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UNIT-2:SECURITY ANALYSIS AND VALUATION OF SECURITIES
Factors affecting share prices Fundamental analysis in detail Technical Analysis in detail Macro Economic factors
Factors affecting share prices
Demand AND SUPPLY Market Cap News Earning/Price Ratio
Another important factor affecting stock price
is the earning/price ratio. This gives you a fair idea of a company’s share price when it is compared to its earnings. The stock becomes undervalued if the price of the share is much lower than the earnings of a company. But if this is the case, then it has the potential to rise in the near future. The stock becomes overvalued if the price is much higher than
That is why. unlike stock split. As a result. which in turn will adjust the share price accordingly. the share price drops the same proportion of the number of exercised shares. Although long term investors do not care much about it. these factors are diluting the earnings per share (EPS) of the stock. you have the right to buy shares from a company after the exercise date at specified price. Bonus share issues Warrants exercise With warrants. In general. swing traders. the stock price will normally drops by 10% as well. day trader. its earnings will be diluted as more shares are sharing the same earnings pie. and position traders) should consider these factors . For example. the stock price will get affected if any of the events happen. Unfortunately. stock traders (esp. if the exercised share is 10% of the existing number of shares.
the continuing buying back of share of a company will also acts as a support for the share price that helps to maintain or increase the share price.Take-over or merger Share buy-back The act of share buy-back by a company will reduce the number of share available in the open market. this will normally help increase the share price. Also. The investors may also see the share buy-back by company as a confidence booster for them in the company itself. Due to the law of supply and demand. share buy-back is quite often used as a tool to deliver value to the investors. . a reduction in share available for trading in this case will cause a drop in supply. Therefore.
There are three basic types of market analysis: 1. but to tell you the truth.Market Analysis To begin. Technical Analysis 3. let's look at three ways on how you would analyze and develop ideas to trade the market. you need to know all three. Fundamental Analysis 2. Sentiment Analysis There has always been a constant debate as to which analysis is better. .
Fundamental analysis Fundamental analysis is the stock investing method. . Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. basing on some basic factors. This method is widely used in order to determine intrinsic value of shares in the market. which have a great impact on the changes of stock value. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.
Fundamental Analysis Fundamental analysis the practice of evaluating the information contained in economic factors (economic analysis) industry reports and (industry analysis) financial statements (company analysis) to determine the intrinsic value of a firm .
in the long run.Basic assumptions is that the price on the stock market does not fully reflect a stock’s “real” value. . the stock market will reflect the fundamentals.
Basic philosophy By focusing on a particular business. . an investor can estimate the intrinsic value and find opportunities where he or she can buy at a discount. If all goes well. the investment will pay off over time as the market catches up to the fundamentals.
.The big unknowns are: You don’t know if your estimate of intrinsic value is correct. and You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
Criticisms of Fundamental Analysis The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis believers of the efficient market hypothesis. .
Tax and political system .Local Economy Analysis Inflation Growth Rate (GDP) Currency instability World trade Stock Market Trends Fiscal Trends Foreign Investments Foreign Exchange Reserves Legal.
Economic Analysis Forecasting business cycles to determine when to expect changes in the business cycle.or the direction in which aggregate economic activity is moving .
Economic Analysis Business cycle the movement in aggregate economic activity as measured by the gross domestic product (GDP) Expansion increasing economic activity Contraction decreasing economic activity .
Economic Analysis Gross Domestic Product (GDP) a measure of all of the goods and services produced in the economy during a specified time period Recession two consecutive quarters of economic contraction. in the GDP . or decline.
Business Cycles .Monetary Policy and Fiscal Policy Monetary Policy the means by which the RBI influences economic conditions by managing the nation’s money supply .
Monetary Policy and Fiscal Policy Fiscal Policy Government spending.Business Cycles . which is primarily supported by the government’s ability to tax individuals and businesses .
