Selection of Securities

Selection of Bonds
• YTM
• Default risk
• Tax shield
• Liquidity
• Duration

Selection of stocks
• Technical analysis
• Fundamental analysis
 Portfolio Management Approaches

Selection of stocks
• Technical analysis
• Fundamental analysis
Fundamental Analysis
• Evaluating the intrinsic value of a security
or investment by analyzing various
financial and economic factors.
Steps Involved:
 Step 1: Economic and Market Analysis
 Step 2: Analysis of Financial Statements
 Step 3: Forecasting relevant payoffs
 Step 4: Formulating a security value and
finding intrinsic value
 Step 5: Making a recommendation
Fundamental Analysis
• Macroeconomics Analysis
• Industry Analysis
• Financial Statement Analysis
• Equity Valuation Model
Fundamental Analysis: Top down
approach
 EIC analysis or Economic, Industry and
Company analysis is a top down approach
 Economic: Macroeconomics Analysis
 Industry Analysis
 Company Analysis: a) Financial Statement
Analysis
• b) Equity Valuation Model
Fundamental Analysis: Bottom
up approach
 CIE analysis or Company, Industry and
Economic analysis approach is a bottomup
approach
Equity Valuation
Major categories of equity valuation models:
• Present value models or discounted cash flow models:
Estimate the intrinsic value of a security as the present
value of the future benefits expected to be received
• Multiplier Models or market multiple models: Based
mainly on share price multiples or enterprise value
multiples
• Asset based valuation models: Estimates the intrinsic value
of a common share from the estimated value of the assets
of a firm minus the estimated value of its liabilities and
preferred shares
 Equity Valuation- Present Value Models
• Discounted Cash Flow Models

V0 =
•

V0 = Value of the share today, at t=0

Dt = Expected Cash flow in year t
r = required rate of return
 Equity Valuation- Present Value Models
• Dividend Discount Model
• If the issuing firm is assumed to be a going

concern, the intrinsic value of a share is the

present value of expected future dividends

V0 =
V0 = Value of the share today, at t=0
Dt = Expected dividend in year t
r = required rate of return
Equity Valuation- Present Value Models
• Gordon Growth Model
• For companies in the mature stage of their life cycle, assumes dividends grow
indefinitely at a constant rate perpetually
• V0 = =
g=b*ROE
b = earnings retention rate
ROE = return on equity

• Multistage Dividend Discount Models

• Assumes that at some point company will start paying dividends that grow at a
constant rate
V0 = +
 Ques: If the dividends paid by a firm in the
current year is Rs 10/share, and the growth
rate of dividends is 8 %. Calculate the
price/share is the required rate of return is
16%
  Ques: If the dividends paid by a firm is
Years 0-3 4-8 9 yr onwards

Dividend (Rs) 6 10 12

require rate of return is 16 %.

Price/intrinsic value of the share today =?
  Ques: If the dividends paid by a firm is
Years 0-3 4-8 9th year

Dividend (Rs) 6 10 12

 After 9 years the growth rate of dividends is

10 %, and require rate of return is 16 %.
 Price/intrinsic value of the share today =?
 Ques : The dividends on a stock are
expected to be Rs.18, Rs.25, and Rs.30 for
the next three years. The share price is
expected to be Rs.350 at the end of three
years. If the required rate of return is 15%,
estimate the intrinsic value of the share.
 A firm has 1 crore outstanding shares. In the
current year, out of 100 crores of its
earnings (net income), it paid 70 crores as
dividends. Its current return on equity is
14% and required rate of return by the
investors is 16 %.
 Calculate the estimated intrinsic value.
 Equity Valuation- Multiplier Models
• Price multiples that are generally used are:
• Price to earnings ratio (P/E): Ratio of the stock price to

earnings per share, and is used most frequently

• Price to book ratio (P/B): Ratio of the stock price to book

value per share

• Price to sales ratio (P/S): Ratio of stock price to sales per share

• Price to cash flow ratio (P/CF): Ratio of stock price to per

share measure of cash flow (free cash flow or operating cash

flow)
• Method of comparables is the most widely used approach.
Economic rationale underlying this method is the law of one
price, identical assets should sell for the same price
Multiplier Models - Example

Following data provides the P/E for the followings firms:

Firm Price Earnings P/E

A 554 38.7 14.3

B 688 43.2 15.9

C 670 34.2 19.6

D 521 37.7 13.8

Ques: Which stock appears to be undervalued?

