (IDRBT) in the same year and the RBI coffered the 'Bilingual House

Magazine' Award for the Bank's house journal 'Shree Vayam'. As of 2007, the Bank has

totally 432 branches, 18 extension counters and 523 ATMs spread across 255 cities,

reflects its effort to spread its wings across the country.

The Bank has entered into fourth tie-up for trading in carbon credits with Sumitomo of

Japan as on July 2007. Under this arrangement, companies could get single-point

assistance pertaining to origination and implementation of CDM projects, as well as

advisory services on generation and trading of carbon emission reductions (CERs). As of

April 2008 IDBI Fortis launched Life insurance business through joint venture with

Federal Bank and Fortis NV. IDBI Bank will set up a mutual fund subsidiary with IDBI

Capital markets, its wholly-owned subsidiary, after life insurance venture gets off the

ground. The bank will have a 65 per cent stake in the asset management company (AMC)

with IDBI Capital holding the remaining share. The banks odyssey has just begun. In the

quest for inclusive banking, pervasive growth and unbounded prosperity. Dividend of Rs.

20.00 per Equity Share of Rs.10/- each for the year ended 31st March, 2008 (Previous

year Rs. 15.00 per Equity Share of Rs.10/- each) is recommended.



Table No. 4.1

Table showing important Ratios of IDBI Bank Ltd

Ratios 31st 2008 Previous year

Debt-Equity Ratio 10.74 6.95

ROG-Capital Employed (%) 26.44 14.99

RONW (%) 11.19 7.37

ROG-Gross Sales (%) 26.4 17.93

Payout (%) 20.5 17.76

4.2 PORTFOLIO CONSTRUCTION USING FUNDAMANTAL

ANALYSIS

4.2.1 Calculation of Beta

BETA - Beta is a measure of a stock's volatility in relation to the market. The beta

coefficient is a key parameter in the capital asset pricing model (CAPM). It measures the

part of the asset's statistical variance that cannot be mitigated by the diversification

provided by the portfolio of many risky assets, because it is correlated with the return of

the other assets that are in the portfolio. The formula for the Beta of an asset within a

portfolio is,

MarketVar

stockmarketCoBeta

),var(



Table No. 4.2

Table showing beta calculation

Particulars Value

Variance of market 3.25

Covariance(market, stock) 3.95

beta 1.216

4.2.2 Calculation of Weighted Cost of Capital

WACC – It is firm's cost of capital in which each category of capital is proportionately

weighted. All capital sources - common stock, preferred stock, bonds and any other long-

term debt - are included in a WACC calculation. WACC is the average of the costs of

these sources of financing, each of which is weighted by its respective use in the given

situation. Firm‘s WACC is the overall required return on the firm as a whole. WACC is

calculated by multiplying the cost of each capital component by its proportional weight

and then summing:

WACC = (E / V)*RE + (D / V)*RD *(1-TC)

Where:

Ke = cost of equity

Kd = cost of debt

E = market value of the firm's equit

D = market value of the firm's debt

V = E + D



Tc = corporate tax rate

Table No. 4.3

Table showing calculation of WACC

4.2.3 Calculation of Capital Expenditure

Capital Expenditure - (CAPEX) are expenditures creating future benefits. A capital

expenditure is incurred when a business spends money either to buy fixed assets or to add

to the value of an existing fixed asset with a useful life that extends beyond the taxable

year.

Formula:

CAPEX= (Increase in Fixed Assets) + (Increase in Capital Work-in-progress) –

(Increase in Investments) – (Increase in depreciation)

The CAPEX was directly taken from the Capitaline database and for the current year

capex for IDBI bank Ltd is Rs. 112.14 crore.

Particulars Value

Cost of equity 10.16%

Market value of equity (Crores) 3,877.49

Proportion of Equity 0.09

Cost of debt 9.24%

Book value of debt (Crores) 38,612.56

Proportion of Debt 0.91

WACC 9.32%



4.2.4 FCFF Evaluation

Free Cash Flow to Firm model is used to value companies to be included in the portfolio.

The proportion of each of the undervalued stock to be included is determined by

assigning weights to the expected future growth rates of the companies. These weights

are used to calculate the Portfolio return and beta, the above mentioned FCFF procedure

used for valuing IDBI BANK LTD was used for each of the other nine Banking

companies mentioned in the table and the results are mentioned below.

