SYBFM-Equity MARKET-II

Session-II

UNIT-2:SECURITY ANALYSIS AND VALUATION OF SECURITIES

Factors affecting share prices Fundamental analysis in detail Technical Analysis in detail Macro Economic factors

Factors affecting share prices

Demand AND SUPPLY Market Cap News Earning/Price Ratio
Another important factor affecting stock price

is the earning/price ratio. This gives you a fair idea of a companys share price when it is compared to its earnings. The stock becomes undervalued if the price of the share is much lower than the earnings of a company. But if this is the case, then it has the potential to rise in the near future. The stock becomes overvalued if the price is much higher than

 Bonus share issues Warrants exercise

With warrants, you have the right to buy shares

from a company after the exercise date at specified price. As a result, its earnings will be diluted as more shares are sharing the same earnings pie. In general, the share price drops the same proportion of the number of exercised shares. For example, if the exercised share is 10% of the existing number of shares, the stock price will normally drops by 10% as well. Unfortunately, unlike stock split, these factors are diluting the earnings per share (EPS) of the stock, which in turn will adjust the share price accordingly. That is why; the stock price will get affected if any of the events happen. Although long term investors do not care much about it, stock traders (esp. swing traders, day trader, and position traders) should consider these factors

Take-over or merger Share buy-back

The act of share buy-back by a company will

reduce the number of share available in the open market. Due to the law of supply and demand, a reduction in share available for trading in this case will cause a drop in supply, this will normally help increase the share price. Also, the continuing buying back of share of a company will also acts as a support for the share price that helps to maintain or increase the share price. The investors may also see the share buy-back by company as a confidence booster for them in the company itself. Therefore, share buy-back is quite often used as a tool to deliver value to the investors.

Market Analysis
To begin, let's look at three ways on how

you would analyze and develop ideas to trade the market. There are three basic types of market analysis: 1. Fundamental Analysis 2. Technical Analysis 3. Sentiment Analysis There has always been a constant debate as to which analysis is better, but to tell you the truth, you need to know all three.

Fundamental analysis
Fundamental analysis is the stock investing

method, basing on some basic factors, which have a great impact on the changes of stock value. This method is widely used in order to determine intrinsic value of shares in the market. Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.

Fundamental Analysis
Fundamental analysis the practice of evaluating the

information contained in
economic factors (economic analysis) industry reports and (industry analysis) financial statements (company

analysis)
to determine the intrinsic value of a firm

Basic assumptions
is that the price on the stock market

does not fully reflect a stocks real value. in the long run, the stock market will reflect the fundamentals.

Basic philosophy
By focusing on a particular business,

an investor can estimate the intrinsic value and find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.

The big unknowns are:

You dont know if your estimate of intrinsic value is correct; and You dont know how long it will take for the intrinsic value to be reflected in the marketplace.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental

analysis come primarily from two groups:

proponents of technical analysis believers of the efficient market hypothesis.

Local Economy Analysis

Inflation Growth Rate (GDP) Currency instability World trade Stock Market Trends Fiscal Trends Foreign Investments Foreign Exchange Reserves Legal, Tax and political system

Economic Analysis
Forecasting business cycles
to determine when to expect changes in the

business cycle,or the direction in which aggregate economic activity is moving

Economic Analysis
Business cycle
the movement in aggregate economic

activity as measured by the gross domestic product (GDP)

Expansion
increasing economic activity

Contraction
decreasing economic activity

Economic Analysis
Gross Domestic Product (GDP)
a measure of all of the goods and services

produced in the economy during a specified time period

Recession
two consecutive quarters of economic

contraction, or decline, in the GDP

Business Cycles - Monetary Policy and Fiscal Policy

Monetary Policy
the means by which the RBI influences

economic conditions by managing the nations money supply

Business Cycles - Monetary Policy and Fiscal Policy

Fiscal Policy
Government spending, which is primarily

supported by the governments ability to tax individuals and businesses

Business Cycles - Monetary Policy and Fiscal Policy

Deficit spending
situation that occurs when the government

spends more than it collects in taxes

Industry Analysis
Each industry has differences in terms

of its
customer base, market share among firms, industry-wide growth, competition, regulation and business cycles.

