https://www.wallstreetprep.

com/blog/its-all-about-valuation-getting-at-the-heart-of-the-finance-interviews/
http://finexecutive.com/en/news/valuation_interview_questions__answers_basic_2_4_2015
http://www.ibankingfaq.com/category/interviewing-technical-questions/valuation/
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/valquestions.htm
https://www.slideshare.net/pankajbaid17/valuation-of-banks

It’s all about Valuation – Getting at the Heart of the Finance Interviews!
The WSP Blog > IB Interview Tips + Quick Lessons
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Last month, we published a quick guide to answering most frequently asked accounting questions during the

finance interviews, and in this issue are sharing our thoughts on how to answer valuation questions, which

make up the meat of the technical questions students can be expected to answer. Stay tuned for M&A help

coming next week!

All students who want to successfully complete the finance recruiting process must demonstrate their basic

understanding of valuation. Such questions are typically not hard – if one takes the time to prepare and

understand the basic valuation concepts. Below we have selected most common valuation questions you

should expect to see during the recruiting process.

1. How do you value a company?

This question, or variations of it, should be answered by talking about 2 primary valuation methodologies:
1. Intrinsic value (discounted cash flow valuation)
2. Relative valuation (comparables/multiples valuation)

Intrinsic value (DCF)

This approach is the more academically respected approach. The DCF says that the value of a productive asset

equals the present value of its cash flows. The answer should run along the line of “project free cash flows for

5-20 years, depending on the availability and reliability of information, and then calculate a terminal value.

Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted

average cost of capital for unlevered DCF and cost of equity for levered DCF). In an unlevered DCF (the more
common approach) this will yield the company’s enterprise value (aka firm and transaction value), from which

we need to subtract net debt to arrive at equity value. Divide equity value by diluted shares outstanding to

arrive at equity value per share.-

Relative valuation (Multiples)

The second approach involves determining a comparable peer group – companies that are in the same industry

with similar operational, growth, risk, and return on capital characteristics. Truly identical companies of course

do not exist, but you should attempt to find as close to comparable companies as possible. Calculate

appropriate industry multiples. Apply the median of these multiples on the relevant operating metric of the

target company to arrive at a valuation.

2. What is the appropriate discount rate to use in an unlevered DCF analysis?

Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to

think of unlevered cash flows as the company’s cash flows as if it had no debt – so no interest expense, and no

tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity

providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital

(both debt and equity). The cost of debt is readily observable in the market as the yield on debt with equivalent

risk, while the cost of equity is more difficult to estimate. Cost of equity is typically estimated using the capital

asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market

(see WSP’s DCF module for a detailed analysis of calculating the cost of equity).

3. What is typically higher – the cost of debt or the cost of equity?

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest

expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because

unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.

4. How do you calculate the cost of equity?

There are several competing models for estimating the cost of equity, however, the capital asset pricing model

(CAPM) is predominantly used on the street. The CAPM links the expected return of a security to its sensitivity

the overall market basket (often proxied using the S&P 500). The formula is:

Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf)
Risk free rate: The risk free rate should theoretically reflect yield to maturity of a default-free government

bonds of equivalent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity

in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the preferred proxy for the

risk-free rate for US companies.

Market risk premium: The market risk premium (rm-rf) represents the excess returns of investing in stocks

over the risk free rate. Practitioners often use the historical excess returns method, and compare historical

spreads between S&P 500 returns and the yield on 10 year treasury bonds.

Beta (β): Beta provides a method to estimate the degree of an asset’s systematic (non-diversifiable) risk. Beta

equals the covariance between expected returns on the asset and on the stock market, divided by the variance

of expected returns on the stock market. A company whose equity has a beta of 1.0 is “as risky” as the overall

stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the

stock market. A company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop

twice as fast as the overall market.

5. How would you calculate beta for a company?

Calculating raw betas from historical returns and even projected betas is an imprecise measurement of future

beta because of estimation errors (i.e. standard errors create a large potential range for beta). As a result, it is

recommended that we use an industry beta. Of course, since the betas of comparable companies are distorted

because of different rates of leverage, we should unlever the betas of these comparable companies as such:

β Unlevered = β(Levered) / (1+ (Debt/Equity) (1-T))

Then, once an average unlevered beta is calculated, relever this beta at the target company’s capital structure:

β Levered = β(Unlevered) x [1+(Debt/Equity) (1-T)]

6. How do you calculate unlevered free cash flows for DCF analysis?

Free cash flows = Operating profit (EBIT) * (1 –tax rate) + depreciation & amortization – changes in net working

capital – capital expenditures

7. What is the appropriate numerator for a revenue multiple?

The answer is enterprise value. The question tests whether you understand the difference between equity

value and enterprise value and their relevance to multiples. Equity value = Enterprise value – Net Debt (where

net debt = gross debt and debt equivalents – excess cash).

EBIT, EBITDA, unlevered cash flow, and revenue multiples all have enterprise value as the numerator because

the denominator is an unlevered (pre-debt) measure of profitability. Conversely, EPS, after-tax cash flows, and

book value of equity all have equity value as the numerator because the denominator is levered – or post-debt.

8. How would you value a company with negative historical cash flows?

Given that negative profitability will make most multiples analyses meaningless, a DCF valuation approach is

appropriate here.

9. When should you value a company using a revenue multiple vs. EBITDA?

Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, Revenue

multiples are more insightful.

10. Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk.
Company A is trading at a 15 P/E multiple, while the other trades at 10 P/E. Which would you prefer as an
investment?

10 P/E: A rational investor would rather pay less per unit of ownership.
1. What are the 3 major valuation methodologies?

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

2. Rank the 3 valuation methodologies from highest to lowest expected value.

Trick question - there is no ranking that always holds. In general, Precedent Transactions will be higher than
Comparable Companies due to the Control Premium built into acquisitions.

Beyond that, a DCF could go either way and it's best to say that it's more variable than other methodologies.
Often it produces the highest value, but it can produce the lowest value as well depending on your
assumptions.

3. When would you not use a DCF in a Valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or
when debt and working capital serve a fundamentally different role. For example, banks and financial
institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't
use a DCF for such companies.

4. What other Valuation methodologies are there?

Other methodologies include:

• Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities
to determine how much capital, if any, equity investors receive

• Replacement Value - Valuing a company based on the cost of replacing its assets
• LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the
20-25% range

• Sum of the Parts - Valuing each division of a company separately and adding them together at the end

• M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid, and
using this to establish what your company is worth

• Future Share Price Analysis - Projecting a company's share price based on the P / E multiples of the public
company comparables, then discounting it back to its present value

5. When would you use a Liquidation Valuation?

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any
capital after the company's debts have been paid off. It is often used to advise struggling businesses on
whether it's better to sell off assets separately or to try and sell the entire company.

6. When would you use Sum of the Parts?

This is most often used when a company has completely different, unrelated divisions -a conglomerate like
General Electric, for example.

If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing
division and a technology division, you should not use the same set of Comparable Companies and Precedent
Transactions for the entire company.

Instead, you should use different sets for each division, value each one separately, and then add them together
to get the Combined Value.

7. When do you use an LBO Analysis as part of your Valuation?

Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also used to establish how
much a private equity firm could pay, which is usually lower than what companies will pay.

It is often used to set a "floor" on a possible Valuation for the company you're looking at.

8.What are the most common multiples used in Valuation?

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and
P/BV (Share Price / Book Value).

9. What are some examples of industry-specific multiples?

Technology (Internet): EV / Unique Visitors, EV / Pageviews

Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rent)

Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D = MCFE per Day), P / NAV
(Share Price / Net Asset Value)

Real Estate Investment Trusts (REITs): Price / FFO, Price / AFFO (Funds From Operations, Adjusted Funds From
Operations)

Technology and Energy should be straightforward - you're looking at traffic and energy reserves as value drivers
rather than revenue or profit.
For Retail / Airlines, you often remove Rent because it is a major expense and one that varies significantly
between different types of companies.

For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the
sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of
properties are assumed to be non-recurring, so FFO is viewed as a "normalized" picture of the cash flow the
REIT is generating.

10. When you're looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you
use Enterprise Value rather than Equity Value?

You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both debt
and equity) in a company. The same logic doesn't apply to everything, though - you need to think through the
multiple and see which investors the particular metric is "available" to.

11. Would an LBO or DCF give a higher valuation?

Technically it could go either way, but in most cases the LBO will give you a lower valuation.

Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a
company in between Year 1 and the final year - you're only valuing it based on its terminal value.

With a DCF, by contrast, you're taking into account both the company's cash flows in between and its terminal
value, so values tend to be higher.

Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and
determine how much you could pay for the company (the valuation) based on that.

12. How would you present these Valuation methodologies to a company or its investors?

Usually you use a "football field" chart where you show the valuation range implied by each methodology.
You always show a range rather than one specific number.

As an example, see page 10 of this document (a Valuation done by Credit Suisse for the Leveraged Buyout of
Sungard Data Systems in 2005):

http://edear.sec.eov/Archives/edear/data/789388/000119312505074184/dex99c2.htm

13. How would you value an apple tree?

The same way you would value a company: by looking at what comparable apple trees are worth (relative
valuation) and the value of the apple tree's cash flows (intrinsic valuation).

Yes, you could do a DCF for anything - even an apple tree.

14. Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is
also available to all shareholders so it makes sense to pair them together.

Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the
company's entire capital structure - only the part available to equity investors.

15. When would a Liquidation Valuation produce the highest value?

This is highly unusual, but it could happen if a company had substantial hard assets but the market was
severely undervaluing it for a specific reason (such as an earnings miss or cyclically).
As a result, the company's Comparable Companies and Precedent Transactions would likely produce lower
values as well - and if its assets were valued highly enough, Liquidation Valuation might give a higher value than
other methodologies.

16. Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you
value it?

You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such
as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.

You would not use a "far in the future DCF" because you can't reasonably predict cash flows for a company that
is not even making money yet.

This is a very common wrong answer given by interviewees. When you can't predict cash flow, use other
metrics - don't try to predict cash flow anyway!

