UNIT 3

1. Dividend discount models

The Dividend Discount Model (DDM) is a quantitative method
of valuing a company’s stock price based on the assumption
that the current fair price of a stock equals the sum of all of the
company’s future dividends discounted back to their present
value.
Types of dividend discount models
1. Zero Growth DDM-This is the traditional method of dividend
discount model which assumes that the entire dividend paid
during the course of stock will be the same and constant
forever until infinite. It considers that there will be no growth in
the dividend and thus the stock price will be equal to the
annual dividend divided by the rate of returns.
2. Constant Growth Rate DDM-This model takes into an
assumption that the dividends are growing only at a fixed
percentage or on a constant basis annually. There is no
variability and the percentage growth is the same throughout.
This is also known as the Gordon Growth Model and assumes
that dividends are growing by a fixed specific percentage each
year.
3. Two stage growth model- Model to determine the value of
equity of business with dual growth stage. There is an initial
period of faster growth and then a subsequent period of stable
growth.
4. Multiple stages- The multistage dividend discount model is
an equity valuation model that builds on the Gordon growth
model by applying varying growth rates to the calculation.
Under the multistage model, changing growth rates are applied
to different time periods.

2. Relative valuation models

A relative valuation model compares a firm's value to that of its
competitors to determine the firm's financial worth. Investors
may use relative valuation models when determining whether a
company's stock is a good buy.
A. P/E ratio- One of the most popular relative valuation
multiples is the price-to-earnings (P/E) ratio. It is calculated by
dividing stock price by earnings per share (EPS), and is
expressed as a company's share price as a multiple of its
earnings. A company with a high P/E ratio is trading at a higher
price per dollar of earnings than its peers and is considered
overvalued. Likewise, a company with a low P/E ratio is trading
at a lower price per dollar of EPS and is considered
undervalued.
B. Book value to market value- The Market to Book Ratio (also
called the Price to Book Ratio), is a financial valuation metric
used to evaluate a company’s current market value relative to
its book value. The market value is the current stock price of all
outstanding shares. The book value is the amount that would
left if the company liquidated all of its assets and repaid all of
its liabilities.

3. Technical analysis
A technical analysis believes that the share price is determined
by the demand and supply forces operating in the market. a
technical analysis concentrate on the movement of share
prices.
The basic premise of technical analysis is that prices move in
trends or waves which may be upward or downward.
A rational behind the technical analysis is that share price
behavior repeat itself over time and analyst attempt to drive
methods to predict this repetition.