A. Results of FCFF Valuation

Table No. 4.4

Table showing results of valuation

SI

No Name of the Stock Stock Price as on

8/4/2009

Valuation

Price Remarks

1 Allahabad Bank 45.350 62.965 Undervalued

2 Andhra Bank 48.500 61.265 Undervalued

3 Bank of Baroda 244.650 233.345 Overvalued

4 Bank of India 229.450 372.031 Undervalued

5 Bank of Maharashtra 22.800 22.663 At par

6 Corporation Bank 189.200 170.203 Overvalued

7 IDBI Bank 53.500 80.310 Undervalued

8 Indian Bank 88.750 105.732 Undervalued

9 Indian Overseas

Bank 50.500 70.721 Undervalued

10 Oriental Bank of

Commerce 117.800 147.202 Undervalued

The above table compares the stock price of the companies as on 8th

April 2008 with the

stock price determined as per the valuation (Intrinsic Value). The Stocks which are

undervalued are only considered in the portfolio construction using fundamental analysis.



The stocks of Bank of Baroda, Bank of Maharastra & Corporation bank are overvalued

and remaining stocks are undervalued.

B. Expected returns on portfolio constructed using fundamental analysis

Table No. 4.5

Table showing the expected returns and beta for portfolio constructed using

fundamental analysis

SI

No Company Name

Expected

Return Weights

Proportionate

Expected

Return

Beta

of

Stock

Portfolio

Beta

1 Allahabad Bank 0.1156 0.14439 0.01669 0.867 0.12519

2 Andhra Bank 0.081 0.13137 0.01064 0.943 0.12388

3 Bank of India 0.1748 0.16862 0.02948 1.214 0.20471

4 IDBI Bank 0.145 0.15611 0.02264 1.216 0.18984

5 Indian Bank 0.0601 0.1239 0.00745 0.959 0.11882

6 Indian Overseas

Bank 0.1188 0.14564 0.01730 1.003 0.14608

7 Oriental Bank of

Commerce 0.0771 0.12996 0.01002 1.022 0.13282

Sum 1.000 0.11421

1.04133

The Expected returns on each stock of the portfolio are calculated by multiplying the

expected return the company with the weights or proportion of each stock to be included

in the portfolio. The Portfolio returns are the sum of the expected returns of each

individual stock. The expected return on the portfolio is found to be 11.42% The Beta of

the portfolio is also calculated by summing up the product of the individual stock beta

and their respective weights. The beta of the portfolio is 1.041



4.3 PORTFOLIO CONSTRUCTION BASED ON SHARPE’S SINGLE

INDEX MODEL

Every investor faces the dilemma, of which scrip‘s to select for his portfolio to get

adequate return. Besides, the investor has to decide how much to invest in each scrip.

Simple Sharpe Portfolio optimisation model enables the investor to find a portfolio that

best meets the goals, objectives and risk tolerance of the investor. The method also

stresses on portfolio optimisation, which is an important component of the portfolio

selection process. It helps to select a set of scrip‘s, which provides the highest rate of

return for the lowest risk that the investor is willing to take.

Steps for finding the stocks to be included in the optimal portfolio are:

1. Find out the ―excess return to beta‖ ratio for each stock under consideration.

2. Rank them from the highest to the lowest.

3. Proceed to calculate Ci for all stocks according to the ranked order using the

following formula-

2

2

2

2

2

1

)(

cj

j

m

cj

jfi

m

i

RR

C

The cumulative values of Ci start declining after a particular Ci and that point is taken as

the cut-off point and that stock ratio is the cut-off ratio C.

4.3.1 Sharpe’s Excess Return To Beta Ratio

It is a single number that measures the desirability of any stock to be included in the

optimal portfolio. The excess return to beta ratio measures the additional return on a

security (excess of the risk free asset return) per unit of systematic risk or non-

diversifiable risk.



Excess return to beta = (Ri – RF) / i

Where: Ri = expected return on stock i

Rf = return on risk free asset

i = expected change in the rate of return on stock i associated with a 1% change

in the market return. Stocks are ranked by excess return to beta (from the

highest to the lowest). The higher the excess return to beta ratio, the more is

the desirability of the stock to be included in the portfolio.