17. What would you use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise Value?

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow
you would use Equity Value.

Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors,
whereas Levered already includes Interest and the money is therefore only available to equity investors.

Debt investors have already "been paid" with the interest payments they received.

18. You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value /
Revenue?

Never say never. It's very rare to see this, but sometimes large financial institutions with big cash balances have
negative Enterprise Values - so you might use Equity Value / Revenue instead.

You might see Equity Value / Revenue if you've listed a set of financial and non-financial companies on a slide,
you're showing Revenue multiples for the non-financial companies, and you want to show something similar
for the financials.

Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

19. How do you select Comparable Companies / Precedent Transactions?

The 3 main ways to select companies and transactions:

1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past
1-2 years.

The most important factor is industry - that is always used to screen for companies/transactions, and the rest
may or may not be used depending on how specific you want to be.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in revenue
Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1
billion in revenue

Precedent Transaction Screen: Retail M&A transactions over the past year

20. How do you apply the 3 valuation methodologies to actually get a value for the company you're looking
at?

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of
a set of companies or transactions, and then multiply it by the relevant metric from the company you're
valuing.

Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company's
EBITDA is $500 million, the implied Enterprise Value would be $4 billion.

To get the "football field" valuation graph you often see, you look at the minimum, maximum, 25 th percentile
and 75thpercentile in each set as well and create a range of values based on each methodology.

21. What do you actually use a valuation for?

Usually you use it in pitch books and in client presentations when you're providing updates and telling them
what they should expect for their own valuation.

It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that "proves" the
value their client is paying or receiving is "fair" from a financial point of view.

Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples
are based off of comps), and pretty much anything else in finance.

22. Why would a company with similar growth and profitability to its Comparable Companies be valued at a
premium?

This could happen for a number of reasons:

• The company has just reported earnings well-above expectations and its stock price has risen recently.

• It has some type of competitive advantage not reflected in its financials, such as a key patent or other
intellectual property.

• It has just won a favorable ruling in a major lawsuit.

• It is the market leader in an industry and has greater market share than its competitors.

23. What are the flaws with public company comparables?

• No company is 100% comparable to another company.

• The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates
depending on the market's movements.

• Share prices for small companies with thinly-traded stocks may not reflect their full value.

24. How do you take into account a company's competitive advantage in a valuation?

1. Look at the 75th percentile or higher for the multiples rather than the Medians.

2. Add in a premium to some of the multiples.

3. Use more aggressive projections for the company.

In practice you rarely do all of the above - these are just possibilities.

25. Do you ALWAYS use the median multiple of a set of public company comparables or precedent
transactions?

There's no "rule" that you have to do this, but in most cases you do because you want to use values from the
middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at a
competitive disadvantage, you might use the 25 th percentile or something in the lower range instead - and vice
versa if it's doing well.

26. You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies
- can you think of a situation where this is not the case?

Sometimes this happens when there is a substantial mismatch between the M&A market and the public
market. For example, no public companies have been acquired recently but there have been a lot of small
private companies acquired at extremely low valuations.

For the most part this generalization is true but keep in mind that there are exceptions to almost every "rule" in
finance.

27. What are some flaws with precedent transactions?

• Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market
sentiment all have huge effects.

• Data on precedent transactions is generally more difficult to find than it is for public company comparables,
especially for acquisitions of small private companies.

28. Two companies have the exact same financial profile and are bought by the same acquirer, but the
EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Possible reasons:

1. One process was more competitive and had a lot more companies bidding on the target.

2. One company had recent bad news or a depressed stock price so it was acquired at a discount.

3. They were in industries with different median multiples.

29. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?"

He dislikes EBITDA because it excludes the often sizable Capital Expenditures companies make and hides how
much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive,
for example, will show a big disparity.

30. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability. What's the
difference between them, and when do you use each one?
P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital structure-
neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments
/ expenses are critical.

EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it -you're more likely to use EV /
EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g.
manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is
comparatively smaller (e.g. Internet companies).

31. If you were buying a vending machine business, would you pay a higher multiple for a business where
you owned the machines and they depreciated normally, or one in which you leased the machines? The cost
of depreciation and lease are the same dollar amounts and everything else is held constant.

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both
companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and
the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it
would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

32. How do you value a private company?

You use the same methodologies as with public companies: public company comparables, precedent
transactions, and DCF. But there are some differences:

• You might apply a 10-15% (or more) discount to the public company comparable multiples because the
private company you're valuing is not as "liquid" as the public comps.

• You can't use a premiums analysis or future share price analysis because a private company doesn't have a
share price.

• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with
public companies.

• A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would
probably just estimate WACC based on the public comps' WACC rather than trying to calculate it.

33. Let's say we're valuing a private company. Why might we discount the public company comparable
multiples but not the precedent transaction multiples?

There's no discount because with precedent transactions, you're acquiring the entire company - and once it's
acquired, the shares immediately become illiquid.

But shares - the ability to buy individual "pieces" of a company rather than the whole thing - can be either
liquid (if it's public) or illiquid (if it's private).

Since shares of public companies are always more liquid, you would discount public company comparable
multiples to account for this.

34. Can you use private companies as part of your valuation?

Only in the context of precedent transactions - it would make no sense to include them for public company
comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and
therefore have no values for market cap or Beta.

Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?

Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital.
That is to say, because EV incorporates all of both debt and equity, it is NOT dependant on the choice of capital
structure (i.e. the percentage of debt and equity). If we use EV in the numerator of our valuation metric, to be
consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the
denominator, such as Sales, EBIT or EBITDA. These such metrics are also not dependant on capital structure
because they do not include interest expense. Operating metrics such as earnings do include interest and so
are considered leveraged or capital structure dependant metrics. Therefore EV/Earnings is an apples to
oranges comparison and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or
equity value) is dependant on capital structure (levered) while EBITDA is unlevered. Again, apples to oranges.
Price/Earnings is fine (apples to apples) because they are both levered.
Category: Valuation | Comments are closed
What are some common valuation metrics?

Probably the most common valuation metric used in banking is Enterprise Value (EV)/EBITDA. Some others
include EV/Sales, EV/EBIT, Price to Earnings (P/E) and Price to Book Value (P/BV).
Category: Valuation | Comments are closed
How do you use the three main valuation methodologies to conclude value?

The best way to answer this question is to say that you calculate a valuation range for each of the three
methodologies and then “triangulate” the three ranges to conclude a valuation range for the company or asset
being valued. You may also put more weight on one or two of the methodologies if you think that they give
you a more accurate valuation. For example, if you have good comps and good precedent transactions but
have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent
Transaction analyses than on your DCF.
Category: Valuation | Comments are closed
What are some other possible valuation methodologies in addition to the main three?

Other valuation methodologies include leverage buyout (LBO) analysis, replacement value and liquidation
value.
Category: Valuation | Comments are closed
Of the three main valuation methodologies, which ones are likely to result in higher/lower value?

Firstly, the Precedent Transactions methodology is likely to give a higher valuation than the Comparable
Company methodology. This is because when companies are purchased, the target’s shareholders are typically
paid a price that is higher than the target’s current stock price. Technically speaking, the purchase price
includes a “control premium.” Valuing companies based on M&A transactions (a control based valuation
methodology) will include this control premium and therefore likely result in a higher valuation than a public
market valuation (minority interest based valuation methodology).

The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation than the Comparable
Company analysis because DCF is also a control based methodology and because most projections tend to be
pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that
DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or
assumptions.
Category: Valuation | Comments are closed
What is the formula for Enterprise Value?

The formula for enterprise value is: market value of equity (MVE) + debt + preferred stock + minority interest –
cash.
Category: Valuation | Comments are closed
What are the three main valuation methodologies?

The three main valuation methodologies are (1) comparable company analysis, (2) precedent transaction
analysis and (3) discounted cash flow (“DCF”) analysis.

A valuation method in which the price paid for similar companies in the past is considered an indicator of a
company’s value. Precedent transaction analysis creates an estimate of what a share of stock would be worth
in the case of an acquisition.
Also known as "M&A comps."
BREAKING DOWN 'Precedent Transaction Analysis'

Precedent transaction analysis relies on publicly available information to create a reasonable estimate
of multiples or premiums that others have paid for a publicly traded company. The analysis looks at the type of
investors that have purchased similar companies under similar circumstances in the past, and examines
whether the companies making the acquisitions are likely to make another acquisition soon.
One of the most important components of precedent transaction analysis is identifying the transactions that
are the most relevant. First, companies should be chosen based on having similar financial characteristics and
for being in the same industry. Second, the size of the transactions should be similar in size to the transaction
that is being considered for the target company. Third, the type of transaction and the characteristics of the
buyer should be similar. Transactions that occurred more recently are considered more valuable.
Data sources for precedent transaction analysis include the Securities Data Corporation, which is a repository
of mergers and acquisitions data. Trade publications, research reports, and the annual filings are also good
sources of data.
While this type of analysis benefits from using publicly available information, the amount and quality of the
information relating to transactions can sometimes be limited. This can make drawing conclusions difficult. This
difficulty can be compounded when trying to account for differences in the market conditions during previous
transactions compared to the current market. For example, the number of competitors may have changed or
the previous market could have been in a different part of the business cycle.
While every transaction is different, and thus makes direct comparisons difficult, precedent transaction analysis
does help provide a general assessment of the market’s demand for a particular asset.

The three financial statements are the income statement, balance sheet, and statement of cash flows.

The income statement is a statement that illustrates the profitability of the company. It begins with the

revenue line and after subtracting various expenses arrives at net income. The income statement covers a

specified period like quarter or year.

Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot

of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the

company’s resources (assets) and funding for those resources (liabilities and stockholder’s equity). Assets must

always equal the sum of liabilities and equity.

Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for

the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net

income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from

operating. Cash from investing and financing are then added to cash flow from operations to arrive at net

change in cash for the year.”

Q: Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes,
etc., do not create any asset, and instead instantly create an expense on the income statement that reduces
equity via retained earnings?
A: Capital expenditures are capitalized because of the timing of their estimated benefits – the lemonade stand

will benefit the firm for many years. The employees’ work, on the other hand, benefits the period in which the

wages are generated only and should be expensed then. This is what differentiates an asset from an expense.

