Portfolio Management

Portfolio can be defined as a collection of assets in which an investor invests to gain profit. 

So it can range from one assets to multiple assets. And portfolio management is an art of

managing these diversified assets. An investor can choose to diversify investments based 

on their risk appetite. I.e they can choose to invest in less risky assets or high risky assets,

or build a combination of investment in these two risk ranges. Applying the technique of 

investing in a combination of assets reduces risk as well as optimizes return. Thus, it helps

to keep investment safe. This is the gist of portfolio management practice. 

Portfolio management can also be said as an art of investing in several assets so that the 

risk is minimized or the return is maximized. There are two ways of portfolio management: 

Active and Passive. Active management is the process of actively managing investments 

by frequently checking the trends and investing according to it. They also involve

investments in IPO. Passive management, on the other hand, focuses on long-term growth 

by investing in index funds or exchange-traded funds (ETFs) that mirror the market’s 

performance.

As said earlier, the key concept of portfolio management is diversification. In this technique 

assets are diversified among several investments so that the risk of investing in only one 

asset is reduced. This risk reduction protects the property of a company and makes sure 

that the company become sustainable. We can also make the risk of investing theoretically

zero. This means, there will be virtually no risk in the investment. Thus, an investor is 

considered safe if they invest according to rules of portfolio management. 

Investment returns and risk

While managing a portfolio, the return on investment and the risk associated with it is

considered. Investment is decided only if the expected return on a fixed level of risk is high 

enough to meet expectations. Not only expectations, it should give higher return than the 

market is providing. This is because market investment choices such as Banks give good 

return and are considered less risky. Thus, there should be tradeoff between investment 

return and risk. The more risk an investor takes, the more return he/she should get. This 

is a general principle of investment theory and portfolio management is also guided by 

this theory. As a result, some investors take higher risk and expect higher return and 

others take lower risk and are ok with lower return.

To choose which investment to consider, one can use the Markowitz model of portfolio 

management or CAPM model. In the Markowitz model all the risk and return of all of the

possible combinations of investments are calculated. By doing this it is understood which 

combinations give the highest return with the same level of risk or which combinations give 

higher return on the higher level of risk. It is suggested to choose the assets in the efficient 

frontier shown by this model. An efficient frontier is the area on Markowitz model where the 

highest return giving combination of assets in comparison to risk lies.

Another model to consider in portfolio management is the CAPM model. In this model, the 

required rate of return is calculated by a formula. If the expected return is higher than the 

required rate of return, then an investor decides to invest, otherwise not. The formula is based

on risk free rate, the market rate of return and stock beta, where stock beta is the relation 

between share market index and the share’s movement. If the beta is higher, the required rate 

of return is higher and vice versa.

There is a technical way to find out the rate of return which we can expect from our investment. 

It’s called Security Market Line. It indicates the required rate of return for our investment. Its

formula is based on the risk free rate of return, expected market return and the beta coefficient 

of the portfolio.

 

Its formula is:

E(Ri​)=Rf​+βi​(E(Rm​)−Rf​)

Where:

• E(Ri)) = Expected return on security i
  
  

• Rf​ = Risk-free rate of return
  
  

• βi​ = Beta of security i

• 
  

• E(Rm) = Expected return of the market portfolio
  
  

• E(Rm)−Rf = Market risk premium

We can easily find the required rate of return using this formula. 

Let

Let’s take an example. Suppose the risk free return (The return on treasury bills) is 3%. 

The market return is expected to be 10% and the portfolio beta is o.7, then the required 

rate of return

is: 

3%+(10%-3%)*0.72

=8.04%

It shows that the required return on invested portfolio is 8.04%. Thus if the return is lower 

than this, then the stocks is overvalued and if the return is higher than this then the stocks 

is undervalued. If overvalued, one should understand that the price of stocks should be

lower and take decision accordingly. But if the stock is undervalued, one should understand 

that the price of stock should be higher.

Trend Analysis

 

In this financial era, people want to invest by gaining an outlook about how a company is 

going to perform in the future. For this,  they have to gain an understanding of the past to

predict future. Here comes the use of trend analysis. Trend analysis helps to recognize a

pattern and on its basis, predict the future.

