Module4 Stockevaluations

Stock Evaluations
Module 4
Manoj Morais
Stock Evaluations
 How to pick a stock?

 When should I buy a stock/ Hold it/ sell a stock?
 Behavior of stock prices – important research area in finance
 Stock market – provides market price - how much per share?
 Investors – what the price could be – is it going to fall or rise
Stock Evaluations
 How to pick a stock?
How to evaluate stock
Efficient Market
Fundamental Analysis Technical Analysis
Hypothesis
Stock Evaluations
 FUNDAMENTAL ANALYSIS
 Identifying the intrinsic value of an asset
 Intrinsic value – present value of all expected value of
future cash flows (earnings) from that asset.
 Equity shares – present value of future earnings -
dividend, capital gain etc.
Stock Evaluations
 Expected earnings from equity depends on variety of

factors
 FA – in depth analysis of factors
 Forecasts – future GDP, Future sales, earnings etc

Stock Evaluations
 Two Approaches
 Top Down Approach
 Bottom up Approach
Stock Evaluations
 Top Down Approach
Forecast
1. Economy
2. Industry
3. Company
Stock Evaluations
 Bottom up Approach
Forecast
1. Company
2. Industry
3. Economy
Stock Evaluations
 Company Analysis
 IT industry – IT companies - Infosys, Wipro, TCS
 Operating performance, Financial performance
 Future prospects
Stock Evaluations
 Company Analysis
 Characteristics of a company
 Operating performance, Financial performance
 Future prospects
Stock Evaluations
 FUNDAMENTAL ANALYSIS – Company analysis
 Identifying Future dividends, earning – depends on past

performance
 Possible outcome of company analysis – expected future

cash inflow from the share --- used to determine intrinsic
value
 Intrinsic value – compared with current market prices

Stock Evaluations
 Intrinsic value of share < its market price -

undervalued
 Decision making ? – Buy it
 Intrinsic value of share > its market price –
Overvalued - do not purchase – existing investor- sell
it
Stock Evaluations

 Intrinsic value – depends on amounts of dividends,
growth rate and earnings
 How shall we identify these information?
 Balance sheet, Income statement, Cash flow
statement, Auditors report etc
Stock Evaluations

 Financial & Non-Financial parameters
 Financial ratio analysis, Analysis of company

management & governance, analysis of product
differentiation and Innovations
Stock Evaluations

 Financial Ratios – Accounting rations
 Historical performance of the company
 Includes analysis of Profitability, Liquidity, Solvency,

Efficiency level
Stock Evaluations

 Financial Ratios – Accounting rations
 Earnings analysis or Profitability
 Past profitability – good indicator – future prospects

 Cash inflows depends on earnings
Stock Evaluations
 Company analysis – Financial Ratios

 Return on Equity (ROE)
 Part of total earnings of the company which belongs to equity share holders
PAT − Preference 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
 ROE = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒 𝐻𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐹𝑢𝑛𝑑𝑠
x 100
PAT −Preference 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

 ROE = x 100
𝑁𝑒𝑡𝑤𝑜𝑟𝑡ℎ
Stock Evaluations

 Return on Equity (ROE)
 Indicates whether equity share holders getting adequate return on
their funds
 ROE > ROI - Company is profitable
 Shareholders are interested to analyse ROE than overall company
profitability
Stock Evaluations

 Earning per share (EPS)
 Part of total earnings of the company which belongs to
equity share holders
PAT −Preference 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

 EPS =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
Stock Evaluations
 How much amount is earned per equity share of the

company
 Reported in the media

Stock Evaluations
 Past EPS future forecast – could be used in valuation

of equity shares.
Stock Evaluations
 Price Earnings Ratio (P/E) – P/E Ratio
 Popularly called P/E ratio
Market Price 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

 Price Earnings Ratio =
𝐸𝑃𝑆
Stock Evaluations
 Indicates relative valuation of the share of a company

in the stock market
Stock Evaluations

 High P/E ratio – Market is optimistic – company growth –
earnings potential
 Pays a high price to buy the share.
 High P/E ratio - Overpriced
Stock Evaluations
 Low P/E ratio – Market is Pessimistic – company growth
 Shares traded at relatively lower price – underpriced
 Some investors may buy – believed to be undervalued