Q: Walk me through a cash flow statement.

A. Start with net income, go line by line through major adjustments (depreciation, changes in working capital

and deferred taxes) to arrive at cash flows from operating activities.

 Mention capital expenditures, asset sales, purchase of intangible assets, and purchase/sale of
investment securities to arrive at cash flow from investing activities.
 Mention repurchase/issuance of debt and equity and paying out dividends to arrive at cash flow from
financing activities.
 Adding cash flows from operations, cash flows from investments, and cash flows from financing gets
you to total change of cash.
 Beginning-of-period cash balance plus change in cash allows you to arrive at end-of-period cash
balance.

Q: What is working capital?

A: Working capital is defined as current assets minus current liabilities; it tells the financial statement user how

much cash is tied up in the business through items such as receivables and inventories and also how much cash

is going to be needed to pay off short term obligations in the next 12 months.

Q: Is it possible for a company to show positive cash flows but be in grave trouble?

A: Absolutely. Two examples involve unsustainable improvements in working capital (a company is selling off

inventory and delaying payables), and another example involves lack of revenues going forward in the pipeline.

Q: How is it possible for a company to show positive net income but go bankrupt?

A: Two examples include deterioration of working capital (i.e. increasing accounts receivable, lowering

accounts payable), and financial shenanigans.

Q: I buy a piece of equipment, walk me through the impact on the 3 financial statements.

A: Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and

the purchase of PP&E is a cash outflow (cash flow statement)

Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by

depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a

non-cash expense that reduced net income) in the cash from operations section (cash flow statement).
Q: Why are increases in accounts receivable a cash reduction on the cash flow statement?

A: Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to

net income to reflect the fact that the company never actually received those funds.

Q: How is the income statement linked to the balance sheet?

A: Net income flows into retained earnings.

Q: What is goodwill?

A: Goodwill is an asset that captures excess of the purchase price over fair market value of an acquired

business. Let’s walk through the following example: Acquirer buys Target for $500m in cash. Target has 1 asset:

PPE with book value of $100, debt of $50m, and equity of $50m = book value (A-L) of $50m.
 Acquirer records cash decline of $500 to finance acquisition
 Acquirer’s PP&E increases by $100m
 Acquirer’s debt increases by $50m
 Acquirer records goodwill of $450m

Q: What is a deferred tax liability and why might one be created?

A: Deferred tax liability is a tax expense amount reported on a company’s income statement that is not actually

paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company

actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting

period.

Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences

in income between the two, which ultimately leads to differences in tax expense reported in the financial

statements and taxes payable to the IRS.

Q: What is a deferred tax asset and why might one be created?

A: Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an

expense on their income statement in a reporting period.

 Differences in revenue recognition, expense recognition (such as warranty expense), and net operating
losses (NOLs) can create deferred tax assets.

If you buy a Current Asset for $100 how does it flow through the three financial statements?
Let’s run through a purchase of inventory:
1) Buying Inventory
Debit: Inventory
Credit: Cash
Inventory then sits on the balance sheet until it is recognized as a Cost of Goods Sold per the matching
principle.
2) Recognizing COGS
Debit: COGS
Credit: Inventory

Accounting Quick Lesson

There are three financial statements that you should use to evaluate a company: Balance Sheet, Cash Flow

Statement, Income Statement. There is actually a 4th statement, the Statement of Shareholder’s Equity, but

questions about this statement are rare.

The four statements are published in periodic and annual filings for companies and are often accompanied with

financial footnotes and management discussion & analysis (MD&A) to help investors better understand the

specifics of each line item. It is critical that you take time to not only look at the four statements, but also read

through the footnotes and MD&A carefully to better understand the composition of these numbers.

Balance Sheet

It is a snapshot of the company’s economic resources and funding for those economic resources at a given

point in time. It is governed by the fundamental accounting equation:

Assets = Liabilities + Shareholders’ Equity

Assets are the resources a company uses to operate its business and includes cash, accounts receivable,

property, plant & equipment (PP&E). Liabilities represent the company’s contractual obligations and include

accounts payable, debt, accrued expenses, etc. Shareholders’ Equity is the residual – the value of the business

available to the owners (shareholders) after debts (liabilities) have been paid off. So, equity is really assets less

liabilities. The easiest way to intuitively understand this is to think of a house worth $500,000, financed with a

$400,000 mortgage and a $100,000 down-payment. The asset in this case is the house, the liabilities are just

the mortgage, and the residual is the value to the owners, the equity. One thing to note is that while both

liabilities and equity represent sources of funding for the company’s assets, liabilities (like debt) are contractual

obligations that have priority over equity. Equity holders, on the other hand, are not promised contractual

payments. That being said, if the company increases its overall value, the equity investors realize the gain while

the debt investors only receive their constant payments. The flip side is also true. If the value of the business

drastically falls then equity investors take the hit. As you can see, equity investors’ investments are more risky

than that of debt investors.

Income Statement

The income statement illustrates the profitability of the company over a specified period of time. In a very

broad sense, the income statement shows revenue less expenses equaling net income.

Net Income = Revenue – Expenses

Revenue is referred to as the “top-line.” It represents the sale of goods and services. It is recorded when

earned (even though cash may not have been received at the time of transaction).

Expenses are netted against revenue to arrive at net income. There are several common expenses among

companies including: cost of goods sold (COGS); selling, general, and administrative (SG&A); interest expense;

and taxes. COGS are costs directly associated with the production of the goods sold while SG&A are

costs indirectly associated with the production of the goods sold. Interest expense represents expense related

to paying debt holders periodic payments while taxes is an expense related to paying the government.

Depreciation expense, a non-cash expense accounting for the use of plant, property and equipment, is often

either imbedded within COGS and SG&A or shown separately.

Net Income is referred to as the “bottom-line.” It is revenue – expenses. It is the profitability available to

common shareholder’s after debt payments have been made (interest expense).

Related to net income is earnings per share. Earnings per share (EPS) is the portion of a company’s profit

allocated to each outstanding share of common stock.

EPS = (net income – dividends on preferred stock) / weighted average shares outstanding)

Diluted EPS expands on basic EPS by including shares of convertibles or warrants outstanding in the

outstanding shares number.

A very important part of accounting is understanding how these financial statements are inter-related. The

balance sheet is linked to the income statement through retained earnings in shareholder’s equity,

specifically net income. This makes sense because net income is the profitability available to shareholders

during a specific period and retained earnings is essentially undistributed profits. So, any profits not

distributed to shareholders in the form of dividends should be accounted for in retained earnings. Getting

back to the house example, if the house generates profits (via rental income), cash will go up and so will equity

(via retained earnings).

Cash Flow Statement

The income statement discussed in the previous section is needed because it illustrates the company’s

economic transactions. While cash is not necessarily received when a sale occurs, the income statement still

records the sale. As a result, the income statement captures all the economic transactions of the business.

The cash flow statement is needed because the income statement uses what is called accrual accounting. In

accrual accounting, revenues are recorded when earned regardless of when cash is received. In other words,

revenues include sales using cash AND made on credit (accounts receivable). As a result, net income reflects
cash and non-cash sales. Since we also want to have a clear understanding of the cash position of a company,

we need the statement of cash flows to reconcile the income statement to cash inflows and outflows.

The cash flow statement is divided into three subsections: cash from operating activities, cash from investing

activities, and cash from financing activities.

Cash from operating activities can be reported using the direct method (uncommon) and indirect method (the

predominant method). The indirect method starts with net income and includes the cash effects of

transactions involved in calculating net income. Essentially, cash from operating activities is a reconciliation of

net income (from the income statement) to the amount of cash the company actually generated during that

period as a result of operations (think cash profits vs accounting profits). The adjustments to get from

accounting profit (net income) to cash profits (cash from operations) are as follows:

Net income (from income statement)

+ non-cash expenses

– non-cash gains

– period-on-period increases in working capital assets (accounts receivable, inventory, prepaid expenses, etc.)

+ period-on-period increases in working capital liabilities (accounts payable, accrued expenses, etc.)

= Cash from operations

For a stable, mature, “plain vanilla” company, a positive cash flow from operating activities is desirable.

Cash from investment activities is cash related to investments in the business (i.e., additional capital

expenditures) or divesting businesses (sale of assets). For a stable, mature, “plain vanilla” company, a negative

cash flow from investing activities is desirable as this indicates that the company is trying to grow by buying

assets.

Cash from financing activities is cash related to capital raising and payments of dividends. In other words, if

the company issues more preferred stock, we will see such an increase in cash in this section. Or, if the

company pays dividends, we will see a cash outflow related to such a payment. For a stable, mature, “plain

vanilla” company, there is not a preference for positive or negative cash in this section. It ultimately depends

on the cost of such capital relative to the investment opportunity schedule.

Net Change in Cash Over the Period = Cash Flow from Operating Activities + Cash Flow from Investing

Activities + Cash Flow from Financing Activities

The cash flow statement is linked to the income statement in that net income is the top line of the cash flow

from operations section when companies use indirect method (most companies use indirect). The cash flow

statement is linked to the balance sheet in that it represents the net change in cash over the period
(magnification of the cash account on the balance sheet). So, a previous period’s cash balance plus the net

change in cash this period represents the latest cash balance on the balance sheet.

Statement of Shareholder’s Equity:

Bankers are rarely asked questions about this statement. Essentially, it is a magnification of the retained

earnings account. It is governed by the formula below:

Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

The statement of shareholder’s equity (also called “statement of retained earnings”) is linked to the income

statement in that it pulls net income from there and links to the balance sheet, specifically, the retained

earnings account in equity.

A company's bottom line can also be referred to as net earnings or net profits. ... The top line refers to
a company's gross sales or revenues
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What Is the Difference between Tier 1 Capital and Tier 2 Capital?

