Chapter Two: Security Analysis and Valuation

2.1. Security analysis

2.2. Fundamental analysis
– Economic Analysis
– Industry Analysis
– Company Analysis
2.3. Valuation of Securities
2.4. Technical analysis
2.5. Fundamental vs Technical analysis

04/02/2021 1
 Introduction

Security
 A security is a legal document that
represent contractual or ownership
claim.
 Portfolio ?
 Most investors invest their saving
in a group of securities rather than
single security.

04/02/2021
 Cont.
3

 Large number of company’s shares and bonds, debentures, government

securities with different maturity period and industry line are available in
the market.
 Share of over 7000 companies were listed in Indian stock exchange
market in 2011
 Over 3000 company's share were listed in New York stock exchange in
2006
 Analysis that answer:
 Which security (stocks)should I buy?
 which industry and company's security should I buy?
 At What price?
This questions are at the heart of security analysis.

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 Definition-Security Analysis
4

 Security analysis is the part of investment decision process

involving the valuation and analysis of individual securities.
 Security analysis involves the valuation of particular securities
that might be included in the portfolio.
 The process of gathering and organizing information and then
using it to determine the intrinsic value or future price of a
security
 Intrinsic Value – is estimated value of security
 The present value of the expected future cash flows
discounted at the decision maker’s required rate of return.
 It is the detail examination of risk and return characteristics of
individual security in the light of different fundamental factors.
04/02/2021
 To determine the intrinsic value:
1. Future Cash flows from security are forecasted
2. Determine required rate of return.

 Intrinsic value is then compared with the security’s

current market price.
 If security is ‘underpriced’, a purchase is
recommended because it is perceived to be
underpriced
 If security is ‘overpriced’, sell is recommended
04/02/2021 5
 Approaches of Security Analysis
• Security analysis is one vital part of
investment decision process involving the
analysis and valuation of individual
securities.

04/02/2021 6
 Two basic approaches of security analysis

Security Analysis

Fundamental Analysis Technical Analysis

Economic analysis Industry Analysis Company analysis

Past price movement

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 Fundamental Analysis
8

 To determine a proper price for a firm’s stock, the security analyst must
forecast the dividends and earnings that can be expected from the firm.
This is the heart of fundamental analysis, that is, the analysis of
determinants of value such as earnings prospects.

 It can be defined as a systematic approach to estimate future cash flow

and determine intrinsic value of securities through analyzing of
fundamental factors and then compares this intrinsic value with current
market value and make investment decision.
 It is based on the assumption that the security price is determined by the
fundamental factors like economy, industry and company.

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9

 Fundamental analysis consists of detailed analysis of the

factors affecting the performance of company such as
Competition faced by company, Market share, EPS of the
company, Management quality, Technological changes,
Foreign exchange, Inflation, Row material, etc.

 It forecasts the security price on the basis of economic,

industry and company analysis.
 And so called E.I.C analysis (Economic, Industry and
Company analysis).

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 Security Analysis (cont.)

10

Top to down approach of Fundamental analysis

Economy Industry Company

GDP Supply of raw material Financial and non financial data

GDP rate
Inflation Supply oflife
raw material Financial and non financial data
Inflation rate Industry cycle stage income statement
Exchange rate Industry life cycle stage income statement
Exchange rate
Interest rate
Competitive condition in the industry balance sheet
Interest rate
Competitive condition policy
Government in the industry balance
Ratio sheet
analysis
Infrastructure facility
Infrastructure Government policy
Technological change Ratio analysis
Management quality
Employment facility
rate
Employment rate Technological change Management quality

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 Economic Analysis
11

 The performance of the company is depend on the industry in

which the company is grouped and industry is depend on
economic condition.
 If the economy grows rapidly, the industry can also be

expected to show rapid growth and vice versa.