Ques: If these firms have 95% of the total market (in terms of
sales), What will be the estimated share price of a firm E if its
earnings are 100 crores?
Equity Valuation- Asset Based Valuation

• Uses estimates of the market or fair value of the

company’s assets and liabilities.

• Works well for companies that do not have high

proportion of intangible assets.

• Asset based valuations models estimate value of equity

as the value of assets less the value of liabilities
Asset Based Valuation - Example

• An analyst has determined that the appropriate

EV/EBIDTA for company XYZ is 10.2. Using the
following information estimate the value of equity
• EBIDTA = 22,000,000

• MV of debt = 56,000,000

• Cash = 1,500,000
Technical Analysis
 What Proponents and opponents thinks
about Technical analysis
 Random Walk

• Stock prices followed a random walk, implying that

successive price changes are independent of one another.

• Academic researchers concluded that the randomness

of stock prices was the result of an efficient market.

 What Is An Efficient Market
• An efficient market is one in which the market price of a
security is an unbiased estimate of its intrinsic value

• Market efficiency is defined in relation to information that is

reflected in security prices. Fama distinguishes three
levels of market efficiency.

• Weak-form efficiency
• Semi-strong form efficiency
• Strong-form efficiency
• The weak form efficient market hypothesis says that the
current price of a stock reflects all information found in the
record of past prices and volumes.

• The semi-strong form efficient market hypothesis holds that

stock prices adjust rapidly to all available public
information.

• The strong form efficient market hypothesis holds that all

available information, public and private is reflected in stock
prices.
• Empirical evidence seems to provide strong support for
weak- form efficiency, mixed support for semi-strong form
efficiency, and weak support for strong-form efficiency.

• Indian equity market show which form of efficiency ?

 Returns over Long Horizons
While returns over short horizons are characterised by minor positive serial
correlation, returns over long horizons seem to be characterised by
pronounced negative serial correlation. To explain the latter result, a “fads
hypothesis” has been proposed, which says that stock prices tend to overreact
to news. Such overreaction results in positive correlation over short horizons
and negative correlation over long horizons. Put differently, prices overshoot
in the short run but correct in the long run. Thus, market prices display
excessive volatility in comparison with intrinsic value.

Robert J. Shiller and others argue that the presence of mean reversion and
excessive volatility in prices imply market inefficiency.
Empirical Evidence On Semi-Strong Efficient
Market Hypothesis

• Possible to earn superior risk-adjusted return by trading

on information events? (Event study)
 Strong-Form efficient Market Hypothesis
The strong-form efficient market hypothesis holds that all available
information, public as well as private, is reflected in the stock prices. To test
this hypothesis, researchers have analysed the returns earned by certain groups
who have access to information which is not publicly available or ostensibly
possess greater resources and expertise to intensively analyse information
which is in the public domain. More specifically, researchers have tested this
form of EMH by analysing the performance of corporate insiders, stock
exchange specialists, security analysts, and professional money managers.
 Implications For Investments
• Substantial evidence in favour of randomness suggests
that technical analysis is of dubious value.
• Routine and conventional fundamental analysis is not of
much help in identifying profitable courses of action
• The key levers for earning superior rates of returns are:
• Early action on any new development.
• Access to inside information and its sensible
interpretation
 What Is Technical Analysis
According to Martin J. Pring :

“The technical approach to investing is essentially a reflection of the

idea that prices move in trends which are determined by the
changing attitudes of investors toward a variety of economic,
monetary, political and psychological forces. The art of technical
analysis - for it is an art - is to identify trend changes at an early
stage and to maintain an investment posture until the weight of the
evidence indicates that the trend has been reversed.”
 Basic Premises Of Technical Analysis

• Shifts in demand and supply bring about changes in

trends.

• Irrespective of why they occur, shifts in demand and

supply can be detected in charts.
 Technical Analysis Versus Fundamental
Analysis
Technical Analysis Fundamental Analysis

• Predicts short-term • Establishes long-term values

price movements

• Focuses on internal market • Focuses on fundamental

data factors
• Appeals to short-term traders • Appeals to long-term
investors
 Charting Techniques

• The Dow theory

• Bar and Line charts

• Point and figure chart

• Moving average analysis

• Relative strength analysis

Basic Concepts Underlying Chart Analysis

• Volume and trend go hand in hand

• There are resistance and support levels

 The Dow Theory
The market has three movements, all going at the same time:

• Daily fluctuations : Random day-to-day wiggles

• Secondary movements : Corrections that last for a few

weeks or months

• Primary trends : Representing bull and bear

phases of the market
The concept of Dow Theory
 Bar And Line Charts
• The bar chart depicts the daily price change along with
the closing price.

