Investment Analysis & Portfolio Management: Lecture # 1 DR

INVESTMENT ANALYSIS
&
PORTFOLIO MANAGEMENT
Lecture # 1
Dr. Shahid A. Zia
The Course
• INVESTMENT
• ANALYSIS
• PORTFOLIO
• MANAGEMENT
2
Text book
• PRACTICAL INVESTMENT MANAGEMENT, 3rd

Edition, (Southwestern/Thomson)
• Robert A. Strong
• ISBN 0-324-17164-1
• INVESTMENT ANALYSIS and MANAGEMENT,
9th EDITION, (by Charles P. Jones)
3
Investment Alternatives
Assets are things that people own.
Assets
Financial Assets Real Assets

e.g. bond, stock e.g. land
4
Investment Alternatives
There are three broad categories of securities.
Securities
Equity Fixed Income Derivative

Securities Securities Assets
e.g. common e.g. bonds, e.g. futures,
stock preferred stock options
5
Three Reasons for Investing
Why invest ???
People invest to …
• supplement their income
– Dividends and Interest.
• earn capital gains
– Appreciation refers to an increase in the value
of an investment.
• experience the excitement of the
investment process. 6
Investing
To consume, to save, or to invest
a rupee that is earned ?
Both saving and investing amount to

consumption shifting through time.
However, saving involves little, if any,

risk, while investing is a risky
endeavor.
7
Fundamental Analysis
Fundamental Analysis include the evaluation of
the;
• Balance Sheet
• Annual Report
• Profit & Loss Figures
• Profitability Ratios
• Liquidity Ratios
• Operational Ratios
8
Technical Analysis
Focus on the movement of the share prices
going up or going down.
Scenario Analysis
9
Investments
Investment means to invest something in

some where.
10
Uses of Investments
Three uses of investments;
1. Consumption
2. Savings
3. Investing
11
Investing
You consume less than you save and then
from saving you can always think about
investment.
12
Savings
It is very important to see that how you
save the money.
• You save money in your home at secure
place.
• Committees.
13
Channels of Savings
• Banking
• Non-financial institutions
• National saving schemes
14
Portfolio Management
How to manage different sectoral things.
“Don’t Keep all your eggs in one basket”
15
Investment Analysis and Portfolio
Management
Mutual fund are also used in the portfolio.

• Collection of eggs.
• Collection of different shares, cash and
foreign exchange.
16
Bonds
• Term Finance Certificates
• Bearer bonds
• Fixed Income bonds
• Euro bonds
17
INVESTMENT ANALYSIS
&
Lecture # 2
Dr. Shahid A. Zia
The Role of the Capital Markets
An exchange serves three principal functions:
• Economic Function
• Continuous Pricing Function
• Fair Pricing Function
19
Economic Function
Capital markets facilitate the flow of
capital from lenders to borrowers.
Capital
Lenders Borrowers
Capital Market
20
Economic Function: An Example
Mortgage
$ Bank
Banks offer home

mortgages so that home
Home Buyer buyers who are short of
cash can borrow money
$
Home to buy houses.
Ownership
Home Seller
21
Fair Pricing Function
Capital markets remove the fear that people have of

buying or selling at a rip-off price. This creates trust in
the system.
The greater the number of participants ( a lot of
potential sellers and buyers) and the more formal the
marketplace, the “fairer” the price. (Exchanges – very
formal).
22
Continuous Pricing Function
Capital markets enable market participants to
get accurate, up-to-date price information.
Compare against alternative of prices that are not up-to-date:

Antique clocks, Chinese porcelain, Pine timberland, Houses.
23
• Borrowings ¾ or 75% from debt market
i.e. Bank.
• Borrowings ¼ or 25% from equity market
i.e. Stock Exchange
24
In stock market this is relatively free place in
which you borrow easily.
25
Dividend
Dividend is the return whether in the form of

cash or shares (assets) on the amount invested
with you.
26
Advantage of Equity Market
But the advantage of going to the equity market

to raise capital is that you have to pay a dividend
only if you have made a profit.
27
Economic Function
The primary market is the “new

securities” market where securities
are sold to the public for the first
time.
The secondary market is the “used securities”

market, where previously issued securities are
traded among security holders.
28
Initial Public Offering IPO
Initial public offering means those shares that
are being offered first time.
Offer For Sale OFS

Offer for sale means offer those shares that are
already issued.
29
The Exchanges
United States
National Exchanges
New York Stock Exchange (NYSE)
American Stock Exchange (till 1999)
Regional Exchanges
e.g. Philadelphia Stock Exchange and others
International
Exchanges
e.g. London SE,
Euronext,
Tokyo SE,
Bolsa Mexicana
30
de Valores
The Exchanges
• National Exchanges
1. New York Stock Exchange (NYSE)
2. American Stock Exchange (AMEX)
• Regional Exchanges
1. Philadelphia Stock Exchange (Oldest US
exchange)
31
The Exchanges
• International Stock Exchanges
1. London Stock Exchange
2. Hong Kong Stock Exchange
3. Kuala Lumpur Stock Exchange
32
National and Regional Exchanges
• National Exchanges
1. New York Stock Exchange (NYSE)
 Also known as the Big Board
 In 2004, on an average day, 1.46 billion
shares, valued at $46.1 billion, traded on the
NYSE
2. American Stock Exchange (AMEX)
• Merged with NASDAQ in 1999
33
Regional Exchanges
Philadelphia Stock Exchange (oldest US

exchange).
Others (Boston, Cincinnati, Chicago,
Pacific).
Some securities are dual listed.
Traded on both national and regional
exchanges.
Some traded on international exchanges.
34
Trading Systems - NYSE
• Specialists are charged with making a fair and
orderly market in one or more assigned securities at
posts on the exchange floor.
– Distinct feature of NYSE and AMEX.
– A post is a location where a particular stock trades.
– Human runners physically take wired orders from brokers to the
specialist.
– Specialists post screen shows bid/ask/last price.
• Bid price – highest price at which anyone is willing to buy.
• Offer (Ask) price – lowest price at which anyone is willing to sell.
• Difference between the two prices is the spread.
– Specialists ensure buyers will find sellers and sellers will find buyers
(important in crisis situations like October 27, 1997- the Asian flu –
DJ Industrials dropped 554 points)
35
Trading Systems - NYSE
• SuperDot is an electronic system enabling NYSE firms to send

market orders (up to 30,000 shares before open and up to 2,100
shares after open) and limit orders directly - without human runner - to
the specialists’ posts (up to 100,000 shares). Trades are confirmed by
specialists, so there is the potential for price improvement (“Split the
spread”).
– Covers about 85% of orders that reach the specialist
• NYSE Direct is a system offering automatic execution of limit
orders up to 1,099 shares (small orders). No possibility of price
improvement. Execution price will be the bid or ask price. No
exchange fees charged on such transactions.
36
Pakistan Trading System
• LOTS:
Lahore Online Trading System.
• KATS:
Karachi Automated Trading System.
• ISECTS:
Islamabad Stock Exchange Computerized
Trading System.
37
Trading Systems - CBOE
• Market makers are groups of competing

individuals – “the crowd” - (rather than a
single person) who maintain a fair and
orderly market through open outcry trading
in pits on the exchange floor.
– Used in Options trading like Chicago Board
Options Exchange (CBOE – world’s largest
options exchange)
38
Participants of Stock Market
Member:
A very important participant is member. Member
would mean a member of stock exchange. If
missed a member of stock exchange, you
cannot do business for people. You are
authorized to do business by the exchange if
you are a member.
39
Brokers:
Brokers are those which participate in the
brokerage industry. They may be a member or a
part of corporate entity.
Agents:
Agents are the authorized representatives of
members licensed by regulatory body as well as
exchanges.
40
Traders:
Trader is somebody who is directly in touch with
the investors. Traders helps execute your trade.
41
Capital Market
Money market and capital market are
types of Financial markets. Stock market
is a type of capital market.
42
Corporate Culture
Corporate Culture is not mature culture till
yet because when we develop our
organization from scrap, we have some
emotional attachment with organization.
43
If you have no dividend in your company,
then you are not bound to pay dividend.
This is basic difference between borrowing
from debt market and equity market.
44
Forms of Organization
• Proprietorship
• Partnership
• Private Limited Companies
• Public Limited companies
Public Unlisted Company
Public Listed Company
45
Types of Stock Exchanges
• Physical Stock Exchange
• Electronic Stock Exchange
46
Physical Stock Exchange
The trading in Physical Stock Exchange is
on:
• Actual Physical Tradition.
• Auction Market.
47
Overview of Lecture
INVESTMENT ANALYSIS
&
Lecture # 3
Dr. Shahid A. Zia
Trading Curbs and Circuit Breakers
Both trading curbs and circuit

breakers are designed to reduce
temporary volatility in the market.
At the NYSE, when the Dow Jones Industrial Average
fluctuates by more than 2%, the circuit breaker is
activated and computerized trading becomes
restricted.
When a trading curb is triggered, all trading at the
exchange is halted. Only occurred once at NYSE –
October 27, 1997 - (DJ down 550+ points).
50
The NASDAQ Stock Market
• In NASDAQ trading, bids and offers for securities
ranging from small unfamiliar firms to some of the
largest companies in the world are posted to an
electronic bulletin board. (Apple, Microsoft, Intel, etc.).
• Trades up to 1,000 shares can be executed in less
than one minute via the Small Order Execution
System (SOES).
– Basically assures that an order of less than 1,000
shares will be filled at a single “best prevailing”
price in the market (for actively traded stocks).
51
The NASDAQ Stock Market
• The NASDAQ stock market comprises two distinct markets:
 The NASDAQ National Market. The largest and most
established firms in the NASDAQ market are the national
market issues. (About 4,100).
- Have net tangible assets of at least $6 million
 The NASDAQ Small-Cap Market. These small-cap issues
have a (relatively) low level of capitalization (About 1,250).
• Firms may be delisted from either NASDAQ market if their
financial situation deteriorates too much (i.e. cannot maintain
listing requirements).
52
The Over-the-Counter Market
• Today, the term OTC equity security refers to an equity
security that is not traded on NASDAQ, National or regional
exchange.
• OTC securities trade in two ways:
 The OTC Bulletin Board (OTCBB) is a regulated
quotation service providing real-time information.
(~3,700).
- Does not provide listing service as NASDAQ.
- No financial standard requirement but need to comply
with corporate governance requirements.
 Data on the smallest and often most speculative pink
sheet stocks can be accessed via the Internet (Pink
Sheets LLC - www.otcquote.com).
53
Other Markets
• Secondary Market – trades are posted on the Intermarket
Trading System (ITS), an electronic communications network
linking the trading floors of seven registered exchanges to
permit trading among them in stocks listed on either the NYSE
or AMEX and/or one or more regional exchanges.
• The trading on listed securities of NASDAQ market is known
as the Third market.
– May provide more flexibility with respect to trading rules
and fees than exchanges.
• Direct trades between large institutional investors comprise
the Fourth market.
– Traded over the phone or Instinet.
– Instinet users pay much lower trading commissions.
54
The Over-the-Counter Market
Insert Figure 3-5 here.
55
Regulation - Exchanges
• The Exchanges have rules regarding:
– The financial capacity of members serving as
stock specialists.
– The financial & market activity of listed
companies, either these are sound or not.
– Best information is obtained or not and the
advantages to the investors.
56
Regulation – Government
• The Securities and Exchange Commission (SEC)
was established …
– Established to promote “honest and open securities
markets”.
– Ensure that investors have adequate information to make
an informed investment decision – but no judgment on
investment quality.
• Two primary acts influencing the investment industry today
are:
– The Securities Act of 1933 – covers primary market.
– The Securities Exchange Act of 1934 – covers secondary
market (registration of brokers, trading practices, etc.).
57
Regulation
• The National Association of Security Dealers
(NASD) is a self-regulatory body that licenses brokers
and generally oversees the trading practices of OTC
securities. The NASD is the owner and proponent of
the NASDAQ price quotation system. The SEC
oversees the NASD.
• In 1970, the Securities Investor Protection Act

established the Securities Investor Protection
Corporation (SIPC), which protects investors from
loss due to brokerage firm failure, fraud, natural
disaster, or theft. It does not protect investors against
investment losses. The SEC supervises the SIPC.
58
Ethics
• A wide range of investment activities may be
legal but carry substantial ethical baggage.
(e.g. investment advice).
• The Chartered Financial Analyst (CFA)
program promotes investment education and
ethical behavior among those involved in the
investment business.
• The program is administered by the CFA
Institute (CFAI).
59
Ethics
• The LIFA Financial Analyst Program.
• The LIFA Financial Analyst (LIFA) program

promotes investment education and ethical
behavior among those involved in the
investment business.
• The program is administered by the

International Research Association (IRA).
60
Instruments in Stock Markets
Stocks/Shares
• A share is one of a finite number of equal
portions in the capital of a company entitling the
owner to a proportion of distributed, non-
reinvested profits known as dividends and to a
portion of the value of the company in case of
liquidation.
• Shares can be voting or non-voting.
61
Instruments in Stock Markets
Bonds
• A bond is a debt security, in which the issuer
owes the holders a debt and is obliged to:
– Repay the principal,
– Pay Interest (the coupon),
At a later date or termed maturity.
62
Difference between Shares and
Bonds
Bonds and stocks are both securities, but the
difference is:
• Stock holders own a part of the issuing company
(have an equity stake), whereas bond holders
are in essence lenders to the issuer.
• Also bonds usually have a defined term, or
maturity, stocks may be outstanding indefinitely.
63
Instruments in Stock Markets (Cont’d)
Mutual Funds
• A mutual fund is a form of collective investment that
pools money from many investors and invests in
securities.
• In a mutual fund, the fund manager trades the fund's
underlying securities, realizing capital gains or loss, and
collects the dividend or interest income.
• The value of a share of the mutual fund, known as the
Net Asset Value (NAV), is calculated daily based on the
total value of the fund divided by the number of shares
purchased by investors.
64
Why invest ???
People invest to …
• Supplement their income
– Dividends and Interest.
• Earn capital gains
– Appreciation which refers to an increase in the
value of an investment.
• Experience the excitement of the
investment process.
65
Why Dividends Do Not Matter
• Dividends are an important part of the

investment business, but not because they
instantly increase an investors’ wealth:
• Dividends do not grow on tress.
• They come from the issuer’s checking account
and reduce the value of the firm when they are
paid.
• Dividends do provide current income, but they
do so at the expense of future growth.
66
Why Stock Splits Do Not Matter
• Do not alter the collective wealth of the

shareholders.
• They are analogous to cutting pieces of a
pie into smaller slices.
• The total quantity of pie does not change
as the serving size changes.
67
INVESTMENT ANALYSIS
&
Lecture # 4
Dr. Shahid A. Zia
Categories of Stocks
• Blue Chip Stocks
• Income Stocks
• Cyclical Stocks
• Defensive Stocks
• Growth Stocks
• Speculative Stocks
• Penny Stocks
69
A blue chip stock is a stock that usually has a long
history of uninterrupted dividends.
Income Stocks are those stocks that have paid a

larger than average percentage of their income on
regular basis.
Cyclical stocks are those stocks whose results are

tied with the overall state of the national economy.
CS have higher than average market risk.
A defensive stock is largely immune to changes in

the economy.
70
Growth stocks reinvest most of their
earnings rather than paying them out as
dividends and may be good candidates for
above-average returns.
Speculative stocks have the potential of

making quick money for their owners.
Penny stocks are unusually risky stocks.
71
Market Mechanics Placing
Orders(1)
• Order Information Flow
• Types of Orders
• Settlement Procedures
• A precise protocol should be followed when

placing orders with a broker.
• This protocol helps eliminate uncertainty about

the investor’s exact wishes.
72
Types of Orders
Most common are:
• Market Orders
• Limit Orders
• Stop Orders
73
Types of Orders
• Market orders are to be executed as soon as
they reach the exchange floor at the best
prevailing price.
• Limit orders must specify a price limit.
• Stop order
- especially useful in protecting profits.
- can also be used to minimize losses.
- unfortunately, investors seldom use them.
74
Other Orders
• One cancels the others
• All or none
• Fill or kill
• Stop limit
• Market if triggered order (MIT)
• Good till cancel (GTC)
75
The Stock Exchange Specialist
The specialist performs several useful functions:
• Helps maintain a fair and orderly market in his/her

assigned securities.
• Maintains an inventory of shares for sale.
• Are willing to be buyers for those who wish to sell.
• When the spread gets too wide, the specialist may
enter the market on both sides to provide better
prices for customers.
76
The Ticker Tape
• Provides a chronological listing of trades
at the exchange.
• No longer on paper.
• The electronic display shows stock
symbols, volume and the price at which
trades occurred.
• On busy days, the tape may run late.
77
INVESTMENT ANALYSIS
&
Lecture # 5
Dr. Shahid A. Zia
When we go to stock market we need to
have an account with a broker.
• Trading or investment in a stock market is
a direct form of investments.
• Trading or investments through mutual
fund is indirect form of investment.
79
In direct form of investment, to do
business in the stock market, we open an
account with brokers. Although we are
trading directly in the stock market but we
need to have an account with member of
stock exchange.
80
Regulations
The requirement of the regulations is that

all transactions are done through banking
channels.
81
Cash transactions are not allowed which
means channelizing of money is
paramount. Tracking is also significant.
82
Types of Accounts
Different accounts in stock brokerage firms:
• Cash Accounts
• Margin Accounts
• CFS Investments Accounts
83
Types of Accounts
• Cash Account (Type 1)