Stock Evaluations

 Book Equity to Market Equity Ratio (BE/ME)
Book Value 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
 BE/ME=
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
 Book Value per share - Net Asset value per share

 Relative value of a share of the company in the stock
market
Stock Evaluations

 Relative value of a share of the company in the stock
market
 Comparing book value of a company to its market
value
Stock Evaluations
 Book value calculated – historical cost or accounting value.
 Market value in the stock market – market capitalization
 Comparing book value of a company to its market value

Stock Evaluations
Technical Analysis
Stock Evaluations
Technical Analysis
Stock Evaluations
Stock Evaluations
 Company analysis – Technical Analysis
 Trend analysis
 Direction in which a security or market is headed.
 Price fluctuations – Rise, decline, No much movement
 Overall highs and lows – trend

Stock Evaluations
 Trend analysis – 3 types

Trend
Sideways/Horizontal
Uptrend Downtrend
trend
Stock Evaluations
 Trend analysis –
 Uptrend – higher highs and higher lows
 Downtrend - lower lows and lower highs
 Sideways – little movement up or down in the peaks and

troughs.
Stock Evaluations
 Trend analysis –
 Uptrend – higher highs and higher lows
 Downtrend - lower lows and lower highs
 Sideways – little movement up or down in the peaks and

troughs.
Stock Evaluations

 Trend analysis – Trend Line
 Charting technique where line is added to a chart to imply
trend in a market or stock
 Trend lines – connects lower lows or higher highs
 Shows where price are headed - support and resistance
levels are determined
Stock Evaluations

 Charting technique where line is added to a chart to imply
trend in a market or stock
 Trend lines – connects lower lows or higher highs
 Shows where price are headed - support and resistance
levels are determined
Stock Evaluations
Stock Evaluations
Stock Evaluations

 When drawing trend lines in a downtrend, you draw them above the price.
 When you draw trend lines in an uptrend, you draw them below the price. It
is the highs on a downtrend and the lows on an uptrend that will determine
a trend line.
 At least two swing highs or swing lows are needed to draw a trend line in
either direction.
Stock Evaluations

 support and resistance are certain predetermined
levels of the price of a security at which it is thought
that the price will tend to stop and reverse. These
levels are denoted by multiple touches of price
without a breakthrough of the level..
Stock Evaluations
support and resistance

Stock Evaluations
support and resistance

Stock Evaluations

 Candlesticks - open, high, low and close value for
each time period
 Hollow/Filled portion – Body
 Long thin lines above and below – high and low range
– shadows- wicks and tails
Stock Evaluations

 Candlesticks -
 High- marked top of the upper shadow
 Low – bottom of the lower shadow
 Stock closes higher than its opening price -white
candlestick – bottom of body – opening price, top of body-
closing price
Stock Evaluations
 Candlesticks -
Stock Evaluations

 Candlesticks -
 Green & Red Candlesticks
 Green candlestick – share price closed at a higher price
compared to the previous.
 Stock closes higher than its opening price -white candlestick –
bottom of body – opening price, top of body- closing price
Stock Evaluations
 Candlesticks -
Stock Evaluations

 Candlesticks -
 White/Green candlesticks – close price > open price –
buying pressure /price gains
 Black /Red candlesticks – close price < open price and
previous close price – selling pressure/ price declining
Stock Evaluations
 Candlesticks -
Stock Evaluations
 Candlesticks - Long Vs Short body
 Long body – more intense the buying or selling

pressure
 Short – little price movement

Stock Evaluations
 Long hollow candle– the longer the white candlestick –

the further the close is above the open
 Prices advanced significantly – buyers are aggressive
 White long candles – bullish

Stock Evaluations
 Long filled candle– longer the candlestick is, the

further the close is below the open.
 Prices declined significantly – sellers are aggressive

Stock Evaluations

 Candlesticks - Long Vs Short shadows
 Upper shadows – session high .
 Lower shadows – session low
 Candlestick with short shadow – trading action was confined near
the open and close.
 Candlestick with long shadows – price extended above the open
and close.
Stock Evaluations

 Candlesticks - Doji
 Doji forms – security’s open and close are almost equal
 Length of upper and lower shadows vary – almost like a plus sign.
 Conveys a sense indecision between buyers and sellers - price move
above or below the opening level during session – close at or near
the opening level.
Stock Evaluations
 Moving Averages
 Widely used technique
 MA helps traders identify trends and enable them to make

more number of profitable trades
 Average of a series of numeric values.