 When the level of economic activity is low, stock prices
are low, and
 when the level of economic activity is high, stock prices
are high reflecting the prosperous outlook for sales and
profits of the firms.
 Thus, The analysis of economic environment is essential to
understand the behavior of the stock prices.
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 Economic analysis
12

The key variables commonly used to describe the state of the

macro economy are :
1. Growth domestic product
2. Inflation rate
3. Level of employment rate
4. Foreign exchange rate
5. Interest rate
6. Infrastructure facility
In Ethiopia
 NBE,
 MOFED, and other like world bank are some
agencies/institutions publish yearly economic
04/02/2021 data.
 Gross Domestic Product
13

 GDP is a measure of the total production of final goods and

services in the economy during a year.

 It is indicator of economic growth

 When the economy is growing faster,
 income rises,
 demand for goods increases,
 production and sales volume increase
 hence profit of industries and companies increase
which ultimately has favorable effect on security
price
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 Inflation
14

 Inflation has considerable impact on the performance of the

companies.
 Higher rate of inflation:
 increase the cost of production which lead to increase price of
goods and services which in turn decrease demand of the product
and sales volume and then company profit and ultimately
influence security price negatively.
 Higher inflation rate increases uncertainty about future prices
and costs, and it harms firms that cannot pass their cost to
consumers.
 industry under price control policy of the government may lose the
market, like sugar industry.
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 Interest rate
15

 Lower interest rate stimulates investment by making credit

available easily and cheaply.
 If there is Lower interest rate –
 cheap cost of finance for company
 lower cost of production
 Lower price and increase the demand
 increase production /investment and sales volume
 increase profitability of company and favorable impact on stock prices

 Higher interest rate result in higher cost of production and higher

price of the product which may lead to lower demand and
profitability.
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 Exchange rate
16

 One of the determinants of import and export

oriented company.
 Depreciation of the birr improve the competitive
position of Ethiopian products in foreign market,
thereby stimulating exports.
 But it would also make import more expensive
 The performance of Import oriented Company are
affect adversely.

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 Infrastructural facilities
17

Infrastructure facilities play an important role in growth of

industry and agriculture sector.
 A wide network of communication system,
 Regular supply of power,
 A well developed transportation system (railways,
transportation, road network, inland waterways, port facilities,
air links) and
 Telecommunication system improve the industrial production
and improves the growth of the economy.
 Thus, good infrastructure facilities have favorable effect
on stock market.
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 Industry analysis

18

 Investor ultimately invest his money in the

securities of two or more specific companies.
“which industries have attractive investment
opportunity?
 This will lead to several industries, and industrial
analysis will lead us to choose financially sound
and strong industries.
 Security analyst has to study the fundamental factor

affecting the performance of different industry.

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 Step 2. Industry analysis

19

 The main purpose of industry analysis is to seek industry that are

expected to grow faster by considering industry information on:
 Trend of demand,
 Competing units,
 Capacity utilization,
 Cost and availability of inputs,
 Substitution products,
 Government policy,
 Technology changes

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 Industry analysis

20

Generally, Factors to be considered while analyzing

industry are:
1. Industry life cycle stage
2. Supply of raw material
3. Competitive condition in the industry
4. Government policy
5. Technological change , etc

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 Industry life-cycle stages(product life cycle theory)
21

1. Pioneering stage (introduction)

 At Initial stage: industry is new and risks are very high, negative or low profit while rapid
growth of demand and sale
2. Expansion stage(growth)
 Profit, demand, sale are growing continuously
 Investors can get high return at low risk because demand exceed supply in this stage
3. Stagnation stage (maturity)
 Increase in sale but at slower rate,
 investment opportunities with in the industry may diminish and member firms may
pay larger dividends and may be deemed ‘cash caws’
4. Decay stage(decline)
 Decline in Profitability, demand,
 new product and technology have come to market
 demand for product is diminishing and investors avoid this stage

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 Nature of Competition
22

 Some of the questions to be answered are:

 What companies are in the industry?
 What are their market shares?
 Has the number of competitors been rising, fallen, or
remained stable?
 The numbers of the firms in the industry and the market
share of the top firms in the industry should be analyzed.
 If too many firms are present in the industry, the

competition would be severe. This will lead to a decline in

price of the product.