Business Cycles .Monetary Policy and Fiscal Policy Deficit spending situation that occurs when the government spends more than it collects in taxes .
market share among firms. . competition. regulation and business cycles.Industry Analysis Each industry has differences in terms of its customer base. industry-wide growth.
a military supplier who has 100% of its sales with the Indian government. One change in government policy could potentially wipe out all of its sales. .Industry Analysis Customers Some companies serve only a handful of customers. For example. . while others serve millions.
Market share is important because of economies of scale. .Industry Analysis Market Share Company's present market share can tell volumes about the company's business.
Industry Analysis Industry Growth Examine whether the amount of customers in the overall market will grow. In some markets. This is crucial because without new customers. . there is zero or negative growth. a factor demanding careful consideration. a company has to steal market share in order to grow.
Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.Industry Analysis Competition looking at the number of competitors goes a long way in understanding the competitive landscape for a company. .
. They can drastically affect the attractiveness of a company for investment purposes.Industry Analysis Regulation Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services.
Industry Analysis Industry life cycle the various phases of an industry with respect to its growth in sales and its competitive conditions .
Industry Life Cycle Industr y Sales Expansion (Growth) Introductory Mature Life-Cycle Stages .
Company Analysis Business Model One of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. .
and keep it. . When a company can achieve competitive advantage.Company Analysis Competitive Advantage A company's long-term success is driven largely by its ability to maintain a competitive advantage . its shareholders can be well rewarded for decades.
.Company Analysis Management A company relies upon management to steer it towards financial success. Even the best business model is doomed if the leaders of the company fail to properly execute the plan.
Company Analysis Past Performance Check and see how executives have done at other companies in the past. . Identify the companies they worked at in the past and do a search on those companies and their performance.
.Company Analysis Financial and Information Transparency Sufficient transparency implies that a company's financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company's current financial situation.
80 -“Distress” Zone .2T1 + 1.999T5 T1 T2 T3 T4 T5 = = = = = Working Capital / Total Assets Retained Earnings / Total Assets Earnings before Interest and Taxes / Total Assets Market Value of Equity / Total Liabilities Sales/ Total Assets Zones of Discrimination: Z > 2.3T3 + .6T4 + .Company analysis –Financial performance The company analysis is done on base of fundament analysis which is done on the bases of: Edward Altman’s Z score Z Score Bankruptcy Model: Z = 1.99 -“Grey” Zone Z < 1.4T2 + 3.8 < Z < 2.99 -“Safe” Zone 1.
Price to Earning Ratio The Price to Earnings Ratio (P/E) indicates the relationship between stock prices and company earnings. Price to Sales ratio (P/S) is very helpful for judging new companies. Another method is to divide the current share price by sales per share. but that does not indicate that they are bad investments. P/S ratio indicates the value that the market places on sales. Low earnings and low outstanding shares could be more valuable than high earnings along with a high number of outstanding shares. The P/E indicates how much investors are willing to pay for a particular company's earnings. Lower the P/S. there are other tools that help investors judge its worth. Earnings per Share The overall earnings of a company are not in itself a useful indicator of a particular stock's worth. . In both cases. further analysis needs to be done to determine the accurate value of a particular stock. Earnings per share (EPS) is arrived at by dividing the net earnings by number of outstanding shares. It is calculated by dividing the market cap (stock price times the number of outstanding shares) by the total revenues. New companies in particular mostly have no earnings. The Earnings per share is much more practical information than earnings by itself. A high P/E can mean that the company is overpriced or it could also mean that investors are expecting the company to continue growing and generate profits. better the value. A low P/E can mean that investors are wary of the company or it could also indicate a company that majority of the investors have overlooked. Price to Sales Ratio When a company is having no earnings. It is computed by dividing the share price by the Earnings per Share.