Stock Evaluations

 Moving Averages
 Predefined length for the number of values to average - this set of
values moves forward as more data is added with time.
 Given a Series of numbers and fixed subset size, 1st element of MA
series obtained by taking average of the initially fixed subset of the
number series.
 Subset is modified by shifting it forward by one value
Stock Evaluations
 Moving Averages
Stock Evaluations
 Moving Averages
Stock Evaluations
 Moving Averages
 MA helps cut down noise in a trading chart
 10 day, 50 day, 200 day MAs
 Add up the closing prices and divide by 10

Stock Evaluations

 Moving Averages – Simple Moving Average
 Arithmetic moving average calculated by adding the elements in
a time series and dividing it by the number of time period.
 Very popular technique used in trading – trend direction
 All elements in the SMA have equal weightage
 If MA period is 5, weightage is 1/5
Stock Evaluations

 Moving Averages
 Triple Moving Average Crossover Strategy
 Plotting 3 different moving averages to generate buy and sell
signals
 3 MAs of different lookback period – trader can confirm whether
market has actually witnessed a change in trend – resting
momentarily – then continue the existing trend
Stock Evaluations

 Moving Averages
 Buy signal is generated if there is a trend and sell is
triggered when the trend ends
 Third MA is used to confirm or deny the signals – reduces
the probability of entering trade on false signals
Stock Evaluations
 Moving Averages
 Up trend – shorter MA (fast moving MA) will begin rising

than the slower ones (long term )
 Helps in to enter a trade at right time.

Stock Evaluations
 Moving Averages

Stock Evaluations
 Moving Averages Triple Moving Average Crossover
Red Line – Fast MA (10 days), Green –Medium, Purple- Slow

Stock Evaluations
Sell triggered – FMA crosses below Med and Slow Mas- Short term
shift in the trend- Avg price of last 10 days fallen below the avg
price of last 20 and 30 days
Stock Evaluations
Sell confirmed – Med MA crosses below slow MA – shift in

the momentum is significant
Stock Evaluations
Triple MA – generates signal to sell – slow MA is above

Med MA, Med MA is above Fast MA – Aggressive
traders – Fast Mas crossing over med and slow MAs
Stock Evaluations
 Efficient Market Hypothesis- EMH
 Proposition – current market prices fully reflect

available information about the value of the firm-
there is no way to earn excess profit by using this
information.
 Fundamental question – why price changes occur in

security market and how such changes takes place.
Stock Evaluations
 Investors look for undervalued securities – expected
to a rise in the value in future more than others
 EMH asserts that such techniques are not effective-
advantages gained does not exceed the transaction
cost and research costs incurred.
 EMH – profiting from predicting price movements is
tough and unlikely.
Stock Evaluations
 Price changes – arrival of new information
 Market is efficient – if prices adjust quickly and

without any bias to the new information
 Current prices reflects all available information.
 Mispriced security – under priced and over priced

Stock Evaluations
Three versions of Efficiency
Weak Form Semi-Strong Form Strong Form

Efficiency Efficiency efficiency
Stock Evaluations
 Weak Form Efficiency
 Current prices incorporates information contained in the
past history of prices only
 No one can detect mispriced securities - beat the market
by analysing past prices
 Technical analysis
 Transaction cost of analysing and trading securities – cant
make extra money on publicly available information.
Stock Evaluations
 Semi Form Efficiency
 Current prices incorporates all publicly available
information .
 Past prices, data published on company’s financial
statements
 One cant make profit based on information that
everybody knows.
Stock Evaluations
 Strong Form Efficiency
 Prices reflect all information – public and private – inside

information
 No one should be able to make profits on the inside

information or info not know in public at a specific time
period.
 Company management, research team - pharmaceuticals.

