15) Sops by way of ESOPs

Employee Stock Options offer the carrot of potential capital gains in addition to your regular salary. Here is more about this compensation tool.

Employee stock options (ESOPs), a compensation tool long followed in the IT sector, are gradually becoming a part of the salary package in media, retail and other high-growth sectors. What is so special about ESOPs and are they any replacement for hard cash?

An ESOP is, quite literally, an option but not an obligation to buy the shares of the company you work for. An agreement is signed with the employer that gives the employee the right to buy a specific number of shares of the company’s stock, during a specific period, and at a price that the employer specifies. ESOP Ownership

Owning options is not the same as owning the company’s shares. It simply confers the right to buy shares of the company. The price the company sets on the stock is called the grant or exercise price. Since this must appear rewarding to the employees, it is usually lower than the market price of the share at the time the employee is given the options. Converting options into shares by paying the exercise price is known as exercise of options. Most companies have tie-ups with brokerage firms to enable this conversion process.

If your company does well and its stock price rises beyond your exercise price, you now have the option to buy shares at the exercise price and sell it at the market price for a profit. Incentive enough for you to work harder, got it?

The plus side is if the stock price goes down, then you need not really exercise the option. Nothing lost, nothing gained. . ESOPs, therefore, simply offer the carrot of potential capital gains in addition to your regular salary. To illustrate, suppose one has options to buy 100 shares of the company at an exercise price of Rs 100. The stock is currently trading in the stock market at Rs 125.

You have the choice of converting options into shares by paying Rs 100 per share and selling them at Rs 125 in the market. Voila! You have made a profit of Rs 2,500. On the other hand, if the market price of the share is Rs 75, you can choose to not exercise the option at all.

Also if you want to maintain a ‘wait and watch’ approach, in anticipation of further gains in stock price, you can sell, say 50 shares now and the remaining 50 shares later.Timing and quantity restrictions

Another important concept with regard to ESOP is that of vesting. Vesting has two associated aspects, vesting period and vesting percentage. Vesting percentage is the portion of total options granted to the employee which he is eligible to exercise.

Vesting period is the period on completion of which the said portion can be exercised. Both of these are decided by the company and are part of the original agreement on ESOPs. So, as in the previous case, if you have been allotted options to buy 100 shares of the company, you may have a vesting period of, say, four years. There may also be a vesting percentage of 25 per cent per year.

This means that you can buy 25 shares of the company by paying the exercise price, at the end of the first year, 25 shares at the end of the second year and so on until the end of the fourth year when your options will be fully vested.

Lapse of options

It is important to know that ESOPs have an expiration date. That is, even within the vesting period, one can

exercise his options only within a particular time window specified in the agreement.

If the options are not exercised within that period, they lapse. This period is called the exercise period.
If the employee decides to leave the company, he can exercise only the vested options, but all future vestings will be void.ESOPs of unlisted companies

In unlisted companies, there is no ‘market price’ or a grant price available for an employee. The company here fixes an internal value to its shares. This is decided by the board of directors of the company through a voting system.

This value is reviewed and re-set periodically. In such cases, an employee can exercise the option if he finds it advantageous and sell the shares back to the company.Variations of compensations

Employee stock purchase plan:

The company issues shares to employees after a specific time period in the job.
A predetermined amount is withheld from the employee’s salary towards the share purchases.
Restricted stock units: This entitles the employee to receive stock or cash equivalent of the stock after a vesting period.

Tax Implications:

In India, ESOPs are taxable as a fringe benefit.

14) PE ratio: An effective screen-test

The PE (price-earnings) ratio is among the basic tools used to measure how cheap or expensive a stock is. This ratio measures the number of times a stock quotes as a multiple of its earnings per share and is also commonly referred to as the PE multiple.

The PE multiple is simply the amount of rupees the market is willing to pay for one rupee of the company's earnings. The inverse of this ratio is known as the earnings yield. In calculating the PE multiple, various time-frames can be used to arrive at the earnings per share — annualised quarterly earnings or future earnings. However, the commonly used time-frame to calculate price-earnings multiple is the trailing 12-month period.
When computing the earnings per share, investors may also have to make a choice between basic and diluted earnings, and standalone and consolidated profits. Conservatively, investors would be better off taking the diluted earnings, as that would factor in potential issue of equity shares on conversion of bond, debentures and preference shares. The importance of diluted earnings stems from the fact that, of late, India Inc. has taken to the FCCB (Foreign Currency Convertible Bond) route to obtaining funds at competitive rates.

