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UNIT-II STOCK ANALYSIS AND VALUATION
TOPICS COVERED
Online trading of stocks
Understanding stock quotations
Types and placing of order
Risk: its valuation and mitigation
Analysis of the company:
Financial characteristics
ratio analysis
future prospects of the company
assessing quality of management using financial and
non-financial data
balance sheet and quarterly results
cash flows
capital structure
comparative analysis of companies
Non-Financial characteristics
Stock valuations:
using ratios
PE ratio
PEG ratio
Price Revenue ratio
Use of Historic prices
simple moving average
basic and advanced interactive charts
Examining the shareholding pattern of the company
Pitfalls to avoid while investing:
high P/E stocks
low price stocks
stop loss
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excess averaging
1. ONLINE TRADING OF STOCK
The act of buying and selling of security through on-line
platform is on-line trading of
stock. Online trading generally requires an online trading
platform offered by most online
brokers for order execution. The online trading platform for NSE
is national automated
trading (NEAT) and for BSE is Bombay stock exchange on – line
trading (BOLT).
On-Line Trading of Stock-Process: following are the steps in
on-line trading:
Selection of a broker: The buying and selling of securities can
only be done through
SEBI registered brokers who are members of the Stock Exchange.
The broker can be
an individual, partnership firms or corporate bodies. So the
first step is to select a
broker who will buy/sell securities on behalf of the
investor.
Opening De-Mat Account with Depository: Second step in trading
procedure is to
open a De-Mat account. De-Mat (De-Materialized) account refer to
an account which
an Indian citizen must open with the depository participant to
trade in listed securities
in electronic form. The securities are held in the electronic
form by a depository.
Depository is an institution or an organization which holds
securities. At present in
India there are two depositories: NSDL (National Securities
Depository Ltd.) and
CDSL (Central Depository Services Ltd.) There is no direct
contact between
depository and investor. Depository interacts with investors
through depository
participants only. Depository participant will maintain
securities account balances of
investor and intimate investor about the status of their
holdings from time to time
Placing the Order: After opening the De-Mat Account, the
investor can place the
order. The order can be placed to the broker (DP) either
personally or through phone,
email, mobile App etc. Investor must place the order very
clearly specifying the range
of price at which securities can be bought or sold.
Executing the Order: As per the Instructions of the investor,
the broker executes the
order i.e. he buys or sells the securities. Broker prepares a
contract note for the order
executed. The contract note contains the name and the price of
securities, name of
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parties and brokerage (commission) charged by him. Contract note
is signed by the
broker.
Settlement: This means actual transfer of securities. This is
the last stage in the
trading of securities done by the broker on behalf of their
clients. There can be two
types of settlement.
On the spot settlement: It means settlement is done immediately
and on spot
settlement follows i.e. T + 2 rolling settlement. This means any
trade taking place
on Monday gets settled by Wednesday.
Forward settlement: It means settlement will take place on some
future date. It
can be T + 5 or T + 7, etc. All trading in stock exchanges takes
place between 9.15
am and 3.30 pm. Monday to Friday.
Advantages of on-Line Trading
It is convenient: In online trading, you only need to open a
trading account via internet
and you’re good to go. You’re not bound by time and place as
long as you have an
internet connection. Hence, online trading is convenient and
accessible from
anywhere with limited hassle. It also saves time.
It is cheaper: In online stock trading, the stock broker fee
which you will have to pay
is lower when compared to the commission charged by traditional
method. If you trade
in a sufficiently large volume of stocks, it is possible for you
to be able to negotiate
your broker’s fees.
Monitor of investments anytime: Online trading allows you to buy
or sell shares
according to your convenience. It offers advanced interfaces and
the ability for
investors to see how their money is performing throughout the
day. You can use your
phone or your computer to evaluate your profit or loss.
It almost eliminates the middleman: Online trading allows you to
trade with virtually
no direct broker communication. Apart from reducing the overall
trading cost, this
benefit also makes the trading hassle free, making this service
much more lucrative.
Investor has greater control: Online traders can trade whenever
they wish to. On
the other hand, in traditional trading, an investor may be stuck
until he or she is able
to contact their broker or when the broker is able to place
their order. Online trading
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allows nearly instantaneous transactions. Also, investors are
able to review all of their
options instead of depending on a broker to tell them the best
bets for their money.
They’re able to monitor their investments, make decisions and
buy/sell stock on their
own without any outside interference; thus, giving them greater
control over their
investment.
Faster Transactions: Online banking is fast and efficient. Funds
can be transferred
between accounts almost instantly, especially if the two
accounts are held at the same
banking institution. All it takes to be able to buy or sell
stocks is a single click of the
mouse. Through this, a quicker exchange can be made which may
also ensure quicker
earnings.
Better understanding of one’s money: This is a hidden advantage
of online trading
which you wouldn’t want to pass up on. Just like conventional
stock trading, you can
predict the market behavior and use this to predict a rise or
fall in price of the stock.
You’ll be handling your own finances and be responsible for
them. Over time, you
become more experienced in understanding the market, and good
investment
opportunities from the bad ones. This knowledge about money is
very useful, and
having this on your resume makes you more marketable to
companies looking to fill a
well-paying position in the finance department.
Disadvantages of Online Trading
Technical Problems: Online trading platform are only as good as
the underlying
servers and software. High volumes on volatile trading days can
slow processing
speeds and information flow. Software bugs can lead to delays in
getting price quotes
and information on order status. This also could result in
trading losses, because you
might enter orders based on incorrect price quotes or delayed
order-execution reports.
Investors depend on Internet and cellular service providers for
researching information
and placing trades
Customer Service: Online brokers have a lean cost structure,
which allows them to
offer discounts on commissions. You might need to place certain
trades over the
phone if your online portal malfunctions or your Internet
connection is down. In
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addition, you might not be able to place certain types of orders
over the phone, such
as spread orders involving options.
Feedback Mechanisms: Online trading means that you are your own
investment
manager, but this independence comes at a price. You do not have
the benefit of a
professional feedback loop, such as a reliable sounding board
for your investment
decisions. Online brokers typically do not provide buy-sell
recommendations. You
have to set aside time for research, such as reviewing financial
statements on
corporate investor relations websites and price charts on
financial websites
Addictive nature: Online traders can experience a certain high
when trading that is
similar to what people experience when gambling, according to a
recent study on
excessive trading published in the journal Addictive Behaviors.
The study noted that
some investors choose short-term trading strategies that involve
investing in risky
stocks offering the potential for large gains but also
significant losses.
a) Understanding Stock Quotations
A stock quote is the price of a stock as quoted on an exchange.
A basic quote for a
specific stock provides information, such as its bid and ask
price, last-traded price and
volume traded.
Bid price represents the maximum price that a buyer or buyers
are willing to pay for
a security.
Ask price represents the minimum price that a seller or sellers
are willing to receive
for the security.
A trade or transaction occurs when the buyer and seller agree on
a price for the security.
b) Types and Placing of Orders
There are four different types of orders:
Market order - this order is designed to be executed
immediately, at the current
market price - no price is specified on the order.
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Limit order - this order does specify the price desired;
however, there is no guarantee
that the order will be filled. There are two types of limit
orders:
Buy limit order - this order is entered at a price below the
current
market price.
Sell limit order - this order is placed above the current market
price.
Stop order this order is used to trigger an execution only if
the market reaches a
certain level; when this limit is reached, the stop order
becomes a market order. As a
result, there is no way to predict the actual price the security
will receive. As with limit
orders, there are two types:
Buy stop order these are used to limit losses on short stock
positions and are
always placed above the current market price and filled only if
the market rises.