By Steven Nickolas | Updated November 17, 2017 — 8:00 AM EST

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A:
Under the Basel Accord, a bank's capital consists of tier 1 capital and tier 2 capital, and the two types of capital
are different. Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. A
bank's total capital is calculated by adding its tier 1 and tier 2 capital together. Regulators use the capital
ratio to determine and rank a bank's capital adequacy.
Tier 1 Capital

Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a
bank's financial health and is used when a bank must absorb losses without ceasing business operations.
Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1
capital by its total risk-based assets.
For example for the quarterly period ended September 30, 2017, Wells Fargo & Company (WFC) had tier 1
capital of $176.263 billion and risk-weighted assets worth $1.243 trillion. So, the bank's tier 1 capital ratio for
the period was $176.263 billion / $1.243 trillion = 14.18%, which met the minimum Basel III requirement of
10.5%.
Tier 2 Capital

Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general
loan-loss reserves, and undisclosed reserves. Tier 2 capital is supplementary capital because it is less reliable
than tier 1 capital. In 2017, under Basel III, the minimum total capital ratio is 12.5%, which indicates the
minimum tier 2 capital ratio is 2%, as opposed to 10.5% for the tier 1 capital ratio.
Wells Fargo & Company reported tier 2 capital of $32.526 billion. Its tier 2 capital ratio for the quarter was
$32.526 billion / $1.243 trillion = 2.62%. Thus, Wells Fargo's total capital ratio was 16.80% (14.18% + 2.62%).
Under Basel III, Wells Fargo met the minimum total capital ratio of 12.5%.

Read more: What Is the Difference between Tier 1 Capital and Tier 2 Capital? |
Investopedia https://www.investopedia.com/ask/answers/043015/what-difference-between-tier-1-capital-and-
tier-2-capital.asp#ixzz53i7fE0PQ
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1) Explain what is “Over the Counter Market”?

Over the counter market is a decentralized market, which does not have a physical location, where market
traders or participants trade with one another through various communication modes such as telephone, e-
mail and proprietary electronic trading systems.
2) Mention what are levels of traders?
 Senior Trader
 Intermediate Trader
 Junior Trader
3) Explain what do you mean by private equity transactions?

When private equity firms make investments in particular target companies, it is referred as private equity
transaction. A target company is an enterprise that has potential to perform in the short period of time.
4) Explain what are two types of orders issuers may issues in equity trading?

The two basic types of orders issuer’s issues in equity trading are
 Buy Orders
 Sell Orders
5) Explain what is equity funding?

Insurance policy paid for by a mutual fund is referred as equity funding. The value of the mutual fund shares
pay the premiums of the insurance policy, enabling individual investors to have a benefit of a traditional mutual
fund investment.
6) Explain what is weighted average rating factor?

The technique of calculating, analysing and communicating the overall risk of a portfolio of investments is
known as weighted average rating factor.
7) Explain can you judge whether the stock is expensive by looking at its price?

Looking just at its price you cannot judge the stock price, a $200 stock can be cheap if the company’s earnings
prospects are high enough, while a $10 stock can be expensive if earning potential is low. The P/E ratio is the
correct judge of the valuation of the stock.
8) Explain what is call option?

Call option is a right of the shareholder and not an obligation to purchase share at a specified price and a
specified date in future.
9) When purchasing a stock what charges are payable?

The charges that are payable while purchasing a stock are

 Stock Brokers
 Commission
 Stamp duty
 Cost of the stock
10) Mention what are certain measures for which you have to be ready for equity trading?
 It is important to spend time after researching and learning about trading, even when a broker is
handling your equity account. It requires knowledge, discipline and time
 Ready to lose money, if you are not ready for taking risks, then equity trading is not right for trading
 If you are running into heavy losses or the market is not performing as expected than cut losses and
stop for the day
 Don’t be foolish enough to turn profits into losses. Consider selling some of your stocks and not all of
them.
11) Explain what is Option trading?

Option trading is a contract between the seller and buyer to buy or sell a one or more lot of underlying assets
at a fixed price on or before the date of expiry of the contract.
12) Explain how options are different than equities?
 Options are derivatives which means their values is derived from the value of an underlying
investment
 Options are traded among institutional investors, professional traders, individual investors and
securities market places
 By Put or Call, option trade is defined
 Option trading can limit an investor’s risk; it offers a known risk to buyers
 More than the price of the option, option buyer cannot lose money
 Regular equities can be held for indefinite time while options have expiry date
 Like regular equities, option does not have physical certificates
 Owning an option does not mean right to ownership of any share or dividends of a company unless
the option is exercised
13) Explain what is the role of equity analyst?

Equity analyst do research and analysing financial data and trends for a company. Equity analyst writes reports
on company finances, assigning financial ratings, apart from this it also helps the company to overcome
financial crisis by giving them plan to get out of debt.
14) How software program for private equity is helpful?

Software program for private equity can hold useful information like
 Support fund administration, accounting and operational tasks
 It includes document template which can be useful for marketing process
 Also may include an in built templates which can be used for reporting information to a regulatory
body
 It enables to track various important deals and helps in managing contracts
15) Explain what is cash equity?

Cash equity is the total amount of cash or net worth of all the cash which could be gained from the
investments and securities mentioned in the portfolio. To know whether your current mix of investment is
working, cash equity monitoring is a better way to know this and it also helps to determine what to hold and
what to sell.
16) Explain what is short sell in equity trading?

In equity trading the technique of profiting from a falling stock price by borrowing shares of the stock, and
selling them at the market price, and then repurchasing them at lower price to return them to the original
lender is referred as short sell. If you put in simple word “buy low, sell high”.
17) Explain what is capital loss?

The negative difference between the buying price of the stock and selling price is referred as Capital loss.
18) Explain the term double bottom?

Term double bottom is used in a reference to a stock which shows down trend, hits a support level twice and
reverse to continue in an uptrend.
19) Explain what is MF or Minimum Fill Order?

Minimum Fill Order or MF is an attribute attach to an order so that a minimum number of shares has to be
available in order to trigger an order.
20) Explain what is debt or equity ratio?

To measure the debt against the proportion of equity, equity ratio is used, which is used to finance various
portions of a company’s operations. For judging any company’s financial stability, it is used as a standard.
21) Explain what is bridge equity?

Bridge equity is a financing technique which enables potential acquirers of companies or assets to commit to
an acquisition before the equity necessary for such acquisition is raised.
22) What is debenture?
Debenture is a type of debt that is not secured by physical assets or collateral. It is given on the basis of general
credit worthiness and reputation of the issuer.
23) What are derivatives?

Derivative is a specialized contract for buying or selling the underlying assets of a particular period of time in
the future at a pre-decided price.
24) What are the different types of Equity market?

• Public Issue
• Right Issue
• Private Placements
• Preferential Allotment
25) What is the dividend?

The profit share of the company after tax, which is distributed to its shareholders according to their class and
the total number of shares held by them is referred as dividend.

26) Mention some of the mutual fund scheme?

• Maturity Period: Open and Closed ended schemes

• Investment Objective: Growth Scheme, balanced Scheme and Income Scheme
• Other Schemes: Liquid fund, sector fund and Tax saving fund
27) Explain the difference between the convertible and non-convertible debenture?

• Convertible debenture: Convertible debenture can be converted into equity shares of the company which is
issuing after a predetermined period of time. They have lower interest rates.

• Non-convertible debenture: They carry higher interest rate, and they are not convertible into the equity
shares
28) Explain what is ROE?

ROE stands for Return Of Equity, it is a measure of profitability that calculates how much profit a company
generates with each shareholders equity.

To calculate ROE,

ROE = Net Income/ Shareholder Equity

29) Explain what is the difference between equity financing and debt financing?

Issuing additional share of common stock to an investor is referred as Equity Financing. While debt financing is
borrowing money and not giving up ownership.
30) Explain what is Net Asset Value (NAV)?

The value of one unit of a fund is referred as NAV or Net Asset Value. It is calculated by totalling the current
market values of all securities held by the fund, adding in cash and accumulated income and then subtracting
liabilities, expenses and dividing the result by the number of units outstanding.
31) What is equity share?

Equity share represents the net-asset value backing up each share of the company’s stock. Whether a company
is increasing shareholder wealth over time is determined on the growth of equity share.
32) Why convertible securities are more attractive to investors?
Convertible gives the facility of prior claim if the common equity does not perform. If the stock appreciates, the
convertible may participate in the good fortune of the company.
33) What leads assets to turn into a private equity?

Following reasons leads to turn assets to private equity

 • Raising Capital
• Increasing Regulation of Public Markets
• Effect of Public Markets
• Financing the Private Equity firms
34) Explain what are the types of derivatives?

Derivatives are classified into three types

• Future or forward contract

• Options and
• Swaps
35) What are the characteristics of derivatives?

• Underlying
• Notional Amount
• Minimal Initial Investment
• No required delivery
36) Explain what are ETF’s? What is the advantage of it?

ETF’s ( Exchange traded funds) are funds that track the indexes like NASDAQ, DOW JONES, S&P five hundred
and so on. In other words, it’s a mutual fund that trades like stock.

The advantage of using ETF is that

• You get the diversification of an index

• Ability to sell, short, buy on margin and purchase as little as one share
• You have to pay the same commission to your broker as you pay for regular order
• The expense ratios for most ETF’s are lower than the average mutual fund
37) Explain what is secondary markets? What is the difference between the secondary and primary market?

Secondary market is where the trading of securities is done. It consists of both equities as well as debt markets.

The main difference is that in the primary market an investor can buy securities directly from the company
through company’s IPO while in the secondary one buy’s securities from other investors willing to sell the
same. Equity shares, bonds, preference shares, etc. are available in the secondary market.
38) What are Preference Shares?

Preference share is a share that enables an investor to claim a stake at the issuing company with the condition
that whenever the company liquefies or decides to pay a dividend the preference shares holder will be the first
to be get paid after clearing their debt.