Though this strategy augurs well for a company to shore up its earnings, it involves a cost to the shareholder as he has to share the earnings of the company with a new set of shareholders. While choosing between standalone and consolidated earnings, it would be prudent to use the latter as that would capture the overall performance of a company with its subsidiaries.

Once the earnings per share is calculated, the multiple at which a stock trades generally reflects the investors' expectations of earnings growth. Another key factor that drives this ratio is the cost of equity which, in turn, is linked to risk-free return and volatility of the stock.

Value investors tend to adopt a low PE as a rulebook for an investment. While a low PE multiple is desirable, it would be inappropriate to adopt this ratio as a stock-picking tool across industries. Technology stocks tend to quote at trailing 12-month PE multiples between 30 and 40 compared to basic industry stocks that usually have single-digit PE multiples. As such, investors would be better off adopting this tool for peer comparisons within the same sector.

This tool has its own defects; it bypasses investment opportunities in companies that are making losses and are on the verge of a turnaround. For instance, investors who focus on the PE multiple alone may have missed out on stupendous gains in India Cements, which has more than doubled within a space of a year. In December 2005, the company reported a loss on a trailing 12-month basis; however, this December, the stock quotes at a price-earnings multiple of 20.

Adopting moderate price-earnings multiple as a filter, an investor would also miss out on companies with substantial growth prospects. For instance, Infosys Technologies. In December 2005, the stock commanded a price-earnings multiple of about 35 times (trailing 12-month earnings of consolidated entity) and, in today's market, it quotes at about 40 times its earnings. Though it could be argued that the capitalisation factor has gone up by 12 per cent, the stock has gained about 50 per cent within the space of twelve months.

The other defect of a low PE multiple filter is that companies that are just out of the red would be off the radar as they tend to command high PE multiples. Take the case of an investor who had adopted this tool in September 2003. SAIL, which traded at Rs 40, would not have been on his radar then as it quoted at about 60 times its trailing 12-month (standalone) earnings. Within a span of three-and-quarter years, the stock doubled to about Rs 80 (commanding an earnings multiple of 8).

Going by a low PE would also filter out most stocks in the retail, media and technology space and leaving only those in the basic industries. A good number of stocks with a low PE are those perceived to have little opportunity for earnings growth or are highly volatile. Therefore, while the PE multiple is the most commonly used valuation metric, it cannot be the only one you use to decide on an investment.

13) Create a hedge and cut your losses

After a market correction, most of us are haunted by the "If only I had booked my profits!" syndrome, thanks to the benefit of hindsight. But, then, is it not always easier said than done? For instance, take the case of Mr Gupta, a medium/long-term investor. His portfolio value had soared each day with the market touching new highs, but after a week of market correction, these notional profits in no time became notional losses. If only he had booked his profits!

Identifying market crests and troughs is next to impossible. But premature profit-booking can make an investor as miserable as a delayed one. So what can investors with a sound portfolio do at such times? If your portfolio consists of stocks with good future prospects, exiting them is probably not the right solution. At such times, hedging comes to the rescue. Hedging, in general, can be defined as an investment made to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security. These can take the form of an option or a short sale. However, remember that hedging is not a way to increase your profits, it is just an effective way to reduce losses.

Who needs to hedge?

Investors who are uncomfortable with market volatility or those with financial goals that involve selling shares in the future (which would be affected severely if the market drops) are the ones who need to consider hedging. Or any investor who wants to lock into a particular sale price for stocks, despite a crash in the market, can also consider hedging.

Consider this: Say, you hold 1,000 shares of XYZ Company. While being bullish on the long-term prospects of the company, you are also worried about the short-term blips that your stock might face due to market volatility. To protect yourself from any short-term downside risk, you can buy a put option on the stock, which gives you the right to sell that share at a specified price. So, even when your stock price falls below the current (strike) price, the loss would be offset by the gains in the futures market. But this strategy works well with only those stocks that are traded in the derivatives segment of the exchanges. Then, how do you hedge stocks that do not have any derivative counterpart? For such stocks, you can consider buying a put option on the index. This would help you neutralise the impact of the market (index) movement on your stock, leaving you with a position that depends purely on the performance of the XYZ share. In other words, you have now effectively reduced the influence of market movements on your stock.

But if you have a portfolio of several stocks, it may not be feasible to take offsetting positions for each. So, you can consider hedging the entire portfolio. Going short on Nifty futures or buying index puts would help.