• Margin Account (Type 2)
84
Cash Accounts (Type 1)
Cash accounts are normally used when
you want to buy shares and hold them for
long time.
• Investing in stock market is a long term
investment.
• Long term means more than 1 year.
• You invest in money market for short term
which is less than 1 year, it can be 1 day.
85
Margin Accounts (Type 2)
• A portion of the share cost can be borrowed
from the brokerage firm
• When you borrow funds you must pay a cost i.e.
markup.
• Margin call
- When account equity deteriorates too far, the
investor may get a margin call –
It requires either:
i) The deposit of additional funds
or
ii) The sale of some security positions and sell a
part of shares to off-set the requirement 86
CFS Accounts
Investors place funds to be borrowed by financee.
The securities are pledged with the financier and in

case financee does not roll it over or payback
the amount borrowed, the risk rests with the
financier.
Then the shares become the ownership and

liability of financier. The rates are determined
through electronic supply / demand mechanism.
87
Borrowing and Lending process is every
day process that happens only in
exchanges through brokers or members.
88
The claim of profitability on buying or
selling depends on supply and demand
mechanism.
• If people need more money, then interest
rate will go up.
• If demand is not more than supply, then
markup is less which is good for borrowing
people.
89
Buying Power
Buying Power is a measure of how much more
can be spent for securities without having to put
up with extra cash with a 50% initial margin
buying power =equity-debt balance
90
Buying Power
• You can buy first and sell later, which is

simple.
• You can sell first and buy later, is another
interesting phenomenon.
91
Selling Short (SS)
Rationale: SS are bearish towards the
market. SS sell first and buy later.
• There are regulatory constraints in
different parts of the world, where may be
short selling is not allowed.
• Locally short selling is not permitted in the
regular market but short selling is
permitted in the future market.
92
Regular Market and Future Market
A Regular Market is a current market in
which all buying and selling is on cash or
margin.
A Future Market is about trading in the

future.
Future is a form of derivative.
93
Derivative Investment
In derivative market, you can sell in future.
94
• Criticisms:
1. In favor, margin trading encompasses
two activities i.e. buying on margin and
selling short.
2. Those who are against say that it
destabilizes markets, manipulation and
squeezing cornering.
• Mechanics of a Short Sale: The SS has
an eventual obligation to replace the
borrowed shares and dividends.
95
• Short against the box:
You can always give delivery of shares
instead of covering back the shares. It is a
type of Hedge Mechanism.
96
Trading Fee
Trading fee is the income which is the
source of revenue for members or brokers.
• The Costs of Trading
• The Commission Structure
• Full-Service Brokers
• Discount Brokers
• Electronic Brokers
97
Trading Fee
• Brokers receive a commission for executing
customer trades
• Some firms are full-service firms:
– Provide extensive research and advice.
• Others are discount firms:
– Provide few other services but executing orders.
Many firms also provide the facility of making trades via

a home computer. It is a viable option. All facilities are
available to good brokers like research & web page.
98
Internet Trading
Internet Trading is another big option that
you need to use because of:
• Time value for money.
• To read for distances that are too great to
travel.
99
Commission
Commission will vary from broker to broker.
• Charges are high in cash accounts.
• Charges are low in trading accounts.
You have it in printed form. It is a very

clear and transparent. Not a big issue any
more because of computerization.
100
Valuation
Evaluating what you need to buy. At this
stage:
• We will be analyzing stock.
• Fundamental analysis.
• Technical analysis.
101
Valuation Philosophies
• Investors’ Understanding of Risk
Premiums.
• The Time Value of Money.
• Focus on financial strength, stability &
certainty.
• Finances of company and its internal
strengths.
• The Importance of Cash Flow.
• Cash inflows are higher than cash
outflows, so the profit is generated. 102
• The Tax Factor.
• Look at companies tax status.Whether it is
exempted from tax or whether it has to pay
a lot of tax.
103
EIC Analysis
• Economic Analysis
• Industry Analysis
• Company Analysis
104
EIC Analysis
It is a pyramid analysis.
• Economic analysis at the base of pyramid.
• Middle of pyramid is Industry.
When you purchases the shares of industry
than you evaluate:
Industry norms
Averages
Rate of Returns
Yields
Earnings per Share
• On the top there is Company where you are
going to invested.
105
INVESTMENT ANALYSIS
&
Lecture # 6
Dr.Shahid A. Zia
Fundamental Stock Analysis
• Valuation Philosophies
• Value Vs. Growth Investing
• Some Analytical Factors
107
• Investors’ Understanding of Risk
Premiums.
• The Time Value of Money.
• The Importance of Cash Flow.
• The Tax Factor.
• Tax privileges to Modaraba Companies.
• EIC Analysis.
108
Value Vs. Growth Investing
In value investing, we need to understand what
is the investment procedure for value investing.
We need to understand the difference between:
• The value approach to investing
• The Growth Approach to investing
• Value Stocks and Growth Stocks
109
Categories of Stocks
• Blue Chip Stocks
• Income Stocks
• Different Cyclic Stocks
• Speculative Stocks
• Defensive Stocks
• Penny Stocks
110
Value Investing
The value investors will wait for reaping
the benefits of investments, means he will
be patient.
A value investor believes that he must wait

for the stock to pay him a handsome
return in due course of time.
111
Values vs. Growth Investing
• The Value Approach to Investing.
• The Growth Approach to Investing.
• How Price Relates to Value.
• Values Stocks and Growth Stocks: How to
guess by looking.
• The Price to Book Ratio.
• The Price to Earnings Ratio.
• Differences between Industries.
112
Fundamental vs. Technical
• Fundamental analysts believe that securities are priced
according to fundamental economic data.
• Technical analysts think supply and demand factors play
the most important part.
• We cannot ignore Technical Analysis aspect of analyzing
a company.
• Technical Analysis compliment the Fundamental
Analysis.
• Fundamental Analysis is suitable for long term
investments.
• Technical Analysis is suitable for short term investments.
113
Value Investment
• A value investor believes that a security should
only be purchased when the underlying
fundamentals justify the purchase.
• The bottom line is value comes form utility; utility
comes form a variety of sources.
• Value investors are willing to wait.
• Value investing means you buy nothing based
on future value… no bets on new products,
earnings or sales. You’re trying to buy a Rs.100
stock for Rs.50 today.
114
Growth Investment
• Investors want quick returns.
• A Growth investor seeks rapidly growing
companies.
• Growth investors believe that a body in motion
tends to stay in motion. Strong companies tend
to get stronger.
• Growth company might not have historical
perspective in background but it will find a place
in the future depending on the product or
industry to which it belongs.
• Oil Exploration: It is one of the most key element
in progress in a country. 115
Some Analytical Factors
• Growth Rates.
• The Dividend Discount Model.
• Importance of Hitting the Earnings Estimates.
• The Importance of Dividend Discount Policy
(DDM).
• Caveats about the Dividend Discount Policy
(DDM).
• False Growth.
116
Some Analytical Factors
• Firms Cash Flows.
• Small-Capitalize Companies, Large Capitalize
Companies, Mid-Size Capitalize Companies &
Initial Public Offerings.
• Ratio Analysis.
• Juggling in the accounting procedure.
• Cooking the Books
117
Growth Rate
• Most investment research deals with
predicting future earnings.
• A future earning growth rate is
unobservable.
• Most analysts use several methods to
estimate this statistics to determine likely
range for the value rather than a single
number.
118
Time Value of Money
• The idea that money available at the present
time is worth more than the same amount in the
future, due to its potential earning capacity.
• This core principle of finance holds that,
provided money can earn interest.
• Any amount of money is worth more the sooner
it is received. Also referred to as "present
discounted value".
• You will get something cheaper today but it will
be more of value in future.
119
The Dividend Discount Model
• Also called Gordon’s growth model.
• Can be used to value stock as a growing
perpetuity.
• The shareholders’ required Rate of Return RR.
• The Importance of Hitting the Earning Estimate.
• Whether growth rate is present or not and that is
something that is found out in the data provided
in the Balance Sheet.
120
The Dividend Discount Model
• You have current data of the year and then you
have past data of 10 years.
• The Multistage DDM.
• Shortfall of DDM.
121
Dividend Discount Model - DDM
• A procedure for valuing the price of a stock is by
using predicted dividends and discounting them
back to present value.
• The idea is that if the value obtained from the
DDM is higher than what the shares are
currently trading at, then the stock is
undervalued.
122
• This procedure has many variations, and it
doesn't work for companies that don't pay out
dividends.
123
Dividend
• Distribution of the portion of the companies profit
with the sock investors in the particular
company.
• We can also discuss it in the term of percentile
yield. 10% or 20%.
• Dividends per share or DPS.
• It can also be quoted in terms of a percent of the
current market price, referred to as dividend
yield.
• Dividends may be in the form of cash, stock or
property. Most secure and stable companies
offer dividends to their stockholders. Their share
prices might not move much, but the dividend
attempts to make up for this. 124
Discount Rate
• The interest rate that an eligible depository
institution is charged to borrow short-term funds
directly from a Federal Reserve Bank.
• The interest rate used in determining the present
value of future cash flows.
125
The Multistage DDM
• 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.
• Various versions of the multistage model exist
including the two-stage, H, and three-stage
models.
126
False growth in earnings
• False Growth occurs anytime a firm acquires
another firm with a lower price-earnings ratio.
• When the asset is disposed off, than good

companies used at the superb area of the city.
127
Cash Flow
• Cash Flow from operations is a firm’s lifeblood
because the earning of that year is important.
They have to be understood what the profitability
have been all about.
• It is also important because we focus on cash
flows when we invest.
• But you should also see that in which type of
companies you want to invest.
128
Size of Company
• Large Capitalize Company
• Medium Size Capitalize Company
• Small Size Capitalize Company
129
Small-Cap, Mid-Cap, and Large-Cap
• Small-cap stocks : A firm with capitalization

less than $500 million.
• Mid-cap stocks: Capitalization between $500
million and $2billion.
• Large-cap stocks: Capitalization more than $2
billion.
These three companies are important because
synergy of large companies is different from
small companies.
130
• Large capitalize company is a stable company.
All small capitalize company has less share float
in market.
• It is difficult to corner, to squeeze, to manipulate
a large capitalize company.
• Growth is going to be steady & slow in large
companies and growth in small companies is
quick.
131
• When we do fundamental analysis, we do

relative strength valuations with industry.
• Lets say in stock market there are 500
companies, then you have ratios of total 500
companies.
Earning per share.
Price earning ratio.
Dividend yield.
132
• Different industries have different synergies.

• In cement industry, during monsoon weather, the
production is less.
• Sales of air conditioners are more in summer
season.
• IPO's (Primary market sale to general public)
Buying IPO's is like trying to hit a million dollars
on the slot machines in Vegas. You’ll play many,
many times and hit nothing.
133
INVESTMENT ANALYSIS
&
Lecture # 7
Dr.Shahid A. Zia
The Underlying Logic
• Technical analysis is a controversial topic
• A great deal about price movements has yet to
be discovered.
• They believe that supply and demand are the
determinants of security prices.
• Supply is more, then stock market price will be
down. If demand is more, then stock market
price will go up.
• Changes in supply and demand cause prices to
change.
135
The Underlying Logic
• Technical Analysis has more to do with the
movement in prices than it has to do with the
actual Balance Sheet.
136
Charts
• Technical analysts like to use charts.
• Charts are the graphic representation of prices
on day to day basis, on week to week basis, on
month to month basis or on a year to year basis.
• Charts shall expand horizontally.
137
Charts
• Popular types of charts are:
- line chart
- bar chart
- candlestick chart
- point & figure chart
138
Types of Charts: Line Charts
• This is a line chart (end of the day).
139
• Line chart is basically formed by using separate
data points and linking them with a simple line.
• Minimal information is available.
140
Types of Charts: Bar Charts
• This is a bar (open, high, low, close or OHLC)
chart.
141
• The difference between Bar Charts & Line
Charts is that in Line Chart, lines drawn between
simple data points. A Bar Chart gives you an
economic data on weekly basis and yearly
basis.
• It is a vertical line which is known as bar.
• This bar has vertical limits. On top, where
vertical limits end and on bottom, where the
limits begin, you have information.
142
• Open, high, low & close information is
embedded in bar charts.
• OHLC is a short form.
• On the left side, the dash represents the
opening price.
• On the right side, it is the indication of last
transaction done on the day.
• On top, is the highest point achieved on that day
by the share or the index.
143
• At the bottom, the lowest point is achieved by
the index or the share.
• Blue color indicates that market or share price is
going up.
• Red color indicates that market or share price is
going down.
144
Types of Charts: Candlesticks Charts
• This is a Japanese Candlestick.

• (open, high, low, close) chart.
145
• This is an expanded version of bar charts.

• You may have white body of candle or a black
body of the candle.
• White body candle depicts when prices are
moving up.
• Black body candle depicts when prices are
moving down.
• In color coding, there is a difference between
white & black color coding.
146
• Two common things in candlestick charts are the

body which could be white or which could be
black.
• Different formations of candlestick charts.
Hammers
Stars
Hangman
Gravestones
147
• Candlestick chartings also give you a collective

graphic representation of the movement of the
prices.
• These are measures of economic and no
economic activity.
• Writing it off is nothing at all.
148
Chart Types: Point & Figure Charts
• This is a Point & Figure chart.
149
• A Point & Figure Charts is a collection of zero’s

or O’s and X’s.
• No data points.
• No lines.
• No candlesticks.
• No bars.
• It is significant where there are price changes.
• O’s and zero’s depicts the price variations.
150
• X’s are used when market / prices are moving
up.
• O’s are used when market are going down.
• If one X and one O is representing Rs. 1.
• Every rise with one X shows Rs. 1 rise in price.
• Every O shows Rs. 1 decrease in the price.
• To change it over from positive to negative and
negative to positive, you need a reversal of 3
data points.
151
• Days do not matter.

• It is drawn on simple piece of paper preferably
on graph.
152
• Free line break.
• Candlestick volume charts.
• Equi-volume.
• Ranko.
153
Formations of Charts
• Data points.
• Volume.
• Volume increase and decrease indicates the
level of interest in the market.
• If there is an increase in volume, it means there
is interest in the market.
• If you have decline in volume, you will notice
that there is lack of interest in the market.
154
History
• Bull
• Bear
• When the market is going up, it is called Bull
market.
• When the market is going down, it is called Bear
market.
155
• When Volume is going up, we use up arrow.
• When Volume is going down, we use down
arrow.
• When the market is going up on increased
volume, we can do believe the strength in the
market and the market shall be able to continue
upward for some time.
156
• If the prices are moving up and the volume is
not increasing, we can assume that interest level
of the investors is weakening and then we can
also consider the probability is high that the
upward activity of the market or prices may not
continue for longer and we may find a decline in
prices soon.
• Upward prices with increased volume is good.
• Upward prices with decreased volume is weak.
157
• If the market or prices are going down with
increased volume, we can believe that there is
definite weakness in the share price movement
and the people are keen to get rid of shares or
commodities or assets.
• If prices are continue to go down with lesser
volume or low volume, you should consider that
may be the bottom, might just be coming and we
might perhaps find a reversal soon.
158
• There is no reason for us to know that which is
bottom or top but there can only be calculated
guess.
159
Different Formations
• Bowl formation
• Saucer formation
• Rounding off prices
• This is an indicator that prices might not go
down any more and this can be an opportunity
to enter into the market at the bottom.
• Extended flat formation can also be an indication
that share price is bottoming out and people are
really not wanted to sell at levels lower than this
and this could be an opportunity.
160
Different Formations
• On the top, similar formation can be formed
where there will be a progressive weakness in
the share price. This is an indication for you to
be getting out of the market.
• These tops or bottoms may be converting into
supports or resistances.
• Peak’s / Tops
• Valleys or Troughs / Bottom
161
• In technical analysis chartists must have the
facility of expertise to be able to interpret the
chart formation.
• Head & Shoulder formation.
162
Head & Shoulders Example
Sell Signal
Minimum Target Price

Based on measurement rule
163
• You may have symmetrical shoulders through
prices.
• You may have one higher shoulder or one lower
shoulder where the head obviously between the
shoulders.
• Neckline
• Triangles
• Rectangles
164
Support & Resistance Lines
• Support means that prices which are formed
from trend lines.
• Trend lines can be from up to downwards and
from downwards to upwards.
• Choose the low points on the graph and join
these points with a line and this a support.
• From the top to bottom, combine different tops
and than resistance line is formed.
165
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 KSE
with a 10-day moving
average. Note how the
moving average shows
much less volatility than
the daily stock price.
166
Relative Strength Index (RSI)
• RSI was developed by Welles Wilder as an
oscillator to gauge overbought/oversold levels.
• 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).
167
Stochastic Oscillator
The value is 80 to 20.

INVESTMENT ANALYSIS
&
Lecture # 8
Dr.Shahid A. Zia
What is Technical Analysis?
• Technical Analysis is the information on
published market data and the reaction to all the
information data that has been put into the
movement of the share prices.
• It is also used by investors.
• It is also one of the oldest form of analyzing
companies.
Technical Approach
• Prices move in trends determined by changing
attitudes of investors
• Identify change in trend at an early stage and
maintain investment posture until evidence
indicates otherwise
• Market itself is best source of data about trends
– Data includes prices, volume, and technical indicators
Theoretical Foundation
• Edwards & Magee (1997) state the basic

assumptions of technical analysis.
Technical Methodologies
Basics of Technical Analysis
Theoretical Foundation
• Edwards & Magee (1997) state the basic
assumptions of technical analysis:
– A security’s market value is based on supply
and demand.
– Supply and demand are based on both
rational and irrational factors.
– Security prices tend to move in persistent
trends.
– Changes in trends occur due to shifts in
supply and demand.
– Shifts in supply and demand can be detected
using charts of market transactions.
– Some chart patterns tend to repeat
themselves.
Charts
• Popular types of charts are the:
- line chart
- bar chart
- point and figure chart
- candlestick chart
176
Basic Technical Tools
• Indicators
• Moving Averages
• Trend Lines
• Stochastic Charts
• Relative Strength Index
• This is a line chart (end of the day).
• This is a bar (open, high, low, close or OHLC)
chart.
• This is a Japanese Candlestick.