A. RANKING OF STOCKS ACCORDING TO EXCESS RETURN TO BETA

Table No. 4.6

Table showing ranking of stocks according to excess return to beta (ERTB)

SI. No STOCKS Ri Sei2 βi ERTB Rank

1 Allahabad bank 11.56% 8.468 0.867 5.26% 3

2 Andhra Bank 8.10% 8.808 0.943 1.16% 6

3 Bank of Baroda 11.83% 10.845 1.104 4.37% 5

4 Bank of India 17.48% 12.462 1.214 8.63% 1

5 Bank of Maharastra -0.20% 8.301 0.766 -9.39% 10

6 Corporation bank 6.08% 8.669 0.797 -1.16% 9

7 IDBI bank 14.50% 14.531 1.216 6.17% 2

8 Indian bank 6.01% 16.046 0.959 -1.03% 8

9 Indian overseas bank 11.88% 11.011 1.003 4.86% 4

10 Oriental bank of Commerce 7.71% 10.204 1.022 0.70% 7



4.3.2 Determination Of Cutoff Rate C*

Cut-off rate of ‗i‘ stock can be calculated using the simple formula –

2

2

2

2

2

1

)(

cj

j

m

cj

jfi

m

i

RR

C

Where: m2

= variance in the market index

cj2 = unsystematic risk

Ri – Expected return of the stock

Rf – Risk free return



Table No. 4.7

Table showing the calculation of the cut-off rate

R A

N

K

Security Ri Sei2 Beta

(Ri -

Rf)Bi/

Sei2

∑(Ri -

Rf)Bi/

Sei2

β2/Sei

2

∑(β2/

Sei2)

Ci =

(Sm2∑(R

i -

Rf)Bi/Sei

2)/( 1 +

Sm2∑Bi2

/Sei2 )

1 Bank of India

17.4% 12.46 1.214 0.010 0.010 0.118 0.118 0.024

2 IDBI Bank 14.5% 14.53 1.216 0.006 0.016 0.102 0.220 0.031

3 Allahabad Bank

11.5% 8.468 0.867 0.005 0.021 0.089 0.309 0.034

4 Indian overseas Bank

11.8% 11.01 1.003 0.004 0.026 0.091 0.400 0.036

5 Bank of Baroda

11.8% 10.84 1.104 0.005 0.031 0.112 0.513 C*= 0.037

6 Andhra Bank

8.10% 8.808 0.943 0.001 0.032 0.101 0.614 0.034

7 Oriental Bank of Commerce

7.71% 10.20 1.022 0.001 0.032 0.102 0.716 0.032

8 Indian Bank 6.01% 16.04 0.959 -

0.001 0.032 0.057 0.773 0.029

9 Corporation Bank

6.08% 8.669 0.797 -

0.001 0.031 0.073 0.847 0.027

10 Bank of Maharastra

0.20% 8.301 0.766 -

0.007 0.024 0.071 0.917 0.020

If we see in the above table only five stocks has more that excess return to beta and for

other securities excess return to beta is less than Ci. So cut – off rate is fixed at 0.037 and

only five stocks are included in the portfolio.



4.3.3 Determination of Optimal Portfolio

Once the securities to be included in the portfolio are decided, the next step is to

determine the weight of each security to be included in the portfolio as follows -

Wi = Zi / Zj

Where, Zi = i/ei2 [(Ri – RF)/I – C*]

In the above formula the second expression determines the relative investment in each

security. The first determines the weight of each security in the portfolio so that they

sum to 1. This ensures full investment.