Assume that your portfolio value is about Rs 10 lakh. You sell a Nifty futures contract at 3,900. So, if the Nifty future falls to 3,750, you will make profit from the futures contract.
The profit will be 3,900 minus 3,750 (multiplied by the number of contracts you bought). This would help contain the losses that your portfolio will incur due to the fall in prices of stocks.

An alternative strategy can be to buy Nifty put options. Say, you buy a Nifty put option at a strike price of 3,800, trading at Rs 50, when the index is at about 3,950.

So, if Nifty falls to 3,750, your put option would trade at a price higher than the purchase cost. The profit, thus made, would help you contain the notional loss of your portfolio.

Buying Nifty puts, unlike the Nifty futures, requires no exposure and are limited loss instruments that can be more useful provided the time value of money is acting in your favour. In other words, the value of your option might diminish as it nears the expiry date. Futures can be quite risky if not monitored regularly and, at times, can result in huge losses.

Risk-return trade-off

However, to effectively hedge yourself , you need to know the extent to which your portfolio moves in tandem with the market (its correlation with the index). You can use beta values (available in the NSE monthly newsletters) of the stocks against the index for arriving at that.

`Beta' captures the extent to which the value of your portfolio mirrors every movement in the index; higher the Beta, higher the correlation with the index.

This would help you estimate the number of contracts you need to buy/sell so as to completely hedge your portfolio.

You can either partially or fully hedge your portfolio depending on your risk appetite; but remember lowering of risk also reduces your return prospects. Nevertheless, even a reasonable estimation of beta value would help deliver a satisfactory hedge.

But in case you are wondering about what happens to the hedged positions if markets do not correct as expected, the answer is simple.

Those positions would expire with time and the money that you had invested in creating the hedge would be offset by the increase in value of the stock prices. After all, is that not why we all invest?

12) Arbitrage your free lunch

There is opportunity in market mis-pricing of stocks

Aditya who holds a portfolio of stocks, saw a news item on the front page of a financial daily, which said that Hell is to be merged with Heaven, with every shareholder in Hell getting a share in Heaven (namely, a stock swap ratio of 1:1). He immediately turned to the stocks page and found that while Hell was trading at Rs 80, Heaven closed on that trading day at Rs 100, leaving a Rs 20 price gap between the two stocks.

Aditya wondered if he had spotted an opportunity to lock into a riskless profit or what in stock market parlance is called arbitrage. He decided to dig deeper by browsing the Net and what he found left him intrigued.
Just as day trading fascinates hordes of people, there is a separate set of professionals who make a living by spotting arbitrage opportunities.

Mind you, in the developed world, there are special funds that make money only by looking for these mis-pricing opportunities. Arbitrage, also known as risk less profit and, more popularly, as free lunch, is the simultaneous purchase and sale of assets to make a profit from the difference in pricing.

Aditya, in this hypothetical illustration, could have acquired shares in Hell and sold Heaven in the futures market. (Futures market is one where agreement over price and quantity of an asset is reached for transactions that are to be undertaken at a specified future date.)

This transaction, stemming from a merger or acquisition, is called risk arbitrage. It involves short-selling the stock of the acquiring company and going long (buying) on the target company. Short sales is the act of selling a stock without actually owning it.

In an efficient market, however, it is almost rare to spot such opportunities. The Indian stock markets, however, have thrown up some such opportunities in the recent past. Making a straight-forward profit, however, in such transactions may not be easy, since only a small list of securities can be traded in the derivatives market. With only about 110 securities available in the single stock futures list, traders in most cases would have to resort to the cumbersome set of day-trading transactions to put through this strategy. But before you lose heart, read on to see if one can work around these limitations.

Strategy 1

Traders could profit from adopting a modified strategy of buying the stock of the target company and selling it just before the delisting date or after the shares of the acquiring company are allotted.
You, however, need to take a call on whether the prices of the acquiring company will remain flat or move up. For instance, take the case of the merger of Williamson Tea Assam with McLeod Russel earlier this year.
In early July, when Williamson Tea Assam was de-listed, McLeod Russel traded at about Rs 100 and Williamson at Rs 280. Based on the stock swap ratio of three shares of McLeod for every one of Williamson, the latter should have traded at a readjusted price of about Rs 300.
Investors using the arbitrage concept could have pocketed a 4 per cent profit by taking an exposure in Williamson on July 13 (the last trading day) and exiting the McLeod stock on August 3, about a week after fresh shares of the McLeod were issued.

Traders could have also pocketed similar gains had they taken up exposures in the stock of Vanavil Dyes trading at about Rs 60 on April 12 and exited the Clariant Chemicals stock in early May when it was quoting at about Rs 360.