• (open, high, low, close) chart.
Drawing Point & Figure Charts
• Point & Figure charts are
independent of time.
• An X represents an up move.
• An O represents a down
move.
• The Box Size is the number of
points needed to make an X or
O.
• The Reversal is the price
change needed to recognize a
change in direction.
• Typically, P&F charts use a 1-
point box and a 3-point
reversal.
• This is a Point & Figure chart.

“Make the trend your friend”
Or
“Never trade against the trend”
Because it is going to be difficult to be able to

talk about activities relating to stock market.
Evaluation Techniques
Strong understanding of evaluation
techniques like:
• Fundamental Analysis
• Technical Analysis
Activities of Stock Market
• Greed
• Fear
• Patience
Style of Investment
•Buy and Hold Procedure

• Capital market investment is for short term.
• Quick returns or quick gains are short lived.
• Slow returns or steady returns are long lasting.
• Investment is very important in stock market.
Practical Example
• Experts
• Chimpanzee
• Three years old girls
Result
• Chimpanzee
• Three years old girls
• Experts
Why Point & Figure Chart is not
Popular
• Continuously monitoring
• No time frame
• Trend
• 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
decreasing.
– A side ways band and
moving in a Trading
Range.
Waves is also a part of stock market.
Support & Resistance
• Support and resistance
lines indicate likely ends
of trends.
• Resistance results from
Breakout
the inability to surpass
prior highs.
• Support results from the
inability to break below to
prior lows.
• What was support
becomes resistance, and Support Resistance
vice-versa.
• 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.
• The share price is above the red line then we infer that
market is positive.
• If the market price is below the red line then we infer that
market is weak.
• This chart shows KSE with a 10-day moving average.
Note that how the moving average shows much less
volatility than the daily stock price.
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 don’t forget that the Effective Market
Hypothesis (EMH) says these patterns are
illusions, and have no real meaning. In fact, they
can be seen in a randomly generated price
series.
INVESTMENT ANALYSIS
&
Lecture # 9
Dr.Shahid A. Zia 198
• Price Patterns
• Trends
• Moving Averages
• Charts
• Indicators
199
Trend Lines
• There are three basic
kinds of trends:
– An Up trend where
increasing.
– A Down trend where
decreasing.
– A Trading Range.
200
Breakout
Resistance
Support
201
• Previous highs becoming a bench mark for
resistances.
• Previous lows becoming a bench mark for
supports.
• Breach of previous resistances and previous
supports being as direction towards a new trend
in the market.
• Support results from the inability to break below
to prior lows.
• Resistance results from the inability to surpass
prior highs.
202
• All supports changed into resistances once
breached.
• All resistances changed into support once
breached.
203
204
• Moving Averages are smoothing of the price
movements over an N period of time.
• Good time to be in the market would be when
prices are upward of the moving average.
• Bad time is when market prices are moving
below the moving average.
205
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 don’t 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.
206
Head and Shoulders
207
Head and Shoulders
• Price pattern in which a certain price pattern will
make one shoulder, may be the left shoulder
and then peak towards a higher pedestal turning
it into a head and then a right shoulder.
• A neckline in a breach would determine a
reversal in trend.
• A general head and shoulder would show may
be this is going to be a reversal on the
downside.
208
Head and Shoulders
• Inverse head and shoulder would may be tell
you that it would have change in the trend on the
upside.
• When and if the necklines are breached in the
head and shoulder formation, the trend then
continuous in the direction where the head and
shoulder formation has been made.
• A straight one.
• Inverse one.
209
Head and Shoulders
• Reversals can be found in the breach of a head
and shoulder formation.
• These head and shoulder formations can be
applied on the entire market or one’s specific
individual stock. It all depends how you look at
the market.
210
Rounded Tops & Bottoms
• Rounding formations
are characterized by
a slow reversal of
trend.
211
Sell Signal
Minimum Target Price

Based on measurement rule
212
• We are also able to measure the distance of the
change in the trend based on the neckline and
head distance.
• Minimum reversals.
213
Double Tops and Bottoms
214
• Double top and double bottom would be a
formation which is little different than Head and
Shoulder because in the head and shoulder,
there is head higher than shoulders. But in
double top you have almost identical tops and
on the lower side bottoms would be identical too.
• One top would indicate a previous high reached.
• One bottom would tell you a previous low level
being reached.
215
• Top would look like “M”.
• Bottom would look like “W”.
216
Double Bottom Example
217
Triangles
218
Triangles
• Three flavors:
– Ascending
– Descending
– Symmetrical
• If we have an ascending triangle, we shall
assume that market is going to go upwards.
• If we have descending triangle, it shall be
assumed that there is a weakening in the market
and market is going to go down.
• A symmetrical triangle.
219
Triangles
• You are able to find out and you are able to
make decisions where to get out of the stock, or
the shares or the market or you are able to
make remandoments to whatever decisions you
make in your trading activity.
220
Rounded Bottom Chart
Example
221
Broadening Formations
• These formations are
like reverse triangles.
• These formations
usually signal a
reversal of the trend.
222
DJIA Example
What could you have known,

and when could you have known it?
223
DJIA Example
Nov to Mar
Trading range
Descending
triangles
Gap, should get

Double bottom
filled
224
Technical Indicators
• Indicators indicate trends.
• There are, literally, hundreds of technical
indicators used to generate buy and sell signals.
• We will look at just a few:
– Moving Average Convergence/Divergence (MACD)
– Relative Strength Index (RSI)
– On Balance Volume
– Bollinger Bands
225
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).
226
MACD Example Chart
227
• 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 isn’t
always a great timing tool.
228
• RSI tells you whether there is actually strength in
the share or not.
• RSI overbought condition above 70 tells you that
it is not good idea to buy yet. It is actually good
idea to get rid of shares.
229
RSI Example Chart
Overbought Oversold
230
On Balance Volume (OBV)
• On Balance Volume was developed by Joseph Granville,
one of the most famous technicians of the 1960’s and
1970’s.
• 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.
231
OBV Example Chart
Divergence, OBV failed
OBV confirms
trend change
but doesn’t
lead
232
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.
• There are two standard deviations above and below the
moving average.
• A buy signal is given when the stock price closes below
the lower band.
• A sell signal is given when the stock price closes above
the upper band.
• When the bands contract, it 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.
233
Bollinger Bands Example Chart
Sell signal
Buy signals
Sometimes, the buy

signals just keep coming and
you can go broke!
234
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.
235
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 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
236
237
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.
238
INVESTMENT ANALYSIS
&
Lecture # 10
TECHNICAL ANALYSIS
240
Dow Theory
• This theory was first stated by Charles Dow in a
series of columns in the WSJ between 1900 and
1902.
• Tide.
• Biggest move in the market.
• Tide was as a big major bull and bear move in
the market.
• 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.
241
• 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).
– These can occur between a major trend.
• Day to day fluctuations
– Little ripples between bigger waves and bigger tides.
– Small intraday ripple affects or small changes do not
matter in the bigger scheme of affairs.
242
• These small intraday changes may be good for
intraday traders or jobbers.
• Intraday traders and jobbers are the market
participants who take part into stock market
activities and do trading on day to day basis and
do not switch over position to the next.
• Long term investments are going to give you a
long term benefits.
• Dow’s attitude about bigger moves.
243
Elliot Wave Theory
• 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.
• The Elliot Wave Theory worked on the same
principle like Dow in a way that you had bigger
trends, intermediate trends and small trends.
244
The Elliot Wave Principle
245
Elliot Wave Theory
• Elliot Wave adherents also make extensive use
of the Fibonacci series.
246
Does Elliot Wave Work?
• Rhythmic pattern in the future wherever the
future is going to.
• Smaller waves and still smaller waves within a
bigger pattern.
• Fibonacci numbers.
• Mathematical representation.
247
Does Elliot Wave Work?
• 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
what to come.
• Made several correct predictions in the 1980’s,
but hasn’t been so prescient since (he no longer
gets much press attention).
248
Fibonacci Numbers
• Some people believe that Fibonacci series help
in predicting changes in security trading
patterns.
• Example of Rabbit.
• Fibonacci numbers work in predicting future
price trends.
• 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 adjacent249
numbers approaches the Golden Mean: 1:1.618.
Fibonacci Numbers
• 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.
250
Too Many Others To List
• Gann angles
• Kondratev Wave Theory
• Chaos Theory
• Neural Networks
251
Kondratev Cycle
• Kondratev cycle is given the name to
mathematician in Russia called Kondratev. He
was sensation in his time.
• States there is a 50-60 year business cycle.
• Being a Russian he studied the pattern and
predicted rightly about the changes of 19 & 20
centuries.
252
Chaos Theory
• Another popular area of research today. It is the

search for patterns in randomness.
• Example: fish in ocean or seas.
253
Neural Networks
• The notion that computer algorithms can be

taught to look for optimum patterns.
254
Different Theories
• Dow Theory
• Elliot Wave Theory
• Fibonacci Numbers
• Kondratev Theory
• Chaos Theory
• Neural Networks
255
• Fundamental analyst, I must admit that do
take the advantage of technical analysis
which may not admitted.
256
Te
Value
Economic c
Based
Traders
The closet: Indicators h
Fundamental Analyst n
who follow
Technical indicators i
but won’t admit c
it.
Growth Witchcraft a
Traders
l
A
n
257
a
Witchcraft
• This is a part of technical analysis.

• Certain phenomenation about good luck and
bad luck.
• Super Bowl Theory.
• World Cup Theory.
258
Charting Price Patterns
• Price changes can be recognized and
categorized;:
• Support price level: significant increase in
demand is expected.
• Resistance price level: significant decrease in
demand is expected.
• Trend line: identifies a trend or direction
• Momentum: speed of price changes.
259
Different Patterns
• Double tops & Double Bottoms
• Head & Shoulders
• Inverse Head & Shoulders
• Moving Averages
• Oscillators
260
Different Types of Charts
• Line charts
• Bar Chart
– Vertical bar’s top (bottom) represents the high (low)
price of the day.
• Point-and-Figure Chart
– Compresses price changes into small space
• Areas of “congestion” identified
– X (O) used to indicate significant upward (downward)
movement
• Candlestick Charting
261
Relative Strength
• Ratio of price to index or past average
price over some period
– Ratios plotted to form graph of relative price
across time.
– Rising (falling) ratio indicates relative strength
(weakness).
– Volumes.
262
Breadth Indicators
• Advance-Decline Line
• Example
– Measures the net difference between number of
stocks advancing and declining
– Plot of running total across time is compared to a
stock average to analyze any divergence
• Divergence implies trend changing
• Number hitting new highs (lows)
• High trading volume regarded as bullish
263
Sentiment Indicators
• Short interest is a number of stocks that have
been sold short.
• When there is no strength in the market then the
more you buy, there is probability that market will
be bearish.
• Short interest ratio =
– Total short interest/Avg. daily volume
• Many technicians take a high short interest ratio
as a bullish sign
– Short interest figures may be distorted
264
Opinions of Investment
Advisory Services
• Bearish sentiment index
– Ratio of advisory services bearish to total number with
an opinion.
– When at 60% (15%), the DJIA goes from bearish to
bullish (bullish to bearish).
– Advisory services assumed wrong at extremes.
• Do services follow trends rather than forecast
them?
265
Mutual Fund Liquidity
• Based on contrary opinion.
• Mutual funds, viewed like odd-letters,
assumed to act incorrectly before a market
turning point:
– Low liquidity implies funds fully invested
(bullish) and market is near or at peak.
– High liquidity implies funds are bearish.
• Considered a good time to buy.
266
Moving Averages
• Used for analyzing both overall market and
individual stocks.
• Used specifically to detect both the direction and
rate of change.
– New value for moving average calculated by dropping
earliest and adding latest observation to the average.
– Comparison to current market prices produces buy or
sell signal.
267
Conclusions About
Technical Analysis
268
INVESTMENT ANALYSIS
&
Lecture # 11
In the previous 4 lectures we talked about
technical analysis.
Conclusions About Technical Analysis
270
• Analytical Values
• Time Value of Money
271
• Thorough tests of technical analysis have failed
to confirm their value, given all trading costs and
the alternatives, such as a buy-and-hold
strategy.
• Several interpretations of each technical tool
and chart pattern are not only possible but
usual. Strong evidence exists suggesting that
stock price changes are weak-form efficient.
• Impossible to test all techniques of technical
analysis.
• Technical analysis remains popular with many
investors.
272
• Growth Investment
• Value Investment
• Time Value of Money
• Discount Models
• Different Strategies
• EIC Analysis
• Dividend Discount Model
• Analytical Factors
273
• Valuation Philosophies
• Value Investing Vs. Growth Investing
274
• Time Value for Money

• EIC Analysis
• The Tax Factor
275
Value Vs. Growth Investing
• The Value Approach to Investing

• The Growth Approach to Investing
• Value Stocks and Growth Stocks
276
Analytical Factors
• Growth Rates
• The Dividend Discount Model
• The Importance of DDM
• Firms Cash Flows
• Small-Cap, Large Cap Stocks and Mid-Cap
• Ratio Analysis
• Cooking the Books
• Notes
277
• Small-cap stocks: A firm with capitalization less
than $500 million.
• Mid-cap stocks: Capitalization between $500
million and $2billion.
• Large-cap stocks: Capitalization more than $2
billion.
• IPO's (Primary market sale to general public)
Buying IPO's is like trying to hit a million dollars
on the slot machines in Vegas. You’ll play many,
many times and hit nothing.
278
• Present value approach:
– Capitalization of expected income.
– Intrinsic value based on the discounted value
of the expected stream of cash flows.
• Multiple of earnings approach:
– Valuation relative to a financial performance
measure.
– Justified P/E ratio.
279
Required Inputs
• Discount rate:
– Required rate of return.
– Minimum expected rate to induce purchase.
– The opportunity cost of rupees used for
investment.
• Expected cash flows:
– Stream of dividends or other cash payouts
over the life of the investment.
280
Required Inputs
– Dividends are paid out of earnings.
– Earnings are important in valuing stocks.
– Retained earnings enhance future earnings
and ultimately dividends.
• Retained earnings imply growth and future
dividends.
• Produces similar results as current dividends in
valuation of common shares.
281
Dividend Discount Model
• Current value of a share is the discounted
value of all future dividends
282
• Multistage Dividend Discount Model
• Constant Growth Model
• No Growth Discount Model
283
• A procedure for valuing the price of a stock by
using predicted dividends and discounting them
back to present value. The idea is that if the
value obtained from the DDM is higher than
what the shares are currently trading at, then the
stock is undervalued.
284
• This procedure has many variations, and it
doesn't work for companies that don't pay out
dividends.
• To get a fair value of a stock currently based on
the calculation that we do to find out whether we
have a good fair value stock or under value
stock.
285
• Problems:
– Need infinite stream of dividends.
– Dividend stream is uncertain.
• Must estimate future dividends.
– Dividends may be expected to grow over
time.
• Must model expected growth rate of dividends and
need not be constant.
286
• Assume no growth in dividends:
– Fixed Rupee amount of dividends reduces the
security to a perpetuity.
– Similar to preferred stock because dividend remains

unchanged.
– Risk is minimum.
– Money remains constant.
287
• Assume a constant growth in dividends
– Dividends expected to grow at a constant
rate, g, over time.
– Value of stock or price of stock is determined
by improved version of improved cash flows
and improved dividends.
– D1 is the expected dividend at end of the first

period.
– D1 =D0  (1+g).
288
• Implications of constant growth:
– Stock prices grow at the same rate as the dividends.
– Stock total returns grow at the required rate of return.
• Growth rate in price plus growth rate in dividends
equals to the required rate of return.
– A lower required return or a higher expected growth in
dividends raises prices.
289
• Multiple growth rates: two or more expected
growth rates in dividends.
– Ultimately, growth rate must equal that of the
economy as a whole.
– Assume growth at a rapid rate for n periods
followed by steady growth.
290
• Multiple growth rates:
– First present value covers the period of super-
normal (or sub-normal) growth.
– Second present value covers the period of
stable growth.
• Expected price uses constant-growth model as of
the end of super- (sub) normal period.
• Value at n must be discounted to time period zero.
291
Example: Valuing equity with growth of
30% for 3 years, then a long-run constant
growth of 6%
0 k=16% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 4.00 D1=5.20 D2=6.76 D3=8.788 D4=9.315
Pt=Dt * (1+g)/(k-g)
P4=D4 * (1+g)/(k-g)
P4=9.315 * (1+.06)/(0.16-0.06)
P4=98.739 292
Example: Valuing equity with growth of
30% for 3 years, then a long-run constant
growth of 6%
0 k=16% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 4.00 D1=5.20 D2=6.76 D3=8.788 D4=9.315
P4=98.739
4.48
5.02
5.63
59.68
74.81 = P0 293
What About Capital Gains?
• Is the dividend discount model only capable of
handling dividends?
– Capital gains are also important.
• Price received in future reflects expectations of
dividends from that point forward.
– Discounting dividends or a combination of
dividends and price produces same results.
294
Intrinsic Value
• “Fair” value based on the capitalization of
income process.
– The objective of fundamental analysis.
• If intrinsic value > current market price, hold or
purchase because the asset is undervalued.
• If intrinsic value < current market price, avoid or
sell because the asset is overvalued.
– Decision will always involve estimates.
295
P/E Ratio
• Price Earning is one of the most widely used
ratios.
• It compares the current price with earnings to
see if a stock is over or under valued.
PE=Market Value per Share
Earnings per Share
• Generally a high P/E ratio means that investors