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
Absolute Returns
There are 2 ways in which returns are depicted- Absolute and annualised. Generally, returns for a less than one
year period are shown as absolute returns while returns for a period greater than one year are shown as
annualised returns or per annum returns.
Account Statement
A mutual fund account statement is a document similar to a bank account statement that indicates the mutual
fund units owned by an investor, the cost and current value of the units (in Rs.). One can receive an account at
any frequency at any time by email and monthly if it is physical.
Accrual Strategy
There are two ways in which a bond fund earns returns - bond price appreciation and bond coupon receipts. An
accrual strategy uses the latter approach to generate returns by predominantly investing in stable interest
bearing securities.
Actively Managed
There are two ways in which funds are managed. One is the discretionary style while the other is non-
discretionary. The former uses the fund manager's judgment to buy and sell securities and is termed as Active
Management and the funds are called as Actively Managed Funds.
Alpha
Actively managed funds aim to generate Alpha which is the excess return generated over and above the
benchmark index. This is attributable to the fund manager's skills.
AMFI
Association of Mutual Funds in India or AMFI represents all Fund Houses as a group in terms of any discussion
with SEBI, distributors or investor associations. It also aims to promote best practices among mutual funds. All
mutual fund distributors need to be registered with AMFI.
Annual Report
A write-up given to unit-holders containing the yearly record of a mutual fund’s performance. The report also
informs the investor about the fund’s earnings and operations. Reports are sent out annually.
Annualised Returns
There are 2 ways in which returns are depicted- Absolute and annualised. Generally, returns for a less than one
year period are shown as absolute returns while returns for a period greater than one year are shown as
annualised returns.
Application Amount
This is the minimum investment amount for a new investor in a mutual fund scheme.
Arbitrage Funds
Invest in stocks and derivatives where the latter is an equal and opposite position. Arbitrage funds thus carry a
relatively lower risk being a completely hedged portfolio. They are classified as equity funds for tax purposes as
they predominantly invest in equities.
ARN
AMFI Registration Number or ARN is issued by AMFI to all mutual fund distributors who are registered with it
as financial intermediaries selling mutual funds. It is stamped on the application form so that assets mobilized
can be captured to compute brokerage of the distributor. All ARN holders must clear the AMFI / NISM
certification test.
Asset
Any holding with monetary value such as stocks, bonds, real estate, gold and cash.
Asset Allocation
Investment strategy that diversifies assets among stocks, bonds, gold and money market instruments to help
reduce investment risk. It describes the composition of a fund’s or an individual’s portfolio. For equity funds,
this would include a geographic and sector breakdown. For bond funds, it would show the split between
government, corporate and other fixed-income securities.
Asset Class
Different types of investments such as stocks, bonds, gold, real estate and cash. Each asset class depicts similar
characteristics
Asset Management Company (AMC)
A firm that invests the pooled funds of investors in securities, in line with the stated investment objectives. For
a fee, the investment company provides diversification, liquidity, and professional management service.
Assets under management (AUM)
Refers to the cumulative market value of investments managed by a mutual fund.
Average Maturity
Maturity of a bond portfolio is a key variable to understand the impact of interest rates or interest rate risk.
This is calculated as the average maturity of all bonds weighed by the percentage holding of each in the
portfolio. Longer the maturity, higher the interest rate risk.

Balanced Fund
A mutual fund scheme with an investment objective of both long-term growth and income, through
investment in stocks and bonds. Generally 65% is invested in stocks and 35% in bonds, in order to provide
access to relative stability of fixed income securities and the growth potential of equities.
Basis Point
It is the smallest measure used in quoting yields on fixed income securities. One basis point is one percent of
one percent, or one hundredth of a percentage point or 0.01%.
Bear Market
 A period of time during which securities prices are falling in the stock market.
Benchmark
A standard used for comparison. Usually to provide a point of reference for evaluating a fund’s performance.
The common benchmarks for diversified equity funds are the BSE Sensex, Nifty 500 or Nifty 50.
Beta
A measure of a fund’s volatility in relation to the stock market, as measured by a stated index. By definition, the
beta of the stated index is 1; a fund with a higher beta has been more volatile than the index, and a fund with a
lower beta has been less volatile. Based on past historical records, a beta higher than 1.0 indicates that when
the index rises, the stock will rise to a greater extent than the index; likewise, when the index falls, the stock
will fall to a greater extent. A beta lower than 1.0, indicates that the stock will usually change to a lesser extent
than the index. The higher the beta, the greater the investment risk.
Blue Chip
Stock of a nationally known company that has a long record of profit, growth, and dividend payment, and a
reputation for quality management, products, and services.
Bond
A debt security or IOU issued by a government entity or corporation, which generally pays a stated rate of
interest, and plans to return the principal amount of the loan on the maturity date. Unlike stockholders,
bondholders do not have corporate ownership privileges.
Broker
A broker is basically a sales person who distributes stocks, bonds, or mutual funds. A broker is a licensed person
authorised to receive commissions. Brokers are always affiliated with a brokerage company or broker-dealer
network.
Bull Market
A distinctive time period, during which the prices of securities are rising, usually characterised by high trading
volumes.
Business Day
A Business Day is any day other than a Saturday, a Sunday or a day on which banks are not required or
obligated by law or executive order to remain closed including the occasions when the functioning of the
Banks/ RBI is affected due to a strike call made by a Recognised Union/ Management in any part of the country
or those days on which normal business cannot be conducted due to natural calamities or any other events.

CAGR
Compounded annualised growth rate or CAGR is the rate of compounding of interest or growth. It is also
known as annualised growth rate or internal rate of return at which cash flows grow over a period of time.
Call Money
Money that is loaned in the call market, which can be demanded for repayment on call. The term call money is
also known as money at short notice as it is repayable in 24 hours. It is also traded in the money market.
Capital (or principal)
Initial amount of money invested, excluding any subsequent earnings.
Capital Appreciation
Increase in the value of an asset such as a stock, bond, commodity or real estate.
Capital Gains/Losses
Net profit or losses from the sale of securities in the fund’s portfolio. These are further classified as short term
and long term capital gains. The holding period for each type of capital gains as defined in the Income Tax Act
1964 varies from instrument to instrument.
Capital Growth
A rise in the market value of a mutual fund’s securities shown by its net asset value per unit. This is a long-term
objective of many mutual funds.
Certificate of Deposit (CD)
Money market instrument issued by banks or financial institutions (FIs) for a specified time period. Banks can
issue CDs for maturities from 7 days to one year whereas FIs can issue CDs for maturities of 1 year to 3 years.
Closed-end Fund
A type of fund that has its units listed on stock exchanges. Unlike open-end mutual funds, closed-end funds do
not issue and redeem units on a continuous basis but only at the time of their new fund offer or NFO. Their
listed price is determined by supply and demand. They also carry a NAV besides the traded price.
Closing Price
The price of a security after the final trade at the end of the day.
Collateralized Borrowing & Lending Obligation (CBLO)
Collateralized Borrowing & Lending Obligation (CBLO) is an RBI approved Money Market instrument backed by
gilts as collaterals. CBLO was aimed to benefit those who were phased out of the inter-bank call money market.
Clearing Corp of India (CCIL) manages CBLO transactions.
Commercial Paper
Short term unsecured debt issued by companies, usually to finance working capital requirements. They are of
upto one year maturity.
Commission
A fee charged by a broker or distributor for his or her service in the buying or selling of securities/ mutual fund
units.
Commodity
A commodity is a product that trades on a commodity exchange. Examples of these are gold, food, metal or
another physical substance that investors buy and sell on an exchange.
Compounding
Interest earned not only on the initially invested principal but also on accumulated interest during the period.
Consolidated Account Statement (CAS)
A statement of transactions and investments across mutual funds and depository accounts. Depository
companies have the responsibility of consolidating the investment information of an investor by PAN number
and sending a monthly statement to the investor’s email ID or physical address. CAS contains all financial
transactions (buy, sell, switch) made in mutual fund folios or equity account(s) of the investor besides complete
list of holdings and their current value. Starting October 2016, CAS would also carry information on commission
paid to distributors for mutual fund folios.
Consumer Price Index
The index compiled by a governmental agency which tracks the cost of living by following the change in prices
of basic goods and services over time. This index measures inflation.
Contingent Deferred Sales Charge (CDSC)
A type of exit sales load which is charged when units are redeemed within a specific time period following their
purchase. These charges decline as the holding period increases.
Contrarian
Someone who goes counter to the herd. A contrarian seeks out-of-favour sectors and may sell when others
buy.
Convertible Security
Corporate security (usually preferred stock or bond) that is exchangeable for another form of security (usually
common stock) at a predetermined price.
Convexity
Convexity is a measure of the way duration and price change when interest rates change. A bond is said to have
positive convexity if the instrument's value increases at least as much as duration predicts when rates drop and
decreases less than duration predicts when rates rise.
Corpus
The portfolio of securities of a mutual fund aggregated by market value of the securities held is known as
corpus or Assets Under Management or AUM. Mutual funds disclose AUM at a scheme level and at a fund
house level.
Coupon
The interest rate on a bond or other debt security that the issuer is obliged to pay the holder until it matures. It
is usually given as a percentage of the face value of the security.
Credit Rating
A measure indicating the bond issuer’s credit worthiness or the company’s ability to repay the loan. The bonds
are rated by an independent rating agency such as CRISIL, ICRA, and CARE, etc.
Credit Risk
The potential for an issuer to default on its obligation to pay interest or principal on its debt security. Most
government securities are considered to have little, if any credit risk.
Cumulative Total Return
Usually calculated in the same manner as standardised average annual total return, except that these figures
represent the total change in value of an investment over the stated periods and do not reflect any sales
charges.
Current Assets
Assets that can be converted to cash within a year.
Current Liabilities
Liabilities that must be paid within a year.
Custodian
Appointed to hold and safe keep the assets and investments of mutual fund. A custodian helps ensuring the
interests of the investors by keeping track and ensuring the safety of their investments under a custodial
agreement.
Cyclical Stocks
Stocks which rise and fall in price with the state of the economy, in such industries as construction, automobile,
engineering or those affected by the international economy such as shipping, aviation, and tourism. Cyclical
stocks are also stocks which are affected by the natural environment such as fertilisers and tea. Examples of
non-cyclical stocks would be drugs, insurance, basic foodstuffs and many other consumer products.

