Equity Grading Fulfils a long felt need

In today's context, the capital market in India has a pivotal role to discharge in channelling the savings in the economy from households and corporate, to productive use in nation building. As our economy matures the dynamics of the market place are becoming increasingly significant in the process of resource allocation. The growth and development of our financial markets while offering new opportunities to investors, issuers and other market participants, is also introducing new complexities and risks. In this environment, inadequate information can lead t market inefficiencies. Therefore, availability of quality information is a necessary pre-condition for the healthy operation of the capital markets.
We at ICRA felt that as an information disbursing agency, it was incumbent upon us to take the initiative in contributing towards the enhancement of the capital mobilising process through equity by way of authentic information, particularly when equity remains the dominant fund option. As you know, equity does not have any specific obligations to service which makes it an "open-ended" instrument, in contrast to debt which may be called "close-ended" as the interest charge and principal repayments are defined and the cash accruals of a company can be measured against these obligations (benchmark) to arrive at a "cushion" or safety rating (credit rating). The open-ended nature of equity poses a problem of a lack of benchmark against which the performance of the company can be compared with. However, the need to discriminate between equity issues required us to find solutions to overcome these character constraints of equity in a manner that would encourage can investment process rather than fuel speculation in stocks. At the same time, to enable the information (on quality of equity available through an issue) to be disseminated widely (to retail investors) and in a user-friendly manner, the analysis of the fundamentals of the company require to be "packaged" in form of a Grade, which holds true for the concept of debt rating also. While packaging the equity analysis as a grade, keeping in mind the problem of the open-ended nature of equity (where there are no benchmarks to start with), requires that these performance benchmarks be created (proprietary benchmarks) which will then enable the performance of the company to be compared with these benchmarks and thus impart a close-ended character to the equity analysis. Equity Grading is designed to examine-equity in the medium to long-term context. The opinion on the earnings prospects and the inherent risks is arrived at through comprehensive information acquisition, interaction with management of the corporate, critical analysis and a collective judgmental process. Although Equity Grades are not forecasts of the future market price performance of the stock and do not indicate the companies compliance or violation of any statutory requirements related to the issue, they differentiate equity based on the fundamentals of a company. The unique advantage of Equity Grading is in its symbolic expression which can be easily understood by any investor. Equity Grading is structured to examine in detail the complex combination of variables affecting the company's functioning leading to a judgement on the level, growth and quality of the expected earnings over the medium and long term along with the risks inherent in these prospects. Previous track record is an important element in influencing the judgement on the future. Although it is commonly argued that equity returns (mainly capital appreciation) rarely follow any logic, the importance of the fundamentals cannot be underestimated. Although market sentiment, rumours or insider information tend to delink fundamentals form returns to investors in the short term (more so in the absence of a credible opinion on fundamentals from an independent agency), it is in fact the fundamentals that not only determine the return on the investment over the medium and long term, but also decide the resource allocative dynamics of he market.
Equity Grading thus encourages the investment strategy of investing in a company rather than the stock market. By this logic, Equity Grading facilitates an information enhanced investment decision and in the process strengthens the hands of all those entities and participants in the capital market who want to help the flow of investible funds towards productive and competitive enterprise.
ICRA's equity gradings are differentiated into four Earnings Prospect categories with three levels of associated risk factors in each. The grades are :

ERA1:Excellent Earnings Prospects; Low Risk
ERA2:Excellent Earnings Prospects; Moderate Risk
ERA3:Excellent Earnings Prospects; High Risk
ERB1:Good Earnings Prospects; Low Risk
ERB2:Good Earnings Prospects; Low Risk
ERB3:Good Earnings Prospects; High Risk
ERC1:Moderate Earnings Prospects; Low Risk
ERC2:Moderate Earnings Prospects; Moderate Risk
ERC3:Moderate Earnings Prospects; High Risk
ERD1:Poor Earnings Prospects; Moderate Risk
ERD2:Poor Earnings Prospects; Moderate Risk
ERD3:Poor Earnings Prospects; High Risk

The function of the grate is to help the investor discriminate between investment option at a given point of time. These grades act as an additional input in the investors' ongoing efforts of portfolio maintenance. Although the grading is designed to help investors, in their decisions, the grades are not recommendations to buy, hold or sell, since it is left to the investor to decide for himself as to what he prefers. For example, a risk averse investor may prefer an ERB1 (Good earnings prospects; Low risk) whereas a risk taker may find ERA2 (Excellent earnings prospects; moderate risk) more suitable to his profile. The EPRA range of services includes Equity Grading and Equity Assessment. Equity Grading is done at the request of the issue proposing to make an equity offer to the public. The issuer has the option of using or not using the assigned Grade. Once accepted, the grade and the rationale are made public and the grades are kept under surveillance.
Equity Assessment is done at the request of an investor and with the consent of the corporate whose equity is under study this results in a private report to the investor.
The function of the grades is to help the investor discriminate between investment option at a given point time. These grades act as an additional input in the investors' ongoing efforts of portfolio maintenance. It is essential for an investor to know about a company and its future prospects in order to make a choice between the various alternatives available to him. This choice, so far has largely been associated with name recognition. The perception of a common investor of the prospects of a company largely depended on his familiarity with the names of the promoter or collaborators. An astute investor knows that name recognition is no substitute for objective risk and prospects evaluation. It is not true that every venture promoted by a well known name will be successful and therefore provide attractive returns on investment. Neither is it true that ventures promoted by relatively lesser known names may not be good investment options. On the one hand name recognition restricts the options available to an investor, on the other, it denies relatively lesser known entrepreneurs access to the wider investor base notwithstanding his true prospects. In this environment it is rarely feasible for a corporate issuer to offer every prospective investor the opportunity to undertake a detailed evaluation of the investment option. Further is even rarer for a heterogeneous group of investors to arrive at a meaningful and consistent conclusion as to the relative quality of equity, especially when they do not possess the requisite skills of evaluation.
Internationally, credit rating agencies like Standard and Poor's (S&P) and Moody's Investors Service (Moody's) have long been in the business of giving opinions on the equity quality of corporates. While S&P has a method of ranking common stocks on the basis of earnings and dividend records, Moody's has a system of classifying stocks based on their quality into grades.
We believe that Equity Grading fulfils a long felt need. It bridges critical information gaps and will go a long way in deepening investor confidence. As equity grading extends the perimeters of the disclosure requirement for corporates to access the capital market, it is an enhancement of the disclosure process.