Sell stop order - these are used to limit losses on long stock
positions and are
always placed below the current market price and filled only if
the market fails.
Stop-limit order -this order is used to ensure that a specific
price is received, but the
order is only placed when a specific stop price is reached. The
stop price and the limit
price do not need to be the same. However, there is a risk that
the stop price could be
reached, but the market never reaches the limit price. In that
case, the order will never
be filled.
2. Risk : Its Valuation & Mitigation
Risk: Risk is associated with uncertainty. It refers to the
possibility that you will lose some
or all of your investment or that an investment will yield less
than its anticipated return.
Simply stated, risk is the probability that an investment will
make or lose money. Every
investment carries some degree of risk because its returns are
unpredictable. The more
volatile an investment more is the risk.
Each investment is subject to general risks associated with that
type of investment. These
risks are called systematic risks and are caused by conditions
outside a company or
industry. Risk also arises from factors and circumstances that
are specific to a particular
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company, industry, or class of investments. These are called
unsystematic or diversifiable
risks. As the name implies, unsystematic risks can be reduced by
diversifying your
investment portfolio.
Types of Risk
Risk can be classified under two main groups:
Systematic Risk
Unsystematic Risk
SYSTEMATIC RISK
Systematic risk, also known as "market risk" or
"un-diversifiable risk". It is the uncertainty
inherent to the entire market. Systematic risk consists of the
day-to-day fluctuations in a
stock's price. Volatility is a measure of risk because it refers
to the behavior, or
"temperament," of your investment rather than the reason for
this behavior. Because
market movement is the reason why people can make money from
stocks, volatility is
essential for returns, and the more unstable the investment the
more chance there is that
it will experience a dramatic change in either direction.
Types of systematic Risk
Market Risk: Market risk refers to the change in the price of
securities caused by
fluctuations in overall market conditions or in a specific
sector of the market due to
outside forces.
Political events
Economic factors
war or disaster
Interest Risk: Interest rate risk is the risk of loss due to
variation in the price of bonds
(debentures) because of changes in interest rates. When interest
rates rise, bond
prices fall; when interest rates go down, bond prices rise.
Purchasing power, inflation risk, or price level risk:
Purchasing power risk, also
referred to as inflation or price level risk, refers to the
possibility that the return on your
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investments won’t keep pace with increasing price levels. As
prices rise, the value of
currency falls, resulting in a decreased ability to purchase
goods and services. People
who hold cash, savings accounts, and bonds assume this kind of
risk. The danger is
that their money may not grow enough over the years to allow
them to achieve their
financial goals.
Social risk: Social risk refers to the possibility that a
segment of society will institute
boycotts, litigation, publicity campaigns, or lobbying efforts
against a company due to
its social policy or business practices. The actions of society
can negatively affect that
company’s performance.
Reinvestment rate risk: Reinvestment rate risk refers to the
possibility that you will
have to reinvest funds at a lower rate of return than the
investment originally earned
Exchange rate or currency risk: Exchange rate or currency risk
arises because of
fluctuating foreign exchange rates. These fluctuations may
affect the value of foreign
investments or profits when converting them into other currency
the corresponding
drop in the relative value of the foreign currency could cause
your investments to lose
value.
Political risk: Political risk refers to possible changes in the
government or legal
environment. For example, taxes may rise, tariffs may be
imposed, or wages and
prices may be controlled. All of these things could result in
reducing a company’s
profits
RISK VALUATION (Systematic risk (Beta)
Systematic risk, also known as "market risk" or
"non-diversifiable risk", is the uncertainty
inherent to the entire market or entire market segment. Also
referred to as volatility,
systematic risk consists of the day-to-day fluctuations in a
stock's price. Volatility is a
measure of risk.
Beta is a measure of the volatility, or systematic risk, of a
security or a portfolio in
comparison to the market as a whole. In other words, beta gives
a sense of a stock's
market risk compared to the market. Beta is also used to compare
a stock's market
risk to that of other stocks. Investment analysts use the Greek
letter 'ß' to represent
beta. Beta is used in the capital asset pricing model (CAPM) to
determine required
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rate of return. Beta is calculated using regression analysis,
and you can think of beta
as the tendency of a security's returns to respond to swings in
the market. A beta of 1
indicates that the security's price will move with the market. A
beta of less than 1
means that the security will be less volatile than the market. A
beta of greater than 1
indicates that the security's price will be more volatile than
the market. For example,
if a stock's beta is 1.2, it's theoretically 20% more volatile
than the market.
Negative beta - A beta less than 0 - which would indicate an
inverse relation to the
market - is possible but highly unlikely. Some investors used to
believe that gold and
gold stocks should have negative betas because they tended to do
better when the
stock market declined, but this hasn't proved to be true over
the long term.
Beta of 0 - Basically, cash has a beta of 0. In other words,
regardless of which way
the market moves, the value of cash remains unchanged (given no
inflation).
Beta between 0 and 1 - Companies with volatilities lower than
the market have a beta
of less than 1 (but more than 0). Many utilities fall in this
range.
Beta of 1 - A beta of 1 represents the volatility of the given
index used to represent
the overall market against which other stocks and their betas
are measured. The S&P
500 is such an index. If a stock has a beta of 1, it will move
the same amount and
direction as the index. So, an index fund that mirrors the
S&P 500 will have a beta
close to 1.
Beta greater than 1 - This denotes a volatility that is greater
than the broad based
index.
UNSYSTEMATIC RISK
Unsystematic risk is due to the influence of internal factors
prevailing within an
organization. Such factors are normally controllable from an
organization's point of view.
It is a micro in nature as it affects only a particular
organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate
(reduce the effect) the
risk. The types of unsystematic risk are depicted and listed
below. This risk is diversifiable
risk
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Business failure risk: It refers to the risk associated with a
particular company can
be caused by changes in a company’s sales due to operating
problems, such as a
strike, an unfavorable outcome of litigation, or technical
obsolescence.
Financial, credit, or default risk: Financial or credit risk
arises when a company incurs
excessive debt. Financial risk is related to the company’s
debt-to-equity ratio. That
means the company has a high fixed obligation (interest) to pay
each year. If the firm
does not perform well, it may be unable to satisfy that
obligation and pay bond holders.
Liquidity risk: Liquidity risk refers to the chance that an
asset may not be easily
sold, or may not receive its full market value, especially with
short notice.
RISK IDENTIFICATION
Risk identification is the process of determining risks that
could potentially prevent
investment from achieving its objectives. Risk evaluation is
concerned with assessing
probability and impact of individual risks, taking into account
any interdependencies or
other factors outside the immediate scope under
investigation:
Following are ways of risk mitigation
Diversification: it is the process of allocating capital in a
way that reduces the
exposure to any one particular asset or risk. A common path
towards diversification is
to reduce risk or volatility by investing in a variety of
assets. The kinds of risk depend
on the combination of investments. One can reduce risk but
cannot eliminate it
completely. One way to manage risk is by using an investment
strategy called
diversification. Diversification means buying a variety of
investments in different asset
classes, so as to minimize risk.
Risk Control: This is the process of actually managing the risk.
Taking proactive steps
to reduce the identified risks wherever possible. Risk Control
is the most widely used
strategy, when combined with the other strategies.
Risk Transfer: This is the proactive process of transferring
unwanted risk away from
your organization to another person or organization. Risk can be
transferred to another
party as follows:
By law
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Through a written agreement or contract between two parties,
or
Through a conventional insurance policy.