are anticipating higher growth in the future.
296
P/E Ratio
• The average market P/E ratio is 10-15 times

earnings.
• The P/E ratio can use estimated earnings to get
the forward looking P/E ratio.
• Companies that are losing money do not have a
P/E ratio.
297
P/E Ratio or Earnings Multiplier Approach
• Alternative approach is often used by security

analysts.
• P/E ratio is the strength with which investors
value earnings as expressed in stock price.
– Divide the current market price of the stock by
the latest 12-month earnings.
– Price paid for each Rupee of earnings.
298
• Factors that effect the P/E Ratio.
• If growth is less then P/E Ratio is also less.
• If 10 or 15 P/E multiples, it means that the
identified shares are lower than that multiple.
299
P/E Ratio Approach
• The higher the payout ratio, the higher the
justified P/E.
– Payout ratio is the proportion of earnings that are paid
out as dividends.
• The higher the expected growth rate, g, the
higher the justified P/E.
• The higher the required rate of return, k, the
lower the justified P/E.
• High P/Es and low P/Es does not mean that
there is any fault in the company.
300
Understanding the P/E Ratio
• Does rapid growth affect the riskiness of
earnings?
– Will the required return be affected?
– Are some growth factors more desirable than
others?
• P/E ratios reflect expected growth and risk.
• Will future growth prospects be affected?
301
P/E Ratios and Interest Rates
• A P/E ratio reflects investor optimism and
pessimism.
– Related to the required rate of return
• As interest rates increase, required rates of
return on all securities generally increase.
• P/E ratios and interest rates are indirectly
related.
302
Which Approach Is Best?
• Best estimate is probably the present value of
the (estimated) dividends.
– Can future dividends be estimated with accuracy?
– Investors like to focus on capital gains not on
dividends.
• P/E multiplier remains popular for its ease in
use and the objections to the dividend discount
model.
303
INVESTMENT ANALYSIS
&
Lecture # 12
• Investment is one of the rarer subject that one
individual person as a whole or as a part of an
organization can perform
• Can be of immense value in increasing the
wealth of an individual or the wealth of
corporation or an organization in which you may
be associated with.
305
• People who are:
Cash Cows
Dogs
Stars
306
• Fundamental Analysis has a very broad scope.
• One aspect looks at the general (qualitative)
factors of a company.
• The other side considers tangible and
measurable factors (quantitative).
• The scope of fundamental analysis is both
qualitative and quantitative.
307
• This means crunching and analyzing numbers
from the financial statements.
• If used in conjunction with other methods,
quantitative analysis can produce excellent
results.
308
• Ratio analysis isn't just comparing different
numbers from the balance sheet, income
statement, and cash flow statement.
• It's comparing the number against previous
years, other companies, the industry, or even the
economy in general.
• Ratios look at the relationships between
individual values and relate them, how a
company has performed in the past, and might
perform in the future.
309
• Time Value of Money: whether you are getting a
stock at discounted value today which is going
to be much more valuable in the future.
• For example current assets alone don't tell us a
whole lot, but when we divide them by
current liabilities, we are able to determine
whether the company has enough money to
cover short term debts or not.
310
• P/E Ratio
• Best Estimates
• Earning per Share
• Estimates of Future Dividends
• Capital Gains
• Why P/E multiplier is important
311
• Despite all things, some of the ratios remain the
most popular.
• P/E Ratio tends to be one of the more popular
ratios to be considered as a good way of
measuring investment opportunities.
• Dividend Discount Model.
312
• Complementary approaches?
– P/E ratio can be derived from the constant
dividend discount model.
– P/E ratio can be derived from the static
growth model.
PE=Market Value per Share
Earnings per Share
– Dividends are paid out of earnings.
313
• Dividends are paid out from current income, then
the strength of the company is also affected
because you are paying what you are earning
and then there is a big debate whether you
should payout what you earn or whether you
should retain what you earn.
• Dealing with uncertain future is always subject to
error.
• Hitting the estimates right.
314
Other Multiples
• Price-to-book value ratio:
– Ratio of share price to stockholder equity as
measured on the balance sheet.
– Price paid for each Rupee of equity.
• Price-to-sales ratio
– Ratio of a company’s total market value (price times
number of shares) divided by sales.
– Market valuation of a firm’s revenues.
315
Ratio Analysis
• The ratio analysis of a balance sheet can
identify potential liquidity problems.
• These may signify the company's inability to
meet financial obligations.
• An investor could also spot the degree to which
a company is leveraged, or indebted.
• As an investor, you will want to know if a
company, you are considering is in danger of not
being able to make its payments.
316
Liquidity Ratios
• The following liquidity ratios are all designed to
measure a company's ability to cover its short-
term obligations.
1. Current Ratio:
Current Ratio measures a firm's ability to pay
its current obligations.
Current Ratio = Current Assets/Current Liabilities
317
Current Ratio
• Current ratio tells us what the current
obligation are and the company's ability to
meet them.
318
Liquidity Ratios
2. Acid Test or Quick Ratio:
• Acid Test or Quick Ratio is very similar to the
Current Ratio except for the fact that it
excludes inventory.
• For this reason, it's also a more conservative
ratio.
Acid test = (Current Assets – Inventory)

________________________
Current Liabilities
319
Acid Test or Quick Ratio
• In acid test ratio, we first subtract the
inventory from current assets and then
divide the result by current liabilities.
320
Liquidity Ratios
• Working Capital:
Working Capital is simply the amount that
current assets exceed current liabilities.
Here it is in the form of the equation:
Working Capital = Current Assets - Current Liabilities
321
Leverage Ratio
• Leverage is a ratio that measures a
company's capital structure.
• In other words, it measures how does a
company finances its assets.
Leverage = Long-term Debt/Total Equity
322
Leverage Ratio
• Its not a bad idea to carry a debt.
• Long term debt.
• Short term debt.
• Ability of a company to be able to payout
the debts.
• We will be able to look at the things that
are not really very uncomfortable.
323
Profitability Ratios
• Profitability is often measured in percentage
terms in order to facilitate comparison of a
company's financial performance against past
year's performance and against the
performance of other companies.
1. Gross Margin:
Gross Margin is the resulting percentage when

Gross Profit is divided by Net Sales.
324
Gross Margin
• Gross Margin represents the percentage
of revenue remaining after Cost of Goods.
Gross Margin = Gross Profit/Net Sales
325
2. Operating Margin:
• As the name implies, operating margin is the
resulting ratio when Operating Income is divided
by Net Sales.
• This ratio measures the quality of a firm's
operations.
Operating Margin = Operating Income/Net Sales
326
• In fundamental analysis, you not only
consider the balance sheet or retained
earnings but you also consider the
previous track record.
327
3. Net Margin:
• Net Margin is a measure of profitability for
the sum paid for a firm's operations.
• It is equal to Net Profit divided by Net
Sales.
Net Margin = Net Profit/Net Sales
328
4. Earnings per share:
It represents the per share profit available for
distribution to the shareholders.
• EPS serves as an indicator of a company's
profitability .
• The EPS is the key figure investors are
interested in.
329
Leverage Ratios
1. Interest Coverage (Times Interest Earned):
• Interest Coverage is the measurement of
how many times interest payments could
be made with a firm's earnings, before
interest expenses and taxes are paid.
Interest Coverage Ratio =

Earnings Before Interest and Taxes (EBIT)/Interest Expense
330
Leverage Ratios
2. Debt Coverage Ratios:
Debt Coverage Ratio =
(Operating Profit + Depreciation + Amortization) /
(Interest Expense + current portion of long term liabilities)
• Debt Coverage Ratio indicate the ability of a

company to repay its current liabilities (interest +
current portion of long term liabilities) from its
operating cash flow (EBIT + Non-cash
expenses)
331
INVESTMENT ANALYSIS
&
Lecture # 13
• Fundamental Analysis means crunching and
analyzing numbers from the financial statements
.
• If used in conjunction with other methods,
quantitative analysis can produce excellent
results.
• The other side considers tangible and
measurable factors (quantitative).
333
• This is all what fundamental analysis told us all
about by looking at the analytical aspects of
common stock.
334
• Ratio analysis isn't just comparing different
numbers from the balance sheet, income
statement, and cash flow statement.
• It's comparing the number against previous
years, other companies, the industry, or even the
economy in general.
• Ratios look at the relationships between
individual values and relate them as to how a
company has performed in the past, and might
perform in the future.
335
• For example, current assets alone don't tell us a
whole lot, but when we divide them by
current liabilities we are able to determine
whether the company has enough money to
cover short term debts.
• Only a positive outcome of current assets minus
current liabilities will give us go ahead signal to
invest in such company.
336
Ratio Analysis
• The ratio analysis of a balance sheet can
• As an investor, you will want to know if a
company you are considering is in danger of not
being able to make its payments.
337
Liquidity Ratios
• The following liquidity ratios are all designed to
measure a company's ability to cover its short-
term obligations.
1. Current Ratio:
Current Ratio measures a firm's ability to pay
their current obligations.
Current Ratio = Current Assets/Current Liabilities
338
Liquidity Ratios
2. Acid Test or Quick Ratio:
• Acid Test or Quick Ratio is very similar to the
Current Ratio except for the fact that it excludes
inventory. For this reason, it's also a more
conservative ratio.
Acid test = (Current Assets – Inventory)

________________________
Current Liabilities
• The inventory part is the only difference between
current ratio and quick ratio.
339
Liquidity Ratios
3. Working Capital:
• Working Capital is simply the amount that
• Here it is in the form of the equation:
Working Capital = Current Assets - Current Liabilities
340
Leverage Ratio
• It measures how a company finances its
assets.
Leverage = Long-term Debt/Total Equity
341
• Profitability is often measured in percentage
terms in order to facilitate making comparisons
of a company's financial performance against
past year's performance and against the
performance of other companies.
1. Gross Margin:
Gross Margin is the resulting percentage when Gross
Profit is divided by Net Sales.
Gross Margin = Gross Profit/Net Sales
342
2. Operating Margin:
As the name implies, operating margin is the
resulting ratio when Operating Income is divided
by Net Sales.
Operating Margin = Operating Income/Net Sales
• This ratio measures the quality of a firm's

operations.
343
3. Net Margin:
• Net Margin is a measure of profitability for
the sum of a firm's operations.
• It is equal to Net Profit divided by Net
Sales.
Net Margin = Net Profit/Net Sales
344
4. Earnings per share:
• EPS serves as an indicator of a company's
profitability.
345
Leverage Ratios
1. Interest Coverage (Times Interest Earned):
• Interest Coverage is the measurement of
how many times interest payments could
be made with a firm's earnings before
interest expenses and taxes are paid.
Interest Coverage Ratio =

Earnings Before Interest and Taxes (EBIT)/Interest Expense
346
Leverage Ratios
2. Debt Coverage Ratios:
Debt Coverage Ratio =

(Operating Profit + Depreciation + Amortization) /
(Interest Expense + current portion of long term liabilities)
• Debt Coverage Ratio indicate the ability of a