Industry Analysis
Customers
Some companies serve only a handful of

customers, , while others serve millions. For example, a military supplier who has 100% of its sales with the Indian government. One change in government policy could potentially wipe out all of its sales.

Industry Analysis
Market Share Company's present market share can tell volumes about the company's business. Market share is important because of economies of scale.

Industry Analysis
Industry Growth Examine whether the amount of customers in

the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow. In some markets, there is zero or negative growth, a factor demanding careful consideration.

Industry Analysis
Competition looking at the number of competitors goes a

long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.

Industry Analysis
Regulation Certain industries are heavily regulated due

to the importance or severity of the industry's products and/or services.

They can drastically affect the

attractiveness of a company for investment purposes.

Industry Analysis
Industry life cycle
the various phases of an industry with respect to

its growth in sales and its competitive conditions

Industry Life Cycle

Industr y Sales Expansion (Growth) Introductory

Mature

Life-Cycle Stages

Company Analysis
Business Model
One of the most important questions that

should be asked is: What exactly does the company do?

This is referred to as a company's business

model it's how a company makes money.

Company Analysis
Competitive Advantage A company's long-term success is driven

largely by its ability to maintain a competitive advantage - and keep it. When a company can achieve competitive advantage, its shareholders can be well rewarded for decades.

Company Analysis
Management A company relies upon management to

steer it towards financial success. Even the best business model is doomed if the leaders of the company fail to properly execute the plan.

Company Analysis
Past Performance
Check and see how executives have done at

other companies in the past. Identify the companies they worked at in the past and do a search on those companies and their performance.

Company Analysis
Financial and Information Transparency Sufficient transparency implies that a

company's financial releases are written in a manner that stakeholders can follow what management is doing and
therefore have a clear understanding of the

company's current financial situation.

Company analysis Financial performance

The company analysis is done on base of fundament analysis which is done on the bases of: Edward Altmans Z score Z Score Bankruptcy Model: Z = 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5
T1 T2 T3 T4 T5

= = = = =

Working Capital / Total Assets Retained Earnings / Total Assets Earnings before Interest and Taxes / Total Assets Market Value of Equity / Total Liabilities Sales/ Total Assets

Zones of Discrimination:
Z > 2.99 -Safe Zone 1.8 < Z < 2.99 -Grey Zone Z < 1.80 -Distress Zone

 Earnings per Share

The overall earnings of a company are not in itself a useful indicator of a particular stock's worth. Low earnings and low outstanding shares could be more valuable than high earnings along with a high number of outstanding shares. The Earnings per share is much more practical information than earnings by itself. Earnings per share (EPS) is arrived at by dividing the net earnings by number of outstanding shares.

Price to Earning Ratio

The Price to Earnings Ratio (P/E) indicates the relationship between stock prices and company earnings. It is computed by dividing the share price by the Earnings per Share. The P/E indicates how much investors are willing to pay for a particular company's earnings. A high P/E can mean that the company is overpriced or it could also mean that investors are expecting the company to continue growing and generate profits. A low P/E can mean that investors are wary of the company or it could also indicate a company that majority of the investors have overlooked. In both cases, further analysis needs to be done to determine the accurate value of a particular stock.
Price to Sales Ratio

When a company is having no earnings, there are other tools that help investors judge its worth. New companies in particular mostly have no earnings, but that does not indicate that they are bad investments. Price to Sales ratio (P/S) is very helpful for judging new companies. It is calculated by dividing the market cap (stock price times the number of outstanding shares) by the total revenues. Another method is to divide the current share price by sales per share. P/S ratio indicates the value that the market places on sales. Lower the P/S, better the value.

 Price to Book Ratio

Book value is calculated by subtracting liabilities from assets. Value of a growing company would always be greater than book value owing to the potential for future revenue. The P/B ratio is the value that the market places on book value of the company and is calculated by dividing current price per share by book value per share (i.e. book value / number of outstanding shares). Companies having a low P/B are good and often chosen by long term investors who see the companys potential.

Dividend Yield

Certain investors look for stocks that are able to maximize dividend income. Dividend yield is helpful for determining the percentage return that a company pays in form of dividends. Dividend yield is calculated by dividing annual dividend per share by stock's price per share. Generally the older & well-established companies pay a higher percentage, and such companies also have a more consistent dividend history as compared to younger companies.