Loss Reduction: This is a “post-loss” strategy that is
essentially a response plan that
addresses what will be done if a loss does occur. An effective
Loss Reduction strategy
can effectively reduce the impact of a loss and can make the
difference between an
inconvenience and a catastrophe.
3. Analysis of The Company
It is a process carried out by investors to evaluate securities,
collecting info related to the
company’s profile, products and services as well as
profitability. It is also referred as
‘fundamental analysis.’ A company analysis incorporates basic
info about the company.
During the process of company analysis, an investor also
considers the company’s
history, focusing on events which have contributed in shaping
the company. Also, a
company analysis looks into the goods and services offered by
the company. If the
company is involved in manufacturing activities, the analysis
studies the products
produced by the company and also analyzes the demand and quality
of these products.
Fundamental Analysis
Fundamental analysis is a “bottom up” valuation technique used
to determine the market
value of a stock, common share or equity security. Fundamental
analysis is a “bottom up”
valuation technique used to determine the market value of a
stock, common share or
equity security. All securities can be valued by calculating the
present value of their future
cash flows.
The information needed to value a company is clearly stated in
its financial statements.
The Balance Sheet totals up the value of the Total Assets of a
company and equates this
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to the value of the Total Liabilities plus the “Owner’s Equity”.
Some simple algebra
establishes that, at any point in time, the value of the
“Owners’ Equity” of a company
equals the value of its Total Assets minus its Total
Liabilities.
A Fundamental Analysis or “Bottom Up” financial analysis of a
company is used to
establish it’s actual or “Intrinsic Value”. When you divide this
value by the number of
common shares, you get the “Intrinsic Share Value” on a per
share basis.
The tools required for fundamental analysis are extremely basic,
most of which are
available for free. Specifically you would need the
following:
i) Annual report of the company – All the information that you
need for FA is available
in the annual report. You can download the annual report from
the company’s website
for free.
ii) Industry related data – You will need industry data to see
how the company under
consideration is performing with respect to the industry. Basic
data is available for free,
and is usually published in the industry’s association
website.
iii) Access to news – Daily News helps you stay updated on
latest developments
happening both in the industry and the company you are
interested in. A good
business newspaper or services such as Google Alert can help you
stay abreast of
the latest news.
a) Financial Characteristics
Financial statements, such as comparative statements, common
size percentages, trend
analysis, cash flow statement and ratios analysis are used in
analyzing company.
Financial statements are prepared to meet external reporting
obligations and also for
decision making purposes. They play a dominant role in setting
the framework of
managerial decisions. But the information provided in the
financial statements is not an
end in itself as no meaningful conclusions can be drawn from
these statements alone.
However, the information provided in the financial statements is
of immense use in
making decisions through analysis and interpretation of
financial statements.
i) Ratio Analysis: Ratio analysis is a tool that was developed
to perform quantitative
analysis on numbers found on financial statements. Ratios helps
in linking the three
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financial statements together and offer figures that are
comparable between
companies and across industries and sectors. Ratio analysis is
one of the most widely
used fundamental analysis techniques. Financial ratios fall into
several categories. For
the purpose of this analysis, the commonly used ratios are
grouped into four
categories: activity, liquidity, solvency and profitability.
Activity Ratios: Activity ratios are used to measure how
efficiently a company
utilizes its assets. The ratios provide investors with an idea
of the overall
operational performance of a firm. The activity ratios measure
the rate at which the
company is turning over its assets or liabilities. In other
words, they present how
many times per year inventory is replenished or receivables are
collected.
Inventory turnover: It is calculated by dividing cost of goods
sold by average
inventory. A higher turnover than the industry average means
that inventory is
sold at a faster rate, signaling inventory management
effectiveness.
Additionally, a high inventory turnover rate means less company
resources are
tied up in inventory.
Receivables turnover: this ratio is calculated by dividing net
revenue by
average receivables. This ratio is a measure of how quickly and
efficiently a
company collects on its outstanding bills. The receivables
turnover indicates
how many times per period the company collects and turns into
cash its
customers’ accounts receivable.
Payables turnover: it measures how quickly a company pays off
the money
owed to suppliers. The ratio is calculated by dividing purchases
(on credit) by
average payables. The payables turnover increases as more
purchases are
made or as a company decreases its accounts payable. A high
number
compared to the industry average indicates that the firm is
paying off creditors
quickly, and vice versa. An unusually high ratio may suggest
that a firm is not
utilizing the credit extended to them, or it could be the result
of the company
taking advantage of early payment discounts. A low payables
turnover ratio
could indicate that a company is having trouble paying off its
bills or that it is
taking advantage of lenient supplier credit policies.
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Asset turnover: Asset turnover measures how efficiently a
company uses its
total assets to generate revenues. The formula to calculate this
ratio is simply
net revenues divided by average total assets. A low asset
turnover ratio may
mean that the firm is inefficient in its use of its assets or
that it is operating in a
capital-intensive environment. Additionally, it may point to a
strategic choice by
management to use a more capital-intensive (as opposed to a more
labor-
intensive) approach.
Liquidity Ratios: It is one of the most widely used ratios, they
are especially
important to creditors. These ratios measure a firm’s ability to
meet its short-term
obligations. The level of liquidity needed varies from industry
to industry. Certain
industries are more cash-intensive than others.
Current ratio: The current ratio measures a company’s current
assets against
its current liabilities. The current ratio indicates if the
company can pay off its
short-term liabilities in an emergency by liquidating its
current assets. Current
assets include items such as cash and cash equivalents, accounts
receivable
and inventory, among others. A low current ratio indicates that
a firm may have
a hard time paying their current liabilities. A high ratio
indicates a high level of
liquidity and less chance of a cash squeeze. A current ratio
that is too high,
however, may indicate that the company is carrying too much
inventory,
allowing accounts receivables to balloon with lax payment
collection standards
or simply holding too much in cash.
Quick ratio: The quick ratio is a liquidity ratio that is more
stringent than the
current ratio. This ratio compares the cash, short-term
marketable securities
and accounts receivable to current liabilities. The major item
excluded in the
quick ratio is inventory, which can make up a large portion of
current assets but
may not easily be converted to cash.
Solvency Ratios: Solvency ratios measure a company’s ability to
meet its longer-
term obligations. Analysis of solvency ratios provides insight
on a company’s
capital structure as well as the level of financial leverage a
firm is using. Some
solvency ratios allow investors to see whether a firm has
adequate cash flows to
consistently pay interest payments and other fixed charges. If a
company does not
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have enough cash flows, the firm is most likely overburdened
with debt and
bondholders may force the company into default.
Debt-to-assets ratio: The debt-to-assets ratio is the most basic
solvency ratio,
measuring the percentage of a company’s total assets that is
financed by debt.
The ratio is calculated by dividing total liabilities by total
assets. A high number
means the firm is using a larger amount of financial leverage,
which increases
its financial risk in the form of fixed interest payments.
Debt-to-capital ratio: The debt-to-capital ratio is very
similar, measuring the
amount of a company’s total capital (liabilities plus equity)
that is provided by
debt (interesting bearing notes and short- and long-term debt).
Once again, a
high ratio means high financial leverage and risk. Although
financial leverage
creates additional financial risk by increased fixed interest
payments, the main
benefit to using debt is that it does not dilute ownership. In
theory, earnings are
split among fewer owners, creating higher earnings per share.
However, the
increased financial risk of higher leverage may hold the company
to stricter
debt covenants. These covenants could restrict the company’s
growth
opportunities and ability to pay or raise dividends.
