POWER SECTOR

It is very important to know what the business is like & whats the industry is all about before you start investing in a company. So here is something about POWER Sector

Profile
Power can be generated from water (hydro), thermal (coal or naphtha), wind and nuclear. Since the Indian power sector has not been opened up for private sector participation in its true sense, the centre and state governments have a major role to play. It is a politically sensitive sector i.e. tariffs cannot be hiked as the vote bank could be affected.

A power company can be a generator, a transmitter, a distributor or a combination of all three. Barriers to entry are high because it is capital intensive and regulated. While technology in state government undertakings is poor, it will play a big role in the future, as consumers will require good quality and uninterrupted supply of power. Currently, in India, we have 1,07,533 MW of generation capacity out of which private sector contributes 11%. Let's have a look at the revenue model for a power company.

Total revenues = Revenues from generation + transmission + distribution.

Generation
For a company involved in generation of power, revenues will be a function of electricity generated and tariffs applicable. Generation of electricity is a function of PLF (plant load factor) and the capacity installed. PLF, in simple words, is like capacity utilisation. The level of PLF varies depending upon the kind of generation plant. Generally, a hydro power plant or a wind energy plant have low PLF (industry average 35%-50%). Thermal and nuclear power plants have higher PLF (industry average 50%-65%), which ultimately results in higher production.

Investment in capacity in the power sector depends on various factors like:

demand-supply gap (in simpler words we can say deficiency), availability of funds, economic growth and regulatory framework. All these factors are inter-related to some extent.

Demand and supply
One critical factor when it comes to analyzing a power company is the fact that demand expands as per supply. There is nothing like a 'market size' per se. The level of the growth in the industrial sector, per capita consumption of consumer durable and electronic goods would indicate the growth potential. For instance, the penetration level of air conditioners in India is just 0.5%. If more people buy A/C or television or refrigerator, demand for power will increase. Therefore, as far as demand-supply gap for a developing economy like India is concerned, it is irrelevant. The country is power deficient.

Availability of funds
As we had mentioned before, the sector is capital intensive. It costs almost Rs 40 m to Rs 45 m to set up one megawatt (MW) of capacity. If a company is planning to increase capacity by 1,000 MW, it requires Rs 40 bn. From a retail investor perspective, look at the cash balance and the current debt to equity ratio of the company from the balance sheet. This will give an idea whether the company really has the muscle power to expand the stated capacity in the time frame mentioned.

Economic Growth will lead to increase the purchasing power of the people, which will raise the living standard and in turn increase electricity demand. So, the circle starts again.

Regulatory framework
If a company is just into generation, it has to supply to a distributor for realising value for the quantity of power sold. If the distributor is a SEB ( i.e. state electricity board), the chances of delayed payment are high, as SEBs are in poor state. Failure to receive money from SEBs could hamper a company's capacity expansion plans.

Having looked at the capacity side, consider factors involved on the tariffs front.

For a generation company that supplies electricity to a SEB, the respective state governments fix tariffs. However, a power generation company can also supply to the national grid at a specific rate. The national grid say, Power Grid Corporation, in turn could take the onus of meeting SEB requirements. While the advantage is lower risk of delayed payment and fewer losses on account of T&D, the disadvantage is that the tariffs are lower compared to a T&D player. To put things in simple terms, the generation company gets a specific rate on power supplied whereas it is not the case with a T&D player where there is differential tariff structure.

For a distribution company (like Tata Power or BSES in Mumbai), tariffs are different depending upon the customers. Usually, industrial units are charged higher as compared to households (cross-subsidisation). Agricultural sector is a mixed bag. While some states actually charge for power supplied (like Tamil Nadu), in most other states, it is free. The advantage for a generation and distribution company is that it can pass a rise in cost to customers in a deregulated market. However, power theft and default rates are high for a distribution major. Watch out for this as well.

Transmission
There can be independent transmission companies as well (like backbone service providers in the telecom sector). The revenue model is similar. A transmission company buys power from a generation company and hands it over to SEBs or a distribution company. When it comes to advantages, it is like less capital and technology intensive. But a transmission company faces the risks of default of payment by a distributor, high leakage losses and a cap on transmission charges. Approximately 30%-35% or power generated is lost in transmission currently.

Distribution
The distribution company can also generate electricity in-house, but the process remains same. Distribution Companies have pre-defined areas called 'circles' where they can supply electricity. For a distribution company, metering plays a vital role. Metered units = Inhouse power generated (if any) + Power sourced from a generator to meet additional requirement – T&D losses. A major concern for the Indian distribution companies is heavy T&D losses due to poor infrastructure. Due to weak anti-theft laws, 10%-15% of power supplied is lost in distribution.

Key operating and financial parameters to be looked at

• Guaranteed return: A power company is guaranteed a certain return on capital employed on generation by the government. If input cost increases, a generation company passes on the cost through increasing the capital employed to maintain margins. Watch out whether there is a possibility of the government reducing the guaranteed return. If it does, it could affect profitability of a power company.
  