Debentures
Instruments of debt, usually unsecured. They are also usually credit rated.
Debt funds/Securities
A general term for any security representing money loaned that must be repaid to the lender at a future date.
Bonds, T-bills and money market instruments are debt securities, but they vary in maturities.
Default
A term that denotes the failure to pay the principal or interest on a financial obligation (such as a bond).
Defensive Stocks
Those that are not impacted too much by cyclicality in the economy. They tend to be accumulated when the
economy is on the down turn. Pharma and fast moving consumer goods or FMCG companies are generally
defensive sectors.
Demat Account
Electronic trading of shares required that shares be transferred electronically owing to which physical shares
were dematerialised. One holds these shares in a demat account.
Derivative
A derivative is an instrument whose value is derived from the value of one or more underlying security, which
can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples
of derivative instruments are Forwards, Futures, Options and Swaps.
Direct Plan or Direct Share Class
SEBI introduced direct plans from Jan 1, 2013 in which investors wishing to buy units directly from a fund house
were allowed to do so through direct plans. These plans have lower expenses to the extent of commission paid
to distributors. The returns in direct plans are also higher to that extent vis-a-vis regular plans.
Discount
Refers to the selling price of a bond when its price is below its maturity value.
Distribution
A payment to shareholders resulting from a mutual fund’s realised capital gains, interest, or dividend income. A
mutual fund dividend, or distribution, may be physically paid to the investor, or it may be reinvested in the
fund, giving the investor more units.
Diversification
Diversification is a proven strategy to reduce portfolio risk wherein investment takes place across asset classes
like equity, debt, gold, real estate. It also cushions against the negative returns from a single asset class as all
asset classes typically do not move in the same direction.
Dividend
An income distribution to shareholders that generally comes from the net profit or earnings of a corporation
(or net income from a mutual fund). A change in the dividend rate, or amount, does not affect the fund’s share
price but the NAV of a mutual fund unit falls after the dividend is paid.
Dividend Yield
Used to know how much dividend has been paid by a scheme in a year for the price an investor has paid for
buying its units. Any investor whose investment objective is capital consumption may choose to invest in a
scheme with high dividend yield.
Duration
Duration is a measure of interest rate risk meaning the relation between the price and the yield of the bond. It
is weighted average of all the cash flows associated with a bond in terms of their present value. The higher the
duration the higher the interest rate risk.
Duration Strategy
 There are two ways in which a bond fund earns returns - bond price appreciation and bond coupon receipts.
The former refers to a duration strategy while the latter is an accrual strategy. A duration strategy is useful
when interest rates in the economy are on the decline as bond prices and interest rates move in opposite
directions.

Earnings (per share) or EPS

The profit after tax for a company during a specific period for every share held. It is calculated by subtracting
the cost of sales, operating expenses and taxes from revenues, for a specific time period. It is the reason
corporations exist and often the single most important determinant of a stock’s price. If the profit after tax is
Rs.1000 and number of shares is 100, then EPS is Rs.10.
ELSS
Equity Linked Savings Scheme or ELSS allows an investor to get the benefit under Sec 80C of the Income Tax Act
upto a limit of Rs. 1.5 lakh per year. They have a lock-in period of 3 years.
Entry load
The upfront sales charge on mutual fund purchases, currently abolished in India.
Equity
A type of security representing part ownership in a company or corporation. Common stocks, preferred stock,
and convertible stock are types of equity securities.
ETF or Exchange Traded Fund
These are similar to index funds which replicate a benchmark index but have lower expenses charged to the
fund. Popularly known as ETFs, they are traded on stock exchanges like equity stocks. One needs a demat
account to trade in ETFs.
EUIN
Employee Unique Identification Number or EUIN is issued by AMFI to employee/ relationship manager/ sales
person of the distributor interacting with the investor for the sale of mutual fund products. EUIN aims to assist
in tackling the problem of mis-selling even if the EUIN holder leaves the distributor.
Exit Load
The charge levied at the time of exit is called exit load. This may be applicable in some schemes and for a
certain period. One must check exit loads before investing to map with the investment horizon.
Expense Ratio
Each category of mutual funds is allowed to charge a particular percent of its AUM as scheme expenses. The
term is commonly called Expense Ratio. Generally Equity funds have a higher expense ratio vis-à-vis debt funds.

Face Value
The value printed on the face of a stock, bond or other financial instrument or document. It is also the issue
price of a mutual fund unit. Percentage dividends are calculated on face value.
Fact Sheet
Contains the details of the investments (portfolio) made by a mutual fund scheme besides returns, fund
manager details, asset allocation, etc. A factsheet is released on a monthly basis.
Financial Planning
It is very important to plan your investments so that you are able to meet all your life time goals. There is a
scientific process called financial planning which you can follow involving risk profiling, goal analysis, asset
allocation, product selection and goal monitoring.
Fixed Assets
A long-term asset that will not be converted to cash within a year such as a house or a plot of land.
Fixed Income Securities
A security that pays a certain rate of return but offers limited potential for growth in capital. This usually refers
to government and corporate bonds, which pay a fixed rate of interest until the bonds mature. A mutual fund
investing in these types of securities may also be referred to as a fixed-income investment or security.
Traditional assured returns products like bank fixed deposits are also fixed income securities.
Floating Rate
An interest rate which is periodically adjusted, usually based on a standard market rate outside the control of
the institution. These rates often have a specified floor and ceiling, which limit the floating rate. The opposite
of having a floating rate is having a fixed rate.
FMP
Fixed Maturity Plan or FMP has a defined term after which the scheme ceases to exist. It is a closed ended fixed
income scheme.
Folio
A folio is an investor's unique mutual fund account. Much like a bank account number, a Folio number depict
their holdings in the schemes of a fund house.
Front-end Load
A one- time charge that investors pay at the time they buy fund units. It is also called as entry load which is
currently abolished in India.
Fund Manager
An employee of the asset management company such as a mutual fund or life insurer, who manages
investments of the scheme. He is usually part of a larger team of fund managers and research analysts. A fund
manager may also be referred as a Portfolio Manager.
Fund of Funds (FOF)
A fund that invests in other mutual funds, unlike a normal fund which invests in equity and fixed income
securities.

Gilts
A type of government security.
Government Securities
Securities that are sold to the public by the government, also called Gilts.
Growth Funds
Mutual funds with a primary investment objective of long-term growth of capital. Unlike income, which is
somewhat regular and consistent in most cases, growth is much less certain. Growth investments, however,
usually outpace the returns on income investments over the long-term (five to ten years, or longer). A growth
fund invests mainly in common stocks with significant growth potential.
Growth Investing
A style of investing that invests in fundamentally sound businesses with the belief that the stock will go up in
price. The stocks in this portfolio are well researched, liquid and of high quality and will usually give you a high
P/E ratio and lower dividend yields in comparison to the market.

Holdings
The possessions or securities in an investor’s portfolio.
Hybrid Funds
One can avail ready-made diversified products in mutual funds through hybrid funds. Within hybrid funds,
some invest predominantly in equity or debt while there are some which dynamically allocate between equity
and debt based on market conditions or a mathematical model.

Inception Date
The first date from which a fund's returns are calculated.
Income Funds
A fixed income mutual fund that primarily seeks interest income rather than growth of capital
Individual/ Independent Financial Distributor (IFA)
An IFA helps an investor plan for his financial goals like children's education, buying a house, retirement, etc. He
helps decide the investor's portfolio across asset classes and mutual funds as well as executes and monitors
investments.
Index
A fixed pool of securities whose performance represents that of the overall market whether equity, debt or any
other asset class. They are also referred to as a benchmark and every asset class may have multiple
benchmarks either from an exchange or from an independent research provider. Indian equity indices are
largely sourced from stock exchanges like BSE and NSE and debt indices are mainly from rating agencies like
CRISIL.
Indexation
All non-equity oriented mutual fund units if held for a period of more than 3 years are allowed to adjust their
purchase price for inflation. In other words only returns over and above inflation rate are taxed. This is known
as indexation. Hence post tax returns are relatively higher if indexation benefits are availed.
Indexing
An investment strategy that consists of the construction of a portfolio (generally stocks) based on an Index.
Funds that follow this approach are designed to track the total return of an index.
Inflation
 Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
Remember, the price of all goals be it buying a house, college education, marriage of children, retirement,
would keep rising because of inflation. Hence it is important to invest and earn returns higher than inflation to
maintain purchasing power over the years.
Interest Rate Risk
The risk that a security's value will change due to an increase or decrease in interest rates. A bond's price will
always drop as interest rates rise and when interest rates fall, a bond’s price will rise.
Investment Objective
Each mutual fund is guided by a broad investment objective like wealth creation, steady income, etc. so that
the fund manager invests in the securities which are in line with this broad objective.
Investment Style
This defines the way in which the fund manager would invest to meet the fund’s objective.

KIM or Key Information Memorandum

Accompanies the application form and contains key information required to take an informed decision. KIM is
the summary of the offer document (SID and SAI).
KYC
Know your Customer or KYC details are a must to start any financial transaction with a mutual fund, bank
account, broker account, etc. SEBI has mandated a common KYC for all capital market entities so that investors
do not have multiple procedures across entities.

Liabilities
The claims of investors who have loaned to a company. The debts of a company.
Liquidity
The ease with which an asset can be converted to cash. Open ended mutual fund units are generally
considered highly liquid investments as they can be sold on any business day at their prevailing net asset value.
Lock-in Period
A period of time during which the investor is restricted from selling a particular investment.