Debt-to-equity ratio: The debt-to-equity ratio measures the
amount of debt
capital a firm uses compared to the amount of equity capital it
uses. A ratio of
1 indicates that the firm uses the same amount of debt as equity
and means
that creditors have claim to all assets, leaving nothing for
shareholders in the
event of a theoretical liquidation.
Interest coverage ratio: The interest coverage ratio, also known
as times
interest earned, measures a company’s cash flows generated
compared to its
interest payments. The ratio is calculated by dividing EBIT
(earnings before
interest and taxes) by interest payments. With interest coverage
ratios, it’s
important to analyze them during good and lean years. Most
companies will
show solid interest coverage during strong economic cycles, but
interest
coverage may deteriorate quickly during economic downturns.
Profitability Ratios: Profitability ratios are the most widely
used ratios in
investment analysis. These ratios include “margin” ratios, such
as gross, operating
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and net profit margins. These ratios measure the firm’s ability
to earn an adequate
return. When analyzing a company’s margins, it is always prudent
to compare
them against those of the industry and its close competitors.
Margins will vary
among industries.
Gross profit margin: Gross profit margin is simply gross income
(revenue less
cost of goods sold) divided by net revenue. For most firms,
gross profit margin
will suffer as competition increases. If a company has a higher
gross profit
margin than industry, it likely to holds a competitive advantage
in quality,
perception or branding, enabling the firm to charge more for its
products.
Alternatively, the firm may also hold a competitive advantage in
product costs
due to efficient production techniques or economies of
scale.
Operating profit margin: Operating profit margin is calculated
by dividing
operating income (gross income less operating expenses) by net
revenue.
Operating expenses include costs such as administrative overhead
and other
costs that cannot be attributed to single product units.
Operating margin
examines the relationship between sales and
management-controlled costs.
Increasing operating margin is generally seen as a good sign,
but investors
should simply be looking for strong, consistent operating
margins.
Net profit margin: Net profit margin compares a company’s net
income to its
net revenue. This ratio is calculated by dividing net income, by
net revenue. It
measures a firm’s ability to translate sales into earnings for
shareholders. Once
again, investors should look for companies with strong and
consistent net profit
margins.
ROA and ROE: Two other profitability ratios are also widely
used—return on
assets (ROA) and return on equity (ROE). Return on assets is
calculated as
net income divided by total assets. It is a measure of how
efficiently a firm
utilizes its assets. A high ratio means that the company is able
to efficiently
generate earnings using its assets. As a variation, some
analysts like to
calculate return on assets from pretax and pre-interest earnings
using EBIT
divided by total assets. While return on assets measures net
income, which is
return to equity holders, against total assets, which can be
financed by debt
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and equity, return on equity measures net income less preferred
dividends
against total stockholder’s equity. This ratio measures the
level of income
attributed to shareholders against the investment that
shareholders put into the
firm. It takes into account the amount of debt, or financial
leverage, a firm uses.
Financial leverage magnifies the impact of earnings on ROE in
both good and
bad years. If there are large discrepancies between the return
on assets and
return on equity, the firm may be incorporating a large amount
of debt. In that
case, it is prudent to closely examine the liquidity and
solvency ratios.
Return on Investment: Return on investment or ROI is a
profitability ratio that
calculates the profits of an investment as a percentage of the
original cost. In
other words, it measures how much money was made on the
investment as a
percentage of the purchase price. It shows investors how
efficiently each dollar
invested in a project is at producing a profit. Investors not
only use this ratio to
measure how well an investment performed, they also use it to
compare the
performance of different investments of all types and sizes.
Conclusion:
Ratio analysis is a form of fundamental analysis that links
together the three financial
statements commonly produced by corporations. Ratios provide
useful figures that are
comparable across industries and sectors. Using financial
ratios, investors can develop
a feel for a company’s attractiveness based on its competitive
position, financial strength
and profitability.
ii) Future Prospects of The Company
Analysing the expected future performance is also crucial as it
is the future expected
appreciation in stock price which helps in defining gains over
the long term. While
analysing the expected future performance of a company following
factors need to be
checked:
Latest quarterly EPS and sales figures of the company
Information on the company's business, Industry and economy in
which it operates
Assessment of the Sensible Investing community
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As an investor, one should look at only that set of data that
together is necessary and
sufficient to analyze whether the company has a great financial
track record and is worth
investing in.
iii) Assessing Quality of Management Using Financial and
Non-Financial Data
Recently, multiple cases of fraud have come to light where
shareholders have suffered
near permanent loss of their capital because of dubious
promoters or management. So
in addition to the financial and business analysis, assessing
the quality of management
is equally important. Before investing in any company you must
evaluate management’s
Competency and Integrity.
Some of the indicators of dubious management and poor corporate
governance are
Poor quality of earnings
Excessive management remuneration
Excessive related party transactions
Convolute company structure
Constant change of auditors
Very high auditor remuneration of independent directors etc.
iv) Balance sheet and quarterly results
Assets, liability and equity are the three main components of
the balance sheet. Carefully
analyzed, they can tell investors a lot about a company's
fundamentals.
Assets: There are two main types of assets:
Current Assets: Current assets represent all the assets of a
company that are
expected to be conveniently sold, consumed, utilized or
exhausted through the
standard business operations, which can lead to their conversion
to a cash value
within one business cycle, normally one year period. Current
assets include cash,
cash equivalents, accounts receivable, stock inventory,
marketable securities, pre-
paid liabilities and other liquid assets. Current assets are
important to businesses
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because they can be used to fund day-to-day business operations
and to pay for
ongoing operating expenses.
Current Assets = Cash + Cash Equivalents + Inventory + Accounts
Receivables +
Marketable Securities + Prepaid Expenses + Other Liquid
Assets
Non-current assets are defined as anything not classified as a
current asset. This
includes items that are fixed assets, such as property, plant
and
equipment (PP&E). Unless the company is in financial
distress and
is liquidating assets, investors need not pay too much attention
to fixed assets.
Since companies are often unable to sell their fixed assets
within any reasonable
amount of time they are carried on the balance sheet at cost
regardless of their
actual value.
Liabilities: There are current liabilities and non-current
liabilities. Current liabilities
are obligations the firm must pay within a year, such as
payments owing to suppliers.
Non-current liabilities, represent what the company owes in a
year or more time.
Typically, non-current liabilities represent bank and bondholder
debt. Generally
speaking, if a company has more assets than liabilities, then it
is in decent condition.
By contrast, a company with a large amount of liabilities
relative to assets ought to be
examined with more diligence
Equity: Equity represents what shareholders own, so it is often
called shareholder's
equity. Equity is equal to total assets minus total liabilities.
The two important equity
items are paid-up capital and retained earnings. Paid-up capital
is the amount of
money shareholders paid for their shares. Retained earnings is
part of earnings the
company has chosen to reinvest in the business rather than pay
to shareholders.
Investors should look closely at how a company puts retained
capital to use and how
a company generates a return on it.
v) Cash Flow Statement
A cash flow statement must depict the cash flows within the
period classifying as
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Operating activities: Cash flows from operating activities
predominantly result from
the main revenue-generating activities of an enterprise.
For example:-
Cash received from the sale of goods and services
Cash received in form of fees, royalties, commissions and
various other revenue
forms
Cash paid to a supplier of goods and services
Investing Activities: Cash flows from investing activities
represent outflows are
made for resources intended for generating cash flows and future
income.
For example:-
Cash paid for acquiring fixed asset
Cash received from disposal of fixed assets (including
intangibles)
Cash paid for acquiring shares, warrants or debt instruments of
other companies
Financing activities: Financing activities are those which
brings changes in
composition and size of owner’s capital and borrowings of an
enterprise.