company to repay its current liabilities.
347
Investment Ratios
1. Dividend per share:
• Dividend per share is the profit paid to
share holders per share that they hold.
348
• Capital depreciation.
• Supplement your investments.
• Supplement your incomes.
• Excitement of investment.
349
Investment Ratios
2.Dividend Yield:
• A financial ratio that shows how much a
company pays out in dividends each year
relative to its share price.
• Dividend yield has to be good number.
350
Investment Ratios
3. Price-Earnings Ratio (P/E Ratio):
Price earning ratio shows how much
investors are willing to pay for Re.1
earning of the company.
• Higher this figure, more optimistic the
investors are about the company.
351
• Analyze economy-stock market  industries 
individual companies.
– Need to understand economic factors that affect stock
prices initially.
– Use valuation models applied to the overall market
and consider how to forecast market changes.
– Stock market’s likely direction is of extreme
importance to investors.
– Should also take a global perspective because of
linkages.
352
Economy and The Stock Market
• Direct relationship between the economy and
the stock market.
• Economic business cycle.
– Recurring pattern of aggregate economic
expansion and contraction.
– Cycles have a common framework
• trough  peak  trough
– Can only be neatly categorized by length and
turning points in hindsight.
353
Cycles
• Business Cycle
• Economic Business Cycle
• Common Stock Variable Cycle
354
Business Cycle
• National Bureau Economic Research:
– Monitors economic indicators.
– Dates business cycle when possible.
• Composite indexes of general economic activity:
– Series of leading, coincident, and lagging indicators of
economic activity to assess the status of the business
cycle.
355
Stock Market and Business Cycle
• Stock prices lead the economy:
– Historically, the most sensitive indicator.
– Stock prices consistently turn before the
economy.
• How reliable is the relationship?
– The ability of the market to predict recoveries
is much better than its ability to predict
recessions.
356
Macroeconomic Forecasts
of the Economy
• How good are available forecasts?
– Prominent forecasters have similar
predictions and differences in accuracy are
very small.
• Investors can use any such forecasts.
• Does monetary activity initiated by the FED
forecast economic activity?
– Changes due to shifts in supply or demand.
– Actions of Federal Reserve important.
357
Reading Yield Curves
• Shows relationship between market yields and
time to maturity.
• Holding all other characteristics, like credit risk.
• Upward sloping and steepening curve implies
accelerating economic activity.
• Flat structure implies a slowing economy.
• Inverted curve may imply a recession.
• Actions of FED, expectations important.
358
Understanding the Stock Market
• Market is measured by index or average.
• Most indexes designed for particular market
segment (ex. blue chips).
• Most popular indexes:
– Dow-Jones Industrial Average DJIA.
– S&P 500 Composite Stock Index.
• Favored by most institutional investors and
money managers.
359
Uses of Market Measures
• Shows how stocks in general are doing at any
time.
– Gives a feel for the market.
• Shows where in the cycle the market is and
sheds light on the future.
– Aids investors in evaluating downside.
• Helps judge overall performance.
• Used to calculate betas.
• Index is the reflective of the health of the market.
360
Determinants of Stock Prices
• Who determines prices.
• Who decides market prices.
• Who decides a particular stock prices.
• Who decides whether the price has to be up or
down.
361
• Exogenous or predetermined variables.
– Potential output of economy (Y*).
• Productivity, resources, investment
opportunities.
– Corporate tax rate (tx).
– Government spending (G).
– Nominal money supply (M).
• Three policy variables subject to
governmental decisions.
362
• G and M affect stock prices by:
– Affecting total aggregate spending (Y), which
together with the tax rate (tx) affects corporate
earnings.
• Total aggregate spending, together with
economy’s potential output (Y*) and past
changes in prices, determine current changes in
the price level (P).
363
• Corporate earnings and expected inflation
affects expected real earnings.
• Interest rates and required rates of return are
also affected by expected inflation.
• Stock prices are affected by earnings, rates.
– If economy is prospering, earnings and stock
prices will be expected to rise.
364
INVESTMENT ANALYSIS
&
Lecture # 14
Top-down Approach
366
Top-down Approach
• Analyze economy-stock market  industries 
individual companies.
– Need to understand economic factors that
affect stock prices initially.
– Use valuation models applied to the overall
market and consider how to forecast market
changes.
– Stock market’s likely direction is of extreme
importance to investors.
– Should also take a global perspective
because of linkages.
367
Economy and the Stock Market
• Direct relationship between the economy and
stock market.
– Recurring pattern of aggregate economic
expansion and contraction.
– Cycles have a common framework
• trough  peak  trough.
– Can only be neatly categorized by length and
turning points in hindsight.
368
Business Cycle
• Statistical Bureau Economic Research:
– Economic indicators.
• Economic activity.
– Series of leading, coincident, and lagging
indicators of economic activity to assess the
status of the business cycle
369
Stock Market and Business Cycle
• Stock prices lead the economy.
– Historically, the most sensitive indicator.
– Stock prices consistently turn before the
economy.
• How reliable is the relationship?
– The ability of the market to predict recoveries
is much better than its ability to predict
recessions.
370
Macroeconomic Forecasts
of the Economy
• How good are available forecasts?
• Fiscal activity at federal level.
• Monetary activity at central bank level.
– Changes due to shifts in supply or demand.
– Actions of Federal Reserve are important.
– Investors can use any such forecasts.
371
Reading Yield Curves
• Shows relationship between market yields and
time to maturity, holding all other characteristics,
like credit risk.
• Upward sloping and steepening curve implies
accelerating economic activity.
• Flat structure implies a slowing economy.
• Inverted curve may imply a recession.
• Actions of FED, expectations are important.
372
Understanding the Stock Market
• Market measured by index or average
• Most popular indexes
– Dow-Jones Industrial Average DJIA.
– S&P 500 Composite Stock Index.
• Favored by most institutional investors and
money managers.
373
Uses of Market Measures
• Shows how stocks in general are doing at
any time.
– Gives a feel for the market.
• Shows where in the cycle the market is
and sheds light on the future.
– Aids investors in evaluating downside and
upside.
• Helps judge overall performance.
374
• Corporate earnings and expected inflation
affects expected real earnings.
• Interest rates and required rates of return are
also affected by expected inflation.
• Stock prices are affected by earnings, rates.
– If economy is prospering, earnings and stock
prices will be expected to rise.
375
Valuing the Market
• To apply fundamental analysis to the market,
estimates are needed of:
– Stream of shareholder benefits.
• Earnings and dividends.
– Required return or earnings multiple.
• Steps in estimating earnings stream.
– Estimate GDP, corporate sales, corporate
earnings before taxes, and finally corporate
earnings after taxes.
376
Valuing the Market
• Because as common shareholders, we are
basically interested in whatever money is
left, after taxes have been paid and that
becomes the basis of earnings per share
which is a measure of valuing the market.
377
Valuing the Market
• The earnings must be basically from operational
activity.
• The earnings multiplier.
– More volatile than earnings component.
• Difficult to predict.
– Cannot simply extrapolate from past P/E
ratios, because changes can and do occur.
– 1928-95 average for S&P 500: 14.
– P/E ratios tend to be high when inflation and
interest rates are low.
• Put earnings estimate and multiplier together.
378
Valuing the Market
• Why do P/E Ratios high when interest rate and
inflations are low.
• The investors feel that the earning capacity of an
organization or corporation will be greater and
will be able to earn more, save more because
cost will be lesser, taxes will be lesser and
prices will not be more expensive.
379
Forecasting Changes in the Market
• Difficult to consistently forecast the stock market,
especially in short term.
– Efficient Market Hypothesis (EMH) states that
future cannot be predicted based on past
information.
– Although market timing is difficult, some
situations suggest strong action.
• Investors tend to lose more by missing a bull
market than by dodging a bear market.
380
Using the Business Cycle
to Make Forecasts 1/2
• Leading relationship exists between stock
market prices and economy.
– Can the market be predicted by the stage of
the business cycle?
• Consider business cycle turning points well in
advance, before they occur.
– Stock total returns could be negative or
positive when business cycle peaks or
bottoms.
381
to Make Market Forecast 1/2
• If investors can recognize the bottoming of
the economy before it occurs, a market
rise can be predicted.
– Switch into stocks, out of cash.
– As economy recovers, stock prices may level
off or even decline.
– Based on past, the market P/E usually rises
just before the end of the slump.
382
Using Key Variables to
Make Market Forecasts
• Best known market indicator is the
price/earnings ratio.
– Other indicators: dividend yield, earnings
yield.
• Problems with key market indicators:
– When are they signaling a change?
– How reliable is the signal?
– How quickly will the predicted change occur?
383
FED’s Approach
• Asset allocation changes imply the returns on
equity and fixed-income securities are related.
• Compare 10-yr. Treasury yields with the
earnings yield (E/P) on the S&P 500.
– E/P > T-note yield implies stocks are attractive
relatively.
– E/P < T-note yield implies stocks are
unattractive relatively.
• Problems: Loses reliability when rates low,
earnings estimated into future.
• Money market was investment for short term.
384
Conclusions
• Market forecasts are not easy, and are subject to
error.
– Investors should count on the unexpected
occurring.
• Intelligent and useful forecasts of the market can
be made at certain times, at least as to the likely
direction of the market.
• If anybody thinks that you can buy today and sell
at profit, tomorrow is going to be taking for a
surprise.
385
Sector/Industry Analysis
• Macro shoes.
• Micros shoes.
• Economies and industries and companies.
• Second step in the fundamental analysis of
common stocks.
– Industries promising the most opportunity in
the future should be considered.
• Concepts of industry analysis related to
valuation principles.
• Continual analysis due to inconsistent industry
performance over time.
386
Industry Performance Over Time
• Potential value of industry analysis can be
seen by assessing the performance of
different industries over time.
– S&P’s monthly stock price index over a long
time period shows industries perform
differently over time.
– Stock performance are affected by industry.
• Industries in decline should be avoided.
387
• Consistency of industry performance.
– Maintaining positions in growth industries
leads to better returns than otherwise.
• Can industry performance be predicted
reliably on the basis past success?
– Rankings inconsistent over time.
– Industries with recent poor performance
should not be ignored.
388
What is an Industry?
• Are industry classifications clear-cut?
• Industries cannot be casually identified
and classified.
– Diversified lines of business cause
classification problems.
– Industries continue to become more mixed in
their activities and less identifiable with
product or service.
389
Classifying Industries
• Standard Industrial Classification (SIC).
– Based on census data and on the basis of
what is produced.
– SIC codes have 11 divisions, A through K.
– Each division has several major industry
groups, designated by a two-digit code.
• Larger the number of SIC digits, the more
specific the breakdown.
• Other Classifications: S&P, Value Line.
390
INVESTMENT ANALYSIS
&
Lecture # 15
Valuing the Market
• To apply fundamental analysis to the market,
estimates are needed of;
1. Required return or earnings multiple.
• Steps in estimating earnings stream.
– Estimate GDP, corporate sales, corporate
earnings before taxes, and finally corporate
earnings after taxes.
392
Valuing the Market
• The earnings multiplier.
– Cannot simply extrapolate from past P/E.
ratios, because changes can and do occur
– 1928-95 average for S&P 500: 14.
– P/E ratios tend to be high when inflation and
interest rates are low.
393
Forecasting Changes in the Market
• Difficult to consistently forecast the stock market,
especially short term.
– EMH states that future cannot be predicted
based on past information.
– Although market timing difficult, some
situations suggest strong action.
• Investors tend to lose more by missing a bull
market than by dodging a bear market.
394
to Make Forecasts 1/2
• Leading relationship exists between stock
market prices and economy.
– Can the market be predicted by the stage of
the business cycle?
• Consider business cycle turning points well in
advance, before they occur.
– Stock total returns could be negative when
business cycle peaks.
– Stock total returns could be positive when
business cycle bottoms.
395
to Make Market Forecast 1/2
• If investors can recognize the bottoming of
the economy before it occurs, a market
rise can be predicted.
– Switch into stocks, out of cash.
– As economy recovers, stock prices may level
off or even decline.
– Based on past, the market P/E usually rises
just before the end of the slump.
396
Using Key Variables to
Make Market Forecasts
• Best known market indicator is the
price/earnings ratio.
– Other indicators: dividend yield, earnings
yield.
• Problems with key market indicators:
– When are they signaling a change?
– How reliable is the signal?
– How quickly will the predicted change occur?
– That are problem areas with the market
indicators.
397
FED’s Approach
• Asset allocation changes imply the returns on
equity and fixed-income securities are related.
• Compare 10-yr. Treasury yields with the
earnings yield (E/P) on the S&P 500.
– E/P > T-note yield implies stocks are attractive
relatively.
– E/P < T-note yield implies stocks are
unattractive relatively.
• Problems:
• Earnings estimated into future.
• Loses reliability when rates low.
398
Conclusions
• Market forecasts are not easy, and are
subject to error.
– Investors should count on the unexpected
occurring.
• Intelligent and useful forecasts of the
market can be made at certain times, at
least as to the likely direction of the
market.
399
Sector/Industry Analysis
• Second step in the fundamental analysis
of common stocks.
– Industries promising the most opportunity in
the future should be considered.
• Concepts of industry analysis related to
valuation principles.
• Continual analysis due to inconsistent
industry performance over time.
400
• Potential value of industry analysis seen
by assessing the performance of different
industries over time.
– S&P’s monthly stock price index over a long
tome period shows industries perform
differently over time.
– Stock performance affected by industry.
• Industries in decline should be avoided.
401
• Consistency of industry performance.
– Maintaining positions in growth industries
leads to better returns than otherwise.
• Can industry performance be predicted
reliably on the basis past success?
– Rankings inconsistent over time.
– Industries with recent poor performance
should not be ignored.
402
What is an Industry?
• Are industry classifications clear-cut?
• Industries cannot be casually identified
and classified.
– Diversified lines of business cause
classification problems.
– Industries continue to become more mixed in
their activities and less identifiable with on
product or service.
403
Classifying Industries
• Standard Industrial Classification (SIC).
– Based on census data and on the basis of
what is produced.
– SIC codes have 11 divisions, A through K.
– Each division has several major industry
groups, designated by a two-digit code.
• Larger the number of SIC digits, the more
specific the breakdown.
• Other Classifications: S&P, Value Line.
404
Analyzing Industries
• By stage in their life cycle.
– Helps determine the health and future
prospects of the industry.
1. Pioneering stage:
– Rapid growth in demand.
– Opportunities may attract other firms and
venture capitalists.
– Difficult identify likely survivors.
405
– Pioneering stage can give you a good idea of
where to think about investing.
– It is very exciting in the beginning.
406
2. Expansion stage:
– Survivors from the pioneering stage are
identifiable.
– Firm operations more stable, dependable.
– Considerable investment funds attracted.
– Financial policies firmly established.
– Dividends often become payable.
• Attractive to a wide group of investors.
407
3. Stabilization or maturity stage:
– Growth begins to moderate.
– Marketplace is full of competitors.
– Costs are stable rather than decreasing.
• Limitations of life cycle approach:
– A generalization that may not always apply.
– Tends to focus on sales, market share, and
investment in the industry.
408
• Implications for stock prices.
– Function of expected returns and risk.
• Pioneering stage offers the highest potential
returns, greatest risk.
• Investors interested in capital gains should avoid
maturity stage.
• Expansion stage is of the most interest to
investors.
– Growth is rapid, but orderly.
409
Qualitative Aspects
• Historical Performance:
– Historical record of sales and earnings growth
and price performance should be considered.
• Although past cannot be simply
extrapolated into the future, it does provide
context.
• Competitive conditions in industry:
– Competition determines an industry’s ability to
sustain above-average returns.
410
Porter’s Competitive Factors
• Influences on return on investment:
– Threat of new entrants.
– Bargaining power of buyers.
– Rivalry between existing competitors.
– Substitute products or services.
– Bargaining power of suppliers.
• Industry profitability is a function of industry
structure.
411
• Governmental effects:
– Regulations and policies have significant
effects on industries.
• Structural changes in how economy creates
wealth:
– U.S. continues to move from an industrial to
an information/communication society.
– Structural shifts can occur even within
relatively new industries.
412
Evaluating Future Industry Prospects
• To forecast long-term industry