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 Raw Material
23

 Availability of raw material

 An industry which has a limited supply of raw
materials domestically and where imports are
restricted will have weak growth prospects.

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24

 Regulatory and Tax Conditions

 Some of the questions to be answered are:

 What are the current regulations that the industry

faces?
 Are there likely to be new regulations?
 Are the industry’s products subject to special taxes
(such as “sin taxes” on alcohol and tobacco
products)
 Are there special tax breaks offered to the industry?

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 3.Company analysis
25

 performance of firms differ within an industry.

Which firm perform well with in the industry?
 it helps to select the profitable company by

analyzing
 profitability,
 efficiency,
 capital structure & sales,
 management quality.
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26

Company analysis
Analysis that involve all factors that affecting the earning of the particular
company are considered
1. Financial indicator: quantitative Issues
 Financial statement analysis
 Balance Sheet

 Income Statement

 Cash flow statement

 Financial Ratio Analysis

2. Non financial indicator :qualitative Issue

 Top Management quality
 Level of Diversification
 Future plan
 Research and Dev’t
 Listing

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 Categories of Financial Ratios
27

 Financial ratios are often divided into different categories based on the information
that they provide:
 Liquidity Ratios: describe the ability of a firm to meet its current obligations.
 Current Ratio
 Cash Ratio
 Quick Ratio
 Leverage Ratios: amount of debt used by the company.
 the extent to which a firm relies on debt financing.
 A high and rapidly increasing debt-to-equity ratio, suggesting problems with servicing debt in future
 debt to total asset ratio
 Debt to Equity
 Long-term Debt to Equity
 Profitability Ratios: the extent to which a firm is profitable.
 ROA=Net income/total asset
 ROE=Net income/total equity
 Net Profit Margin=net income over sale

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 Market Valuation Ratios

The Price/Earnings Ratio

28

P/E = Current Market Share Price / EPS

The Price/Book Ratio

P/B = Current stock Price / book value per share

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 Company Analysis: Qualitative Issues
 Top Management Quality
 Age and experience, qualification of top management
 Strategic planning
 Marketing strategy
 Effectiveness of board of directors
 Research and development
 Progressive companies spend substantial sum of money on R & D
to upgrade their existing products, introducing new product
and adopt new technology
 Listing
 Liquidity

04/02/2021 29
 Sustainable Growth Rate
 It is the maximum rate of growth a firm can maintain
without increasing its financial leverage and using
internal equity only.
 The value of sustainable growth can be calculated as
Sustainable growth rate =ROE x Retention ratio


Example
 If ROE is 11.2 percent. The retention ratio is 1/2, so
we can calculate the sustainable growth rate as
Sustainable growth rate 11.2 (1/2) = 5.6%
 Composite Corporation can expand at a maximum rate of
5.6 percent per year with no external equity financing or
without increasing financial leverage.
04/02/2021 30
 INTRINSIC VALUE
 Fundamental analyst make investment decision based on market price of
share and its intrinsic value.
 Market price and Intrinsic Value are Base for Investment decision process

Determine
required rate
of return
Economic Conditions
Compare
intrinsic value market price

Industry
Conditions Estimate Find I.V
Future of
Cash Flow Security

If Market Price
If market price < >Intrinsic Value,
Intrinsic Value , Buy sell and get profit
Firm Specific
Information Buy underpriced Sell overpriced
security security
Investor Decision to
buy/sell

04/02/2021 31
 ESTIMATING INTRINSIC VALUE OF SHARE
There are two basic approaches for valuation of share using
fundamental analysis
A. Discounted Cash Flow Techniques
B. Discounted Cash Flow model
C. Dividend Discount Model
B. Relative valuation techniques
1. Price earnings ratio (P/E)=Share price/earning per share
2. Price book value ratios (P/BV)=Market price/book
value per share

04/02/2021 32
 Discounted Cash Flow Techniques
It is the present value of its expected future cash flow stream