Market Risk
The potential loss that is possible as a result of short-term volatility of the stock or bond market.
Mark to Market
It is the process of assigning a market value to a portfolio of securities. If the security has a market price then it
is already marked to market. If it does not have a market price, then it is assigned a value to reflect its fair and
realizable value.
Maturity Date
Date on which the principal amount of a debt instrument or bond becomes due and payable in full.
Maturity Value
The amount the issuer agrees to pay out when the bond reaches its maturity date.
Modified Duration
Modified duration in years indicates the percentage change in the price of a bond for a given change in yield.
The percentage change applies to the price of the bond including accrued interest. If modified duration of 2
years and yields fall by 2%, the price will rise by 2 years*2%=4%.
Money Market Fund
A mutual fund that invests in short-term government securities, certificates of deposit and other highly liquid
securities such as T-bills and short-term commercial paper. Such funds generally pay money market rates of
interest. An investment in a money market fund is not insured or guaranteed by the government nor by any
other entity or institution, so there is no assurance that the unit price will be maintained.
Mutual Fund
A mutual fund is an investment that pools unitholders' money and invests it toward a specified goal. Each
fund's investments are chosen and monitored by qualified professionals who use this money to create a
portfolio. That portfolio could consist of stocks, bonds, money market instruments or a combination of those.
Mutual funds offer investors the advantages of diversification, professional management, affordability, liquidity
and convenience.

NACH or National Automated Clearing House

 Web based solution to facilitate interbank, high volume, electronic transactions which are repetitive and
periodic in nature. NACH covers 95% of India’s banking system and is ideal for investors outside the ECS
(electronic clearing services) network of 90 locations.
Net Asset Value
The NAV is the market value of mutual fund units. It is calculated each business day based on the value of the
assets of the fund minus its liabilities, divided by the number of units outstanding.
Net Worth
The value found by subtracting total liabilities from total assets.
NISM
To start a career as a mutual fund distributor one needs to have an NISM (National Institute of Securities
Markets) certification. Certain mutual fund employees also need to be NISM certified. NISM has been
established by SEBI.
Nomination
Facility of naming a person(s) to whom the assets may be distributed upon the death of the account holder.
NRI
A Non-Resident Indian who is an Indian citizen or a person of Indian origin but who resides abroad. NRIs have
to follow specific rules when investing in India.

Offer Document
The Offer Document (OD) is the most important document for any prospective investor in mutual funds. It
consists of 2 parts - Statement of Additional Information (SAI) and Scheme Information Document (SID). It
contains Fund House and Scheme details.
Open-end Fund
Units of open ended mutual fund schemes are issued on a continuous basis at the prevailing net asset value
(NAV). They are highly liquid and can also be redeemed on any business day.

Passively Managed
There are two ways in which funds are managed. One is the discretionary style while the other is non-
discretionary. The latter is also termed as Passive Management and Index funds fall in this category.
Performance
How a fund’s returns have done in the past and how well it is doing at present. Past performance is often used
to get an idea of future performance, however, past performance does not guarantee future performance.
Portfolio
A pool of individual investments owned by an investor or mutual fund. Portfolios may include a combination of
stocks, bonds, and money market instruments. A list of the fund’s current portfolio will usually be contained in
a mutual fund’s factsheet.
Portfolio Rebalancing
Seeks to reallocate gains from an overweight asset class into an underweight one. In short, one books profits in
a well performing asset class and buys more of an underperforming asset class. It is an important part of
Financial Planning.
Portfolio Turnover
Portfolio turnover or portfolio churn is a measure of how frequently assets within a fund are bought and sold.
100% Portfolio turnover indicates that the entire portfolio was changed in one year. 200% would thus mean
that it was done twice over in the same year indicating a high churning. Lower the number, better it is.
Portfolio Yield
Portfolio yield is the weighted average yield to maturity (YTM) of all the securities in the fund’s portfolio.
Price-earnings ratio (P/E)
It is the price of the share for every rupee earned by the company. One of the quantitative measures used by
portfolio managers to help them value companies. It is calculated by dividing a company’s share price by its
earning per share.
Principal (or Capital)
Initial amount of money invested, excluding any subsequent earnings.
Product Label
The depiction of risk using a pictorial meter named "Riskometer" and this meter appropriately depicts the level
of risk of principal in any specific scheme. The riskometer denotes risk of principal at 5 levels, viz., low,
moderately low, moderate, moderately high and high respectively for a mutual fund scheme. Besides the
 pictorial depiction of the riskometer, the product label also mentions Nature of scheme and indicative time
horizon besides a brief about the investment objective and kind of product.
Prospectus (or Offer Document)
The prospectus is a legal document that contains important information about a fund's investment goals, sales
charges, expenses and risks. Its purpose is to provide investors with the information they need to make an
informed decision about investing in the fund. An abridged offer document accompanies the application.

Real Return
The rate of return earned on an investment after adjusting for the rate of inflation during the time the
investment was held.
Redeem
Cashing in units by selling them back to the mutual fund.
Redemption Price
The price at which a mutual fund’s units are redeemed or bought back by a fund. The redemption price is
usually equal to the current net asset value per unit and less the exit load if any.
Repo
Repo or Repurchase Agreements or Ready Forward transactions are short-term money market instruments.
Repo is nothing but collateralized borrowing and lending. In a repo, securities (like Government securities and
treasury bills) are sold in a temporary sale with an agreement to buy back the securities at a future date at
specified price.
RBI
Reserve Bank of India or RBI is India's central bank, established under the Reserve Bank of India Act, 1934. It is
also the money manager of the government as well as prints India’s currency. It is headed by the RBI Governor
who also sets the monetary policy which mainly involves taking interest rate decisions.
Record Date
Stipulated date which is used as a cut-off to distribute corporate actions like dividends, rights, bonus etc. All
unit holders whose name is present on the record date would receive the corporate action.
Residual Maturity
The remaining period until maturity date of a debt security is its residual maturity. For example, a debt security
issued for an original term to maturity of 10 years, after 2 years, will have a residual maturity of 8 years.
Return
The sum of the income of a fund plus its capital gains.
Risk
In general, risk is the possibility of suffering loss. There are many types of risk, such as credit risk, principal risk,
inflation risk, interest rate risk, and investment risk. If you are prepared to accept greater risk, you have the
chance of earning higher returns or profits on your money. Low-risk investments, while are generally safer,
often don't keep investors ahead of inflation.
Riskometer
Pictorial meter which appropriately depicts the level of risk in any specific scheme. The riskometer denotes risk
of principal at 5 levels, viz., low, moderately low, moderate, moderately high and high respectively for a mutual
fund scheme.
Risk/reward Trade-off
The compromise made between high- and low-risk investments. High-risk investments generally have greater
potential for high returns than low-risk investments.
Risk Tolerance
The willingness of an investor to tolerate the risk of losing money for the potential to make money.
RTA or Registrar and Transfer Agent
RTA or Registrar and Transfer agents maintain a registry of unit holders of a fund and their unit ownership.
Normally the registrar also distributes dividends and provides periodic statements to unit holders. Some fund
houses also maintain this function in-house.
R-squared
Statistical measure of how closely the portfolio's performance correlates with the performance of a benchmark
index. R-squared is a proportion that ranges between 0.00 and 1.00. For example, an R-squared of 1.00
indicates perfect correlation to the benchmark index, while an R-squared of 0.00 indicates no correlation.
Therefore, a lower R-squared indicates that fund performance is significantly affected by factors other than the
market.
Rupee Cost Averaging
An investment strategy based on investing equal amounts in a fund at regular intervals. Because more units are
bought when prices are low and fewer units when prices are high, the average cost of your units may be lower
than the average price over the period you bought them. Rupee- cost averaging cannot guarantee a profit or
protect against loss in declining markets.

SEBI
Securities and Exchange Board of India established under Securities and Exchange Board of India Act, 1992. It is
the regulator for capital markets and market intermediaries like mutual funds, stock brokers, portfolio
managers, etc.
Sector Funds
Funds that concentrate on one industry or sector of the economy such as information technology,
pharmaceuticals, FMCG etc. These funds tend to be more volatile than funds holding a diversified portfolio of
securities in many industries, but may offer greater potential returns when the sector booms. Avoid these
types of funds unless you have a fair amount of investment expertise and a higher risk appetite.
Securities
The holdings of a mutual fund, such as stocks or bonds. Stocks are securities representing ownership shares.
Bonds are securities representing a contractual debt obligation of the issuer to repay the holder, with interest.
Securities Transaction Tax or STT
Levied on purchase or sale of securities listed on stock exchanges. This includes shares, derivatives or equity-
oriented mutual funds. Rate of tax varies with transactions and securities. STT is deducted at source by the
stock broker or AMC.
Sharpe Ratio
Statistical measure of a portfolio's historic "risk-adjusted" performance. Calculated by dividing a fund's excess
return by the standard deviation of those returns. As a measure of reward per unit of total risk, the higher the
ratio, the better.
Sponsor
Sponsors are the promoters who establish the mutual fund. . The application to SEBI for registration of the
mutual fund is made by the sponsors. The sponsor needs to have a minimum 40% shareholding in the capital of
the AMC.
Spread
The difference in yields between two securities is called Spread and is usually measured between the security
and its benchmark or a government bond of similar maturity. It helps to know the risk premium or higher
interest rate that a corporate entity pays for the same tenure loan over a sovereign bond. Spreads can also be
calculated for bonds of the same maturity but different credit rating.
Standard Deviation
Statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund's periodic
returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher
the risk.
Stocks
A share or stock represents ownership, or equity, in a corporation. When a company needs money to grow and
expand, it may sell part of its ownership to the public in the form of shares of stock. In exchange for the money
received from the sale, the company gives shareholders a portion of its profits as dividends, as well as a
measure of its decision-making power. These securities generally have the most potential for capital
appreciation, but their rights are subordinated in the event of a company liquidation or bankruptcy. It does not
provide any assurance on returns.
Statement of Additional Information or SAI
All details about investor's rights and services in a mutual fund are available in the SAI or Statement of
Additional Information which in turn is part of the offer document. It is also a statutory document.
Style Box
The pictorial depiction (in the form of a matrix) of the basic investment mix of a mutual fund scheme is known
as a Style Box. A simple equity style box is a 3x3 matrix - vertical boxes denote market capitalisation (large,
medium, small), horizontal boxes denote investment style (value, blend, growth). For a debt fund, a style box
depicts credit quality on the horizontal axis and interest rate sensitivity on the vertical axis.
Switch
A Switch would necessitate redemption from one scheme and deploying the proceeds or purchase in another.
Remember all of this happens with the applicable NAV.
Systematic Investment Plan (SIP)
Under STP or Systematic Transfer Plan, a single instruction can be given to transfer a fixed amount at regular
intervals from one mutual fund scheme to another. This is typically done to transfer from a liquid fund to an
equity fund where a lump sum amount is invested in a liquid fund. It could also be used to transfer from equity
to debt funds in case one is nearing his/her goal where de-risking is needed.
Systematic Transfer Plan (STP)
Under STP or Systematic Transfer Plan, a single instruction can be given to transfer a fixed amount at regular
intervals from one mutual fund scheme to another. This is typically done to transfer from a liquid fund to an
equity fund where a lump sum amount is invested in a liquid fund. It could also be used to transfer from equity
to debt funds in case one is nearing his/her goal where de-risking is needed.
Systematic Withdrawal Plan (SWP)
A Systematic Withdrawal Plan permits the investor to receive regular payments of a fixed amount from his
investment in a mutual fund scheme on a periodic basis. Retirees in need of a regular income often opt for this.

