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Jason O’Bryan 19 September 2006
The Basic Concept
• Growth vs. Value • Evaluating how much the company is worth. • Determine whether the current price falls above or below that range.
Will Buy at
Too expensive, sell
Not cheap enough, hold or sell
Buy or increase position
What Price Should I Buy at?
What is Fundamental Analysis?
• A method of valuing a security by measuring its intrinsic value.
– – – – Economic Factors Financial Statements Industry Conditions Quantitative and Qualitative Factors
– Analyzes key ratios. – Provides concrete data for analysis.
– Analyzes intangible data. – Patents, management, talented workers, etc. – Difficult to measure numerically.
Why use fundamental analysis?
• The goal is to produce a value that investors can compare with the current price. • If it is undervalued you should buy; sell if it is overvalued. • One of the most famous users of fundamental analysis, Warren Buffett, has successfully used this method to turn himself into a billionaire.
E - I - C FRAMEWORK
RESEARCHERS HAVE FOUND THAT STOCK PRICE CHANGES CAN BE ATTRIBUTED TO THE FOLLOWING FACTORS: • • • • ECONOMY-WIDE FACTORS : 30-35 PERCENT INDUSTRY FACTORS : 15-20 PERCENT COMPANY FACTORS : 30-35 PERCENT OTHERS FACTORS : 15-25 PERCENT
BASED ON THE ABOVE EVIDENCE, A COMMONLY ADVOCATED PROCEDURE OF FUNDAMENTAL ANALYSIS INVOLVES A THREESTEP EXAMINATION, WHICH CALLS FOR: • UNDERSTANDING OF THE MACRO-ECONOMIC ENVIRONMENT AND DEVELOPMENTS • ANALYSING THE PROSPECTS OF THE INDUSTRY TO WHICH THE FIRM BELONGS • ASSESSING THE PROJECTED PERFORMANCE OF THE COMPANY.
MACRO ECONOMIC FACTORS IN INDIAN STOCK MARKET
• SENSEX Crossing Again approaching 15000 Points………a celebration for Indian Economy • Perception : The Indian Economy must be doing well
“It would not be over emphasizing to state that, now the stock market is having a tremendous influence in shaping the overall economies around the globe”
• A dynamic capital market is segment of the financial system as it plays a significant role savings and channeling them purposes.
an important of any country in mobilizing for productive
• Indian Capital Market since liberalization has undergone tremendous changes and has evolved as a vibrant system of investment flows. • The efficient fund allocation depends on the stock market efficiency in pricing the different securities traded in it.
Stock Market and Macro Economic Environment
• In the economic environment of the information age, the performance of the stock market is considered an important indicator of the health of a nation’s economy • The performance of any stock market is reflected through stock market prices • When the stock market tumbles, investors and others become tumbles nervous about the weakness of the economy • When the stock market is strong and steady, everyone senses economic prosperity
• The government employs two broad classes of macroeconomic policies, viz. Demand side policies and supply side policies. • Traditionally, the focus was mostly on fiscal and monetary policies, the two major tools of demand-side economics. • From 1980s onward, however, supply-side economics has received a lot of attention.
• Fiscal policy is concerned with the spending and tax initiatives of the government. It is the most direct tool to stimulate or dampen the economy. • An increase in government spending stimulates the demand for goods and services, whereas a decrease deflates the demand for goods and services.
• By the same token, a decrease in tax rates increases the consumption of goods and services and an increase in tax rates decreases the consumption of goods and services.
Monetary policy is concerned with the manipulation of money supply in the economy. Monetary policy affects the economy mainly through its impact on interest rates. The main tools of monetary policy are: • Open market operation • Bank rate • Reserve requirements • Direct credit controls
The Global Economy
•In a globalised business environment, the top down analysis of the prospects of a firm must begin with the global economy. •The global economy has a bearing on the export prospects of the firm, the competition it faces from international competitors, and the profitability of its overseas investors.