 The following applies to any financial asset:

S = Intrinsic value
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return

nn
CC
V S  t t

1(
t t1 (11k )k )
t t

Note: When analyzing various securities (e.g., bonds,

stocks), 04/02/2021
the formula below is simply modified to fit the33
particular kind of asset being evaluated.
 Estimating Intrinsic Value of share
Discounted Cash Flow Techniques
Intrinsic value of share -use share valuation modal

Present Value Models

Intrinsic Value = present value of

expected future benefits
Future benefits = dividends Future benefits = Cash flow

n CF t  Dt
S0   S0  
t  1 (1  K )
t
t  1 (1  K )
t

04/02/2021 34
Discounted Cash Flow model Dividend Discount Model
 Intrinsic value of share

One year holding period or Single Holding Period

• The value of a stock today is the present value of future dividend plus
that of the selling price.
– The first step in valuing common stocks is to determine the
cash flows for a stock,
• Dividend payments
• Future selling price
• And then find the present values of these cash flows and adding them
together will give us the value
D1 S1
S0  
(1 k ) (1 k )
1 1

S0 = Intrinsic value of common stock

D1 = the amount of dividend expected to be received at the end of one year
S1 04/02/2021
=Expected selling price at the end of one year 35
 Multiple -year holding Model
 The value of a stock today is in theory equal to the
present value of all future dividends plus that of the
selling price.
D1 D2 D3 D4 Dn Sn
S0      .......... .  
1  k (1  k ) 2 (1  k ) 3 (1  k ) 4 (1  k ) n (1  k ) n
n
Dt Sn
 
t 1 (1  k ) t (1  k ) n

S0 = Intrinsic value of common stock

D1=The amount of dividend expected to be
received at the end of one year
Sn =Expected selling price at n period
k = Rate of return required by investor
04/02/2021 36
3
 Dividend Discount Model
 Dividend is the only cash flow
 Common stock has no maturity period – they may be expected to
bring a dividend stream of infinite duration.
D1 D2 D3 D4 D
S0      .......... . 
(1  k ) (1  k ) 2 (1  k ) 3 (1  k ) 4 (1  k ) 
 Dt

t 1 (1  k )
t

Commonly used assumptions

To value common stock, you must make assumptions about the growth of future
dividends: constant dividend, constant growth

1. The dividend per share remains constant forever, implying that the growth rate is
nil (THE ZERO GROWTH MODEL)
2. The dividend per share grows at a constant rate per year forever (THE
CONSTANT GROWTH MODEL)

04/02/2021 37
3
 Zero Growth Model
 Investor anticipates to receive the same amount of dividend per year
forever.
 Zero growth model assumes a constant dividend, non-growing
dividend stream:
D1 = D2 = ... = D

 the valuation model becomes as that of the perpetual preference stock;

D D D D D
S0      ........... 
1  k (1  k ) (1  k ) (1  k )
2 3 4
(1  k )
 D D
 
t 1 (1  k )
t
k
Plugging constant value D into the common stock valuation
formula reduces to simple equation for a perpetuity: D/K
04/02/2021 38
3
 Constant Growth model
 Assumes that the dividend per share grows at a constant rate (g)
D 0 (1  g ) D 0 (1  g ) 2 D 0 (1  g ) 3 D 0 (1  g ) n
S0     .......... .   .......
1 k (1  k ) 2
(1  k ) 3
(1  k ) n

 If dividends grow at a constant rate forever, you can value stock as a growing
perpetuity, denoting next year’s dividend as D1:
Where
D0 = Current Dividend (time period 0)
D1 =Dividend received after one year
D1 = D0 x (1+g)
or next year dividend.
D2 = D1 x (1+g) = D0 x (1+g)2 D1= D0 (1+g)
: D2 =Dividend received after two years
K=Estimate the required rate of return (k)
:
g=Estimated dividend growth rate (g)
Dt = D0 x (1+g)t S0 = the present value of the infinite series of
dividends
With a little algebra, this reduces to:
Assumptions