  

• Valuing a power company: Since this sector is all about assets, arriving a NAV is important from a retail investor perspective. It is simple and information is available in the balance sheet itself. As we mentioned earlier, it costs around Rs 40 m – Rs 45 m to set up one MW of capacity (including distribution costs). For a pure generation company, it could range between Rs 20 m to Rs 25 m.
  
  NAV = (Capacity * rate per MW depending whether it is pure generation company or a combination of both) – Debt + Cash. Divide NAV by number of shares outstanding to get an approximate NAV. This could serve as a benchmark.
  
  

• Dividend yield: Since power companies have strong cash flows, dividend is one key parameter to look at. Dividend yield is a very useful parameter. But if the company is in the process of expanding capacity, the dividend payout is unlikely to be high in initial years.

Apart from what all has been said above, the investor needs to look at the past record of the management, its vision and its focus on business. After all it's the management of the company who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

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Sumit K. Gupta
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Top Down Approach & Bottom Up Approach

Top Down & Bottom Up

Top down approach puts a lot of emphasis on macro-economic factors. In this approach, the fund manager first determines the sectors and industries which he expects to do well in the future.

Once he has identified the favorable sectors, he then goes about picking companies within those sectors which he considers investment worthy. For example, if oil prices start registering a sharp decline, a fund manager might form a view that this will stand to benefit the auto sector, and hence start looking for stocks of the companies operating in the auto sector.

In contrast, in the bottom-up approach the focus shifts from industry or the economy to company specific factors. Therefore, the implicit assumption here is that companies can perform well even though the sector/ industry in which they operate is not doing well. The bottom-up approach can get more challenging since there is a huge universe to pick the stocks from, unlike the top-down approach where the universe gets narrowed down to companies operating in select industries. However, it also presents the opportunity to discover some value bargains which otherwise could have been missed in a top-down approach as a result of omission of that industry.

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Sumit K. Gupta
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Sharpe Ratio & Beta: Concepts

WHAT IS SHARPE RATIO & BETA

Sharpe Ratio: The Sharpe ratio is a single number which represents both the risk, and return inherent in a fund. As is widely accepted, high returns are generally associated with a high degree of volatility. The Sharpe ratio represents the trade off between risk and returns. At the same time, it also factors in the desire to generate returns, which are higher than risk-free returns.

Mathematically, the Sharpe ratio is the returns generated over the risk-free rate, per unit of risk. Risk in this case is taken to be the fund's standard deviation. A higher Sharpe ratio is therefore better as it represents a higher return generated per unit of risk.

However, while looking at Sharpe ratio, please keep in mind that it being only a ratio, is a pure number. In isolation it has no meaning. It can only be used as a comparative tool. Thus the Sharpe ratio should be used to compare the performance of a number of funds. Alternatively, one can compare the Sharpe ratio of a fund with that of its benchmark index. If the only information available is that the Sharpe ratio of a fund is 1.2, no meaningful inference can be drawn as nothing is known about the peer group performance. Secondly, it may be misleading at times. For example, a low standard deviation can unduly influence results. A fund with low returns but with a relatively mild standard deviation can end up with a high Sharpe ratio. Such a fund will have a very tranquil portfolio and not generate high returns.

Beta: Beta is a statistical tool, which gives you an idea of how a fund will move in relation to the market. In other words, it is a statistical measure that shows how sensitive a fund is to market moves. If the Sensex moves by 25 per cent, a fund's beta number will tell you whether the fund's returns will be more than this or less.

The beta value for an index itself is taken as one. Equity funds can have beta values, which can be above one, less than one or equal to one. By multiplying the beta value of a fund with the expected percentage movement of an index, the expected movement in the fund can be determined.

Thus if a fund has a beta of 1.2 and the market is expected to move up by ten per cent, the fund should move by 12 per cent (obtained as 1.2 multiplied by 10). Similarly if the market loses ten per cent, the fund should lose 12 per cent (obtained as 1.2 multiplied by minus 10). This shows that a fund with a beta of more than one will rise more than the market and also fall more than market.

But please note that beta depends on the index used to calculate it. It can happen that the index bears no correlation with the movements in the fund. For example, if beta is calculated for a large-cap fund against a mid-cap index, the resulting value will have no meaning. This is because the fund will not move in tandem with the index. Due to this reason, it is essential to take a look at a statistical value called R-squared along with beta.

The R-squared value shows how reliable the beta number is. It varies between zero and one. An R-squared value of one indicates perfect correlation with the index. Thus, an index fund investing in the Sensex should have an R-squared value of one when compared to the Sensex. For diversified equity funds, an R-squared value greater than 0.8 is generally accepted to mean that the underlying beta value is reliable and can be used for the fund.

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Sumit K. Gupta
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