Table No: 4.8

Table showing weightage of different stocks in the portfolio

Ranks Security Ri Sei2 Beta

Z=(β/Var)*(((

Ri-Rf)/β)-C*)

Weight in

%(X)

1 Bank of India 17.48% 12.462 1.214 0.0048 47.31%

2 IDBI bank 14.50% 14.531 1.216 0.0020 20.27%

3 Allahabad bank 11.56% 8.468 0.867 0.0016 15.60%

4 Indian overseas bank 11.88% 11.011 1.003 0.0010 10.30%

5 Bank of Baroda 11.83% 10.845 1.104 0.0007 6.53%

0.0101 100.00%



4.3.4 Expected Returns On Portfolio And Beta Of Portfolio

Table No. 4.9

Table showing portfolio return and beta

Ranks Security Ri Sei2 Beta

Weight

in % (X) Ri*X β*X

1 Bank of India 17.48% 12.46 1.21 47.31% 8.27% 0.574

2 IDBI bank 14.50% 14.53 1.22 20.27% 2.94% 0.246

3 Allahabad bank 11.56% 8.47 0.87 15.60% 1.80% 0.135

4 Indian overseas

bank 11.88% 11.01 1.00 10.30% 1.22% 0.103

5 Bank of Baroda 11.83% 10.84 1.10 6.53% 0.77% 0.072

100.00% 15.01% 1.131

The Expected returns on each stock of the portfolio are calculated by multiplying the

Average daily returns of the company with the weights or proportion of each stock to be

included in the portfolio. The Portfolio return is the sum of the average daily returns of

each individual stock. Here the portfolio return is 15.01% .The Beta of the portfolio is

calculated by summing up the product of the individual stock beta and their respective

weights. The beta of the portfolio is 1.131



4.4 COMPARISON OF RISK AND RETURN OF PORTFOLIO’S

CONSTRUCTED USING FUNDAMENTAL ANALYSIS AND

SHARPE SINGLE INDEX MODEL

Table No. 4.10

Table showing performance of portfolio constructed using fundamental analysis

Measure Value

Mean Return 0.2643

Standard Deviation 0.9850

Beta 1.0000

Sharpe Ratio 0.190

Treynor‘s Ratio 0.188

Jensen‘s Measure 0.17

Fama‘s Measure 0.17

Interpretation of portfolio constructed using fundamental analysis

Portfolio constructed using fundamental analysis was expected to give a return of

26.43%.

Beta for this portfolio is exactly 1 which indicates the volatility of the portfolio is

exactly to the market index.

Sharpe measure of fundamental portfolio is 0.19 which indicates that the excess

returns are the results of the excess risk (standard deviation) which the investor

can bear.



Treynor‘s ratio of fundamental portfolio is 0.188 which indicates that excess

return of 0.188 that of which could have been earned on a riskless investment per

each unit of market risk (Beta).

Jensen‘s measure of fundamental portfolio has positive value which indicates that

the portfolio has beat the market.

Fama‘s alpha of fundamental portfolio has positive value which indicates that the

portfolio has outperformed its benchmark index.

Table No. 4.11

Table showing performance of portfolio constructed using Sharpe optimization

model.

Measure Value

Mean Return 0.3650

Standard Deviation 0.9856

Beta 1.0005

Sharpe Ratio 0.29

Treynor‘s Ratio 0.287

Jensen‘s Measure 0.27

Fama‘s Measure 0.27

Interpretation of portfolio constructed using Sharpe optimization model

Portfolio constructed using Sharpe optimization model was expected to give a

return of 36.50%.



Beta for this portfolio is 1.0005 which indicates the volatility of the portfolio is

more than the market index.

Sharpe measure of Sharpe optimization model is 0.29 which indicates that the

excess returns are the results of the excess risk (standard deviation) which the

investor can bear.

Treynor‘s ratio of Sharpe optimization model is 0.287 which indicates that excess

return of 0.287 that of which could have been earned on a riskless investment per

each unit of market risk (Beta).

Jensen‘s measure of Sharpe optimization model has positive value which

indicates that the portfolio has beat the market.

Fama‘s alpha of Sharpe optimization model has positive value which indicates

that the portfolio has outperformed its benchmark index.

Table No. 4.12

Table showing performance of two portfolios

Measure Value Value

Mean Return 0.2643 0.3650

Standard Deviation 0.9850 0.9856

Beta 1.0000 1.0005

Sharpe Ratio 0.190 0.29

Treynor‘s Ratio 0.188 0.287

Jensen‘s Measure 0.17 0.27

Fama‘s Measure 0.17 0.27



Interpretation of Portfolio constructed using fundamental analysis vs. Sharpe single

index model portfolio

Portfolio constructed as per Sharpe optimization model has higher return compare

to that of portfolio constructed using fundamental analysis.