Assumptions
1. Price Discounts Everything- Technical analysts assume all
investors are already aware of everything about a stock as
anything that affects the price is considered beforehand by
incorporating fundamental analysis.
Therefore, the only thing studied under technical analysis is the
price movement that gets affected by the forces of demand and
supply represented on charts.
2. Prices Follow a Given Trend- This assumption shows the
price follows a past trend rather than moving unevenly. Each
stock chart depicts its unique trend and the stock price moves
within the trend. It shows which stock will trend in the pattern.
When a trend gets established the stock price is assumed of
moving in a particular pattern until a new trend is formed.
3. Patterns in Price Movement Often Repeat Themselves-The
last assumption of technical analysis states that trends are
repetitive, and both human behavior and human history
repeats itself. As the stock price pattern is repetitive, technical
analysts observe the past stock price to predict future price
trends by using the chart patterns.
Difference between fundamental and technical analysis
 4. Price indicators
1. Dow theory-
The theory formulated by Charles H. Dow. Dow who the editor
of the wall street journal in U.S.A Charles dow formulated a
hypothesis that the stock market does not move on random
basis but is influenced by three distinct cyclical trend that guide
its direction. According to dow theory, the market has three
movements and these movements are simultaneous in nature.
Much of what we know today as technical analysis has its roots
in Dow’s work. For this reason, all traders using technical
analysis should get to know the six basic tenets of Dow theory.
1. The Market Discounts Everything-The first basic premise of
Dow theory suggests that all information - past, current and
even future - is discounted into the markets and reflected in
the prices of stocks and indexes.
That information includes everything from the emotions of
investors to inflation and interest-rate data, along with pending
earnings announcements to be made by companies after the
close. Based on this tenet, the only information excluded is that
which is unknowable, such as a massive earthquake. But even
then the risks of such an event are priced into the market.
2. The Three-Trend Market- Dow theory identifies three trends
within the market: primary, secondary and minor. A primary
trend is the largest trend lasting for more than a year, while a
secondary trend is an intermediate trend that lasts three weeks
to three months and is often associated with a movement
against the primary trend. Finally, the minor trend often lasts
less than three weeks and is associated with the movements in
the intermediate trend.
1. Primary Trend- In Dow theory, the primary trend is the major
trend of the market, which makes it the most important one to
determine. This is because the overriding trend is the one that
affects the movements in stock prices. The primary trend will
also impact the secondary and minor trends within the market.
Dow determined that a primary trend will generally last
between one and three years but could vary in some instances.
2. Secondary or Intermediate Trend- In Dow theory, a primary
trend is the main direction in which the market is moving.
Conversely, a secondary trend moves in the opposite direction
of the primary trend, or as a correction to the primary trend.
For example, an upward primary trend will be composed of
secondary downward trends. This is the movement from a
consecutively higher high to a consecutively lower high. In a
primary downward trend the secondary trend will be an
upward move, or a rally. This is the movement from a
consecutively lower low to a consecutively higher low.
3. Minor Trend-The last of the three trend types in Dow theory
is the minor trend, which is defined as a market movement
lasting less than three weeks. The minor trend is generally the
corrective moves within a secondary move, or those moves
that go against the direction of the secondary trend.
The Three Phases of Primary Trends
A. Primary Upward Trend (Bull Market)
1.The Accumulation Phase-The first stage of a bull market is
referred to as the accumulation phase, which is the start of the
upward trend. This is also considered the point at which
informed investors start to enter the market.
2. Public Participation Phase-When informed investors entered
the market during the accumulation phase, they did so with the
assumption that the worst was over and a recovery lay ahead.
As this starts to materialize, the new primary trend moves into
what is known as the public participation phase.
3. The Excess Phase- As the market has made a strong move
higher on the improved business conditions and buying by
market participants to move starts to age, we begin to move
into the excess phase. At this point, the market is hot again for
all investors.

B. Primary Downward Trend

(Bear Market)
1. The Distribution Phase-The first phase in a bear market is
known as the distribution phase, the period in which informed
buyers sell (distribute) their positions. This is the opposite of
the accumulation phase during a bull market in that the
informed buyers are now selling into an overbought market
instead of buying in an oversold market.
2. Public Participation Phase-This phase is similar to the public
participation phase found in a primary upward trend in that it
lasts the longest and will represent the largest part of the move
- in this case downward.
3. The Panic Phase- The last phase of the primary downward
market tends to be filled with market panic and can lead to
very large sell-offs in a very short period of time. In the panic
phase, the market is wrought up with negative sentiment,
including weak outlooks on companies, the economy and the
overall market.

4. Market Indexes Must Confirm Each Other-Under Dow

theory, a major reversal from a bull to a bear market (or vice
versa) cannot be signaled unless both indexes (traditionally the
Dow Industrial and Rail Averages) are in agreement. For
example, if one index is confirming a new primary uptrend but
another index remains in a primary downward trend, it is
difficult to assume that a new trend has begun.
5. Volume Must Confirm the Trend-According to Dow theory,
the main signals for buying and selling are based on the price
movements of the indexes. Volume is also used as a secondary
indicator to help confirm what the price movement is
suggesting. From this tenet it follows that volume should
increase when the price moves in the direction of the trend and
decrease when the price moves in the opposite direction of the
trend. For example, in an uptrend, volume should increase
when the price rises and fall when the price falls.
6. Trend Remains in Effect Until Clear Reversal Occurs-The
reason for identifying a trend is to determine the overall
direction of the market so that trades can be made with the
trends and not against them. In Dow theory, the sixth and final
tenet states that a trend remains in effect until the weight of
evidence suggests that it has been reversed.

Advances and declines

The advance–decline line is a stock market technical indicator
used by investors to measure the number of individual stocks
participating in a market rise or fall. As price changes of large
stocks can have a disproportionate effect on capitalization
weighted stock market indices such as the S&P 500, the NYSE
Composite Index, and the NASDAQ Composite index, it can be
useful to know how broadly this movement extends into the
larger universe of smaller stocks. Since market indexes
represent a group of stocks, they do not present the whole
picture of the trading day and the performance of the market
during this day. Though the market indices give an idea about
what has happened during the trading day, advance/decline
numbers give an idea about the individual performance of
particular stocks.
New highs and lows- circuit filters
The New Highs are the stocks rising to a new yearly high on any
given day. These are the strongest stocks on the exchange, the
leaders in strength.
The New Lows are the stocks that fall to a new yearly low on
any given day. These are the weakest stocks on the exchange,
the leaders in weakness.