For example:-
Cash received from issuing shares.
Cash received from issuing loans, debentures, bonds or
long-term
borrowings.
Borrowings repaid.
Grouping the activities provide information which enables the
users in assessing the
impact of such activities on the overall financial position of
an enterprise and also
assess the value of change in cash and cash equivalents.
vi) Capital structure
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Capital structure analysis is a periodic evaluation of all
components of
the debt and equity financing used by a business. The intent of
the analysis is to
evaluate what combination of debt and equity the business should
have. This
mix varies over time based on the costs of debt and equity and
the risks to which
a business is subjected. Capital structure analysis is usually
confined to short-
term debt, leases, long-term debt, preferred stock, and common
stock. The
analysis may be on a regularly scheduled basis, or it could be
triggered by one
of the following events:
The upcoming maturity of a debt instrument The need to find
funding for the
acquisition of a fixed asset
The need to fund an acquisition
A demand by a key investor to have the business buy back
shares
A demand by investors for a larger dividend
An expected change in the market interest rate
vii) Comparative Analysis of Companies
Comparative statements deal with the comparison of different
items of the Profit and Loss
Account and Balance Sheets of two or more periods. Separate
comparative statements
are prepared for Profit and Loss Account as Comparative Income
Statement and for
Balance Sheets.
Comparative Income Statement: Three important information are
obtained from the
Comparative Income Statement. They are Gross Profit, Operating
Profit and Net
Profit. The changes or the improvement in the profitability of
the business concern is
find out over a period of time. If the changes or improvement is
not satisfactory, the
management can find out the reasons for it and some corrective
action can be taken.
Comparative Balance Sheet: The financial condition of the
business concern can
be find out by preparing comparative balance sheet. The various
items of Balance
sheet for two different periods are used. The assets are
classified as current assets
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and fixed assets for comparison. Likewise, the liabilities are
classified as current
liabilities, long term liabilities and shareholders’ net worth.
The term shareholders’ net
worth includes Equity Share Capital, Preference Share Capital,
Reserves and Surplus
and the like.
Common Size Statements: A vertical presentation of financial
information is followed
for preparing common-size statements. Besides, the rupee value
of financial
statement contents are not taken into consideration. But, only
percentage is
considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100
and the balance items are
compared to the total assets, total liabilities or sales in
terms of percentage. Thus, a
common size statement shows the relation of each component to
the whole. Separate
common size statement is prepared for profit and loss account as
Common Size
Income Statement and for balance sheet as Common Size Balance
Sheet.
Trend Analysis: The ratios of different items for various
periods are find out and then
compared under this analysis. The analysis of the ratios over a
period of years gives
an idea of whether the business concern is trending upward or
downward. This
analysis is otherwise called as Pyramid Method.
b) Non – Financial characteristics
n order to analyze overall performance, an investor should also
analyze non-
financial parameters along with the financial parameters. Some
non- financial
indicators are:
Nature of the business: an investor should try to analyze the
performance on the
basis of nature of product and the position of business in the
industry in which the
company is operating. Eg: whether goods are consumable or
capital goods? What
is the link between future prospects of the company and future
outlook of the
industry?
Share of the company in the market: the investor should know
about the shares
of the company in the market. The share in the market should be
reasonable. If
the share in the market is optimum, there should be a better
chance of leading the
market and earning the sufficient profits.
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Efficiency of the management: the management of the company
should be
honest, efficient, goal-oriented and dedicated. The vision and
operational
efficiency should be examined because these matters a lot in
shaping the destiny
of the company.
Long term prospective: the expansion policy and long term plan
should be
examined. Company’s asset should be satisfactory. Long term
plans should be
able to stabilize its profit earning capability from unfavorable
fluctuations in the
future.
Availability of raw material: if the raw material is available
in the domestic
company, the operational efficiency will be better than the
situation where the
company is dependent on imported raw material. Any shortage in
raw material or
escalation in the cost will adversely affect the cost of
production.
Research and development: the companies who spend a substantial
amount on
research and development for upgrading the techniques,
introducing new
products, manufacturing import substitution etc. have bright
scope for growth and
expansion.
Government policy: the government policy also affect the
efficiency of the
company. If the government policy is not in favour of future
prospect and growth
of company, then investment should not be made.
Product range/ diversification: an investor should examine the
progressiveness
and diversification status of the company. A company is
progressive if it launches
new products frequently as per new liking and taste of the
customers. A well-
diversified company is always better for investment because in
such case business
risk and operational risk can be reduced.
Competitive strength of the company: before making investment,
the
competitive strength in form of both financial and non –
financial asset should be
examined. The competitive position of a company within an
industry can be
determined through the amount of annual sales, the growth of
annual sales and
the stability of annual sales.
Technology: technology plays an important role in the success
and failure of the
organization. A company operating with latest technology has a
higher chances of
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survival than a company having obsolete technology. Companies
depending
mainly on the labour are sensitive to labour strike and unrest
etc. in this case
availability of skilled labour, unskilled labour with wage level
should be analyzed.
4. STOCK VALUATION
Stock valuation: Stock (Security) valuation is important to
decide on the portfolio of
an investor. All investment decisions are to be made on a
scientific analysis of the
right price of a share. Hence, an understanding of the valuation
of securities is
essential. Investors should buy underpriced shares and sell
overpriced shares. Share
pricing is thus an important aspect of trading. Valuation ratios
put that insight into the
context of a company’s share price, where they serve as useful
tools for evaluating
investment potential. Here is a list of principle valuation
ratios.
a) Valuation of stock using ratio:
Valuation of Stock
Fundamental analysis
Dividend Based
Earning Based
Price Earning(P/E)
Ratio PEG Ratio
Price to Sales Ratio
OtherRatios:
(a) EPS
(b) DPS
(c) D/P Ratio
Revenue Based
Technical Analysis
charting / graphical
represenations
(a) Line
(b) Bar
(c) Candle -Stick
(d) Point and figure
market indicators
(a) Trends
(b) Moving average
(c) confidence index
(d) Breadth of Market
(e) Relative Strenght
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i) Price Earnings Ratio (P/E): The price-earnings ratio (P/E
Ratio) is the ratio for
valuing a company that measures its current share price relative
to its per-share
earnings. The price-earnings ratio can be calculated as:
Market Value per Share / Earnings per Share
For example, suppose that a company is currently trading at
Rs.43 a share and
its earnings over the last 12 months were Rs.2 per share. The
P/E ratio for the stock
could then be calculated as 43/2, or 21.5
Significance of P/E Ratio
The P/E ratio indirectly incorporates key fundamentals of the
company such as
future growth and risk. Generally, it takes into account the
following factors:
Past Performance: If the company has proven track record, it
would have a higher
P/E relative to a company, which has had an erratic
performance.
Future Growth: This is the most important factor built into the
P/E ratio. High
growth companies (sale and earnings both) will have higher P/E
than the low
growth companies within the same industry.
Risk (Leverage): P/E ratio is highly dependent on capital
structure. Leverage (i.e.
debt taken on by the company) affects both earnings and share
price in a variety
of ways, including the leveraging of earnings growth rates, tax
effects and impacts
on the risk of bankruptcy, and can sometimes dramatically affect
the company’s
results. Thus, lower the leverage, higher the P/E ratio. As a
result, high capital-
intensive industry gets lower P/E than low capital-intensive
industry.
Corporate Governance: A company with strong corporate governance
will have
higher P/E than its peer group
Dividend Payout: Generally, high and stable dividend paying
companies get high
P/E because it shows the fundamental strength of the company and
the company’s
commitment to rewarding its shareholders.