How Fundamental Analysis is performed

Type of approaches

1.

Top Down Top-down approach: In this approach, an analyst investigates both national and international economic indicators, like energy prices, GDP growth rates, inflation and interest rates. The analysis of total sales, price levels and foreign competition in a sector is also done in order to identify the best business in the sector.

2. Bottom Up Bottom-up approach: In this method, an analyst starts the search with specific businesses, irrespective of the industry or region.

"Top Down" approach for fundamental

analysis means beginning your analysis on a Global Macroeconomic level right from the start, moving to consecutive narrower economic levels until you reach the individual business itself.

"Bottom Up" approach for fundamental analysis means beginning your analysis on a microeconomic level right from the start, typically starting with a particular company itself.

Sentiment Analysis

 Price should theoretically accurately reflect all

available market information. Unfortunately for us traders, it isn't that simple. The markets do not simply reflect all the information out there because traders will all just act the same way. Of course, that isn't how things work. Each trader has his own opinion or explanation of why the market is acting the way they do. The market is just like Facebook - it's a complex network made up of individuals who want to spam our news feeds. Kidding aside, the market basically represents what all traders - you, Pipcrawler, Celine from the donut shop - feel about the market. Each trader's thoughts and opinions, which are expressed through whatever position they take, helps form the overall sentiment of the market. The problem is that as traders, no matter how strongly you feel about a certain trade, you can't move the markets in your favor (unless you're one of the GSs - George Soros or Goldman Sachs!). Even if you truly believe that the dollar is going to go up, but everyone else is bearish on it, there's nothing

Technical Analysis
Technical analysis uses a variety of charts

and calculations to spot trends in the market and individual stocks and to try to predict what will happen next. Technical analysts don't bother looking at any of the qualitative data about a company (for example, its management team or the industry that it is in); instead, they believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables.

 Technical analysis is a method of evaluating

securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identifypatterns that can suggest future activity.
Just as there are many investment styles on the

fundamental side, there are also many different types of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental

Technical analysts use dozens of different quantitative metrics in order to predict stock prices. In this section, we'll introduce you to some of the most popular ones and explain to you what they're all about, but first here are a few key terms you should know about: Resistance Level: The opposite of a support level, the level that the technical analyst believes a stock price will not exceed.

Support Level: The level that the

technical analyst believes a stock price will not fall below (also sometimes called a "floor")

Breakout: If a stock surpasses the

resistance level or falls below the support level, it is said to be a "breakout." Advance-Decline Line: The total number of advancing issues minus the total number of declining issues, added to a cumulative total.

Advantages of Technical Analysis

Unlike fundamental analysis, technical

analysis is not heavily dependent on financial accounting statements

Problems with accounting statements: Lack information needed by security analysts GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements between firms Many psychological and other non-quantifiable factors do not show up in financial statements

Advantages of Technical Analysis

Fundamental analyst must process new

information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust to correct prices as quickly

Challenges to Technical Analysis

Challenges to basic assumptions Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends Challenges to technical trading rules
Rules that worked in the past may not be

repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules all require subjective judgement

Typical Stock Market Cycle

Stock Price

Typical Stock Market Cycle

Stock Price

Declining Trend Channel

Peak Flat Trend Channel Sell Point Rising Trend Channel Buy Point Trough Declining Trend Channel Buy Point Trough

Tools of Technical Analysis

Charting Stocks
Bar Charts and Japanese Candlestick Charts Point and Figure Charts

Major Chart Patterns Price-based Indicators Volume-based Indicators Dow Theory Elliot Wave

Charting the Market

Chartists use bar charts, candlestick, or

point and figure charts to look for patterns which may indicate future price movements. They also analyze volume and other psychological indicators (breadth, % of bulls vs % of bears, put/call ratio, etc.). Strict chartists dont care about fundamentals at all.