• A line chart shows the line connecting successive closing

prices.

• Technical analysts believe that certain formations or

patterns observed on the bar chart or line chart have
predictive value. For example, a head and shoulder pattern
represents a bearish development.
Bar and Line Charts
Technical analysts believe that certain formations or patterns observed on the bar chart
or line chart have predictive value. The more important formations and their
indications are described in coming slides.

Head and Shoulders Top (HST) Pattern As the name suggests, the HST formation has a
left shoulder, a head, and a right shoulder. The HST formation represents a bearish
development. If the price falls below the neckline (the line drawn tangentially to the left
and right shoulders), a price decline is expected. Hence, it is a signal to sell.
 Important Chart Formations
Inverse Head and Shoulders Top (IHST) Pattern As the name indicates, the IHST
formation is the inverse of the HST formation. Hence, it reflects a bullish development.
If the price rises above the neck line, a price rise is expected. Hence, it is a signal to buy.
 Important Chart Formations
Triangle or Coil Formation This formation represents a pattern of uncertainty. Hence,
it is difficult to predict which way the price will break out.
 Important Chart Formations
Flags and Pennants Formation: It typically signifies a pause after which the previous
price trend is likely to continue. Formed when there is a large movement in a security,
known as the flagpole, followed by a consolidation period with converging trend lines—
the pennant—followed by a breakout movement in the same direction as the initial
large movement, which represents the second half of the flagpole
 Important Chart Formations
Double Top Formation: It represents a bearish development, signalling that the price is
expected to fall. A double top is an extremely bearish technical reversal pattern that
forms after an asset reaches a high price two consecutive times with a moderate decline
between the two highs. It is confirmed once the asset's price falls below a support level
equal to the low between the two prior highs.
 Important Chart Formations
Double Bottom Formation: It reflects a bullish development, signalling that the price is
expected to rise.
 Point And Figure Chart

More complex than a bar chart, a point and figure chart (PFC)

condenses the recording of price changes by eliminating the time

scale and small changes.

More complex than a bar chart, a point and figure chart (PFC) has
the following features.

1. On a PFC only significant price changes are recorded.

For example, for a stock that has a price in the range
of, say Rs 30 to Rs 50, price changes of one rupee or
more only may be posted.

2. While the vertical scale on a PFC represents the price

of the stock, the horizon scale does not represent the
time scale in the usual sense.

3. Each column on the horizontal scale of a PFC

represents a significant reversal of price movement
and not a trading day.
 Example
Day Price Day Price
1 31 15 33.5
2 31.5 16 34
3 32 17 34.25
4 32.5 18 34.5
5 33 19 35
6 33.5 20 36
7 33.75 21 35.5
8 34 22 35
9 33 23 34.5
10 32.5 24 34.75
11 32.25 25 34.5
12 32 26 34
13 32.5 27 33.5
14 33
Point and Figure Chart
 Moving Average Analysis
A moving average is calculated by taking into account the most
recent n observations.
A 5-day moving average of daily closing prices is calculated as follows:

Trading day Closing Sum of five most Moving

price recent closing prices average
1 25.0
2 26.0
3 25.5
4 24.5
5 26.0 127.0 25.4
6 26.0 128.0 25.6
7 26.5 128.5 25.7
8 26.5 129.5 29.9
9 26.0 131.0 26.2
10 27.0 132.0 26.4
 Moving Average Analysis

To identify trends, technical analysts use moving averages

analysis: a 200-day moving average of daily prices (or alternatively,
30-week moving average of weekly prices) may be used to identify a
long-term trend; a 60-day moving average of daily prices may be
used to discern an intermediate term trend; a 10-day moving
average of daily prices may be used to detect a short-term trend.
 Sentiment Indicators: Short-Interest Ratio
The short interest ratio is defined as follows:

Total number of shares sold short

Average daily trading volume

A technical analyst considers a high short-interest ratio as a sign of

bullishness
 Put/Call Ratio
Number of puts purchased
Number of calls purchased

A rise in the put/call ratio is a buy signal

A fall in the put/call ratio is a sell signal