D 0 (1  g) D1 1. Dividends grow at a constant rate

S0   2. The constant growth rate will continue for
an infinite period
k -g k -g 3. The required rate of return (k) is greater
04/02/2021 39
Commonly called the Gordon Growth Model. than the infinite growth rate (g) 3
 Technical Analysis
40

 Introduction
 Underlying Assumptions of Technical Analysis
 Advantages of Technical Analysis
 Challenges to Technical Analysis
 History of Technical Analysis
 Technical Tools
 Technical analysis vs Fundamental analysis

04/02/2021
 1. Introduction
41

 There is two method of analyzing

securities
 Fundamental analyses-
 Estimate share prices on the basis of
economic, industry and company statistics.
 Technical analysis is an alternative
method of security analysis
04/02/2021
42

 The technical analyst mainly studies the

stock price movement of the security
market.
 If there is an up trend in the price

movement ,investor may purchase

security.
 With down price trend, investor

may sell it.

04/02/2021
43

 Technical analysis involves the examination of past

market data such as prices and the volume of
trading, which leads to an estimate of future price
trends and then make investment decision.
 Technical analysis is the study of historical prices for
the purpose of predicting prices in the future.
 Technical analysis is the art of identifying market
turning points at a relatively early stage”
 It is the process of identifying trend reversals at an
earlier stage to formulate the buying and selling
strategy. 04/02/2021
 2. Underlying Assumptions of Technical Analysis
44

1. The market value of any good or service is determined

solely by the interaction of supply and demand.
2. Supply and demand are governed by numerous factors, both
rational and irrational.
3. Disregarding minor fluctuations, the prices for individual
securities and the overall value of the market tend to move in
trends(increasing or decreasing), which persist for
appreciable lengths of time and it reverses.
4. Prevailing trends change in reaction to shifts in supply and
demand relationships and these shifts can be detected in the
action of the market.
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 3. Advantages of Technical Analysis
45

 Not heavily dependent on financial accounting

statements
 Problems with accounting statements:
1. Lack of information needed by security analysts
2. GAAP allows firms to select reporting procedures,
resulting in difficulty comparing statements from two
firms.
3. Non-quantifiable factors do not show up in financial
statements (psychological and other)

04/02/2021
46

 Fundamental analysts must process new

information and quickly determine a new
intrinsic value.

 Technical analysts have to recognize movements to

new equilibrium
 Technicians trade when a move to a new equilibrium is
underway.
 Fundamental analysts find undervalued securities that
may not adjust their prices as quickly.
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 4. Challenges to Technical Analysis
47

 Assumptions of Technical Analysis

 Empirical tests of Efficient Market Hypothesis (EMH)
show that prices do not move in trends.
 Technical Trading rules
 The past may not be repeated
 Patterns may become self-fulfilling predictions
 A successful rule will gain followers and become less
successful
 Rules require a great deal of subjective judgment

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 5. History of Technical Analysis
48

 The technical analysis is based on the doctrine given by

Charles H. Dow in 1884, in the wall street journal.
 Technical analysts frequently utilize charts of past prices
to identify historical price patterns
 These price patterns are then used to forecast prices in the
future.
 A basic belief of technical analysts is that market prices
themselves contain useful and timely information.
 Prices quickly reflect all available fundamental

information, as well as other information, such as

traders’ expectations and the psychology of the market.
04/02/2021
49

Role of Technical Analysis

 Identify and predict changes in direction of

price trends
 Determine the timing of action – entry and

exit decisions

04/02/2021
 6. Technical Tools
50

 Technical tools used by analysts include:

a. Dow theory
b. Volume of trading
c. Short selling
d. Odd lot trading
e. Moving averages
f. Chart Analysis

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 A. Dow theory
51

 Dow developed his theory to explain the movement of

the of the indices of Dow Jones Averages.
 He developed the theory on the basis of certain

hypotheses.
1. No single individual or buyer can influence the
major trend of the market. However, an individual
investor can affect the daily price movement by buying
or selling huge quantum of particular scrip(stock).
The intermediate price movement also can be affected
to a lesser degree by an investor.
04/02/2021
52

2. MARKETS DISCOUNTS EVERYTHING.

The market returned back normality even natural
calamities.
3. The Theory is not infallible(perfect). It is not a tool to
beat the market but provides a way to understand it better.