The ratio for this merger was one share of Clariant for every five of Vanavil. This was another instance of a merger offer of Vanavil Dyes with Clariant Chemicals.

Caution
However, this strategy is not without its share of risks. For instance, consider the merger of FCGL Industries with Gujarat NRE Coke.

In December 2005, when the swap ratio was fixed at 1:1, FCGL Industries traded at Rs 80, while Gujarat NRE Coke quoted at Rs 100. The traders who attempted to capitalise on this 25 per cent price gap might have been caught on the wrong foot. In late May, when the FCGL
Industries stock progressed towards the delisting day, the price gap between FCGL and Gujarat NRE Coke narrowed to 10 per cent leaving very little arbitrage opportunity.

STRATEGY 2

Traders may, however, stick to the risk arbitrage strategy for stocks that are listed in the futures space. They could have made commendable gains by adopting this strategy in the merger of Vashisti Detergents with Hindustan Lever (HLL) by simultaneously acquiring the stock of Vashisti Detergents in February and shorting the HLL stock in the futures market, one could have profited by as much as 7 per cent within a span of two months when fresh shares of HLL were allotted. This strategy carries negligible risk, as irrespective of the stock price movement, gains are almost assured. How? Because if the trader loses money in the futures market on account of the rise in HLL's value, he would be making money on the purchase of Vashisti as he would be getting higher value shares of HLL after the merger.

However, this strategy also carries a risk. If the merger is called off or there is a long delay in it going through, it could result in an unattractive payoff to shareholders.

As the late Milton Friedman was fond of saying, ``there is no such thing as a free lunch in this world''. But if you are a savvy investor willing to take a fair share of risks, spotting arbitrage may be just that exception to the general rule.

11) Understanding Financial Ratios

Companies despatch their annual reports once every accounting year (normally 12 months). With these reports running into hundreds of pages, how do you quickly understand a company's performance over this period? As accounts are prepared using the double-entry system, every item is linked to at least one other item.

Hence, understanding financial ratios would help profile a company. These ratios are broadly classified as leverage, liquidity, efficiency and profitability ratios. We shall first focus on the profitability ratios for, as investors, we are more concerned with the company's earnings than with its operational efficiency, capital structure or its ability to meet debt obligations.

Margin ratios

Margin ratios, one of the key measures of profitability, show the efficiency of the firm in retaining revenues. These can be classified further into gross margin, operating margin and net margin ratios.
The operating margin ratio is calculated by dividing the operating income (net sales minus production, administration and selling and distribution costs) by net sales. In other words, it is the percentage of revenue earned in excess of production, administration and selling and distribution costs. Realisations or billing rates and operating cost per unit are among the key factors that drive this ratio. Volumes, though not as pivotal as the earlier mentioned factors, also play a role.

The operating margin also serves as an indicator of the cost-competitiveness compared to peers where individual costs cannot be determined easily. For example, while India Cements has an operating margin of about 13 per cent, its peer, Madras Cements has about 15 per cent.
The net profit margin, another key measure of profitability, is calculated by dividing post-tax earnings by net sales. It is the percentage of revenue that accrues to the owners of the entity. This ratio is a function of the operating margin, interest coverage and the rate of incidence of tax.

While high margins are desirable, as they provide a cushion against the risk of adverse changes, investors need to look at the structure of the margins to determine the sustainability and scope for improvement.

A significantly high margin needs to be treated with caution as threats from new entrants and substitute products are higher. Tendency to hike capacities, leading to overcapacity, is also more; the recent trend in the caustic soda industry is case in point.

While the above two measures of profitability are derived from the income statement (simply, the profit-and-loss account) the following two return ratios are derived from both the income statement and the balance-sheet.

Return on capital employed

This ratio indicates the profitability of an entity's capital investments. Why does this ratio matter to an investor? If this ratio is lower than the rate at which the company borrows, any further rise in debt will lead to negative earnings growth.

Return on Net worth

This ratio indicates an entity's profitability and efficiency, and is arrived at by dividing earnings after taxes by the shareholder's funds. This ratio, a combination of three underlying factors, is related to profit margin, asset management, and leverage. When an investor goes by the price-to-book value measure, he should consider this ratio as it aids in measuring the rate at which a company improves its shareholder funds.

Although a high RONW is desirable, the stability of this ratio plays a significant role. A key reason for the steady run-up in the price of Infosys Technologies is the fact that the company has recorded an average RONW of 40 per cent over the past five years. This would indicate that the company has grown more than four-fold in this period.