Security Analysis and Valuation
This domain tests whether you can convert fundamentals into an intrinsic value and defend it with a model, and whether you can value bonds and measure their interest-rate risk.
Equity models
Gordon growth: P0 = D1/(ke − g), where D1 = D0(1 + g). Cost of equity by CAPM: ke = Rf + β(Rm − Rf). Use two-stage or H-model where growth fades. FCFE = FCFF − interest(1 − t) + net borrowing; discount FCFE at ke and FCFF at WACC - never cross them. Justified P/E = payout ratio/(ke − g); compare with peer multiples only after adjusting for growth and risk differences.
Bonds
YTM solves Price = Σ C/(1 + y)^t + F/(1 + y)^n and assumes coupons are reinvested at y. Macaulay duration = Σ t·PV(CF)/Price; modified duration = D/(1 + y); ΔP ≈ −MD × Δy × P, refined by convexity. Duration rises with maturity and falls with coupon and yield.
Worked example
D0 = ₹4, g = 6%, Rf = 7%, β = 1.2, Rm = 13%: ke = 7 + 1.2 × 6 = 14.2%. D1 = ₹4.24. P0 = 4.24/(0.142 − 0.06) = ₹51.71. With a 60% payout, justified P/E = 0.6/0.082 = 7.3×. At ₹60 (8.5×) the share is rich unless growth is genuinely higher.
Traps
Discounting D0 instead of D1; mechanically using g ≥ ke; applying a peer P/E to a differently levered company; reading current yield as total return; forgetting YTM is a promised return that fails if the bond is sold early or coupons are reinvested at other rates.