THE THEORY
according to Dow theory the trend is divided in to
primary, intermediate and short term trend.
The primary trend may be the broad upward or downward
movement that may last for a year or two.

04/02/2021
53

 The intermediate trends are corrective movement,

which may last for three weeks to three months.
 The primary trend may be interrupted by the
intermediate trend.

 The short term trend refers to the day to day price

movement.
 It is also known as oscillations or fluctuations.
 These three types of trends are compared to tide(rise
and fall of ocean), waves(large ripple on ocean) and
ripples of sea.
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 Trend
54

 Is the direction of movement.

 The share prices can either increases or fall or remain
flat.
 The three direction of share price movements
are rising, falling or flat trends.
 The share prices move in zigzag manner.
 The trend lines are straight lines drawn
connecting either the tops or bottoms of the
share price movement.

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 Trend Reversal
55

 The rise and fall in share price cannot go on

forever.
 The share price movement may reverse in
direction.
 Before the change of direction, certain pattern in
price movement emerges.
 The change in the direction of the trend is shown
by violation of the trend line.
 violation of the trend line means the saturation of
the trend line.
04/02/2021
 Primary Trend
56

 The security price trend may be either increasing or

decreasing.
 When the market exhibits the increasing trend, it is
called bull market.
 The bull market shows three clear-cut peaks.
 Each peak is higher than the previous peak.
 The bottoms are also higher than the previous bottoms.
 The phases leading to three peaks are revival,
improvement in corporate profits and speculation.
04/02/2021
57

 The reverse is true with the bear market.

 Here the first phase of fall starts with the abandonment of
hopes.
 The chances of prices moving back to the previous high
level seemed to be low.
 This would result in the sale of shares.
 In the second phase, companies are reporting lower
profits and dividends.
 This would lead to selling pressure.
 The final phase is characterized by the distress sale of
shares. Eg. Sale of shares below par.
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 The Secondary Trend
58

 The secondary trend or the intermediate trend

moves against the main trend and leads to
correction.
 In the bull market the secondary trend would result
in the fall of about 33 – 66% of the earlier rise.
 In the bear market, the secondary trend carries the
price upward and corrects the main trend. The
correction would be 33 – 66% of the earlier fall.
 Intermediate trend corrects the overbought and
oversold condition.
04/02/2021
 Minor trends
59

 Also called tertiary moves are called random

wriggles.
 They are simply the daily price fluctuations.
 Minor trend tries to correct the secondary
trend movement.
 It is better for the investors to concentrate on
the primary or secondary trends than on minor
trends.

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 Technical Trading Rules and Indicators
60

 Stock cycles typically go through peaks and

troughs.
 Typical stock price cycles show a rising trend
channel, a flat trend channel, a declining trend
channel, and indications of when to trade

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 Typical Stock Market Cycle
61

Stock
Price

04/02/2021
 Typical Stock Market Cycle
62

Stock
Price

Declining Peak
Trend Channel

Flat Trend Channel

Sell Point
Rising Trend Channel

Declining
Buy Point Trend Channel Buy Point
Trough
Trough
04/02/2021
 Basic Techniques: Support Resistance and Basing

63

 Support is level at which a stock stops falling because supply no longer

exceeds demand. i.e, a support level exists at a price where considerable
demand for that stock is expected to prevent further fall in the price
level.

 Demand for the particular stock is expected(the price would be

cheap and investors would buy).

 Resistance is the opposite of support. At this level supply is greater than

demand and the stock stops rising. The selling pressure is greater and the
increase in price is halted fro the time being or may result in price
reversal.

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64

 Support and resistance usually occur whenever the

turnover of a large number of shares tend to be
concentrated at several price levels.