Drawing Bar (OHLC) Charts

Each bar is composed of

4 elements:
Open High Low Close

H ig h C lo s e O pen

H ig h

Note that the candlestick

body is empty (white) on up days, and filled (some color) on down days Note: You should print the example charts (next two slides) to see them more clearly

O pen Low Low

C lo s e

S ta n d a rd B a r C h a rt

Japanese C a n d le s t ic k

S ta n d a rd B a r C h a rt

Japanese C a n d le s tic k

Types of Charts: Bar Charts

This is a bar (open, high, low, close or OHLC)

chart of AMAT from early July to mid October 2001.

Types of Charts: Japanese Candlesticks

This is a Japanese Candlestick (open, high, low,

close) chart of AMAT from early July to mid October 2001

Basic Technical Tools

Trend Lines Moving Averages Price Patterns Indicators Cycles

Trend Lines
There are three basic

kinds of trends:
An Up trend where

prices are generally increasing. A Down trend where prices are generally decreasing. A Trading Range.

Support & Resistance

Support and resistance

lines indicate likely ends of trends. Resistance results from the inability to surpass prior highs. Support results from the inability to break below to prior lows. What was support becomes resistance, and Support vice-versa.

Breakout

Resistance

Simple Moving Averages

A moving average is

simply the average price (usually the closing price) over the last N periods. They are used to smooth out fluctuations of less than N periods. This chart shows MSFT with a 10-day moving average. Note how the moving average shows much less volatility than the daily stock price.

M SFT Daily Prices with 10-day M A

9/23/93 to 9/21/94 60

55

50

e c i r P

45

40

35

30 1 21 41 61 81 101 121 Date 141 161 181 201 221 241

Price Patterns
Technicians look for many patterns in the

historical time series of prices. These patterns are reputed to provide information regarding the size and timing of subsequent price moves. But dont forget that the EMH says these patterns are illusions, and have no real meaning. In fact, they can be seen in a randomly generated price series.

Head and Shoulders

This formation is
H &S Top
H ead

characterized by two small peaks on either side of a larger peak. This is a reversal pattern, meaning that it signifies a change in the trend.

L e ft S h o u ld e r

R ig h t S h o u ld e r

N e c k lin e

H & S B o tto m
N e c k lin e

L e f t S h o u ld e r

R ig h t S h o u ld e r

Head

Head & Shoulders Example

Sell Signal

Minimum Target Price Based on measurement rule

Double Tops and Bottoms

These formations are
D o u b le T o p

similar to the H&S formations, but there is no head. These are reversal patterns with the same measuring implications as the H&S.

T a rg e t T a rg e t

D o u b le B o tt o m

Double Bottom Example

Triangles
Triangles are

continuation formations. Three flavors:

Ascending Descending Symmetrical

A s c e n d in g

S y m m e tr ic a l S y m m e tr ic a l

Typically, triangles

should break out about half to threequarters of the way through the formation.

D e s c e n d in g

Rounded Tops & Bottoms

Rounding formations

are characterized by a slow reversal of trend.

R o u n d in g B o tto m

R o u n d in g T o p

Rounded Bottom Chart Example

Broadening Formations
These formations are

like reverse triangles. These formations usually signal a reversal of the trend.

B ro a d e n in g B o tto m s

B r o a d e n in g T o p s

DJIA Oct 2000 to Oct 2001 Example

What could you have known, and when could you have known it?

DJIA Oct 2000 to Oct 2001 Example

Nov to Mar Trading range

Descending triangles

Double bottom

Gap, should get filled

Technical Indicators
There are, literally, hundreds of technical

indicators used to generate buy and sell signals. We will look at just a few that I use:
Moving Average Convergence/Divergence (MACD) Relative Strength Index (RSI) On Balance Volume Bollinger Bands

MACD
MACD was developed by Gerald Appel as a way

to keep track of a moving average crossover system. Appel defined MACD as the difference between a 12-day and 26-day moving average. A 9-day moving average of this difference is used to generate signals. When this signal line goes from negative to positive, a buy signal is generated. When the signal line goes from positive to negative, a sell signal is generated. MACD is best used in choppy (trendless) markets, and is subject to whipsaws (in and out rapidly with little or no profit).