Price to Book Ratio Book value is calculated by subtracting liabilities from assets.e. Generally the older & well-established companies pay a higher percentage. and such companies also have a more consistent dividend history as compared to younger companies. Value of a growing company would always be greater than book value owing to the potential for future revenue. Dividend yield is calculated by dividing annual dividend per share by stock's price per share. . Dividend Yield Certain investors look for stocks that are able to maximize dividend income. Dividend yield is helpful for determining the percentage return that a company pays in form of dividends. book value / number of outstanding shares). Companies having a low P/B are good and often chosen by long term investors who see the company’s potential. The P/B ratio is the value that the market places on book value of the company and is calculated by dividing current price per share by book value per share (i.
irrespective of the industry or region. an analyst starts the search with specific businesses. Top Down Top-down approach: In this approach.How Fundamental Analysis is performed Type of approaches 1. an analyst investigates both national and international economic indicators. price levels and foreign competition in a sector is also done in order to identify the best business in the sector. Bottom Up Bottom-up approach: In this method. 2. inflation and interest rates. . like energy prices. GDP growth rates. The analysis of total sales.
moving to consecutive narrower economic levels until you reach the individual business itself."Top Down" approach for fundamental analysis means beginning your analysis on a Global Macroeconomic level right from the start. .
typically starting with a particular company itself."Bottom Up" approach for fundamental analysis means beginning your analysis on a microeconomic level right from the start. .
Sentiment Analysis .
The market is just like Facebook . Price should theoretically accurately reflect all available market information. it isn't that simple. which are expressed through whatever position they take.it's a complex network made up of individuals who want to spam our news feeds. there's nothing . no matter how strongly you feel about a certain trade. Each trader has his own opinion or explanation of why the market is acting the way they do. Of course. Pipcrawler. you can't move the markets in your favor (unless you're one of the GSs . Kidding aside. the market basically represents what all traders . that isn't how things work. Even if you truly believe that the dollar is going to go up.George Soros or Goldman Sachs!).you. helps form the overall sentiment of the market. The problem is that as traders. Unfortunately for us traders. The markets do not simply reflect all the information out there because traders will all just act the same way. Celine from the donut shop . Each trader's thoughts and opinions. but everyone else is bearish on it.feel about the market.
its management team or the industry that it is in). .Technical Analysis Technical analysis uses a variety of charts and calculations to spot trends in the market and individual stocks and to try to predict what will happen next. they believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysts don't bother looking at any of the qualitative data about a company (for example. instead.
In any case. Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity. and most use some combination of the two. Some rely on chart patterns. others use technical indicators and oscillators. Unlike fundamental . there are also many different types of technical traders. such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value. Just as there are many investment styles on the fundamental side. technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. but instead use charts and other tools to identify patterns that can suggest future activity.
In this section. but first here are a few key terms you should know about: Resistance Level: The opposite of a support level. .Technical analysts use dozens of different quantitative metrics in order to predict stock prices. we'll introduce you to some of the most popular ones and explain to you what they're all about. the level that the technical analyst believes a stock price will not exceed.
Support Level: The level that the technical analyst believes a stock price will not fall below (also sometimes called a "floor") .
it is said to be a "breakout. added to a cumulative total. ." Advance-Decline Line: The total number of advancing issues minus the total number of declining issues.Breakout: If a stock surpasses the resistance level or falls below the support level.
resulting in difficulty comparing statements between firms Many psychological and other non-quantifiable factors do not show up in financial statements .Advantages of Technical Analysis Unlike fundamental analysis. technical analysis is not heavily dependent on financial accounting statements Problems with accounting statements: Lack information needed by security analysts GAAP allows firms to select reporting procedures.
Advantages of Technical Analysis Fundamental analyst must process new information and quickly determine a new intrinsic value. but technical analyst merely has to recognize a movement to a new equilibrium Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust to “correct” prices as quickly .
Challenges to Technical Analysis Challenges to basic assumptions Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends Challenges to technical trading rules Rules that worked in the past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules all require subjective judgement .
Typical Stock Market Cycle Stock Price .
Typical Stock Market Cycle Stock Price Declining Trend Channel Peak Flat Trend Channel Sell Point Rising Trend Channel Buy Point Trough Declining Trend Channel Buy Point Trough .