 Basing or congestion occurs when a stock trades a

narrow price range on low volumes. Buyers and
seller are evenly matched.

 This period is like a pause and downward/upward

movement resumes.
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65

04/02/2021
 b. Volume of trading

66

 Technical indicators are used to find out the

direction of the overall market.
 The overall market movements affect the individual
share market.
 Aggregating forecasting is considered to be more
reliable than the individual forecasting.
 The indicators are price and volume of trade.
 Volume of trade is influenced by the behavior
of price.
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 Volume of trade
67

Dow gave special emphasis on Volume.



Volume expands along with the bull market and narrows down in


the bear market.

If the volume falls with rise in price or vice versa., it is a matter of



concern for the investor and the trends may not persist for a
longer time.

Technical analyst used volume as an excellent method of



confirming the trend.

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68

 Large rise in price or large fall in price leads to large increase in

volume.
 Large volume with rise in price indicates bull market and

 Large volume with fall in price indicates bear market.

 If volume indicates decline for five consecutive days, then it will

continue for another four and the same is true for increasing volume.

 Using trading volumes to establish market direction

• Large volumes confirm support or resistance or breakout.

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 C. Short selling
69

 Short selling is a technical indicator known as

short interest.
 Short sales refers to the selling of shares that
are not owned.
 The bears are short sellers who sell now in the
hope of purchasing at a lower price in the
future to make profits.

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 d. Odd lot trading
70

 Shares are generally sold in a lot of hundred.

 Shares sold in smaller lots, fewer than 100 are called odd lot.
 Such buyers and sellers are called odd lotters.
 Odd lot purchases to odd lot sales is the odd lot index.
 The increase in odd lot purchase results in an increase in the index.
 Relatively more selling leads to fall in the index.
 Odd lot purchase is concentrated at the top of the market
cycle and selling at the bottom.
 High odd purchase forecasts fall in the market price and
low purchases/ sales ratios are presumed to occur toward
the end of bear market. 04/02/2021
 e. Moving Average
71

The market indices do not rise and fall in straight line. The upward and
downward movements are interrupted by counter moves.

The underlying trend can be studied by smoothening of the data.

To smooth the data moving average technique is used.

 Moving averages are used to determine price trends and trend

changes.
 A moving average is a statistical technique for smoothing price
movements in order to identify trends more easily.

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72

 A simple n-day moving average is the average

of the most recent n daily closing prices
 A 5-day moving average is the average of the last
5 daily closing prices.
 A 25-day moving average is the average of the
last 25 daily closing prices.
 The number of days used to compute the
average determines the sensitivity of the
average to new price movements
 The more days that are used, the less sensitive is
the average 04/02/2021
73

 Weighted moving averages can also be

constructed
 If greater weights are given to more recent prices,
the average becomes more sensitive to price
change

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 Market Trend Analyses:
Simple Moving Averages (SMA)
74

Daily 5-Day 10-Day

Day Close SMA SMA
1 60.33
2 59.44
3 59.38
4 59.38
5 59.22 59.55
6 58.88 59.26
7 59.55 59.28
8 59.50 59.31
9 58.66 59.16
10 59.05 59.13 59.34
11 57.15 58.78 59.02
12 57.32 58.34 58.81
13 57.65 57.97 58.64
14 56.14 57.46 58.31
15 55.31 56.71 57.92
16 55.86 56.46 57.62
17 54.92 55.98 57.16
18 53.74 55.19 56.58
19 54.80 54.93 56.19
20 54.86 54.84 04/02/2021
55.78
 Market Trend Analyses:
Simple Moving Averages (SMA)
75

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 Market Trend Analyses:
Moving Averages: Trading strategy
76

 Sometimes traders use two moving averages to determine buy

and sell decisions.
 Using a slow moving average (more days) together with a fast
moving average (fewer days) generates the following trading
strategies:
 Buy when the faster moving average goes above (crosses) the

slower one (from below). Sell when the faster moving average
goes below (crosses) the slower one (from above).
 Buy when prices are above both the fast and slow moving

averages. Sell when prices are below both the fast and slow
moving averages.