MACD Example Chart

Relative Strength Index (RSI)

RSI was developed by Welles Wilder as an

oscillator to gauge overbought/oversold levels. RSI is a rescaled measure of the ratio of average price changes on up days to average price changes on down days. The most important thing to understand about RSI is that a level above 70 indicates a stock is overbought, and a level below 30 indicates that it is oversold (it can range from 0 to 100). Also, realize that stocks can remain overbought or oversold for long periods of time, so RSI alone isnt always a great timing tool.

RSI Example Chart

Overbought Oversold

On Balance Volume
On Balance Volume was developed by Joseph

Granville, one of the most famous technicians of the 1960s and 1970s. OBV is calculated by adding volume on up days, and subtracting volume on down days. A running total is kept. Granville believed that volume leads price. To use OBV, you generally look for OBV to show a change in trend (a divergence from the price trend). If the stock is in an uptrend, but OBV turns down, that is a signal that the price trend may soon reverse.

OBV Example Chart

Divergence, OBV failed OBV confirms trend change but doesnt lead

Bollinger Bands
Bollinger bands were created by John Bollinger (former

FNN technical analyst, and regular guest on CNBC). Bollinger Bands are based on a moving average of the closing price. They are two standard deviations above and below the moving average. A buy signal is given when the stock price closes below the lower band, and a sell signal is given when the stock price closes above the upper band. When the bands contract, that is a signal that a big move is coming, but it is impossible to say if it will be up or down. In my experience, the buy signals are far more reliable than the sell signals.

Bollinger Bands Example Chart

Sell signal

Buy signals Sometimes, the buy signals just keep coming and you can go broke!

Dow Theory
This theory was first stated by Charles Dow

in a series of columns in the WSJ between 1900 and 1902. Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy. A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order to generate a valid signal.

Dow Theory Trends (1)

Primary Trend
Called the tide by Dow, this is the trend that

defines the long-term direction (up to several years). Others have called this a secular bull or bear market.

Secondary Trend
Called the waves by Dow, this is shorter-

term departures from the primary trend (weeks to months)

Day to day fluctuations

Not significant in Dow Theory

Dow Theory Trends (2)

Does Dow Theory Work?

According to Martin Pring, if you had

invested $44 in 1897 and followed all buy and sell signals, by 1981 you would have accumulated about $18,000. If you had simply invested $44 and held that portfolio, by 1981 you would have accumulated about $960.

Elliot Wave Principle (1)

R.N. Elliot formulated this idea in a series of

articles in Financial World in 1939. Elliot believed that the market has a rhythmic regularity that can be used to predict future prices. The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of similar shorter-term cycles (Big fleas have little fleas upon their backs to bite 'em - little fleas have smaller fleas and so on ad infinitem). Elliot Wave adherents also make extensive use of the Fibonacci series.

The Elliot Wave Principle (2)

5 B A 3 1 2 4 C

Fibonacci Numbers
Fibonacci numbers are a series where each succeeding

number is the sum of the two preceding numbers. The first two Fibonacci numbers are defined to be 1, and then the series continues as follows: 1, 1, 2, 3, 5, 8, 13, 21 As the numbers get larger, the ratio of adjacent numbers approaches the Golden Mean: 1.618:1. This ratio is found extensively in nature, and has been used in architecture since the ancient Greeks (who believed that a rectangle whose sides had the ratio of 1.618:1 was the most aesthetically pleasing). Technical analysts use this ratio and its inverse, 0.618, extensively to provide projections of price moves.

Does Elliot Wave Work?

Who knows? One of the biggest problems with

Elliot Wave is that no two practitioners seem to agree on the wave count, and therefore on the prediction of whats to come. Robert Prechter (the most famous EW practitioner) made several astoundingly correct predictions in the 1980s, but hasnt been so prescient since (he no longer gets much press attention). For example, in 1985 he predicted that the market would peak in 1987 (correct), but he thought it would peak at 3686 ( 100 points). The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.

Too Many Others To List

As noted, there are literally hundreds of indicators and

thousands of trading systems. A whole semester could easily be spent on just a handful of these. To close, just note that there is nothing so crazy that somebody doesnt use it to trade. For example, many people use astrology, geometry (Gann angles), neural networks, chaos theory, etc. Theres no doubt that each of these (and others) would have made you lots of money at one time or another. The real question is can they do it consistently? As the carneys used to say, You pays your money, and you takes your chances.

Macro Economic Factors

Case Studies