Stock Market & Investment Analysis: Valuation, Risk, and Market Trends

Key Concepts & Syllabus Breakdown

This unit covers:

1. Stock Market Basics: Primary vs. secondary markets, stock exchanges (NEPSE, NYSE), and how prices are determined.
2. Stock Valuation Models:
   • Dividend Discount Model (DDM) for preferred/common stocks.
   • Price/Earnings (P/E) ratio and its limitations.
3. Risk and Return: CAPM, beta, and how risk affects stock prices.
4. Investment Analysis Tools: Financial ratios (ROE, EPS), technical vs. fundamental analysis.
5. Market Efficiency: Weak-form, semi-strong, and strong-form efficiency.
6. Portfolio Diversification: Risk reduction through asset allocation.

1. Stock Market Mechanics: How Prices Are Set

Primary vs. Secondary Markets

graph LR
    A["Primary Market\n(IPOs, new issues)"] -->|"Issuer sells shares"| B["Investors\n(Institutions, retail)"]
    B -->|"Trades occur"| C["Secondary Market\n(NEPSE, NYSE)"]
    C -->|"Price discovery"| D["Market Price\n(Demand/Supply)"]
    D -->|"Influences"| A

• Primary Market: Companies raise capital via IPOs (e.g., NEPSE’s IPOs like Nabil Bank’s 2023 listing).
• Secondary Market: Existing shares trade (e.g., NEPSE’s daily trading of stocks like NMB Bank, Himalayan Bank).

Stock Exchange in Nepal (NEPSE)

• Market Segments:
  • NEPSE: Nepal Stock Exchange (Kathmandu, Pokhara, Biratnagar).
  • NEPSE Index: NEPSE Index tracks 30-50 large-cap stocks (e.g., NMB, Global IME).
• Trading Hours: 11:00 AM – 3:00 PM (Nepali time).
• Order Types: Market orders, limit orders, stop-loss.

2. Stock Valuation: Dividend Discount Model (DDM)

Preferred Stock Valuation

Preferred stocks pay fixed dividends (no growth). Their value is calculated as: $$\text{Value of Preferred Stock}=\frac{\text{Dividend}}{\text{Required Return}}$$ Worked Example (Exam-Style):

A preferred stock pays Rs 15 dividend. Investor’s required return is 12%. What is its value? $$\text{Value}=\frac{15}{0.12}=\text{Rs 125}$$

Common Stock Valuation (Gordon Growth Model)

For stocks with constant dividend growth, use: $$P_0=\frac{D_1}{r-g}$$ Where:

• $P_0$ = Current stock price
• $D_1$ = Next year’s dividend ($D_0\times (1+g)$)
• $r$ = Required return (discount rate)
• $g$ = Growth rate of dividends

Worked Example (Nepali Context):

Sagarmatha Company’s stock price = Rs 360, last dividend ($D_0$) = Rs 24, required return = 12%, growth rate = 5%. Question: Is the stock over/under-valued? $$D_1=24\times 1.05=25.2$$ $$P_0=\frac{25.2}{0.12-0.05}=\frac{25.2}{0.07}=\text{Rs 360}$$ Conclusion: The stock is fairly valued (market price = intrinsic value).

3. Risk and Return: CAPM and Beta

Capital Asset Pricing Model (CAPM)

$$E(R_i)=R_f+{\beta }_i(E(R_m)-R_f)$$

• $E(R_i)$ = Expected return of stock $i$
• $R_f$ = Risk-free rate (e.g., 6% for Nepali treasury bills)
• ${\beta }_i$ = Beta (stock’s volatility vs. market)
• $E(R_m)$ = Market return (e.g., NEPSE’s historical avg. ~10%)

Beta Interpretation:

Why Are Common Stocks Riskier Than Bonds?

Real-World Tie-In:

*During the 2021 COVID-19 crash, NEPSE dropped 30%, while bond yields (e.g., Nepal Rastra Bank bonds) remained stable. This shows stocks are riskier but offer higher potential returns.*

4. Investment Analysis: Financial Ratios

Key Ratios for Stock Valuation

Worked Example (Nepali Retailer):

Kathmandu’s Everest Retail has:

• EPS = Rs 10
• Stock Price = Rs 150
• Dividend = Rs 5 Calculate P/E and Dividend Yield. $$\text{P/E}=\frac{150}{10}=15$$ $$\text{Dividend Yield}=\frac{5}{150}\times 100=3.33\%$$ Interpretation: The stock is overvalued (high P/E) but offers low dividend income.