In the field of finance, trend analysis means evaluating company’s key financial indicators 

to determine its future value. These indicators might include revenue, profit, cash flow, 

debt, or stock prices. The goal is to forecast future performance and make informed 

judgement on this basis.

Importance of trend analysis in finance

1. Forecasting future performance: By performing trend analysis of financial

   statements,a company can predict future budget. This is important for cost 

   management of a company.

2. Evaluating investment: By doing the stock market trend analysis, trend 

   analysis of particular industry in which a company is doing business, a company

   can evaluate its investment. If the trend is upward, an investment has chances of 

   growing and if the trend is downward, an investment has chances of not growing.

3. Assessing financial health: Trend analysis helps to access financial health of 

   an organization. For example, by comparing the trend of P/E ratio over time, one 

   can know how well the company will perform in the future. Similarly, the EPS ratio 

   comparison shows if the earning per share of a company is growing over time.

4. Strategic planning: Trend analysis helps in strategic planning. It shows that budget

   can be directed in other sector because the cost in one sector is unlikely to exceed

   a minimum threshold. This helps companies to manage their cost and the likely of their 

   survival will increase in the market.

Types of trends in Financial Analysis (Trend Analysis Of Financial Statements)

1. Revenue trends: This trend analyzes if the revenue is increasing over time or 

   decreasing over time. If the company has consistent revenue growth over time, then

   it is a signal that a company has gained goodwill in a market.

2. Expense Trends: This trend measures the direction that expenses of a company are

   following relative to revenue. I.e they are uptrend or downtrend. If the expenses are

   uptrend continuously, it shows that a company is unable to manage its costs.

3. Profitability Trends: This trend measures the direction that the profit of a company

   is taking. I.e whether the gross profit margin, operating margin or net profit margin are

   increasing with time or they are decreasing with time. If they are increasing over time, 

   then it indicates that the company is in good position in the market. But if it is

   decreasing over time, then it can be the signal that the company is losing market.

4. Liquidity and solvency trends: This metric calculates the trend in ratios like current

   ratio, debt-to-equity ratio and interest coverage ratio. If these ratios maintain a standard

   value, then it indicates that the liquidity and solvency position of a company is good. I.e 

   they are able to pay their liabilities.

5. Stock Market Trends: Stock market trend is the trend shown by stock market. 

   Depending upon information, stock market shows upward or downward or 

   horizontal trend. 

Methods of conducting trend analysis in Finance

1. Horizontal analysis: This analysis method calculates the movement of financial 

   statement items over different time periods. For example: If a company calculates

   the increase in revenue from year 2017 to 2025, then it is an example of horizontal 

   analysis.

2. Vertical analysis: It is an analysis method in which each item of financial statements 

   are represented as a percentage of base figure. For example: showing line items like

   cost of goods sold as a percentage of total revenue. If it is done for one company, it 

   shows the performance of a single company. But If it is done for multiple companies,

   it helps in comparing the financial statements of multiple companies because it 

   standardizes financial datas. Its another name is common size analysis.

3. Ratio analysis: Since ratios are good indicators of financial health of an organization, 

   comparing the change in ratios over time is crucial to understand an organization. We 

   can also compare ratios of different companies to gain a better understanding of them. 

4. Moving average: This technique smoothes out the shorter term fluctuations and show

   longer term trends. Thus they help in trend analysis. To perform this analysis, cluster of 

   samples are made and average is calculated. Now the trend in this average is calculated.

   This calculation is considered more effective because asexplained earlier, it smoothes out

   shorter term fluctuations. 

Conclusion: In this modern era, trend analysis has become part of financial organizations.

This is because these organizations need information about their performance with time. 

Also they need  prior information about how well they will do. Thus, it is crucial that we

have knowledge about trend analysis.

DuPont Equation

 

Return on equity shows how effectively a company is earning money from each unit of 

shareholders investment. But simply knowing ROE doesn’t highlight other important factors

like what’s really driving the ROE of a company? Is the company profitable? Is it efficient with 

assets? Is it heavily leveraged?

At this point we take help from DuPont equation.

DuPont equation breaks down ROE into three major components:

ROE= Net profit margin * Asset turnover * Equity Multiplier

Or in words:

ROE= Profitability * Efficiency * Financial Leverage

In this context, net profit margin indicates a company's profitability, asset turnover reflects

its operational efficiency, and the equity multiplier represents its financial leverage.