CAPM
 Capital Asset Pricing Model (CAPM )
 Developed by W.f Sharpe
 Simplified version of Markowitz Portfolio theory
 Measuring CAPM
 Identification of key components of Total Risk:

Systematic & Unsystematic Risk
CAPM
 Systematic Risk : Market related
 Purchasing power risk, Interest rate risk, Liquidity risk
 Unsystematic Risk: unique to individual asset –

business risk, financial risk
 Portfolio management – Diversifying unsystematic

risk - Systematic risk cant be diversified.
CAPM
CAPM

 Systematic Risk : more SR the investor takes, the greater is
the expected returns.
 CAPM Assumptions
 All investors look only one period expectations about the
future
 Investors are price takers – cant influence market
individually
CAPM
 CAPM Assumptions
 There is risk free rate at which an investor may either

invest or borrow money
 Investors are risk averse
 Tax and transaction costs are irrelevant
 Information is freely and instantly available to all investors.

CAPM
 What CAPM predicts?
 Expected rate of return for the investor
 Other statistics about the expected return in the

market
 Market risk (Systematic risk)

CAPM
 What CAPM predicts?

CAPM
 Security Market Line (SML)?
 Visual representation of the CAPM
 Relationship between expected return of a security

and its risk measured by beta coefficient
CAPM
 Risk free rate : 4.75%
 Expected market return: 15.50%
 Security A beta: 0.6
 E (R) = 4.75 + β x (15.50 – 4.75) = 4.75 + 10.75 x β

CAPM

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Stock Evaluations

 How to pick a stock?

 How to pick a stock?

How to evaluate stock

 Expected earnings from equity depends on variety of

 FA – in depth analysis of factors

 Forecasts – future GDP, Future sales, earnings etc

 Top Down Approach

 IT industry – IT companies - Infosys, Wipro, TCS

 Operating performance, Financial performance

 Operating performance, Financial performance

 FUNDAMENTAL ANALYSIS – Company analysis

 Identifying Future dividends, earning – depends on past

 Possible outcome of company analysis – expected future

 Intrinsic value – compared with current market prices

 FUNDAMENTAL ANALYSIS – Company analysis

 Intrinsic value of share < its market price -

 FUNDAMENTAL ANALYSIS – Company analysis

 FUNDAMENTAL ANALYSIS – Company analysis

 Financial ratio analysis, Analysis of company

 FUNDAMENTAL ANALYSIS – Company analysis

 Historical performance of the company

 Includes analysis of Profitability, Liquidity, Solvency,

 FUNDAMENTAL ANALYSIS – Company analysis

 Earnings analysis or Profitability

 Past profitability – good indicator – future prospects

 Company analysis – Financial Ratios

PAT −Preference 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

 Company analysis – Financial Ratios

 Company analysis – Financial Ratios

PAT −Preference 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

 Company analysis – Financial Ratios

 Earnings analysis or Profitability

 Earning per share (EPS)

 How much amount is earned per equity share of the

 Reported in the media

 Company analysis – Financial Ratios

 Earnings analysis or Profitability

 Earning per share (EPS)

 Past EPS future forecast – could be used in valuation

 Company analysis – Financial Ratios

 Earnings analysis or Profitability

 Price Earnings Ratio (P/E) – P/E Ratio

 Popularly called P/E ratio

Market Price 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

 Company analysis – Financial Ratios

 Price Earnings Ratio (P/E) – P/E Ratio

 Indicates relative valuation of the share of a company

 Company analysis – Financial Ratios

 Company analysis – Financial Ratios

 Earnings analysis or Profitability

 Price Earnings Ratio (P/E) – P/E Ratio

 Low P/E ratio – Market is Pessimistic – company growth

 Shares traded at relatively lower price – underpriced

 Some investors may buy – believed to be undervalued

 Company analysis – Financial Ratios

 Book Value per share - Net Asset value per share

 Company analysis – Financial Ratios

 Company analysis – Financial Ratios

 Book Equity to Market Equity Ratio (BE/ME)

 Book value calculated – historical cost or accounting value.

 Market value in the stock market – market capitalization

 Comparing book value of a company to its market value