5. Market Efficiency and Anomalies

Efficient Market Hypothesis (EMH)

Real-World Example:

When Nepal Rastra Bank cut interest rates in 2023, NEPSE’s financial sector stocks (e.g., NMB, Global IME) rose 8% in a week—showing semi-strong efficiency.

6. Portfolio Diversification

Risk Reduction Through Asset Allocation

• Unsystematic Risk: Company-specific (diversify across sectors).
• Systematic Risk: Market-wide (cannot be diversified away).

Nepali Portfolio Example:

In the Real World

1. NEPSE and IPOs:

   • When Khalti went public in 2022, its IPO was oversubscribed 10x, showing high demand for fintech stocks. Investors used DDM to value Khalti’s growth potential (expected 15% dividend growth).
   • How it works: Khalti’s P/E ratio of 40x reflected its high growth expectations vs. banks (~15x P/E).

2. Daraz and E-Commerce Stocks:

   • Alibaba (Daraz’s parent) uses CAPM to price its stocks. Its beta (~1.2) shows it’s 20% riskier than the market but offers higher returns.
   • Nepali tie-in: If you invest in Nepal’s e-commerce stocks (e.g., Hamrobazaar), you’d analyze their inventory turnover (like Daraz’s 12x/year) to predict cash flows.

3. Ncell and Telecom Stocks:

   • Ncell’s dividend yield (4%) is attractive for conservative investors. Its **low beta (0.8)** makes it a "safe" stock in NEPSE.
   • Real scenario: During the 2021 telecom license auction, Ncell’s stock rose 12% as investors bet on future cash flows (using DCF models).

Exam Tip: How to Score Full Marks

1. For Valuation Questions:

   • Always show all steps (e.g., calculate $D_1$ before plugging into DDM).
   • Label units (e.g., "Rs" for dividends, "%" for growth rates).
   • Compare intrinsic value vs. market price (e.g., "Stock is overvalued by Rs 20").

2. For Risk/Return:

   • Define beta clearly: "Beta of 1.3 means 30% more volatile than the market."
   • Link to CAPM: "Using CAPM, the expected return is X% given the risk-free rate of Y%."

3. For Ratio Analysis:

   • State the industry norm (e.g., "Nepal’s banking sector avg. P/E is 12x; this stock’s 15x suggests growth").
   • Use Nepali examples (e.g., "NMB’s ROE of 18% is better than Himalayan Bank’s 15%").

4. For Market Efficiency:

   • Cite real events: "The 2021 NEPSE crash showed weak-form efficiency—no one predicted it from past data."
   • Avoid vague statements: ❌ "Markets are efficient" → ✅ "NEPSE exhibits semi-strong efficiency as IPO prices adjust quickly to public news."

Final Worked Example: Full Stock Analysis

Scenario: You’re analyzing Nepal Oil Corporation (NOC) for investment.

• Current Price: Rs 450
• Last Dividend ($D_0$): Rs 20
• Growth Rate ($g$): 4% (industry avg.)
• Required Return ($r$): 12% (risk premium + risk-free rate)
• P/E Ratio (Industry): 20x

Steps:

1. Calculate Intrinsic Value (DDM): $$D_1=20\times 1.04=20.8$$ $$P_0=\frac{20.8}{0.12-0.04}=\frac{20.8}{0.08}=\text{Rs 260}$$ Conclusion: Market price (Rs 450) > Intrinsic value (Rs 260) → Overvalued.

2. Check P/E Ratio: $$\text{Industry P/E}=20x⟹\text{Fair Price}=20\times \text{EPS}$$ If NOC’s EPS = Rs 15, fair price = Rs 300. Current price (Rs 450) is 50% over fair value.

3. Risk Assessment:

   • Beta: NOC’s beta = 1.5 (high volatility).
   • CAPM Return: $$E(R)=6\%+1.5\times (10\%-6\%)=12\%$$
   • Dividend Yield: $$\frac{20}{450}\times 100=4.44\%$$ Final Verdict: Avoid (overvalued + high risk). Better options: NMB (P/E 15x, beta 0.9) or Nepal Bank (dividend yield 6%).

Summary Table: Key Formulas