Volume indicators
Volume means the number of shares traded at one time, for
example the total number of shares traded in a day is called
volume. This indicator helps you find breakouts, fake breakouts
and it is used to create a number of other indicators.
small investor volumes
Other indicators
Futures- A futures contract is the obligation to sell or buy an
asset at a later date at an agreed-upon price.
A futures contract gives the buyer the obligation to purchase a
specific asset, and the seller to sell and deliver that asset at a
specific future date unless the holder's position is closed prior
to expiration.
Institutional activity- An institutional investor is a company or
organization that invests money on behalf of other people.
Mutual funds, pensions, and insurance companies are
examples. Institutional investors often buy and sell substantial
blocks of stocks, bonds, or other securities.

Trends
Trend is the movement of share prices in the market. when the
prices move upwards, it is a rising trend or uptrend. When the
prices move downwards, we have a falling trend or downtrend.
We have a flat trend when the prices move within a narrow
range. The change in the direction of trend is referred to as
trend reversal.
Resistance- Resistance occurs when the share price moves
upwards. The price may fall back every time it reaches a
particular level. A horizontal line joining these tops form the
resistance level
Support- Support occurs when price is falling but bounces back
or reverses direction every time it reaches a particular level.
When all these low points are connected by a horizontal line, it
forms the support line.
Consolidation- Consolidation is the term for a stock or security
that is neither continuing nor reversing a larger price trend.
Consolidated stocks typically trade within limited price ranges
and offer relatively few trading opportunities until another
pattern emerges. Technical analysts and traders regard
consolidation periods as indecisive and cautious.
Momentum- Momentum is the speed or velocity of price
changes in a stock, security, or tradable instrument.
Momentum shows the rate of change in price movement over a
period of time to help investors determine the strength of a
trend.

Charts
Line Chart-It is the simplest price chart. In this chart, the closing
prices of a share are plotted on the XY graph on a day to day
basic. the closing price of each day would be represented by a
point on the XY graph. All these points would be connected by a
straight line which would indicate the trend of the market.
Bar chart- It is the most popular chart used by technical
analysts. In this chart the highest price, the lowest price and the
closing price of each day are plotted on a day to day basis. a bar
is formed by joining the highest price and lowest price of a
particular day by a vertical line. The top of the bar represents
the highest price of the day; the bottom of the bar represents
the lowest price of the day.
Candle chart- The Japanese candle stick chart shows the
highest price, the lowest price, the opening price and the
closing price of shares on a day to day basis. The highest price
and the lowest price of a day are joined by a vertical bar. The
opening price and closing price of the day which would fall
between the highest and the lowest prices would be
represented by a rectangle so that the price bar chart looks like
a candlestick. Thus, each day’s activity is represented by a
candlestick.
Point and figure chart- A point-and-figure chart plots price
movements for stocks, bonds, commodities, or futures without
taking into consideration the passage of time.

Patterns
When the price bar charts of several days are drawn together,
certain patterns emerge. these patterns are used by the
technical analysts to identify trend reversal and predict the
future movement of prices, the chart patterns may be classified
as support and resistance patterns, reversal patterns and
continuation patterns.
1. Head and shoulders- Head and shoulder formation occurs at
the end of a long uptrend. This formation exhibits a top
followed by a still higher top or peak and then another hump or
lower top. This formation
resembles the head and two
shoulders of a man and hence
the name head and shoulder
formation.
2. Triangle- a triangle is a continuation pattern on a chart that
forms a triangle-like shape.
Ascending triangles are a bullish formation that anticipates an
upside breakout.
Descending triangles are a bearish formation that anticipates a
downside breakout.

3. Rectangle- A rectangle occurs when the price is moving

between horizontal support and resistance levels. The pattern
indicates there is no trend, as the price moves up and down
between support and resistance.
4. Flag- A flag pattern, in technical analysis, is a price chart
characterized by a sharp countertrend (the flag) succeeding a
short-lived trend (the flag pole). Flag patterns signify trend
reversals or breakouts after a period of consolidation.