performance investors should ask:
– Which industries are obvious candidates for
growth and prosperity?
– Which industries appear likely to have
difficulties as the US moves from industrial to
an information-based economy?
413
– E-commerce.
– Business without Frontiers.
– Globalization.
– The right for industry to survive on its own.
– No more patternization.
– No more subsidies of industries.
414
Picking Industries for Next Year
1. Which industries are likely to show
improving earnings?
– Estimate expected earnings and earnings
multiple for an industry.
– Earning estimates notoriously inaccurate.
improving P/E ratios?
– Investors tend to pay too much for favored
companies in an industry.
415
• Likely direction of interest rates and which
industries most affected by a significant
rate change should be considered.
• Industries most affected by possible
political events, new technology, inflation
should also be considered.
416
Business Cycle Analysis
• Analysis of industries by their operating ability in
relation to the economy as a whole.
– Some industries move closely with the
business cycle, others not.
• Growth industries:
– Earnings expected to be significantly above
the average of all industries.
• Growth stocks suffer less during a
recession.
417
• Defensive industries:
– Least affected by recessions and economic
adversity.
• Cyclical industries:
– Most affected by recessions and economic
adversity.
– “Bought to be sold”.
– Counter-cyclical industries exist as well.
418
• Interest-sensitive industries:
– Particularly sensitive to expectations about
changes in interest rates.
• Careful analysis of business cycle and likely
movements in interest rates help make better
buy/sell decisions.
• Industry knowledge is valuable in selecting or
avoiding industries.
419
INVESTMENT ANALYSIS
&
Lecture # 16
• Analyze By stage in their life cycle.
– Helps determine the health and future
prospects of the industry.
1. Pioneering stage:
– There is Rapid growth in demand.
– Opportunities may attract other firms and
venture capitalists.
– Difficult to identify likely survivors.
421
2. Expansion stage:
– Survivors from the pioneering stage are
identifiable.
– Firm operations more stable, dependable.
– Considerable investment funds attracted.
– Financial policies firmly established.
– Dividends often become payable.
• Attractive to a wide group of investors.
422
• These companies can generally be accepted as
good companies to invest.
• Financial abilities of good value companies.
3. Stabilization or maturity stage:
– Growth begins to moderate.
– Marketplace is full of competitors.
– Costs are stable rather than decreasing.
423
• Limitations of life cycle approach:
– A generalization that may not always apply.
– Tends to focus on sales, market share, and
investment in the industry.
424
• Implications for stock prices.
– Function of expected returns and risk.
• Pioneering stage offers the highest potential
returns, greatest risk.
• Investors interested in capital gains should avoid
maturity stage.
• Expansion stage is of the most interest to
investors.
– Growth is rapid, but orderly.
425
• Pioneering Stage
• Expansion Stage or Growth Stage
• Maturity Stage
426
Qualitative Aspects
• Historical Performance:
– Historical record of sales and earnings growth
and price performance should be considered.
• Competitive conditions in industry:
– Competition determines an industry’s ability to
sustain above-average returns.
427
Porter’s Competitive Factors
• Influences on return on investment:
– Threat of new entrants.
– Bargaining powers of buyers.
– Bargaining powers of suppliers.
– Substitute products or services.
• Industry profitability is a function of industry
structure.
• Good understanding with buyers and sellers.
428
• Governmental effects:
– Regulations and policies have significant
effects on industries.
• Structural changes in how economy creates
wealth:
– Shifts from an industrial to an information /
communication society.
– Structural shifts can occur even within
relatively new industries.
429
• To forecast long-term industry performance
investors should ask:
– Which industries appear likely to have
difficulties as the US moves from industrial to
an information-based economy?
– Which industries are obvious candidates for
growth and prosperity?
430
improving earnings?
– Estimate expected earnings and earnings
multiple for an industry.
– Earning estimates notoriously inaccurate.
improving P/E ratios?
– Investors tend to pay too much for favored
companies in an industry.
431
• Whenever we not identify the industry as a
potential industry we won’t be able to find out the
investment company.
• EIC.
• Economy.
• Fiscal Policy.
• Monetary Policy.
432
SWOT Analysis
• Opportunities
• Threats
• Strengths
• Weaknesses
• We use strengths to our advantages.
• We try to overcome the weaknesses.
433
• Likely direction of interest rates and which
industries most affected by a significant rate
change should be considered.
• Industries most affected by possible political
events, new technology, inflation should also be
considered.
434
• Analysis of industries by their operating ability in
relation to the economy as a whole.
– Growth Phase
– Depression Phase
• Growth industries:
– Earnings expected to be significantly above
the average of all industries.
• Growth stocks suffer less during a
recession.
435
• Defensive industries:
– Macroeconomics are not affected.
– Consumer Goods.
• Cyclical industries:
– Most affected by recessions and economic
adversity.
– “Bought to be sold”.
436
• Interest-sensitive industries:
– Particularly sensitive to expectations about
changes in interest rates.
• Careful analysis of business cycle and likely
movements in interest rates help make better
buy/sell decisions.
• Industry knowledge is valuable in selecting or
avoiding industries.
437
• The Last step in top-down approach is company
analysis.
• The Goal is: to estimate share’s intrinsic value.
– Value justified by fundamentals.
438
• Earnings multiple could also be used:
P0=estimated EPS  justified P/E ratio
• Focus on earnings and P/E ratio;
– Dividends paid from earnings.
– Close correlation between earnings and stock
price changes.
• As long as you have good earnings you have got
good price.
439
• Stock is under- (over-) valued if intrinsic value is
larger (smaller) than current market price.
• Potential of the company to be able to give you
something in return.
• Justified P/E Ratio.
• Estimated EPS.
• Fast historical data.
• Growth in the economy.
440
Accounting Aspects of Earnings
• How is EPS derived and what does EPS
represent?
• Financial statements provide majority of financial
information about firms.
• Analysis implies comparison over time or with
other firms in the same industry.
• Focus on how statements are made.
• Focus on how statements are used.
441
Basic Financial Statements
• Balance Sheet:
– Items listed in order of liquidity or in order of
payment.
– Assets:
• Cash VS non-cash assets.
– Non-cash assets may be worth more or
less than carried on books.
• Depreciation methods for fixed assets.
• Inventory evaluation choices.
442
• Balance Sheet:
– Liabilities / Payables:
• Fixed claims against the firm.
• Institutions.
• Organizations.
• Value for in return for services
requirements.
• Value for in return for goods requirements.
443
• Taxes
• Interest
• Premium
• Installments
– Equity:
• Residual.
• Adjusts when the value of assets change.
– Picture at one point in time.
444
• A Balance Sheet tells you about the position of a
firm in any one given time.
• Balance Sheets are created at the end of
financial year and intend of accounting year.
445
The Financial Statements
• Earnings per share:
– EPS =Net Income / average number of shares
outstanding
– Net Income before adjustments in accounting
treatment or one-time events.
• Certifying statements:
– Auditors do not guarantee the accuracy of
earnings but only that statements are fair
financial representation.
446
– Notes:
• Notes from an integral part of a financial
statements Balance Sheet.
• Notes will tell you a details about what ends
a Balance Sheet.
447
Problems with Reported Earnings
• EPS for a company is not a precise figure that is
readily comparable over time or between
companies.
– Alternative accounting treatments used to
prepare statements.
– Difficult to gauge the ‘true’ performance of a
company with any one method.
– Investors must be aware of these wrinkles.
448
Analyzing a Company’s Profitability
• Important to determine whether a company’s
profitability is increasing or decreasing and why.
• Return on equity (ROE) emphasized because it
is key component in finding earnings and
dividend growth.
EPS =ROE  Book value per share
449
Du Pont Analysis
• Share prices depend partly on ROE.
• Management can influence ROE.
• Decomposing ROE into its components allows
analysts to identify adverse impacts on ROE and
to predict future trends.
• Highlights expense control, asset utilization, and
debt utilization.
450
Du Pont Analysis
• ROE depends on the product of:
1) Profit margin on sales: EBIT/Sales.
2) Total asset turnover: Sales/Total Assets.
3) Interest burden: Pre-tax Income/EBIT.
4) Tax burden: Net Income/Pre-tax Income.
5) Financial leverage: Total Assets/Equity.
• ROE =EBIT efficiency  Asset turnover 
Interest burden  Tax burden  leverage
451
Obtaining Estimates of Earnings
• Expected EPS is of the most value.
• Stock price is a function of future earnings and
the P/E ratio.
– Investors estimate expected growth in
dividends or earnings by using quarterly and
annual EPS forecasts.
• Estimating internal growth rate:
EPS1=EPS0(1+g)
452
Estimating an Internal Growth Rate
• Future expected growth rate matters in
estimating earnings, dividends;
g =ROE  (1- Payout ratio)
– Only reliable if company’s current ROE
remains stable.
– Estimate is dependent on the data period.
• What matters is the future growth rate, not the
historical growth rate.
453
Forecasts of EPS
• Security analysts’ forecast of earnings.
– Consensus forecast superior to individual.
• Time series forecast.
– Use historical data to make earnings
forecasts.
• Evidence favors analysts over statistical models
in predicting what actual reported earnings will
be;
– Analysts are still frequently wrong.
– Hit the Estimates right.
454
Earnings Surprises
• What is the role of expectations in selecting
stocks?
– Old information will be incorporated into stock
prices if market is efficient.
– Unexpected information implies revision.
455
INVESTMENT ANALYSIS
&
Lecture # 17
• The Last step in top-down approach is company
analysis.
• The Goal is: to estimate share’s intrinsic value.
– Value justified by fundamentals.
457
• Earnings multiple could also be used:
P0=estimated EPS  justified P/E ratio
• Stock is under- (over-) valued if intrinsic value is
larger (smaller) than current market price.
• Focus on earnings and P/E ratio;
– Dividends paid from earnings.
– Close correlation between earnings and stock
price changes.
458
Accounting Aspects of Earnings
• Financial statements provide majority of financial
information about firms.
• Analysis implies comparison over time or with
other firms in the same industry.
• Focus on how statements used, not made.
459
• Balance Sheet:
– Items listed in order of liquidity or in order of
payment.
– Assets:
• Cash VS non-cash assets.
– Non-cash assets may be worth more or
less than carried on books.
• Depreciation methods for fixed assets.
• Inventory evaluation choices.
460
• Balance Sheet:
– Liabilities:
• Fixed claims against the firm.
– Picture at one point in time.
461
– Equity:
• Residual.
• Adjusts when the value of assets change.
• Linked to Income Statement.
462
• Earnings per share:
– EPS =Net Income / average number of shares
outstanding
– Auditors do not guarantee the accuracy of
earnings but only that statements are fair
financial representation.
463
Problems with Reported Earnings
• EPS for a company is not a precise figure that is
readily comparable over time or between
companies.
– Alternative accounting treatments used to
prepare statements.
– Difficult to gauge the ‘true’ performance of a
company with any one method.
– Investors must be aware of these problems.
464
Analyzing a Company’s Profitability
• Return on Equity (ROE):
• It is key component in finding earnings and
dividend growth
EPS =ROE  Book value per share
– Important to determine whether a company’s
profitability is increasing or decreasing and
why.
465
Du Pont Analysis
• Share prices depend partly on ROE.
• Management can influence ROE.
• Decomposing ROE into its components allows
analysts to identify adverse impacts on ROE and
to predict future trends.
• Highlights expense control, asset utilization, and
debt utilization.
466
Du Pont Analysis
• ROE depends on the product of:
1) Profit margin on sales: EBIT/Sales.
2) Total asset turnover: Sales/Total Assets.
3) Interest burden: Pre-tax Income/EBIT.
4) Tax burden: Net Income/Pre-tax Income.
5) Financial leverage: Total Assets/Equity.
• ROE =EBIT efficiency  Asset turnover 
Interest burden  Tax burden  leverage
467
• Expected EPS is of the most value.
• Stock price is a function of future earnings and
the P/E ratio.
– Investors estimate expected growth in
dividends or earnings by using quarterly and
annual EPS forecasts.
• Estimating internal growth rate.
EPS1=EPS0(1+g)
468
• Internal strength.
• Intrinsic value.
• Worth of company based on fundamental
values.
• Value of company based on return on equity.
469
Estimating an Internal Growth Rate
– Only reliable if company’s current ROE
remains stable.
• What matters is the future growth rate, not the
historical growth rate.
470
Forecasts of EPS
• Analysts are still frequently wrong.
• Evidence favors analysts over statistical models
in predicting what actual reported earnings will
be different.
471
Earnings Surprises
• Stock prices affected by;
– Level and growth in earnings.
– Market’s expectation of earnings.
• What is the role of expectations in selecting
stocks?
– Old information will be incorporated into stock
prices if market is efficient.
– Unexpected information implies revision.
472
Using Earnings Estimates
• The surprise element in earnings reports is what
really matters.
• Stocks with revisions of 5% or more -up or down
- often show above or below-average
performance.
473
The P/E Ratio
• Measures how much investors currently are
willing to pay per dollar of earnings.
– A relative price measure of a stock.
• A function of expected dividend payout ratio,
required rate of return, expected growth rate in
dividends.
474
Dividend Payout Ratio
• Dividend levels usually maintained.
– Decreased only if no other alternative.
– Not increased unless can be supported.
– Adjust with a lag to earnings.
• The higher the expected payout ratio, the higher
the P/E ratio.
– Growth rate will probably decline, adversely
affecting the P/E ratio.
– Dividend being paid out from current income.
475
Required Rate of Return
• A function of riskless rate and risk premium.
k = RF + Risk premium
• Constant growth version of dividend discount
model can be rearranged so that.
k = (D1/P0) +g
– Growth forecasts are readily available.
476
• Risk premium of a stock is a composite of
business, financial, and other risks.
• If the risk premium falls, then k will fall and P0
will rise.
• If the risk premium rises, then k will rise and P0
will fall.
• If RF rises (falls), then k will rise (fall) and P0 will
fall (rise).
• Discount rates and P/E ratios move inversely to
each other.
477
Expected Growth Rate
• Function of return on equity and the retention
rate.
g = ROE  (1- Payout ratio)
– The higher the g, the higher the P/E ratio.
• P/E ratio depends on;
– Confidence that investors have in expected
growth.
– Reasons for earnings growth.
478
– Investors confidence develops on P/E
multiples.
– Future has to be anticipated on the basis of
higher dividend payout ratio, higher expected
growth rate and higher P/E ratio.
479
Fundamental Security Analysis in
Practice
• Regardless of detail and complexity, analysts
and investors seek an estimate of earnings and
a justified P/E ratio to determine intrinsic value.
• Security analysis always involves predicting an
uncertain future and mistakes will be made and
outlooks will differ.
480
Overview of Financial
Statements
• Balance Sheet.
• Income Statement.
• Statement of Cash Flows.
• Statement of Retained Earnings.
481
Balance Sheet
• Highlights the financial condition of a company
at a single point in time.
• This is important, the cash flow and income
statements record performance over a period of
time.
• While the balance sheet is a snapshot in time.
• It lists all of the assets held by a company in
addition to the portion of those assets that are
financed by debt (liabilities) or equity (retained
earnings and stock).
482
Income Statement
• Tells you how much money a company brought
in (its revenues).
• How much it spent (its expenses).
• The difference between the two (its profit/loss),
over a specified time.
• Expenses < income it is profit.
• Expenses > income it is loss.
• Includes figures such as revenue, net income,
and earnings per share (EPS).
483
Statement of Cash Flow
• Similar to the income statement.
• However, the income statement also takes
into account some non-cash accounting
items such as depreciation.
• The cash-flow statement strips away all of
this and tells you how much actual money
the company has generated.
• Cash flow shows us how the company has
performed in managing inflows and outflows
of cash.
• It provides a sharper picture of the
company's ability to pay bills, creditors, and
finance growth. 484
Understanding Financial Statements
Understanding the Balance Sheet
VALUATIONS
• The balance sheet is one of the most important
financial statements of a company.
• It is reported to investors on quarterly,
semiannually and yearly basis.
• The balance sheet provides information on what
the company owns (its assets), what it owes (its
liabilities), and the value of the business to its
stockholders (the shareholders' equity).
485
Why Balance Sheet Is Important?
• The balance sheet is the fundamental report of a
company's possessions, debts and capital
invested.
• Before investing in any company, an investor
can use the balance sheet to examine the
following:
– Can the firm meet its financial obligations?
– How much money has already been invested
in this company?
486
– Is the company overly indebted?
– What kind of assets has the company
purchased with its financing?
487
Basic Concept behind a Balance Sheet
• In order to acquire assets, a firm must pay for

them with either debt (liabilities) or with the
owners' capital (shareholders' equity).
Assets = Liabilities + Shareholders' Equity
488
Example
Total Liabilities Rs. 30,000

Shareholders' Equity 50,000
Total Assets 80,000
489
Items in Balance Sheet
Assets:
• Current Assets:
• Current assets are assets that are usually
converted to cash within one year.
– Cash is the most basic current asset. In
addition to currency, bank accounts without
restrictions, checks and drafts are also
considered cash due to the ease in which one
can turn these instruments into currency.
490
– Cash Equivalents are not cash but can be
converted into cash so easily that they are
considered equal to cash. Cash equivalents
are generally highly liquid, short-term
investments such as shot-term government
securities and money market funds.
491
Assets
– Accounts receivable represent money
customers owe to the firm. As more and more
business is being done today with credit
instead of cash, this item is a significant
component of the balance sheet.
492
– Inventory is the stock of materials used to
manufacture their products and the products
themselves before they are sold. A
manufacturing entity will often have three
different types of inventory: raw materials,
works-in-process, and finished goods. A retail
firm's inventory generally will consist only of
products purchased that have not been sold
yet.
493
INVESTMENT ANALYSIS
&
Lecture # 18
• Valuations
• Different Techniques
495
Using Earnings Estimates
• The surprise element in earnings reports is what
really matters.
• There is a lag in adjustment of stock prices to
earnings surprises.
• Stocks with revisions of 5% or more -up or down
- often show above or below-average
performance.
496
• EPS.
• Intrinsic Value of Shares.
• Balance Sheet.
• Three Products in Balance Sheet.
497
The P/E Ratio
• Confidence of the investors in the company’s
future.
• Higher the P\E ratio higher the confidence level
of the investors in the company’s future.
• A function of expected dividend payout ratio,
required rate of return, expected growth rate in
dividends.
498
Dividend Payout Ratio
• Dividend levels usually maintained.
– Decreased only if no other alternative.
– Not increased unless can be supported.
– Adjust with a lag to earnings.
• The higher the expected payout ratio, the
higher the P/E ratio.
– Growth rate will probably decline, adversely
affecting the P/E ratio.
499
• Function of return on equity and the
retention rate.
g = ROE  (1- Payout ratio)
– The higher the g, the higher the P/E ratio.
• P/E ratio depends on;
– Confidence that investors have in expected
growth.
– Reasons for earnings growth.
500
Fundamental Security
Analysis in Practice
• Security analysis always involves predicting an
uncertain future and mistakes will be made and
outlooks will differ.
• Regardless of detail and complexity, analysts
and investors seek an estimate of earnings and
a justified P/E ratio to determine intrinsic value.
501
Overview of Financial
Statements
• Balance Sheet.
• Statement of Cash Flows.
• Statement of Retained Earnings.
502
Basic Concept behind a Balance Sheet
• In order to acquire assets, a firm must pay for

them with either debt (liabilities) or with the
owners' capital (shareholders' equity).
Assets = Liabilities + Shareholders' Equity
503
Example
Total Liabilities Rs. 30,000
Shareholders' Equity 50,000
Total Assets 80,000
504
Balance Sheet
• Highlights the financial condition of a company
at any single point of time. This is important, the
cash flow and income statements record
performance over a period of time, while the
balance sheet is a snapshot in time.
• It lists all of the assets held by a company in
addition to the portion of those assets that are
financed by debt (liabilities) or equity (retained
earnings and stock).
505
Income Statement
• Tells you how much money a company brought
in (its revenues), how much it spent (its
expenses), and the difference between the two
(its profit/loss), over a specified time.
• Includes figures such as revenue, net income,
and earnings per share (EPS).
506
Statement of Cash Flow
• Similar to the income statement.
• However, the income statement also takes into
account some non-cash accounting items such
as depreciation.
• The cash-flow statement strips away all of this
and tells you how much actual money the
company has generated.
• Cash flow shows us how the company has
performed in managing inflows and outflows of
cash. It provides a sharper picture of the
company's ability to pay bills, creditors, and
finance growth.
507
VALUATIONS
Understanding Financial Statements
Understanding the Balance Sheet
• The balance sheet is one of the most important
financial statements of a company.
• It is reported to investors on quarterly,
semiannually and yearly basis.
• The balance sheet provides information on what
the company owns (its assets), what it owes (its
liabilities), and the value of the business to its
stockholders (the shareholders' equity).
508
• The balance sheet is the fundamental report of a
company's possessions, debts and capital
invested.
following:
in this company?
purchased with its financing? 509
• Assets.
• Current Assets.
– Cash.
– Cash Equivalent.
510
Assets
Current Assets:
Current assets are assets that are usually
considered cash due to the ease in which one
can turn these instruments into currency.
511
Cash Equivalents are not cash but can be
considered equal to cash. Cash equivalents are
generally highly liquid, short-term investments
such as short-term government securities and
money market funds.
512
yet. 513
• Assets.
• Long-Term Assets.
– Fixed Assets.
– Intangible Assets.
514
Assets
Long-Term Assets:
Long-term assets are grouped into several
categories. The following are some of the
common terms may be encounter:
515
– Fixed assets are those tangible assets with a
useful life greater than one year.
– Generally, fixed assets refer to items such as
equipment, buildings, production plants and
property.
– On the balance sheet, these are valued at
their cost.
– Depreciation is subtracted from all except
land.
– Fixed assets are very important to a company
because they represent long-term illiquid
investments that a company expects will help
it generate profits. 516
– Intangible assets are non-physical assets
such as copyrights, franchises and patents.
– To estimate their value is very difficult
because they are intangible.
– Often there is no ready market for them.
– Nevertheless, for some companies, an
intangible asset can be the most valuable
asset it possesses.
517
Liabilities
• Current liabilities:
– Current Liabilities are those obligations that
are usually paid within the year, such as
accounts payable, interest on long-term
debts, taxes payable, and dividends payable.
– Because current liabilities are usually paid
with current assets, as an investor it is
important to examine the degree to which
518
– Accounts payable are debts owed to
suppliers for the purchase of goods and
services on an open account.
– Almost all firms buy some or all of their goods
on account.
– Therefore, you will often see accounts
payable on most balance sheets.
519
• Long-term debt:
– Long-term debt is a liability of a period greater
than one year. It usually refers to loans a
company takes out.
– These debts are often paid in installments. If
this is the case, the portion to be paid off in
the current year is considered a current
liability.
– We are able to use the current liability as the
method of offsetting a long term liability.
520
Shareholders' Equity:
• Shareholders' equity is the value of a business
to its owners after all of its obligations have been
met.
• This net worth belongs to the owners.
• Shareholders' equity generally reflects the
amount of capital the owners invested plus any
profits that the company generates that are
subsequently reinvested in the company.
• This reinvested income is called retained
earnings.
521
Balance Sheet Analysis
• The analysis of a balance sheet can
• These may signify the company's inability
to meet financial obligations.
• An investor could also spot the degree to
which a company is leveraged, or
indebted.
522
Understanding the Income Statement
• A company's income statement is a record of its
earnings or losses for a given period.
• It shows all of the money a company earned
(revenues) and all of the money a company
spent (expenses) during this period.
• It also accounts for the effects of some basic
accounting principles such as depreciation.
• The income statement is important for investors
because it's the basic measuring stick of
profitability.
523
Understanding the Income Statement
• A company with little or no income has little or no
money to pass on to its investors in the form of
dividends.
• If a company continues to record losses for a
sustained period, it could go bankrupt.
• On the other hand, a company that realizes
large profits will have more money to pass on to
its investors.
524
Items in Income Statement
Net Sales:
• Net sales are the total revenue generated from
the sales of all the company's products or
services minus an allowance for returns,
rebates, etc.
Cost of Goods Sold:
• Cost of goods sold is what the company spent
to make the things it sold. Cost of goods sold
includes the money the company spent to buy
the raw materials needed to produce its
products, the money it spent on manufacturing
its products and labor costs. 525
Gross Profit on Sales:
• Gross profit on sales (also called gross margin)
is the difference between all the revenue the
company earns and the sales of its products
minus the cost of what it took to produce them.
Gross Profit on Sales = Net Sales - Cost of Goods
Sold
• Gross profit on sales is important because it
reveals the profitability of a company's core
business.
526
• Core business results are important.