Tools of Technical Analysis Charting Stocks Bar Charts and Japanese Candlestick Charts Point and Figure Charts Major Chart Patterns Price-based Indicators Volume-based Indicators Dow Theory Elliot Wave .
or point and figure charts to look for patterns which may indicate future price movements. Strict chartists don’t care about fundamentals at all. They also analyze volume and other psychological indicators (breadth. . put/call ratio.). % of bulls vs % of bears.Charting the Market Chartists use bar charts. etc. candlestick.
and filled (some color) on down days Note: You should print the example charts (next two slides) to see them more clearly O pen Low Low C lo s e S ta n d a rd B a r C h a rt Japanese C a n d le s t ic k S ta n d a rd B a r C h a rt Japanese C a n d le s tic k .Drawing Bar (OHLC) Charts Each bar is composed of 4 elements: Open High Low Close H ig h C lo s e O pen H ig h Note that the candlestick body is empty (white) on up days.
low. .Types of Charts: Bar Charts This is a bar (open. close or OHLC) chart of AMAT from early July to mid October 2001. high.
high. close) chart of AMAT from early July to mid October 2001 .Types of Charts: Japanese Candlesticks This is a Japanese Candlestick (open. low.
Basic Technical Tools 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 Trading Range. . A Down trend where prices are generally decreasing.
Resistance results from the inability to surpass prior highs. What was support becomes resistance. Support results from the inability to break below to prior lows.Support & Resistance Support and resistance lines indicate likely ends of trends. and Support vice-versa. Breakout Resistance .
Note how the moving average shows much less volatility than the daily stock price.Simple Moving Averages A moving average is simply the average price (usually the closing price) over the last N periods. This chart shows MSFT with a 10-day moving average. They are used to smooth out fluctuations of less than N periods. M SFT Daily Prices with 10-day M A 9/23/93 to 9/21/94 60 55 50 e c i r P 45 40 35 30 1 21 41 61 81 101 121 Date 141 161 181 201 221 241 .
These patterns are reputed to provide information regarding the size and timing of subsequent price moves. In fact. they can be seen in a randomly generated price series. and have no real meaning. But don’t forget that the EMH says these patterns are illusions.Price Patterns Technicians look for many patterns in the historical time series of prices. .
Head and Shoulders This formation is H &S Top H ead characterized by two small peaks on either side of a larger peak. L e ft S h o u ld e r R ig h t S h o u ld e r N e c k lin e H & S B o tto m N e c k lin e L e f t S h o u ld e r R ig h t S h o u ld e r Head . meaning that it signifies a change in the trend. This is a reversal pattern.
Head & Shoulders Example
Minimum Target Price Based on measurement rule
Double Tops and Bottoms
These formations are
D o u b le T o p
similar to the H&S formations, but there is no head. These are reversal patterns with the same measuring implications as the H&S.
T a rg e t T a rg e t
D o u b le B o tt o m
Double Bottom Example
D e s c e n d in g . triangles should break out about half to threequarters of the way through the formation. Three flavors: Ascending Descending Symmetrical A s c e n d in g S y m m e tr ic a l S y m m e tr ic a l Typically.Triangles Triangles are continuation formations.
Rounded Tops & Bottoms Rounding formations are characterized by a slow reversal of trend. R o u n d in g B o tto m R o u n d in g T o p .
Rounded Bottom Chart Example .
B ro a d e n in g B o tto m s B r o a d e n in g T o p s . These formations usually signal a reversal of the trend.Broadening Formations These formations are like reverse triangles.
DJIA Oct 2000 to Oct 2001 Example What could you have known. and when could you have known it? .
should get filled .DJIA Oct 2000 to Oct 2001 Example Nov to Mar Trading range Descending triangles Double bottom Gap.
We will look at just a few that I use: Moving Average Convergence/Divergence (MACD) Relative Strength Index (RSI) On Balance Volume Bollinger Bands .Technical Indicators There are. hundreds of technical indicators used to generate buy and sell signals. literally.
