Though rating of debt instruments (bonds/debentures) has come of age in India, the rating of equity (IPO/FPO) is relatively new (four years or so). Investors depend on rating to understand the risks involved in investing. While rating a debt instrument, the rating agency is looking at only one risk, that is credit risk (or default risk). This is the risk arising from the possibility of the issuer defaulting on payment of interest or principal or both. This risk can be understood by analysing the financial position of the issuer. Letter grades like AAA, AA+ etc. are assigned by the rating agencies. Higher rating indicates lower risk and, thus higher safety.
As against debt instruments, while rating equity, the risk considered is not default risk. In fact, there is no default risk involved in an equity instrument as the money once paid to the issuer is never received back, and dividends are not mandatory. So, what one looks while rating equity is the market risk or the price risk. That is how safe is the investment from the point of view of generating reasonable rates of returns in the future. Since this risk is difficult to capture, the equity rating is very tricky. Here the fundamental factors like the business of the issuer, the competition, quality of management, experience of promoters, corporate governance and financial performance are considered for rating. Rating agencies assign Grade 1 to 5, with 5 indicating strong fundamentals and 1 indicating weak. A quick look at the IPOs of 2011 tells us that of the 21 issues carrying grade of 3 or below, 15 are traded currently at prices below the issue price. Some are traded at huge discounts of 75-85% to the issue price. Finally a word of caution: The biggest problem in learning investments is that we tend to quickly generalise. Generalisation is dangerous in Investments as there is no "single theory" that explains all situations. So, some of the above IPOs may turn-around in future and some issues with grade of 3 and below, which have already generated high positive returns, may go down.
As against debt instruments, while rating equity, the risk considered is not default risk. In fact, there is no default risk involved in an equity instrument as the money once paid to the issuer is never received back, and dividends are not mandatory. So, what one looks while rating equity is the market risk or the price risk. That is how safe is the investment from the point of view of generating reasonable rates of returns in the future. Since this risk is difficult to capture, the equity rating is very tricky. Here the fundamental factors like the business of the issuer, the competition, quality of management, experience of promoters, corporate governance and financial performance are considered for rating. Rating agencies assign Grade 1 to 5, with 5 indicating strong fundamentals and 1 indicating weak. A quick look at the IPOs of 2011 tells us that of the 21 issues carrying grade of 3 or below, 15 are traded currently at prices below the issue price. Some are traded at huge discounts of 75-85% to the issue price. Finally a word of caution: The biggest problem in learning investments is that we tend to quickly generalise. Generalisation is dangerous in Investments as there is no "single theory" that explains all situations. So, some of the above IPOs may turn-around in future and some issues with grade of 3 and below, which have already generated high positive returns, may go down.
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