Tax Deducted at Source (TDS)

Net amount paid to unit-holders after adjusting for taxes before payout is made is said to be with TDS or tax
deducted at source. Dividend Distribution Tax charged in case of dividends paid on debt oriented funds is a TDS
and dividends to unit holders are net of taxes.
TER or Total Expense Ratio
Each category of mutual funds is allowed to charge a particular percent of its AUM as scheme expenses. The
term is commonly called Total Expense Ratio (TER). Generally equity funds have a higher expense ratio vis-à-vis
debt funds. The expense ratio is capped by SEBI. Returns provided are always post expense ratio. The factsheet
displays 2 expense ratios – one is for the regular plan and the second is for the Direct Plan. The latter is lower
because commissions paid to distributors are not included in the same.
Time Stamp
There is a cut off time associated with a mutual fund application being filed for purchase or redemption. This
cut-off time decides the applicability of the current day's NAV or the NAV of the next day to the investment.
Top-down Investing
There are broadly 2 ways in which stock-picking is done by fund managers - Top Down and bottom up. In a top
down approach, the fund manager researches the sector and picks the best stocks in that sector.
Total Return
Return on an investment over a specified period of time, which includes share-price appreciation, reinvested
dividends or interest, and any capital gains.
Tracking Error
The objective of an index fund is to exactly replicate the benchmark index by portfolio and returns. Any
deviation from this objective is tracked by a mathematical formula called tracking error. A lower tracking error
means the fund is tracking the index very well.
Trail Commission
A mutual fund distributor may be paid commission in two forms - upfront and trail. Trail commission is paid at
the end of pre-defined periods and is calculated on the basis of the outstanding AUM of the distributor in the
fund.
Transaction Costs
The costs incurred by the buying and selling of securities including broker/ distributor commissions/ fees.
Treasury bills (T-bills)
A short-term debt instrument issued by the government with a maturity of one year or less.
Trigger Option
The Trigger option is a useful facility for investors who wish to say, book profit at a certain index level or buy
more units when there is a fall in markets by say 100 points.
Trust Deed
The operations of the mutual fund trust are governed by a Trust Deed, which is executed by the sponsors. SEBI
has laid down various clauses that need to be part of the Trust Deed. The responsibility of the trustees towards
the investors is also laid down in the trust deed.

Units
A portion of ownership in a mutual fund. The value of each unit is called Net Asset Value or NAV and is
calculated by dividing net assets of the scheme by the number of units.
Unitholder
 The owner of units of a mutual fund.

Value Investing
The investment approach which favours buying under-priced stocks that are inexpensive relative to their
intrinsic value and that may have the potential to perform well and increase in price in the future. It first seeks
individual companies with attractive investment potential, then considers the economic and industry trends
affecting those companies. Value managers usually begin their search with fundamental analysis, in order to
find companies whose current prices may fail to reflect their potential longer-term value.
Volatility
The tendency of an investment or market to rise or fall sharply in price within a short-term period. Volatility is
measured by various measures such as beta, Standard Deviation, R-squared, Sharpe Ratio. It is also used
interchangeably with risk.

Yield Curve
The relationship between time and yield on securities is called the Yield Curve. The relationship represents the
time value of money - showing that people would demand a positive rate of return on the money they are
willing to part today for a payback into the future.
Year to Date (YTD)
A time period in a calendar year starting from the first of January and ending on the current date.
Yield to Maturity (YTM)
Rate of return anticipated on a bond if held until maturity. YTM is expressed as an annual rate. The YTM factors
in the bond's current market price, par value, coupon interest rate and time to maturity. Portfolio yield is
weighted average YTM of the securities.

Zero Coupon Bond

A bond that is sold at a fraction of its face value. It does not, however, provide periodic interest payments but
pays principal upon maturity.

What is the difference

between cash flow and free
cash flow?
By Investopedia

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A:
Cash flow refers to a stream of revenue or expense that alters a cash
account over a specified time frame. Free cash flow (FCF) is a measure of a
business’s financial performance. It is calculated as the difference between
cash flow and capital expenditures.

Cash inflows result from any of the following three activities: financing,
investments or operations. Cash outflows, on the other hand, result from
expenses or investments. A statement of cash flows is an accounting
statement that shows the amount of income generated and used by the
business in a given time period. It is calculated by summing non-cash
charges including depreciation, with net income after taxes. The data used in
the statement of cash flows are obtained from the business’ balance sheet.

FCF shows how much cash a company generates after accounting for capital
expenditures, such as buildings and equipment. It is a representation of cash
that a business is able to generate after laying out the money needed for
expansion of its asset base. The importance of FCF is that it allows the
business to take advantage of opportunities that increase shareholder value. It
is impractical to create new products, pay dividends, make acquisitions or
reduce cost when there is no cash.

FCF = Operating cash flow – capital expenditures.The data used for

calculating a company’s free cash flow is usually obtained from its cash flow
statement. For instance, if company ABC’s cash flow statement recorded $20
million from operations and $10 million of capital expenditures for the year:
Company ABC’s free cash flow (FCF) = $20 million - $10 million = $10 million.

Is free cash flow the same as

net free cash flow?
By Investopedia
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A:
Free cash flow is not the same as net cash flow. Free cash flow is the amount
of cash that is available for stockholders once all expenses are extracted from
the total revenue. These different expenses can include the operation
expenses, taxes, all debts, capital expenditures and interest that is owed.
Stockholders use this amount to see if the company has enough cash for
future investments, to determine if profitability is satisfactory and to evaluate
the company’s success.

The free cash flow amount is one of the most accurate ways for stockholders
to gauge a company's financial condition. The net cash flow is the amount of
profit the company has with the expenses that it pays currently excluding long-
term bills or debts. A company that has a positive net cash flow is meeting
operating expenses at the current time, but not long-term expenses, so it is
not always an accurate measurement of the company’s progress or success.

If a company or business has a net cash flow that is barely positive, but it is
not making progress on paying long-term debts, or is barely covering
operation costs, the stockholders may no longer see the company as worth
investing in. The company could easily go into the negative if it doesn't have a
high net cash flow. If the company has a high free cash flow, it shows that it’s
fully capable of supporting itself, and that there is plenty of potential for further
growth. Determine your cash flow before investing more money into your
company.

Free cash flow models can be further categorized into two types. There are certain kinds of models
which pertain to free cash flow that the firm as a whole will generate whereas there are others that
pertain solely to the perspective of equity shareholders.
These models are quite different from each other. It is therefore essential to understand, when and
under what circumstances is one model a better choice than the other. This article will explain the
difference between these two types of free cash flow models:

Free Cash Flow To The Firm:

 Interpretation:This is the amount of cash flow which is available to all the investors of the
firm which would typically include bondholders as well as shareholders. The cash flow being
considered here is operating cash flow and is generated by using the operating assets of the
firm. If there are other assets like cash, marketable securities or any other kind of investments
which are not used in day to day operations, their discounted present value needs to be
added separately to the value of the firm as they are not considered in the free cash flow to
the firm metric.

 Discount Factor:Since the cash flow in FCFF pertains to the entire firm, it must be
discounted at the weighted average cost of capital i.e. WACC. The idea is that the costs of
debt and equity must be combined in the exact proportion in which they are being used. Also,
tax benefits arising because of usage of debt are to be considered.

 Formula:The formula for calculating the value of the firm using FCFF approach is as follows:

Value (Firm ) = Σ FCFF/ (1+(WACC))^n

Free Cash Flow To Equity:

 Interpretation:Free cash flow to equity is the amount of cash flow that accrues to equity
shareholders after all the operating, growth, expansion and even financing costs of the
company have been met. Since this is the amount which is expected to be paid to equity
shareholders, the value of equity shares can be directly calculated using these values.

 Discount Factor: Since FCFE pertains only to equity shareholders, it needs to be discounted
at a rate which reflects its level of risk. The risk of being an equity shareholder is higher than
the risk of the entire firm if the firm is leveraged. Thus, the appropriate discount factor for
these cash flows will be expected return on equity.

 Formula:The value of a firm’s equity can be calculated in one of these two ways:

1. By discounting all the future free cash flows to equity at return on equity.

Value (Firm’s Equity) = ΣFCFE/ (1+(Return on Equity))^n

2. By subtracting the discounted present value of debt from the discounted present
value of the firm.

Value (Firm’s Equity) = Value (Firm) – Value (Firm’s Debt)

Thus, it is possible to calculate the value of the firm’s equity by an indirect route even if we are not
aware of what the free cash flows to that firm’s equity shareholders will be.

Important:

 FCFF calculates the total value of the firm whereas FCFE calculates the value of the firm’s
equity. In a levered firm, the value of a firm’s equity is a subset of the total value of the
firm. Thus they are not two different methods to calculate the same output! The output
derived from discounting FCFF is the firm’s value whereas that derived from
discounting FCFE is the value of the firm’s equity.
 FCFF must be discounted at the weighted average cost of capital i.e. WACC whereas FCFE
must be discounted at the expected cost of equity. Discounting the wrong cash flow with the
wrong discount factor will obviously lead to a wrong valuation!