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77

 As with most tools of technical analysis, moving

averages should not be used on their own, but in
conjunction with other tools that complement
them.
 Using moving averages to confirm other
indicators and analysis can greatly enhance
technical analysis.

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 Technical Analysis:
F. Chart Analysis
78

Chart Analysis - the basic tool of technical analysis

 A price chart is a sequence of prices plotted over a specific
time frame. In statistical terms, charts are referred to as time
series plots.
 Chart analysts plots historical prices in a two-dimensional
graph in order to identify price patterns which can then be
used to predict the futures direction of prices

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79

 The goal of any chart analyst is to find

consistent, reliable, and logical price
patterns with which to predict future price
movements.
 Chart analysts rely primarily on three bodies of
data
 Prices (monthly, weekly, daily, and intra-day)
 Trading volumes, and
 Open interest

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 Technical Analysis:
Chart Analysis
80

Price Pattern Recognition Charts

 The most commonly used price pattern recognition charts are: bar
charts, line charts, candlestick charts, and point-and-figure charts
 On these charts, the Y-axis (vertical axis) represents the price scale and

the X-axis (horizontal axis) represents the time scale. Prices are plotted
from left to right across the X-axis with the most recent plot being the
furthest right.
Bar Charts:
 Bar charts mark trading activity of a specified trading period (e.g.,

day) by a single vertical line on the graph

 This line connects the high and low prices for the trading period

 The closing price is indicated by a horizontal bar

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 Technical Analysis:
Chart Analysis – Bar Chart
81

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 Technical Analysis:
Chart Analysis – Bar Chart
82

 Bar charts can also

be displayed using
the open, high, low
and close. The
only difference is
the addition of the
open price, which
is displayed as a
short horizontal
line extending to
the left of the bar.

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 Technical Analysis:
Chart Analysis – Bar Charts
83

Bar Charts: One-Day Price Reversals

 Bar charts are frequently used to identify one-day price

reversals.
 A one-day price reversal occurs in a rising market when prices

make a new high for the current advance but then close lower
than the previous day’s close
 A one-day price reversal occurs in a falling market when prices

make a new low for the current decline but then close higher
than the previous day’s close

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 Technical Analysis:
Chart Analysis – Line Charts
84

Line Charts:
 In a line chart, only the

closing prices are

plotted for each time
period.
 Some investors and

traders consider the

closing level to be
more important than
the open, high or low.
 By paying attention to

only the close, intraday

swings can be ignored. 04/02/2021
85

Market Efficiency
•Efficient markets hypothesis (EMH) – states that
markets are efficient, with market prices reflecting
all available information at any given time
•Three common forms of market efficiency include:
–Weak form
–Semi-strong form
–Strong form
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86

Random Walk Hypothesis

•RWH argues that technical and fundamental
analysis are not accurate analyzing tools.
•RWH suggests that stock price movements
are unpredictable.

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87

Implications of the EMH

•For the investor the EMH implies:
1.Since all publicly available information is
reflected in current prices, there is no point
researching individual investments
2.Investment advisors advice of recommending
investments is of no value
3.Timing regarding when to buy or sell is
irrelevant.

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 Technical analysis VS Fundamental analysis
88

 Fundamental analysis attempts to calculate the

intrinsic value of a stock using over all
economy, industry and company conditions.

 While technical analysis looks at the price

movement of a security or stock price trends
to predict future price movements.

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 Technical analysis VS Fundamental analysis
89

 Fundamental analysis takes a long-term approach to

analyzing the market, considering data over a number of
years. So fundamental analysis is more commonly used by
long term investors as it helps them select assets that will
increase in value over time
 Technical analysis takes a comparatively short-term
approach to analyzing the market, and is used on a
timeframe of weeks, days or even minutes. So it is more
commonly used by day traders as it aims to select assets
that can be sold to someone else for a higher price in the
short term.
 End of Chapter 2
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