• Core business sales are important.
• Core business profits are important.
527
Operating Income:
• Operating income is a company's earnings from
its core operations after it has deducted its cost
of goods sold and its general operating
expenses.
• Operating income does not include interest
expenses or other financing costs.
• Nor does it include income generated outside
the normal activities of the company, such as
income on investments or foreign currency
gains.
528
Depreciation:
• Depreciation is the gradual loss in value of
equipment and other tangible assets over the
course of its useful life.
Earnings Before Interest and Taxes:
• Earnings before interest and taxes (EBIT) is the
sum of operating and non-operating income.
EBIT = Operating Income +(-) Other Income (Loss) +(-)
Extraordinary Income (Loss)
529
Other Income:
• Other income generally refers to income
generated outside the normal scope of a
company's typical operations.
• It includes ancillary activities such as renting an
idle facility or foreign currency gains.
• This income may happen on an annual basis,
but it is considered unrelated to the company's
typical operations.
530
Extraordinary Income (or loss):
• Extraordinary income (or loss) occurs when
money is gained (or lost) resulting from an event
that is deemed both unusual and infrequent in
nature.
• Example.
• Such extraordinary happenings could include
damages from a natural disaster or the early
repayment of debt.
531
Interest Expenses:
• Interest expense refers to the amount of interest
a company has paid to its debtors in the current
year.
Net Earnings (or Loss)
• Net earnings or net income measures the
amount of profit a company makes after all of its
income and all of its expenses.
• It also represents the total amount that may be
distributed to its shareholders.
532
Dividend:
• Dividends are cash payments made to the
owners or stockholders of the company.
• A profitable year allows them to make such
payments, although there generally are no
obligations to make dividend payments.
• When a company has both common and
preferred stockholders, the company has two
different types of dividends to pay.
533
Retained Earnings:
• Retained earnings are the amount of money that
a company keeps for future use or investment.
• Another way to look at it is as the earnings left
over after dividends are paid out.
Retained Earnings = Net Earnings - Dividends
534
The Importance of the Income
Statement
• The income statement provides the investor with
much insight to the company's revenues and
expenses.
• You can identify where the company spends
much of its income and compare that to similar
companies.
• You can also compare a company's performance
with previous years.
535
Statement
• Most importantly, the income statement tells an
investor if the business is profitable.
• If the company continually makes substantial
profits, it indicates to bondholders that it is a
stable company.
• The savvy investor will compare income
statements of similar companies.
536
Cash Flow Statement
Relationship between CFS and
Balance Sheet
• CFS explains the change in the cash and
the cash equivalents in detail it reconciles
the opening and the closing balance of
cash and cash equivalents.
537
Analysis of Cash Flow Statement
• A statement of CFS assist investors, creditors,
shareholders and other users of financial
statement to analyze the following;
• The companies ability to generate the positive
cash flows.
• The companies ability to meet its obligations.
• The companies need for external finances.
538
• CFS in conjunction with the balance sheet
provides information on liquidity, viability and
financial adaptability of company.
• It gives indication of relationship between
profitability and cash generating ability.
• Buy and Hold strategy in a stock market.
539
INVESTMENT ANALYSIS
&
Lecture # 19
• The balance sheet is the fundamental report of
a company's possessions, debts and capital
invested.
following:
in this company?
purchased with its financing? 541
Assets
Current Assets:
Current assets are assets that are usually
considered cash due to the ease in which
one can turn these instruments into currency.
542
Cash Equivalents are not cash but can be
considered equal to cash. Cash equivalents are
generally highly liquid, short-term investments
such as short-term government securities and
money market funds.
543
yet. 544
Assets
• Long-Term Assets:
– Long-term assets are grouped into several
categories. The following are some of the
common terms may be encounter:
545
– Fixed assets are those tangible assets with a
useful life greater than one year. Generally,
fixed assets refer to items such as equipment,
buildings, production plants and property. On
the balance sheet, these are valued at their
cost. Depreciation is subtracted from all
except land. Fixed assets are very important
to a company because they represent long-
term illiquid investments that a company
expects will help it generate profits.
546
– Intangible assets are non-physical assets
such as copyrights, franchises and patents. To
estimate their value is very difficult because
they are intangible. Often there is no ready
market for them. Nevertheless, for some
companies, an intangible asset can be the
most valuable asset it possesses.
547
Liabilities:
Current liabilities:
Current Liabilities are those obligations that are
usually paid within the year, such as accounts
payable, interest on long-term debts, taxes
payable, and dividends payable. Because
current liabilities are usually paid with current
assets, as an investor it is important to examine
the degree to which current assets exceed
current liabilities.
548
– Accounts payable are debts owed to
suppliers for the purchase of goods and
services on an open account. Almost all firms
buy some or all of their goods on account.
Therefore, you will often see accounts
payable on most balance sheets.
549
• Long-term debt:
Long-term debt is a liability of a period greater
than one year. It usually refers to loans a
company takes out. These debts are often paid
in installments. If this is the case, the portion to
be paid off in the current year is considered a
current liability.
550
Shareholders' Equity:
• Shareholders' equity is the value of a business
to its owners after all of its obligations have been
met. This net worth belongs to the owners.
Shareholders' equity generally reflects the
amount of capital the owners invested plus any
profits that the company generates that are
subsequently reinvested in the company. This
reinvested income is called retained earnings.
551
Balance Sheet Analysis
• The analysis of a balance sheet can identify
potential liquidity problems.
552
Understanding the Income
Statement
• A company's income statement is a record of its
earnings or losses for a given period.
• It shows all of the money a company earned (revenues)
and all of the money a company spent (expenses)
during this period.
• It also accounts for the effects of some basic accounting
principles such as depreciation.
• The income statement is important for investors
because it's the basic measuring stick of profitability.
• A company with little or no income has little or
no money to pass on to its investors in the form
of dividends.
553
Understanding the Income
Statement
• If a company continues to record losses for a
sustained period, it could go bankrupt.
• On the other hand, a company that realizes
large profits will have more money to pass on to
its investors.
554
Net Sales:
• Net sales are the total revenue generated from
the sale of all the company's products or
services minus an allowance for returns,
rebates, etc.
Cost of Goods Sold:
• Cost of goods sold is what the company spent
to make the things it sold. Cost of goods sold
includes the money the company spent to buy
the raw materials needed to produce its
products, the money it spent on manufacturing
its products and labor costs.
555
Gross Profit on Sales:
• Gross profit on sales (also called gross margin)
is the difference between all the revenue the
company earns and the sales of its products
minus the cost of what it took to produce them.
Gross Profit on Sales = Net Sales - Cost of Goods
Sold
• Gross profit on sales is important because it
reveals the profitability of a company's core
business.
556
Operating Income:
• Operating income is a company's earnings from
its core operations after it has deducted its cost
of goods sold and its general operating
expenses.
• Operating income does not include interest
expenses or other financing costs.
• Nor does it include income generated outside
the normal activities of the company, such as
income on investments or foreign currency
gains.
557
Depreciation:
• Depreciation is the gradual loss in value of
equipment and other tangible assets over the
course of its useful life.
Earnings Before Interest and Taxes:
• Earnings before interest and taxes (EBIT) is the
sum of operating and non-operating income.
EBIT = Operating Income +(-) Other Income (Loss) +(-)
Extraordinary Income (Loss)
558
Other Income:
• Other income generally refers to income
generated outside the normal scope of a
company's typical operations.
• It includes ancillary activities such as renting an
idle facility or foreign currency gains.
• This income may happen on an annual basis,
but it is considered unrelated to the company's
typical operations.
559
Extraordinary Income (or loss):
• Extraordinary income (or loss) occurs when
money is gained (or lost) resulting from an event
that is deemed both unusual and infrequent in
nature.
• Examples of such extraordinary happenings
could include damages from a natural disaster or
the early repayment of debt.
560
Interest Expenses:
• Interest expense refers to the amount of interest
a company has paid to its debtors in the current
year.
Net Earnings (or Loss):
• Net earnings or net income measures the
amount of profit a company makes after all of its
income and all of its expenses. It also represents
the total amount that may be distributed to its
shareholders.
561
Dividend:
• Dividends are cash payments made to the
owners or stockholders of the company.
• A profitable year allows them to make such
payments, although there generally are no
obligations to make dividend payments.
• When a company has both common and
preferred stockholders, the company has two
different types of dividends to pay.
562
Retained Earnings:
• Retained earnings are the amount of money that
a company keeps for future use or investment.
• Another way to look at it is as the earnings left
over after dividends are paid out.
Retained Earnings = Net Earnings - Dividends
563
Statement
• The income statement provides the investor with
much insight to the company's revenues and
expenses.
• You can identify where the company spends
much of its income and compare that to similar
companies.
• You can also compare a company's performance
with previous years.
564
Statement
• Most importantly, the income statement tells an
investor if the business is profitable.
• If the company continually makes substantial
profits, it indicates to bondholders that it is a
stable company.
• The savvy investor will compare income
statements of similar companies.
565
Cash Flow Statement
Relationship between CFS and
Balance Sheet
• CFS explains the change in the cash and
the cash equivalents in detail it reconciles
the opening and the closing balances of
cash and cash equivalents.
566
• A statement of CFS assist investors, creditors,
shareholders and other users of financial
statement to analyze the following;
• The companies ability to generate the positive
cash flows.
• The companies ability to meet its obligations.
• The companies need for external finances.
567
• CFS in conjunction with the balance sheet
provides information on liquidity, viability and
financial adaptability of company.
• It gives indication of relationship between
profitability and cash generating ability.
568
Managing Cash Flows
Management’s basic responsibility is to insure
that the company has enough cash to meet its
obligations.
• Management prepares cash budget and
forecasts future cash flows.
• It helps the management to plan in advance by
providing them the resources at their disposal
and the results they are expected to achieve.
569
Managing Cash Flows
• Future is unobservable.
• Factors.
• Opportunity & Threats.
• Strengths & Weaknesses.
• Income & Expenses.
• Reserves.
570
Cash Management
• Provides target in evaluating departmental
performance and warnings of potential cash
shortages.
• Budgeting of Future cash flows is an important
tool while evaluating the viability of a new
investment / project.
• It also helps in identifying the time and amount
of funds needed.
• Positive inflows.
• Negative outflows.
571
Discounted Cash Flows
• Future cash flows give pay back period of the
investment made.
• Return on average investment (ROI) is the
annual net income from an average investment
expressed as a percentage of average amount
invested.
572
• The present value of an investments future cash
flows is the maximum amount that investor
should be willing to pay for the investment.
• An investment is considered desirable when
cost is less then the present value of the future
cash flows.
• The higher the required rate of return for a
particular investment the less investor would be
willing to pay for the investment.
573
Discounted cash flows
• Inflation.
• Time.
• Time Management.
Following is required to arrive at the present
value figure;
• The amount of future cash flows.
• Length of time, an investor must wait to receive
the cash flow.
• The discount rate.
• Discount rate are always changed.
574
Financial Analysis
575
• Ratios.
• Liquidity.
• Balance Sheet.
• Items in Balance Sheet.
• Statement of cash flows.
576
GATHERING INFORMATION
Research Philosophy
• Know Thyself.
• Screening.
• A research philosophy is helpful in making the
best use of research time.
• Many analysts use a combination of
fundamental, technical, and wise man
techniques.
577
GATHERING INFORMATION
Research Philosophy
• Regardless of the approach taken, analysts /
investors need to decide upon what type of
information they want to gather and to be clear
why this information should be useful.
• Screening is necessary in order to reduce the
huge number of possible investments to a
smaller number that can investigated carefully.
578
Resources at the Library
• Economic financial Newspapers.
• Standard & Poor’s Publications.
• Mergent / Moody’s Publications.
• They are competitors and their services largely
duplicate each other.
579
Websites
580
Resources at the Library
Company Information:
• Annual Reports.
• SEC Filings.
• The Prospectus.
• Objective.
581
The Stock Exchanges
The Karachi Stock Exchange.
• www.kse.com.pk
Lahore Stock Exchange.
• www.lahorestock.com
Islamabad Stock Exchange.
• www.ise.com.pk
582
Computer/Internet Services
Screening Services
• Brokerage Firms.
• Investment Seminars.
• Bank Trust Departments.
• Employee Relation Programs.
• Exchange Seminar.
583
INVESTMENT LETTERS
Advisory Letters
The Popular Press
OTHERS:
• Earnings forecasts are the meat of the
I/B/E/S and Zack’s services.
• A great many other sources of information
are available through magazines,
newspapers, or television shows.
584
INVESTMENT ANALYSIS
&
Lecture # 20
• Financial Statements
• Balance Sheet
• Cash Flow Statement
• Statement of Retained Earnings
• Profit & Loss Account
586
NEW Managing Cash Flows
Management’s basic responsibility is to insure
that the company has enough cash to meet its
obligations.
• Management prepares cash budget and
forecasts future cash flows.
• Cash Flow Management is important because it
is paramount to be able to manage cash.
• Cash inflows and cash outflows must be
balanced.
587
Cash Management
• Provides target in evaluating departmental
performance and warnings of potential cash
shortages.
• Budgeting of Future cash flows is an important
tool while evaluating the viability of a new
investment / project.
• It also helps in identifying the time and amount
of funds needed.
588
• Future cash flows give pay back period of the
investment made.
• Return on average investment (ROI) is the
annual net income from an average investment
expressed as a percentage of average amount
invested.
589
• The present value of an investments future cash
flows is the maximum amount that investor
should be willing to pay for the investment.
• An investment is considered desirable when
cost is less then the present value of the future
cash flows.
• The higher the required rate of return for a
particular investment the less investor would be
willing to pay for the investment.
590
Discounted cash flows
Following is required to arrive at the present
value figure;
• The amount of future cash flows.
• Length of time, an investor must wait to
receive the cash flow.
• The discount rate.
• Time.
• Inflation.
591
NEW GATHERING INFORMATION
Research Philosophy
• Know Thyself.
• Screening.
592
NEW GATHERING INFORMATION
Research Philosophy
• A research philosophy is helpful in making the
best use of research time.
• Many analysts use a combination of
fundamental, technical, and wise man
techniques.
• Regardless of the approach taken,
analysts/investors need to decide upon what
type of information they want to gather and to be
clear why this information should be useful.
• Screening is necessary in order to reduce the
huge number of possible investments to a
smaller number that can investigated carefully.
593
Company Information
• The Prospectus.
• Annual Reports.
594
Computer/Internet Services
Screening Services
Investment Seminars
• Brokerage Firms
• Bank Trust Departments
• Employee Relation Programs
• Exchange Seminar
595
Notes
596
Indirect Investing
• Alternative to direct investment in or ownership
of securities.
• Refers to buying and selling the shares of
intermediaries that hold securities in portfolio.
– Shares are ownership interest in portfolio
entitled to portfolio income.
– Shareholders also pay expenses.
597
Investment Companies
• Financial firm that sells shares to the public and
uses the proceeds to invest in marketable
securities.
– Acts as conduit for distribution of dividends,
interest, and realized gains.
– Can elect to pay no federal taxes on
distributions.
– Offers professional management.
598
Company Types
• Unit investment trusts: Typically holds an
managed, fixed-income portfolio.
– Assets not actively traded once purchased.
– Trust ceases to exist when securities mature
– Passive investment.
– Active investment.
599
Professionals
• Consultants
• Asset Managers
• Portfolio Managers
• Financial Managers
• Accountants
• We need somebody to handle cash for us.
600
Banks
• Fixed rate of return
• Acceptable to some or couldn't be acceptable to
other depending on their impression about the
procedure, payouts and the impact on your
incomes.
601
• Bonds
• Term Finance Certificates
• Certificate of Investment
• Prize Bonds
• Shares
• Mutual Funds Industry
602
Mutual Fund
• Mutual Fund is a basket of shares bought for
you by an asset management company.
• Diversified product.
• It is a collection of different marketable
securities.
• Shares
• Foreign exchange
603
Mutual Fund
• Money market
• Real Estate Income Funds
• Cash
• Short-Term Deposits
• 60% funds for Shares
• 25% funds for Bonds
• 15% funds for Cash
604
Mutual Fund
OR
• 5% funds for Cash

• 20% funds for Bonds
• 75% funds for Shares
605
Asset Management Company
606
• Function of Asset Management Companies
• Are they being good to the investors and
whether they are changing excessively.
• Variations
• Funds
607
Closed – End Funds
• Authorized Capital
• Paid-up Capital
608
Open – End Funds
• Shares continue to be sold to the public at NAV
after initial sale that capitalizes the company.
• Net Asset Value: Total market value of the
security portfolio divided by total shares.
– Shares may be sold back to company at NAV
– Company size constantly changes
– Popularly called mutual funds
609
Mutual Fund Categories
• Money market mutual funds invest in portfolio of
money market securities.
– Taxable or tax-exempt.
– Commercial paper important investment.
– Average maturity limit: 90 days.
– Investors pay a management fee but not a
sales or redemption charge (load).
– Not insured by the federal government.
610
• Equity, bond, and income mutual funds invest in
portfolio of securities consistent with the
objectives of the fund.
– Returns.
– Objectives set by the company’s board.
– Disclosure of objectives to investors.
– Major categories of investment objectives.
611
Equity Funds
• Most assets in equity funds rather than bond or
income funds.
• Most equity funds are either:
– Value funds
– Growth funds
612
Equity Funds
– Value funds, which invest in undervalued
stocks as determined by fundamental
financial analysis.
– Growth funds, which invest in stocks of firms
expected to show future rapid earnings
growth.
613
Cost Considerations
• Closed-end fund prices may be at a discount or
premium to NAV.
– Liquidation value different than price.
• “Load” funds charge a front-end fee to cover the
costs of selling the fund to investors.
– May also be a redemption (back-end) fee or
distribution fee (called 12b-1 fee).
614
Cost Considerations
• All fees must be stated in the mutual fund
prospectus.
• No-load funds are purchased at NAV directly
from the investment company.
– No sales force expense to cover.
– Investors must seek out funds.
– Still an annual operating expense paid out of
fund income.
615
Performance
• Reported on a regular basis in the popular
press.
• Measured over a given time period as a percent
of initial investment.
– Total returns include reinvested dividends and
capital gains.
– Average annual return reflects the mean
compound growth rate of investment over a
given time period.
616
International Funds
• Some mutual funds specialize in international
securities.
– US investors can participate in emerging
market economies.
– International funds or global funds emphasize
international stocks.
– Single-country funds concentrate assets.
• Actively or passively managed.
617
• Capital gains
• Supplementing their income
• Excitement
618
Exchange – Traded Funds
619
INVESTMENT ANALYSIS
&
Lecture # 21
Indirect Investing
• Alternative to direct investment in or
ownership of securities.
• Refers to buying and selling the shares of
intermediaries that hold securities in
portfolio.
– Shares are ownership interest in portfolio
entitled to portfolio income.
– Shareholders also pay expenses.
621
• Financial firm that sells shares to the
public and uses the proceeds to invest in
marketable securities.
– Acts as conduit for distribution of dividends,
interest, and realized gains.
– Can elect to pay no federal taxes on
distributions.
– Offers professional management.
622
Company Types
• Unit investment trusts: Typically holds an
managed, fixed-income portfolio.
– Assets not actively traded once purchased.
– Trust ceases to exist when securities mature.
– Passive investment.
623
Closed-Ended Funds
• Mutual funds with fixed paid up capital.