The standard deviation and beta of both the portfolio is more or less similar to

each other.

Sharpe ratio for portfolio constructed using Fundamental analysis has been less

that the Sharpe portfolio which means that the Sharpe portfolio has given more

positive returns for every unit risk.

Portfolio constructed as per Sharpe has higher Treynor‘s ratio compare to that of

fundamental which indicates the returns earned in excess of that which could

have been earned on riskless investment per unit of market risk.

Portfolio constructed as per Sharpe optimization portfolio has given excess return

that what was supposed to be earned , given it beta as per the capital asset pricing

model which is reflected by Jensen‘s alpha where as portfolio constructed using

Fundamental analysis has given lesser return.

Fama‘s measure indicates that portfolio constructed as per Sharpe optimization

portfolio has out performed its bench mark index by 27% and where as

fundamental has outperformed its benchmark index by 17%.

4.5 TEST FOR EQUALITY/DIFFERENCE OF MEAN OF

PORTFOLIO

H0 : No difference in returns from the two portfolios.

H1 : Difference in returns from the two portfolios.



Using the paired-sample t-test to test for difference in mean returns, the results were as

follows:

Table No. 4.13

Table showing t-Test: Paired Two Sample for Means

Particulars Sharpe Portfolio

Return

Fundamental

Portfolio Return

Mean 0.001489784 0.001078723

Variance 0.000829486 0.000606156

Observations 1499 1499

Pearson Correlation 0.961133306

Hypothesized Mean Difference 0

df 1498

t Stat 1.867883872

P(T<=t) one-tail 0.030986682

t Critical one-tail 1.645871463

P(T<=t) two-tail 0.061973364

t Critical two-tail 1.96154882

t – Test interpretation - From the analysis we can see that there is significant difference

between the risk and returns of the two portfolios constructed using fundamental analysis

and single index model and also t- test shows that there is significant difference between

the returns of these two portfolios.



Conclusion:

Fundamental analysis can be valuable, but it should be approached with caution .We all

have personal biases and every analyst has some sort of bias. There is nothing wrong with

this and the research can still be of great value. Corporate statements and press releases

offer good information, but should be read with a healthy degree of skepticism to

separate the facts from the spin. Press releases don't happen by accident and are an

important PR tool for companies. Investors should become skilled readers to weed out the

important information and ignore the hype.

Fundamental analysis helps in identifying the stocks that are undervalued and thus helps

in finding the true worth of the stocks and thereby yielding very good returns in the long

term in relation to short term returns that can be obtained through optimization models.

But Fundamental analysis alone may not sufficient to build a good portfolio various

others factors like global cues should be considered before including a particular sector

stock in the portfolio.



5.1 INTRODUCTION

This study entitled “Portfolio construction using fundamental analysis” was carried

from investors‘ point of view to address the problem associated with selecting the right

stocks to be included in the portfolio. This study was carried out to know the stocks

which are undervalued or which can be included in the portfolio, so as to increase the

returns of the portfolio and to study the attractiveness of banking sectors for investors to

invest in stocks of banking companies. The objectives of the study were, to study and

analyze Banking sector, to identify stocks in Banking sector which trade for less that their

intrinsic value, to construct a portfolio of Banking stocks which are undervalued, to

construct a portfolio of Banking stocks using Sharpe single index model, to find if there

is a significant difference in portfolio mean returns of these portfolios. Data required for

the study was collected through various secondary sources. Sample size is 10 Banking

companies stocks, which were selected based on non-probabilistic judgmental method.

From the data collected findings are drawn, conclusions elicited and suggestions made.

5.2 SUMMARY OF FINDINGS

The banking index has grown at a compounded annual rate of over 51 per cent

since April 2001 as compared to a 27 per cent growth in the market index for the

same period.

Portfolio constructed as per Sharpe optimization model has higher return compare

to that of portfolio constructed using fundamental analysis.

The standard deviation and beta of both the portfolio is more or less similar to

each other.

Sharpe ratio for portfolio constructed using Fundamental analysis has been less

that the Sharpe portfolio which means that the Sharpe portfolio has given more

positive returns for every unit risk.



Portfolio constructed as per Sharpe has higher Treynor‘s ratio compare to that of

fundamental which indicates the returns earned in excess of that which could

have been earned on riskless investment per unit of market risk.