Stock Pricing and Macro Economic factors (Sources of Systematic risk)
• Stock prices are believed to react to economic events • Some macroeconomic changes affect asset prices stronger than others do and some do not even affect them at all • Stock prices are the function of risk – Systematic Risk (Non Diversifiable) – Non-Systematic Risk (Diversifiable)
Each macro economic factor acts as a source for systematic risk
• These risk factors must be priced in the market and must be reflected in stock prices 15
• Chen, Roll and Ross (1986) who considered some significant economic variables to have systematic influence on asset returns implemented one of the most famous APT tests on this subject • Roll and Ross (1980) found that three or four systematic risk factors are statistically adequate to explain the asset returns in the period of 1962-1972 • Chen (1983) found five factors in the NYSE and AMEX during 1963-1978 • Dhrymesetal (1985) found a changing number of factors depending on the period length and the size of 16 the stock groups under analysis
Brief Literature Review…1
• Cheng (1995) implemented factor analysis on both asset returns and macroeconomic variables in order to derive priced security factors and macroeconomic factors, and then compared these two categories of factors with a canonical correlation analysis in order to reach a statistically significant relation • A research by Özcam (1997) can be considered an example of APT testing in Istanbul Stock Exchange. In this research, seven macroeconomic variables of Turkish economy are separated into expected and unexpected series by a regression process, and then two-step testing methodology is implemented on these series 17
Brief Literature Review…2
Brief Literature Review…3
• Altay (2001) is another example of two different APT tests in Istanbul Stock Exchange. In the first test, factor analysis method is employed in daily returns of 121 to 265 stocks in the 1993-2000 periods for each year and one dominant significant factor is found among several minor significant factors for each year • In Indian context, Naka, Atsuyuki, Mukherjee, Tarun K. Tufte, David R. (1998) analyzed relationships among selected macroeconomic variables and the Indian stock market. They found that three long-term equilibrium relationships exist among these variables. Their results suggested that domestic inflation is the most severe deterrent to Indian stock market performance, and domestic output growth is its predominant driving force
Record of A Priori Variables Used in Various Studies
• • • • • • • • • • • • • • • • • • • • • Industrial Production; Inflation; Interest rates; Treasury bill rates; Long and short-terms Govt. bond rates; Corporate bond rates; Equity returns; Per capita consumption; Risk Premium; Term structure; Foreign exchange rate; Market indices; Oil price; Overall production; Gross Domestic Production; Gross national product; Weekly wages; Money supply, Wholesale sales; Labour force; Building construction; • • • • • • • • • • • • • • • • • • • Exports and Imports; Population; Inventories; Book-to market equity value; Dividend yields; Spread of long and short-runs bond yield; High and low-grades bond yield; Current liabilities; Consumer credit outstanding; Commercial bank asset value; Money stock; Consumer price index; Price-earnings ratio; Farm size; Corporate profit; International or global index Federal debt; Federal budget financing; Housing construction;
Industrial Production and Stock Market
• Industrial production index of any economy depicts the trend in growth of that economy. • A falling industrial production is a symbol of recessionary economy and vice versa.
Inflation and stock markets
• Inflation economy is signified by increase in prices of goods and services. Inflation affects every sector of the economy. • Factors like unemployment, interest rate, exchange rate, investment, stock markets indices, are influenced by inflation. • Inflation affects these sectors, directly or indirectly. • If there is inflation, stock markets are the worst affected and much evidence obtained so far has concluded that stock returns and expected inflation are negatively related
Interest rate and stock markets
• The interest rate directly changes the discount rate in the valuation model and thus influences current and future values of corporate cash flows. • Frequently, authors have included both a long term interest rate (e.g a 10 year bond yield) and a short term interest rate (e.g. a 3 month T-bill rate). • Changes in the short term interest rates are mainly driven by the business cycle and monetary policy. • In contrast, the long term interest rate should indicate the longer term view of the economy concerning the discount rate. 22
Money supply and stock markets
The money supply, for example M3, is also likely to influence share prices through at least three mechanisms: First, changes in the money supply may be related to unanticipated increases in inflation and future inflation uncertainty and hence negatively related to the share price; Second, changes in the money supply may positively influence the share price through its impact on economic activity; Finally, portfolio theory suggests a positive relationship, since it relates an increase in the money supply to a portfolio shift from non-interest bearing money to financial assets including equities
Foreign exchange rate and stock markets
• Theory explained that a change in the exchange rates would affect a firm’s foreign operation and overall profits. • This would, in turn, affect its stock prices. The nature of the change in stock prices would depend on the multinational characteristics of the firm. • Conversely, a general downward movement of the stock market will motivate investors to seek for better returns elsewhere. • This decreases the demand for money, pushing interest rates down, causing further outflow of funds and hence depreciating 24 the currency.
• Use multiple regression analysis and investigate the relationship of macroeconomic variable with stock prices
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