• Fixed authorized capital.
624
Open-Ended Funds
• Shares continue to be sold to the public at
NAV after initial sale that capitalizes the
company.
– Shares may be sold back to company at NAV.
– Company size constantly changes.
– Popularly called mutual funds
625
• Money market mutual funds invest in portfolio of
money market securities.
– Average maturity limit: 90 days.
– Investors pay a management fee but not a
sales or redemption charge (load).
– Not insured by the federal government.
– Taxable or tax-exempt.
– Commercial paper important investment.
626
• Equity, bond, and income mutual funds invest in
portfolio of securities consistent with the
objectives of the fund.
– Objectives set by the company’s board.
– Disclosure of objectives to investors.
– Major categories of investment objectives.
627
Equity Funds
• Most assets in equity funds rather than bond or
income funds.
• Most equity funds are either:
– Value funds, which invest in undervalued
stocks as determined by fundamental
financial analysis.
– Growth funds, which invest in stocks of firms
expected to show future rapid earnings
growth.
628
Cost Considerations
• Charges to be paid whenever you buy and sell
shares or whenever you buy or sell units of
mutual funds.
• “Load” funds charge a front-end fee to cover the
costs of selling the fund to investors.
– May also be a redemption (back-end) fee or
distribution fee (called 12b-1 fee).
629
Cost Considerations
• When you redeem the units that would be a

charge that you paying at back end.
• When you buy them from investment you would
be charged in the term called front-end charge.
630
Cost Considerations
• All fees must be stated in the mutual fund
prospectus.
• No-load funds are purchased at NAV directly
from the investment company.
– No sales force expense to cover.
– Investors must seek out funds.
– Still an annual operating expense paid out of
fund income.
631
Performance
• Reported on a regular basis in the popular
press.
• Measured over a given time period as a percent
of initial investment.
– Total returns include reinvested dividends and
capital gains.
– Average annual return reflects the mean
compound growth rate of investment over a
given time period.
632
International Funds
• Some mutual funds specialize in international
securities.
– US investors can participate in emerging
market economies.
– International funds or global funds emphasize
international stocks.
– Single-country funds concentrate assets.
• Actively or passively managed.
633
Exchange-Traded Funds
• Basket of stocks that tracks the value of a
sector, investment style, or market as a whole.
– Characteristics of index mutual funds and
closed-end funds.
• Trades throughout the day on an exchange.
• Bond and equity indexes traded.
• Tax efficient: control over capital gains
distributions.
634
New Directions in Funds
• Mutual fund “supermarkets”:
– Various mutual fund families can be
purchased through a single source.
– Brokerage account may provide access.
– “Supermarket” managers earn fee.
• On-line investment services:
– Internet used to provide mutual fund
information and make transactions.
635
Impact of the Market
• Pervasive and dominant
• The single most important risk affecting the price
movement of common stocks.
– Particularly true for a diversified portfolio of
stocks.
• Accounts for 90% of the variability in a
diversified portfolio’s return.
• Investors buying foreign stocks face the same
situation.
636
• Minimum expected rate of return needed to
induce investment.
– Given risk, a security must offer some
minimum expected return to persuade
purchase.
– Required ROR = RF + Risk premium
– Investors expect the risk free rate as well as a
risk premium to compensate for the additional
risk assumed.
637
Beta
• It is specifically a measure of a volatility of the

stock or mutual fund.
638
Security Market Line
SML • Beta = 1.0 implies as
E(R) risky as market.
• Securities A and B are
A
kM B
more risky than the
market.
C
kRF – Beta >1.0
• Security C is less
risky than the market.
0 0.5 1.0 1.5 2.0 – Beta <1.0
BetaM
639
• Security A and B being more risky because beta

is 1.5 or 2.0
• Security C being less risky having beta of 0.5
640
Understanding the Required
Rate of Return
• Risk-free rate
• RF =Real ROR + Inflation premium
• The risk premium
– Reflects all uncertainty in the asset.
– Nominal RF must contain premium for expected
inflation.
– Interest
– Investment through leverage.
– Real rate of return is basic exchange rate in the
economy.
641
Passive Stock Strategies
• Natural outcome of a belief in efficient markets.
– No active strategy should be able to beat the
market on a risk adjusted basis.
• Emphasis is on minimizing transaction costs and
time spent in managing the portfolio.
– Expected benefits from active trading or
analysis less than the costs.
642
• Buy-and-hold strategy:
– Belief that active management will incur
transaction costs and involve inevitable
mistakes.
– Important initial selection needs to be made.
– Functions to perform: reinvesting income and
adjusting to changes in risk tolerance.
– When we are holding on to investments we
actually saving our cost.
643
• Index funds:
– Mutual funds designed to duplicate the
performance of some market index.
– No attempt made to forecast market
movements and act accordingly.
– No attempt to select under- or overvalued
securities.
– Low costs to operate, low turnover.
644
Active Stock Strategies
• Assumes the investor possesses some
advantage relative to other market participants.
– Most investors favor this approach despite
evidence about efficient markets.
• Identification of individual stocks as offering
superior return-risk tradeoff.
– Selections part of a diversified portfolio.
645
• Majority of investment advice geared to selection
of stocks.
– Value Line Investment Survey.
• Security analyst’s job is to forecast stock returns.
– Estimates provided by analysts.
• expected change in earnings per share,
expected return on equity, and industry
outlook.
– Recommendations: Buy, Hold, or Sell.
646
Sector Rotation
• Similar to stock selection, involves shifting sector
weights in the portfolio.
– Benefit from sectors expected to perform
relatively well and de-emphasize sectors
expected to perform poorly.
• Four broad sectors:
– Interest-sensitive stocks
– Consumer durable stocks
– Capital goods stocks
– Defensive stocks
647
Market Timing
• Market timers attempt to earn excess returns by
varying the percentage of portfolio assets in
equity securities.
– Increase portfolio beta when the market is
expected to rise.
• Success depends on the amount of brokerage
commissions and taxes paid.
– Can investors regularly time the market to
provide positive risk-adjusted returns?
648
INVESTMENT ANALYSIS
&
Lecture # 22
Exchange-Traded Funds
• Basket of stocks that tracks the value of a
sector, investment style, or market as a whole.
– Characteristics of index mutual funds and
closed-end funds.
• Trades throughout the day on an
exchange..
• Bond and equity indexes traded.
• Tax efficient: control over capital gains
distributions.
650
New Directions in Funds
• Mutual fund “supermarkets”
– Various mutual fund families can be
purchased through a single source.
– Brokerage account may provide access.
– “Supermarket” managers earn fee.
• On-line investment services.
– Internet used to provide mutual fund
information and make transactions.
651
Impact of the Market
• Pervasive and dominant.
• The single most important risk affecting the price
movement of common stocks.
– Particularly true for a diversified portfolio of
stocks.
• Accounts for 90% of the variability in a
diversified portfolio’s return.
• Investors buying foreign stocks face the same
situation.
652
• Minimum expected rate of return needed to
induce investment.
– Given risk, a security must offer some
minimum expected return to persuade
purchase.
– Required ROR = RF + Risk premium
– Investors expect the risk free rate as well as a
risk premium to compensate for the additional
risk assumed.
653
SML • Beta = 1.0 implies as
E(R) risky as market.
• Securities A and B are
A
kM B
more risky than the
market.
C
kRF – Beta >1.0
• Security C is less
risky than the market.
0 0.5 1.0 1.5 2.0 – Beta <1.0
BetaM
654
Understanding the Required
Rate of Return
• Risk-free rate.
• RF =Real ROR +Inflation premium
– Real rate of return is basic exchange rate in
the economy.
– Nominal RF must contain premium for
expected inflation.
• The risk premium.
– Reflects all uncertainty in the asset.
655
• Natural outcome of a belief in efficient markets.
– No active strategy should be able to beat the
market on a risk adjusted basis.
• Emphasis is on minimizing transaction costs and
time spent in managing the portfolio.
– Expected benefits from active trading or
analysis less than the costs.
656
• Buy-and-hold strategy:
– Belief that active management will incur
transaction costs and involve inevitable
mistakes.
– Important initial selection needs to be made.
– Functions to perform: reinvesting income and
adjusting to changes in risk tolerance.
657
• Index funds:
– Mutual funds designed to duplicate the
performance of some market index.
– No attempt made to forecast market
movements and act accordingly.
– No attempt to select under- or overvalued
securities.
– Low costs to operate, low turnover.
658
• Assumes the investor possesses some
advantage relative to other market participants.
– Most investors favor this approach despite
evidence about efficient markets.
• Identification of individual stocks as offering
superior return-risk tradeoff.
– Selections part of a diversified portfolio.
659
• Majority of investment advice geared to selection
of stocks.
– Value Line Investment Survey.
• Security analyst’s job is to forecast stock returns
– Estimates provided by analysts.
• expected change in earnings per share,
expected return on equity, and industry
outlook.
660
– Recommendations: Buy, Hold, or Sell

– Company Balance Sheet
– Fundamental Analysis
661
Sector Rotation
• Similar to stock selection, involves shifting sector

weights in the portfolio.
– Benefit from sectors expected to perform
relatively well and de-emphasize sectors
expected to perform poorly.
662
Sector Rotation
• Four broad sectors:

– Interest-sensitive stocks
– Defensive stocks
– Consumer durable stocks
– Capital goods stocks
663
Market Timing
• Market timers attempt to earn excess returns by
varying the percentage of portfolio assets in
equity securities.
– Increase portfolio beta when the market is
expected to rise.
• Success depends on the amount of brokerage
commissions and taxes paid.
– Can investors regularly time the market to
provide positive risk-adjusted returns?
664
The Efficient Market Hypothesis
The essence of the EMH:

So many people watch the marketplace that few,
if any, individuals can consistently make windfall
profits by picking stocks better than the next
person.
665
Efficient Markets
• How well do markets respond to new
information?
• Should it be possible to decide between a
profitable and unprofitable investment given
current information?
• Efficient Markets:
– The prices of all securities quickly and fully
reflect all available information.
666
Efficient Markets and
Active Strategies
• If EMH true:
– Active strategies are unlikely to be successful
over time after all costs.
– If markets efficient, prices reflect fair
economic value.
• EMH Proponents argue that little time should be
devoted to security analysis.
– Time spent on reducing taxes, costs and
maintaining chosen portfolio risk.
667
Conditions for an Efficient Market
• Large number of rational, profit-maximizing

investors.
– Actively participate in the market.
– Individuals cannot affect market prices.
• Information is costless, widely available,
generated in a random fashion.
• Investors react quickly and fully to new
information.
668
Market Efficiency Forms
• Efficient market hypothesis:
– To what extent do securities markets quickly
and fully reflect different available
information?
• Three levels of Market Efficiency:
– Weak form - market level data
– Semi-strong form - public information
– Strong form - all (nonpublic) information
669
The Semi-Efficient Market
Hypothesis
• Security prices already fully reflect all relevant
publicly available information.
• However, insiders can make illegal profits.
670
Weak Form
• Prices reflect all past price and volume data.
• Technical analysis, which relies on the past
history of prices, is of little or no value in
assessing future changes in price.
• Market adjusts or incorporates this information
quickly and fully.
671
Weak Form Evidence
• Test for independence (randomness) of stock
price changes.
– If independent, trends in price changes do not
exist.
– Overreaction hypothesis and evidence.
• Test for profitability of trading rules after
brokerage costs.
– Simple buy-and-hold better.
672
Weak Form Evidence
• Why stock market prices react?

• Stock market prices tend to based their
movements on rumors.
• Facts & Figures.
673
Semi-strong Form
• Prices reflect all publicly available information.
• Investors cannot act on new public information
after its announcement and expect to earn
above-average, risk-adjusted returns.
• Encompasses weak form as a subset.
• Specialized products / models are workable in
specialized working environment.
• EMH is workable in different forms / sectors.
674
Semi-strong Form Evidence
• Event studies:
– Empirical analysis of stock price behavior
surrounding a particular event.
– Examine company unique returns.
• The residual error between the security’s
actual return and that given by the index
model.
675
• Abnormal return (Arit) = Rit – E (Rit)
• Cumulative when a sum of Arit
Residual error between security return & index

return.
676
• Stock Splits
• Accounting Changes
• Initial Public Offerings
• Announcements
• News
• Offer for Sale
677
1. Stock splits:
– Implications of split reflected in price
immediately following the announcement.
– Reverse stock splits
– Forward stock splits
2. Accounting changes:
– Quick reaction to real change in value.
– Depreciation
– Change in procedure
– Change in accounting year
678
Initial public offerings

– Only issues purchased at offer price yield
abnormal returns
679
Announcements and news

– Little impact on price after release
680
Strong Form
• Prices reflect all information, public and private.
• No group of investors should be able to earn
abnormal rates of return by using publicly and
privately available information.
• Encompasses weak and semi-strong forms as
subsets.
681
Strong Form
• Strong form of an efficient market ahs a good

maturity level.
• There will be a level playing field for everybody.
• Everybody will be preview to every information
available to person standing next to you.
682
Strong Form Evidence
• Test performance of groups which have access
to nonpublic information.
– Corporate insiders have valuable private
information.
– Evidence that many have consistently earned
abnormal returns on their stock transactions.
• Insider transactions must be publicly reported.
683
Strong vs. Semi-strong Form
• Strong Form: all relevant publicly, private, inside
information.
• Semi-strong Form: all relevant publicly available

information.
• Considerable empirical research supports the

semi-strong form.
684

Investment Analysis & Portfolio Management: Lecture # 1 DR

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Investment Analysis & Portfolio Management: Lecture # 1 DR

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INVESTMENT ANALYSIS

• PRACTICAL INVESTMENT MANAGEMENT, 3rd

Assets are things that people own.

Financial Assets Real Assets

Equity Fixed Income Derivative

Both saving and investing amount to

However, saving involves little, if any,

Investment means to invest something in

How to manage different sectoral things.

“Don’t Keep all your eggs in one basket”

Mutual fund are also used in the portfolio.

An exchange serves three principal functions:

Banks offer home

Capital markets remove the fear that people have of

Compare against alternative of prices that are not up-to-date:

Dividend is the return whether in the form of

But the advantage of going to the equity market

The primary market is the “new

The secondary market is the “used securities”

Offer For Sale OFS

Philadelphia Stock Exchange (oldest US

• SuperDot is an electronic system enabling NYSE firms to send

• Market makers are groups of competing

Both trading curbs and circuit

Insert Figure 3-5 here.

• In 1970, the Securities Investor Protection Act

• The LIFA Financial Analyst (LIFA) program

• The program is administered by the

• Dividends are an important part of the

• Do not alter the collective wealth of the

Income Stocks are those stocks that have paid a

Cyclical stocks are those stocks whose results are

A defensive stock is largely immune to changes in

Speculative stocks have the potential of

Penny stocks are unusually risky stocks.

• A precise protocol should be followed when

• This protocol helps eliminate uncertainty about

• Limit orders must specify a price limit.

• Helps maintain a fair and orderly market in his/her

The requirement of the regulations is that

• Cash Account (Type 1)

The securities are pledged with the financier and in

Then the shares become the ownership and

buying power =equity-debt balance

• You can buy first and sell later, which is

A Future Market is about trading in the

In derivative market, you can sell in future.

Many firms also provide the facility of making trades via

You have it in printed form. It is a very

A value investor believes that he must wait

• When the asset is disposed off, than good

• Small-cap stocks : A firm with capitalization

• When we do fundamental analysis, we do

• Different industries have different synergies.

• This is a Japanese Candlestick.

• This is an expanded version of bar charts.

• Two common things in candlestick charts are the

• Candlestick chartings also give you a collective

• This is a Point & Figure chart.

• A Point & Figure Charts is a collection of zero’s

• Days do not matter.

Minimum Target Price

The value is 80 to 20.