Portfolio constructed as per Sharpe optimization portfolio has given excess return

that what was supposed to be earned , given it beta as per the capital asset pricing

model which is reflected by Jensen‘s alpha where as portfolio constructed using

Fundamental analysis has given lesser return.

Fama‘s measure indicates that portfolio constructed as per Sharpe optimization

portfolio has out performed its bench mark index by 27% and where as

fundamental has outperformed its benchmark index by 17%.

t-test at 95% confidence level shows that there is a significant difference between

the mean returns of the portfolio constructed by using Sharpe single index model

and Fundamental analysis.

5.3 CONCLUSION

Objective 1 – To undertake study of banking sector

Study shows that banking sector has been playing an important role in growth of

Indian economy. Indian banks have compared favourably on growth, asset quality

and profitability with other regional banks over the last few years. The banking

index has grown at a compounded annual rate of over 51 per cent since April

2001 as compared to a 27 per cent growth in the market index for the same

period. Policy makers have made some notable changes in policy and regulation

to help strengthen the sector. These changes include strengthening prudential

norms, enhancing the payments system and integrating regulations between

commercial and co-operative banks.



Objective 2 – To identify stocks in Banking sector which trade for less than their

intrinsic value.

The Stocks which are trading less than their intrinsic value are only considered in

the portfolio construction using fundamental analysis. Out of ten stocks

considered for the study, three banks namely Bank of Baroda, Bank of Maharastra

& Corporation bank are overvalued and remaining stocks are undervalued.

Objective 3 – To construct portfolio of Banking stocks which are undervalued

Based on the increase in the price of the stocks the weightage has been assigned

to the stocks to construct the portfolio and the expected return on the portfolio is

found to be 11.42%. The Beta of the portfolio is also calculated by summing up

the product of the individual stock beta and their respective weights. The beta of

the portfolio is 1.041.

Objective 4 – To construct a portfolio of Banking stocks using Sharpe single index model

The Expected returns on each stock of the portfolio are calculated by multiplying

the Average daily returns of the company with the weights or proportion of each

stock to be included in the portfolio. The Portfolio return is the sum of the average

daily returns of each individual stock. Here the portfolio return is 15.01% .The

Beta of the portfolio is calculated by summing up the product of the individual

stock beta and their respective weights. The beta of the portfolio is 1.131.

Objective 5 – To find if there is a significant difference in portfolio mean returns

constructed using fundamental and optimization approach

t-test shows that there is a significant difference between the mean returns of the

portfolio constructed by using Sharpe single index model and Fundamental

analysis.



5.4 SUGGESTIONS

Suggestions For Banks

The banking industry is need to focus on consolidation, implementation of Basel-

II norms, risk management, corporate governance, funding the economic growth

with inclusion and creating global brands.

Apart from technical aspects, intangible aspects like goodwill, social and ethical

responsiveness do influence banks‘ performance so bank should concentrate on

these aspects as well.

Suggestions For Investors

Since the stocks markets are declining in India investors should carefully look at

the fundamentals of the company, industry, economy and pick the stocks which

are undervalued.

Before investing in Stock markets it very important to know the International cues

that could have impact on stock markets apart from the fundamentals of company,

industry and economy.

While making projections for variables like sales and operating margin which are

the value drivers of companies one should exercise due caution in projection as

these values could have high impact on value of firm.



MY LEARNING

This Research Project has given me great insight into valuation approaches and

construction of portfolios. I came to know about various approaches to valuation of

stocks like Discount cash flow valuation, Relative valuation etc. I also learned about

Fundamental Analysis where in I learned about Economy Analysis, Industry Analysis,

Company Analysis and also the obstacles in a successful fundamental Analysis along

with the weakness of fundamental Analysis. I also got useful insights into Indian

Banking Industry, wherein I learned about history of Banking, Indian Banking industry,

I also learned about portfolio construction using single index model, and various

performance measures of portfolio. I also got useful insights into the limitations of

valuation models. This study also helped me to learn about paired t-test to test the

equality\difference in mean returns of the portfolio. This study gave a lot of knowledge

and will be helpful in my future endeavors.

portfolio construction using fundamental analysis

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