Economic Cycle: Industries which are affected by economic cycle
usually trade
at lower P/E’s than defensive sectors (those which are
unaffected by the economic
cycle). For example, FMCG and Pharma sector have higher P/E than
Textile and
Capital Goods sectors.
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ii) Price / Earnings to Growth [PEG]: Price/earnings-to-growth
ratio is the relationship
between the P/E ratio and the projected earnings growth of a
company. It is calculated
by dividing the P/E ratio by the earnings-per-share growth. PEG
ratio = PE Ratio/
EPS Growth Rate.
Generally, a company that is growing fast has a higher P/E
ratio. This may give an
impression that is overvalued. Thus, P/E ratio divided by the
estimated growth rate shows
if the high P/E ratio is justified by the expected future growth
rate. The result can be
compared with that of peers with different growth rates.
A PEG ratio of one signals that the stock is valued reasonably.
A figure of less than one
indicates that the stock may be undervalued.
PEG is a widely employed indicator of a stock's possible true
value. Similar to PE ratios,
a lower PEG means that the stock is undervalued more. Many over
the price/earnings
ratio favor it because it also accounts for growth.
The PEG ratio of 1 is sometimes said to represent a fair
trade-off between the values of
cost and the values of growth, indicating that a stock is
reasonably valued given the
expected growth. A crude analysis suggests that companies with
PEG values between 0
and 1 may provide higher returns.
A PEG Ratio can also be a negative number if a stock's future
earnings are expected to
drop (negative growth number).
iii) Price revenue ratio, or (Price Sales Ratio) PSR, is a
valuation metric for stocks. It is
calculated by dividing the company's market cap by the revenue
in the most recent
year; or divide the per-share stock price by the per-share
revenue.
The smaller this ratio (i.e. less than 1.0) is usually thought
to be a better investment
since the investor is paying less for each unit of sales.
However, sales do not reveal
the whole picture, as the company may be unprofitable with a low
P/S ratio. Because
of the limitations, this ratio is usually used only for
unprofitable companies, since they
don't have a price–earnings ratio (P/E ratio). The metric can be
used to determine the
value of a stock relative to its past performance. It may also
be used to determine
relative valuation of a sector or the market as a whole.
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PSRs vary greatly from sector to sector, so they are most useful
in comparing similar
stocks within a sector or sub-sector. Comparing P/S ratios
carries the implicit
assumption that all firms in the comparison have an identical
capital structure. This is
always a problematic assumption, but even more so when the
assumption is made
between industries, since industries often have vastly different
typical capital
structures (for example, a utility vs. a technology company).
This is the reason why
P/S ratios across industries vary widely.
b) Valuation of Stock on Basis of Historic Prices
Technical Analysis can be defined as an art and science of
forecasting future prices based
on an examination of the past price movements. Technical
analysis is not astrology for
predicting prices. Technical analysis is based on analyzing
current demand-supply of
commodities, stocks, indices, futures or any tradable
instrument. Technical analysis
involve putting stock information like prices, volumes and open
interest on a chart and
applying various patterns and indicators to it in order to
assess the future price
movements. The time frame in which technical analysis is applied
may range from
intraday, daily, weekly or monthly price data to many years.
Basic Premises of Technical Analysis
The basic premises underlying technical analysis, as articulated
by Robert A. Levy, are
as follows:
Market prices are determined by the interaction of supply and
demand forces.
Supply and demand is influenced by a variety of factors, both
rational and irrational.
These include fundamental factors as well as psychological
factors.
Barring minor deviations, stock prices tend to move in fairly
persistent trends.
Irrespective of why they occur, shifts in demand and supply can
be detected with the
help of charts of market action
Shifts in demand and supply bring about changes in trends.
Because of the persistence of trends and patterns, analysis of
past market data could
be used to predict future price behavior.
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Tools of Technical Analysis
There are numerous tools and techniques for doing technical
analysis. Basically this
analysis is done from the following four important points of
view:-
Prices: Whenever there is change in prices of securities, it is
reflected in the changes
in investor attitude and demand and supply of securities.
Time: The degree of movement in price is a function of time. The
longer it takes for a
reversal in trend, greater will be the price change that
follows.
Volume: The intensity of price changes is reflected in the
volume of transactions that
accompany the change. If an increase in price is accompanied by
a small change in
transactions, it implies that the change is not strong
enough.
Width: The quality of price change is measured by determining
whether a change in
trend spreads across most sectors and industries or is
concentrated in few securities
only. Study of the width of the market indicates the extent to
which price changes have
taken place in the market in accordance with a certain overall
trends.
The tools of technical analysis can be divided into two main
categories, namely, Charting
Techniques and Technical indicators Charting techniques is based
on chart patterns and
the analyst's tries to identify price patterns. Their goal is to
profit from trading when
patterns occur, some of the important chart patterns are Head
& Shoulders, Support &
Resistance, Gap Analysis, Trend Lines, Triangles, Rectangles,
Double Tops and Double
Bottoms. These are broadly classified below:
Charting or Graphical Representation
Charting is the basic tool in technical analysis, which provides
visual assistance in
defecting changing pattern of price behaviour. The technical
analyst is sometimes called
the Chartist because of importance of this tool. The Chartists
believe that stock prices
move in fairly persistent trends. There is an inbuilt inertia,
the price movement continues
along a certain path (up, down or sideways) until it meets an
opposing force due to
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demand-supply changes. Chartists also believe that generally
volume and trend go hand
in hand. When a major ‘up’ trend begins, the volume of trading
increases and also the
price and vice-versa. The essence of Chartism is the belief that
share prices trace out
patterns over time. These are a reflection of investor behaviour
and it can be assumed
that history tends to repeat itself in the stock market. A
certain pattern of activity that in
the past produced certain results is likely to give rise to the
same outcome should it
reappear in the future. The various types of commonly used
charts are:
Line Charts: The simplest form of chart is a line chart. Line
charts are simple
graphs drawn by plotting the closing price of the stock on a
given day and
connecting the points thus plotted over a period of time. Line
charts take no notice
of the highs and lows of stock prices for each period.
Bar Charts: It is a simple charting technique. In this chart,
prices are indicated on
the vertical axis and the time on horizontal axis. The market or
price movement for
a given session (usually a day) is represented on one line. The
vertical part of the
line shows the high and low prices at which the stock traded or
the market moved.
A short horizontal tick on the vertical line indicates the price
or level at which the
stock or market closed:
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Point and Figure Chart (PFC): Though the point and figure chart
is not as
commonly used as the other two charts, it differs from the
others in concept and
construction. In PFC there is no time scale and only price
movements are plotted.
As a share price rises, a vertical column of crosses is plotted.
When it falls, a circle
is plotted in the next column and this is continued downward
while the price
continues to fall. When it rises again, a new vertical line of
crosses is plotted in the
next column and so on. A point and figure chart that changes
column on every
price reversal is cumbersome and many show a reversal only for
price changes of
three units or more (a unit of plot may be a price change of say
one rupee).
Point & Figure charts consist of columns of X’s and O’s that
represent filtered price
movements. X-Columns represent rising prices and O-Columns
represent falling
prices. Each price box represents a specific value that price
must reach to warrant
an X or an O. Time is not a factor in P&F charting. No
movement in price means
no change in the P&F chart.
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Japanese chart or Candle stick chart: Another kind of chart used
in the technical
analysis is the candlestick chart, so-called because the main
component of the
chart which represents prices looks like a candlestick, with a
thick ‘body’ and
usually, a line extending above and below it, called the upper
shadow and lower
shadow, respectively.