5. Cup and saucer- A cup and handle is a technical chart pattern

that resembles a cup and handle where the cup is in the shape
of a "u" and the handle has a slight downward drift. A cup and
handle is considered a bullish signal extending an uptrend, and
is used to spot opportunities to go long.
6. Double topped- A double top is an extremely bearish
technical reversal pattern that forms after an asset reaches a
high price two consecutive times with a moderate decline
between the two highs.

7. Double bottomed- The double bottom looks like the letter

"W". The twice-touched low is considered a support level. The
double bottom pattern always follows a major or minor
downtrend in a particular security, and signals the reversal and
the beginning of a potential uptrend.
 Moving averages
A moving average is a calculation used to analyze data points by
creating a series of averages of different subsets of the full data
set. In finance, a moving average (MA) is a stock indicator that
is commonly used in technical analysis. The reason for
calculating the moving average of a stock is to help smooth out
the price data by creating a constantly updated average price.
By calculating the moving average, the impacts of random,
short-term fluctuations on the price of a stock over a specified
time frame are mitigated.

Efficient market hypothesis

Efficient Market Hypothesis asserts that financial markets are
“informationally efficient". According to the EMH, stocks always
trade at their fair value on exchanges, making it impossible for
investors to purchase undervalued stocks or sell stocks for
inflated prices. Therefore, it should be impossible to
outperform the overall market through expert stock selection
or market timing, and the only way an investor can obtain
higher returns is by purchasing riskier investments.
There are three major versions of the hypothesis: "weak",
"semi-strong”, and "strong". The weak-form EMH claims that
prices on traded assets (e.g., stocks, bonds, or property) already
reflect all past publicly available information. The semi-strong-
form EMH claims both that prices reflect publicly available
information and that prices instantly change to reflect new
public information. The strong-form EMH additionally claims
that prices instantly reflect even hidden or "insider"
information.
Weak-form efficiency- In weak-form efficiency, future prices
cannot be predicted by analyzing prices from the past. Excess
returns cannot be earned in the long run by using investment
strategies based on historical share prices or other historical
data. Technical analysis techniques will not be able to
consistently produce excess returns, though some forms of
fundamental analysis may still provide excess returns.
Semi-strong-form efficiency- In semi-strong-form efficiency, it
is implied that share prices adjust to publicly available new
information very rapidly and in an unbiased fashion, such that
no excess returns can be earned by trading on that information.
Semi- strong-form efficiency implies that neither fundamental
analysis nor technical analysis techniques will be able to reliably
produce excess returns.
Strong-form efficiency-In strong-form efficiency, share prices
reflect all information, public and private, and no one can earn
excess returns. If there are legal barriers to private information
becoming public, as with insider trading laws, strong-form
efficiency is impossible, except in the case where the laws are
universally ignored.
Random Walk theory
Random walk theory suggests that changes in stock prices have
the same distribution and are independent of each other.
Therefore, it assumes the past movement or trend of a stock
price or market cannot be used to predict its future movement.
In short, random walk theory proclaims that stocks take a
random and unpredictable path that makes all methods of
predicting stock prices ineffective in the long run.

Elliot Wave theory

Wave theory formulated by Ralph Elliot, known as Elliot wave
theory in1934 by Elliot after analyzing seventy-five years of
stock price movements and charts. from his studies he
concluded that the market movement was quite orderly and
followed by a pattern of waves.
A wave is a movement of the market price from one change in
the direction to the next change in the same direction. the
wave is the result of buying and selling impulses emerging from
the demand and supply pressures on the market. Depending on
the demand and supply pressures, wave is generated in the
prices.
According to this theory, the market moves in waves. a
movement in a particular direction can be represented by five
distinct waves. of these five waves, three waves are in the
direction of the movement and are termed as impulse waves.
Two waves are against the direction of the movement and are
termed as corrective waves or reaction wave.
The patterns link to form five and three-wave structures which
themselves underlie self-similar wave structures of increasing
size or higher degree. Note the lowermost of the three
idealized cycles. In the first small five-wave sequence, waves 1,
3 and 5 are motive, while waves 2 and 4 are corrective. This
signals that the movement of the wave one degree higher is
upward. It also signals the start of the first small three-wave
corrective sequence. After the initial five waves up and three
waves down, the sequence begins again and the self-similar
fractal geometry begins to unfold according to the five and
three-wave structure which it underlies one degree higher.