When the signal line goes from positive to negative. MACD is best used in choppy (trendless) markets. When this signal line goes from negative to positive. A 9-day moving average of this difference is used to generate signals. and is subject to whipsaws (in and out rapidly with little or no profit). Appel defined MACD as the difference between a 12-day and 26-day moving average. a sell signal is generated. a buy signal is generated. .MACD MACD was developed by Gerald Appel as a way to keep track of a moving average crossover system.
MACD Example Chart .
.Relative Strength Index (RSI) RSI was developed by Welles Wilder as an oscillator to gauge overbought/oversold levels. realize that stocks can remain overbought or oversold for long periods of time. so RSI alone isn’t always a great timing tool. and a level below 30 indicates that it is oversold (it can range from 0 to 100). Also. The most important thing to understand about RSI is that a level above 70 indicates a stock is overbought. RSI is a rescaled measure of the ratio of average price changes on up days to average price changes on down days.
RSI Example Chart Overbought Oversold .
but OBV turns down. you generally look for OBV to show a change in trend (a divergence from the price trend).” To use OBV. If the stock is in an uptrend. OBV is calculated by adding volume on up days. and subtracting volume on down days.On Balance Volume On Balance Volume was developed by Joseph Granville. Granville believed that “volume leads price. . A running total is kept. that is a signal that the price trend may soon reverse. one of the most famous technicians of the 1960’s and 1970’s.
OBV failed OBV confirms trend change but doesn’t lead .OBV Example Chart Divergence.
that is a signal that a big move is coming. In my experience. and regular guest on CNBC). Bollinger Bands are based on a moving average of the closing price. When the bands contract. They are two standard deviations above and below the moving average. the buy signals are far more reliable than the sell signals. but it is impossible to say if it will be up or down. .Bollinger Bands Bollinger bands were created by John Bollinger (former FNN technical analyst. and a sell signal is given when the stock price closes above the upper band. A buy signal is given when the stock price closes below the lower band.
the buy signals just keep coming and you can go broke! .Bollinger Bands Example Chart Sell signal Buy signals Sometimes.
Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy.Dow Theory This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902. 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. .
Secondary Trend Called “the waves” by Dow. Others have called this a “secular” bull or bear market. this is shorter- term departures from the primary trend (weeks to months) Day to day fluctuations Not significant in Dow Theory . this is the trend that defines the long-term direction (up to several years).Dow Theory Trends (1) Primary Trend Called “the tide” by Dow.
Dow Theory Trends (2) .
If you had simply invested $44 and held that portfolio. .000. by 1981 you would have accumulated about $960.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.
The Elliot Wave Principle is based on a repeating 8-wave cycle.Elliot Wave Principle (1) R. . Elliot formulated this idea in a series of articles in Financial World in 1939. Elliot Wave adherents also make extensive use of the Fibonacci series. and each cycle is made up of similar shorter-term cycles (“Big fleas have little fleas upon their backs to bite 'em .N. Elliot believed that the market has a rhythmic regularity that can be used to predict future prices.little fleas have smaller fleas and so on ad infinitem”).
The Elliot Wave Principle (2)
5 B A 3 1 2 4 C
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 adjacent numbers approaches the Golden Mean: 1.618:1. 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.
Does Elliot Wave Work?
Who knows? 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’s to come. Robert Prechter (the most famous EW practitioner) made several astoundingly correct predictions in the 1980’s, but hasn’t been so prescient since (he no longer gets much press attention). For example, in 1985 he predicted that the market would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points). The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.
etc. neural networks. For example. just note that there is nothing so crazy that somebody doesn’t use it to trade. many people use astrology. and you takes your chances.” . geometry (Gann angles).Too Many Others To List As noted. There’s no doubt that each of these (and others) would have made you lots of money at one time or another. there are literally hundreds of indicators and thousands of trading systems. To close. A whole semester could easily be spent on just a handful of these. The real question is can they do it consistently? As the carneys used to say. “You pays your money. chaos theory.
Macro Economic Factors .
Case Studies .
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