The top of the upper shadow represents the high price, while the
bottom of the
lower shadow shows the low price. Patterns are formed both by
the real body and
the shadows. Candlestick patterns are most useful over short
periods of time, and
mostly have significance at the top of an uptrend or the bottom
of a downtrend,
when the patterns most often indicate a reversal of the
trend.
The wider part of the candlestick is shown between the opening
and closing price.
It is usually colored in black/red when the security closes on a
lower price and
white/green the other way around. The thinner parts of the
candlestick are
commonly referred to as the upper/lower wicks or as shadows.
These show us the
highest and/or lowest prices during that timeframe, compared to
the closing as well
as opening price.
The relationship between the bodies of candlesticks is important
to candlestick
patterns. Candlestick charts make it easy to spot gaps between
bodies.
A slight drawback of candlestick chart is that candlesticks take
up more space than
OHLC bars. In most charting platforms, the most you can display
with a candlestick
chart is less than what you can with a bar chart.
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Market indicators Apart from charting techniques, stock
valuation can also be done by
considering various market indicators:
Movements and Trends:
A trend can be defined as the direction in which the market is
moving. Up trend is the
upward movement and downtrend is the downward movement of stock
prices or of the
market as measured by an average or index over a period of time,
usually longer than six
months. Trend lines are lines that are drawn to identify such
trends and extend them into
the future. These lines typically connect the peaks of advances
and bottoms of declines.
Sometimes, an intermediate trend that extends horizontally is
seen.
Trends can be classified into following major types:
UPTREND: Uptrend is classified as a series of higher highs and
higher lows. It is also
called as higher top and higher bottom formation. As mentioned
in below diagram, point
3 is higher than point 1 which was a previous high, then point 5
is greater than point 3
which was a previous high this indicates continuous formation of
higher high and higher
low. Hence, we say that the stock is trading in uptrend.
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Higher highs indicate that the stock is making consecutive peaks
than previous highs.
Higher lows indicate that bottom is higher than the previous
lows, this can be easily seen
on charts.
DOWNTREND: Downtrend is consists of lower lows and lower high.
It is also called as a
lower top and lower bottom formation in technical analysis.
When the stock is making lower highs & lower lows, it is
considered to be in trading in a
downtrend. Lower highs mean that previous peak is higher than
the current peak. Lower
lows mean the current bottom is lower than the previous bottom
which is shown in
above diagram as point 3 is lower than point 1 and at the same
time point 4 is less than
point 2
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SIDEWAYS TREND: When the stock trades in a range, it is called
sideways trend. In this
trend prices make higher top and lower bottom or lower top and
higher bottom formations,
where as it is very difficult for trader to trade in this trend.
Generally accumulations and
distributions happens in this range.
Sideways trend occurs when the force of demand & supply are
nearly equal. A
sideways trend is also called ‘horizontal trend’ or
‘consolidation’.
DOUBLE TOPS A double top forms when the price makes a high
within an uptrend, and
then pulls back. On the next rally the price peaks near the
prior high, and then falls below
the pullback low. It's called a double top because the price
peaked in the same area twice,
unable to move above that resistance area.
DOUBLE BOTTOMS A double bottom forms when the price makes a low
within a
downtrend, and then pulls back to the upside. On the next
decline the price stalls near
the prior low, then rallies above the pullback high. It's called
a double bottom because the
price stalled in the same area twice, unable to drop below that
support area.
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HEAD AND SHOULDERS TOP A HS top is formed when the price makes a
high, pulls
back, makes a higher high, pulls back, and then makes a lower
swing high. This creates
three peaks, with the one in the middle being the highest. The
topping pattern is typically
only relevant if seen after a substantial advance.
HEAD AND SHOULDERS BOTTOM The head and shoulders (HS) bottom, or
inverse
head and shoulders, occurs after a downtrend, and signals an
uptrend may be starting or
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underway. The pattern is created by a swing low, followed by a
rally, a lower swing low,
a rally, and then a higher low.
i) Moving average analysis:
The statistical method of moving averages is also used by
technical analysts for
forecasting the prices of shares. While trends in share prices
can be studied for possible
patterns, sometimes it may so happen that the prices appear to
move rather haphazardly
and be very volatile. Moving average analysis can help under
such circumstances. A
moving average is a smoothed presentation of underlying
historical data. It is a summary
measure of price movement which reduces the distortions to a
minimum by evening out
the fluctuations in share prices. The underlying trend in prices
is clearly disclosed when
moving averages are used. To construct a moving average the time
span of the average
has to be determined. A 10 day moving average measures the
average over the previous
10 trading days, a 20 day moving average measures the average
values over the previous
20 days and so on. Regardless of the time period used, each day
a new observation is
included in the calculation and the oldest is dropped, so a
constant number of points are
always being averaged. The moving averages are worked out in
respect of securities
studied and depicted on the graph. Whenever the moving average
price line cuts the
actual price line of the security or of the market index from
the bottom it is a signal for the
investors to sell the shares. Conversely, when the moving
average price line cuts the
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actual price line from above, it is the right time to buy
shares. The moving average
analysis is quite a useful method in finding out the trends in
security prices when it is
based on long-term approach. However, a point of caution is in
order. Moving average
analysis always invariably provide signal to buy or sell, after
the trend reversal has begun.
These are neither lead indicators nor juncture points for change
in trends. The moving
averages should therefore, be used only with other indicators,
otherwise these may
provide true, but mathematically inaccurate information. The
technical analysts can use
three types of moving averages -simple, weighted or
exponential.
Relative Strength
The empirical evidence shows that certain securities perform
better than other securities
in a given market environment and this behaviour remains
constant over time. Relative
strength is the technical name given to such securities by the
technical analysts because
these securities have stability and are able to withstand both
depression and peak
periods. Investors should invest in such securities, because
these have constant strength
in the market. The relative strength analysis may be applied to
individual securities or to
whole industries or portfolios consisting of stock and
bonds.
The relative strength can be calculated by:
Measuring the rate of return of securities
Classifying securities
Finding out the high average return of securities
Using the technique of ratio analysis to find out the strength
of an individual security.
Technical analysts measure relative strength as an indication
for finding out the return of
securities. They have observed that those securities displaying
greatest relative strength
in good markets (bull) also show the greatest weakness in bad
markets (bear). These
securities will rise and fall faster than the market. Technical
analysts explain relative
strength as a relationship between risk and return of a security
following the trends in the
economy. After preparing charts from different securities over a
length of time, the
technician would select certain securities which showed relative
strength to be the most
promising investment opportunities.
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Resistance and Support Level
The peak price of the stock is called the resistance area.
Resistance level is the price
level to which the stock or market rises and then falls
repeatedly. This occurs during an
uptrend or a sideway trend. It is a price level to which the
market advances repeatedly
but cannot break through. At this level, selling increases which
causes the price fall.
Support level shows the previous low price of the stock. It is a
price level to which a stock
or market price falls or bottom out repeatedly and then bounce
up again. Demand for the
stock increases as the price approaches a support level. The
buying pressure or the
demand supports the price of stock preventing it from going
lower.
5. Examining the shareholding pattern of the company.
Reviewing the shareholding pattern and the change in
shareholding pattern could be
useful to the investors. It shows how shares of a company are
split among the entities
that make up its owners.
The Shareholding structure is declared every quarter.
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BASIC RULES.
As a rule of thumb, higher promoter’s stake is perceived as
positive and a lower equity
stake could mean low confidence of promoters in their own
company. Rise in
promoter stake is considered positive because promoters will
commit additional fund
only when they are optimistic about future growth of their
company.