In mathematical form,

Net Profit Margin = Net Income / Sales

Asset turnover = Sales / Total Assets

Equity Multiplier = Total Assets / Shareholders equity

Through this equation we can understand that the value of ROE can be arrributed to high 

profitability or high efficiency or because of higher financial leverage. All of these factors

play an important role in analyzing the financial performance of a company. Let’s examine

them one by one.

The profitability factor shows how much net income a company generates in relation to its 

sales. Net income reflects the actual profit the organization retains after all expenses. It can

be used for company chores such as purchasing properties, allocating for administrative 

expenses and distributing to shareholders as dividend. Thus it is solely the property of a 

company. If a company generates higher net income, it shows us that the company is good

in earning return on its investment. Whereas if a company books less net income, it shows

that the company is not earning expected return on investment.

The efficiency factor shows how efficient an organization is in managing its assets to 

generate sales and subsequently profit. For this. Asset turnover ratio is useful because it 

shows the portion of sales on total assets. The target of any company with a growing 

mindset is to generate higher sales with the amount of assets it has. For this, it utilizes 

these assets for several tasks such as purchasing better machineries, hiring skilled 

manpower,  purchasing top notch lands for power plants etc. All these utilization of assets

are directed towards generating higher value among customers. Because of better 

differentiation strategies, customers start to like the brand. It creates goodwill which in turn

increase the sales of an organization. This indicates efficiency and a higher value of this ratio

indicates greater organizational efficiency,while a lower value suggests reduced efficiency.

The financial leverage part shows how much assets an organization is generating by 

utilizing shareholders equity. i.e it shows the portion of assets on shareholders equity. 

When any company collects shareholders equity, its target is to utilize it to the fullest to 

generate profit through sales. For this, it modifies its processes to produce better products. 

It also improves its efficiency through better machineries as well as better training for 

manpowers. Thus, after it becomes able to generate profit through sales, it purchase assets. 

This capacity is highlighted by equity multiplier. This ratio, when higher, reflects a greater 

level of assets held by the company; when lower, it indicates a smaller asset base. Therefore,

it is an important component in DuPont analysis.

For example:

Let’s say a company has:

• Net Income = $100,000
  
  

• Sales = $2,000,000
  
  

• Total Assets = $500,000
  
  

• Shareholder's Equity = $250,000
  
  

Then:

• Net Profit Margin = 10%
  
  

• Asset Turnover = 4
  
  

• Equity Multiplier = 2
  
  

ROE = 10% × 4 × 2 = 80%

This tells us the company’s 40% ROE comes from good profitability, strong operational 

efficiency, and moderate use of debt.

Industry Comparison of DuPont Components

Industry	Net Profit Margin	Asset Turnover	Equity Multiplier	ROE (%)
Tech	20%	0.8	1.5	24%
Retail	5%	2.5	2.0	25%
Manufacturing	10%	1.5	2.0	30%
Banking	15%	0.7	8.0	84%

In the above list, there are different values of ROE for different industry. For tech industry, 

the value of ROE is 24%. If we look more carefully, we can see that this value of ROE is 

directed by higher profit margin of 20% compared to other industries. Other industries such

as Retail, Manufacturing and Banking have lower profit margin compared to tech industry. 

But for retail industry, even if the profit margin is 5%, its ROE is higher than tech industry. 

This is because the asset turnover ratio is way higher than that of tech industry. Also the 

equity multiplier is higher. Thus, as a result, the ROE is higher.

Now lets evaluate manufacturing industry. Its asset turnover ratio and equity multiplier are 

comparatively higher and also net profit margin higher by 10%. As a result, the ROE 

becomes a whooping 30%. For Banking industry, the net profit margin is 15% which is less

than tech industry by 5%. Similarly, the value of asset turnover is 0.7, which is less by 0.1. 

But its ROE is 84% because its equity multiplier is 8, which is higher from the tech industry 

by 6.5. By evaluating above datas, we can clearly see that we need to evaluate three 

factors sothat we can analyze what is the driving force behind ROE.

This is the significance of DuPont analysis.