Similarly a higher FIIs stake is considered as positive and a
lower FII participation
could mean low confidence of FIIs in the company. Rise in FII
stake is considered
positive as they will commit funds only when they are totally
optimistic and confident
about the future prospects of the company.
Too high or too low of promoters stake or FII holding is not
favorable.
SHARE HOLDING PATTERN
Data regarding the share holding pattern is available in the
stock exchange’s website, all
financial websites as well as in the company’s website and
annual reports. Share holding
pattern of a company generally involves:-
Promoters’ Holding – Promoters may include domestic and foreign
promoters.
Promoters are the entities that floated the company, and to a
large extent have seats
on the Board of Directors or the management.
Persons acting in concert with the Promoters. Relatives of the
promoters who hold
shares fall under this class and are termed as the promoter
group.
Holding of the Non-Promoters – these include institutional
investors like Banks,
Financial Institutions, Insurance Companies, Mutual Funds,
Foreign Institutional
Investors and others like private Corporate bodies, Trusts,
Foreign Companies you
and me .
PROMOTERS AND FIIs – The two categories of shareholders to
watch.
While analysing the shareholding pattern of the company, the two
important categories
to be watched are the promoter’s stake and the FIIs stake in
that company. An increase
in promoter stake does not always constitute a sign of
confidence. It is also necessary to
see whether fresh funds have come in. If fresh fund have been
invested, where will they
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be invested. Answers to these questions would help investors to
determine whether jump
in promoter stake is beneficial to the company. However, an
increase in FIIs stake is a
good sign – It shows that they are bullish on the stock. At the
same time, the flip side of
huge FII holding is that the stock price will be subject to huge
price volatility when they off
load the stake.
Analysing the holdings of various categories of investors would
give you insights into the
pattern of control in the company.
Here’s a collection of tips for you –
Rise or fall in promoters holding is to be studied by looking at
two aspects. First what
is purpose of promoters in raising or reducing their equity
stakes and second, the
methods promoters have adopted to increase or reduce their
ownership.
If the promoters are increasing their stake to pay off debts and
strengthen their
balance sheet. This is certainly positive for the
shareholders.
Companies that have gone for share buyback also see rise in
promoter’s stake. The
core objective of a buyback is to create wealth, but it also
increases promoter’s equity
stake at no additional cost. A rise in promoter’s stake due to
merges or buyback means
little for investors in real terms.
Promoters of companies that have opted for rights issue are
forced to step in and bail
out the unsubscribed portion just in case the rights are
undersubscribed. Here, there
will be an unintentional rise in promoter’s stake. Shareholders
declining to subscribe
to rights issue and promoters chipping to rescue the issue do
not qualify to be positive
development.
A decline in promoter holding should also be analyzed in detail.
Decline in promoter
holding can be due to various factors such as issuing fresh
share towards employee
stock option, or it could be due to offloading/issuing of fresh
shares to
strategic/financial partners. These changes should be carefully
studied.
Promoters offloading their holdings in the open market are a
warning signal. Some
dubious companies announce positive development periodically;
promoters keep on
offloading equity stake at the same time. It is well laid-out
trap for investors.
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If you see promoters increasing their stakes in successive
quarters, you know that
the financial performance is going to be good and the stock
prices would possibly be
higher. However, it’s unusual to see promoters’ holding increase
on a regular basis.
They usually step in to buy after a sharp market decline to
shore up their holdings.
A very high promoter holding is not a good sign. A diversified
holding and a good
presence of institutional investors indicates that promoters
have little room to make
and carry out random decisions that benefit them without gauging
how it would affect
earnings and other shareholders.
Very low stake of promoters is perceived as diminishing
confidence of promoters. This
results in rampant sell off which results in loss for
investors.
FII holdings in stocks are used as indicators in stock
selections; stocks with high FII
holdings are largely favored. However, such stocks could take a
hit should the FIIs
decide to sell their stake. Retail investors may perceive such
selling off to be a lack of
faith in the stock by the FII.
Holding by mutual funds and insurance companies is an indicator
on how favored a
stock is. Multiple funds holding the stock could be a sign of
growth potential. Therefore,
such high institutional holding may mean your investment is a
tad safer since that
company may then be more professionally run.
While looking at the shareholding pattern, figures for a single
period is also unlikely to
tell you much. Compare holding patterns with those of the
previous quarters to check
how holdings have changed.
Along with holding patterns, companies also disclose the
entities — other than the
promoters — that hold more than 1 per cent in the share capital.
Companies are also
required to declare the promoters’ shares that have been pledged
as debt collateral.
6. Pitfalls to avoid while investing
a) High P/E stocks: The P/E ratio measures the relationship
between a company's stock
price and its earnings per share. The P/E ratio is calculated by
dividing a company's
current stock price by its earnings per share (EPS). A high P/E
ratio indicates that
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investors expect higher earnings. However, a stock with a high
P/E ratio is not
necessarily a better investment than one with a lower P/E ratio,
as a high P/E ratio
can indicate that the stock is being overvalued. If you invest
in an overvalued stock,
you run the risk of losing money if it doesn't meet investors'
high earnings
expectations. On the other side, when a company's stock has a
low P/E ratio, it may
indicate that the stock is undervalued. Investors can often buy
undervalued stock at a
discount and then profit when the price of that stock
climbs.
b) Low price stocks: There is a common saying: “Don’t judge a
book by its cover.”
Some equally valid words of wisdom for investors could be:
“Don’t judge a stock by its
share price.” Despite so much information available for
investors, many people still
incorrectly assume that a stock with a lower price is cheap,
while another with a heftier
price is expensive. This notion can lead investors down the
wrong path and into some
bad decisions for their money. The cheapest stocks, known as
“penny stocks” also
tend to be the riskiest. A stock that just went from Rs40 to Rs4
may end up at zero,
while a stock that goes from Rs10 to Rs20 might double again to
Rs40. Looking at a
stock’s share price is only useful when taking many other
factors into account.
c) Stop loss: A stop-loss order is an order placed with a broker
to sell a security when
it reaches a certain price. Stop-loss orders are designed to
limit an investor’s loss on
a position in a security. Although most investors associate a
stop-loss order with a
long position, it can also protect a short position, in which
case the security gets bought
if it trades above a defined price. A stop-loss order takes the
emotion out of trading
decisions and can be useful if a trader is on vacation or cannot
watch his or her
position. However, execution is not guaranteed, particularly in
situations where trading
in the stock halts or gaps down (or up) in price. A stop-loss
order may also be referred
to as a “stop order” or “stop-market order.” If an investor uses
a stop-loss order for a
long position, a market order to sell is triggered when the
stock trades below a certain
price; the order then gets filled at the next available price.
This type of order works
efficiently in an orderly market; however, if the market is
falling quickly, investors may
get a fill well below their stop-loss order price.
d) Excess averaging: If the stock you purchased drops, don’t try
to buy more shares to
bring down your average buying price. Investors often try to
cover their losses by
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buying more of the same shares at the lower price. There is
merit in averaging down
the price provided the stock’s fundamentals are strong and the
current drop is external
to the company or owing to a temporary event. If your bet is
right, the upside on the
investment will be much higher. However, if the fundamentals
have deteriorated, then
averaging is like catching a falling knife; your losses will
only worsen as you buy more
of the same junk. There is no point throwing good money after
bad. “Averaging down
is a good idea only if the underlying stock is of good quality.
Even then, fix a limit to
the extent to which you want to increase exposure.