FUNDAMENTAL ANALYSIS AND VALUATION

Structure:-

Learning Objectives

Introduction

Meaning of Fundamental Analysis

Economy-Wide Factors

Industry Analysis

Company Analysis

Self Check Exercise

Summary

Glossary

Answers to Self Check Exercise

Terminal Questions

LEARNING OBJECTIVES

After reading this chapter, you will be able to:-

· Describe the various factors that influence the economy

· Understand the relationship between stock prices and the economy

· Describe the various factors that influence industries

· Evaluate the future prospects of an industry

· Understand the various factors that contribute to a company's strategy and weakness.

INTRODUCTION

In the fundamental approach, an attempt is made to analyze various fundamental or basic factors that affect the risk-return of the securities. The effort here is to identify those securities that one perceives as mispriced in the stock market. The assumption in this case is that the 'market price' of security and the price as justified by its fundamental factors called 'intrinsic value' are different and the marketplace provides an opportunity for a discerning investor to detect such discrepancy. The moment such a description is identified; a decision to invest or disinvest is made. The fundamental factors may relate to the economy or industry or company or all some of this. Thus, economy fundamentals, industry fundamentals and company fundamentals are considered while prizing the securities for taking investment decision.

MEANING OF FUNDAMENTAL ANALYSIS

The basic purpose of buying a security is to earn dividends and ultimately sell it at higher price. An investor, therefore, is interested in obtaining estimates of future dividends, and also the future price of the share. These in turn will depend upon the performance of the industry to which the company belongs, and the general economic situation of the country.

The multitude of factors affecting a company's profitability can be broadly classified as:

1. Economy-wide factors. These include the factors like growth rate of the economy, the rate of inflation, foreign exchange rates etc. which affect profitability of all companies, in general.

2. Industry-wide factor. These include factors, which are specific to industry to which the company belongs. For instance, the demand supply gap in the industry. The emergence of substitutes, and changes in government policies towards industry affect the company belonging to an industry.

3. Company specific factors. These factors are specific to a firm. The firm-specific factors like plant and machinery, the brand image of the product, and ability of the management to affect the profitability.

An investor with rational and scientific approach will therefore be interested in analyzing the influences of the expected performance of the company, industry and the economy as a whole on share prices, even before taking the investment decision. Such analysis is called fundamental analysis. This analysis is based on the premise that share prices are determined by a number of fundamental factors relating to the economy, industry and the company. Based on these fundamental factors, each share is assumed to have an economic value or intrinsic value. The purpose of fundamental analysis is to evaluate the present and future earning capacity of a share based on the economy, the industry and company fundamentals and decide the intrinsic value of a share.

The intrinsic value determined by fundamental analysis is compared with the prevailing market price to arrive at an investment decision. If market price is more than intrinsic value, the share is considered to be overpriced and a "Sell" decision is recommended. On the other hand if intrinsic value is less than market price the share is considered to be underpriced and "Buy Decision" is recommended. The fundamental analytical frame work is called Economy- industry Company Analysis frame work (EIC frame work).

In the present chapter we discuss the analysis of economy wide factors. Industry factors and company factors.

ECONOMY-WIDE FACTORS

The performance of the company depends on the performance of the economy. We shall illustrate how to prospects of a company are influenced by larger economy-wide factors. Suppose, for instance, we are examining the possibility of investing in share of Cement Company. It is true that if the economy is growing fast, the demand for cement in general is expected to grow fast. Besides the cement companies, the firms in other industry will also do well. On the other hand, if the economy is passing through recession, the performance of the cement company will be generally bad.

The investors are concerned with those variables in the economy which affect the performances of company in which they intend to invest. A study of these economy variables will give some idea as to

the potential future performance of the company. We therefore shall look at some of the key economic variables that an investor would have to track down as a part of fundamental analysis.

Growth rate of National Income & Related Measures:

The rate of growth of national economy is an important variable to be considered by an investor. We often hear of Gross Domestic Product (GDP), Gross National Product (GNP) and Net National Product (NNP). These terms vary slightly between themselves. But, they all measure the total income or total economic output of the whole country. The precise conceptual differences between them are not important in the present context but, for most purposes, what is important is the role of growth of the economy. The growth rate in any of these measures is good enough to reflect the growth of the economy, because growth rates of all of them are close to each other. The estimates of the GNP, NNP and GDP and their growth rates are made available by the government from time to time. The estimates of growth rate of the economy would be a good pointer to the prospects of the individual sectors and hence to the returns that the investor can expect from investing in shares. The profitability of the companies are expected to the attractive when the economy grows faster, and the returns to investment in share in turn are expected to be good.

Growth Rate of Industrial Sector

The growth of industrial sector is an important contributor to the growth of national income. The performance and growth of the industry is measured through an index number called index of industrial Production The Industrial growth rate is further disaggregated into growth rates of different sectors like electricity, basic goods, consumer goods and so on the trends in such rates broadly point to the performances of the different industrial sectors to which a specific company of investor's interest belongs.

Inflation

Inflation prevailing in the economy has considerable impact on the performance of the companies high rates of inflation upsets business plans; result in high input costs and hence reduction in profit margins. On the other hand, the inflation erodes purchasing power of buyers and results in reduction in demand for goods. The demand for consumer goods will particularly be affected adversely. The firms in these industries therefore make continuous assessment about inflation rates likely to prevail so that they could tune pricing, distribution and promotion policies to the anticipated impact of inflation on their product demand.

Inflation is measured by a suitable price index number. The wholesale price index (WPI), number is generally used for this purpose. This index number is available on a weekly basis from Central Statistical Organization (CSO) and Reserve Bank of India (RBI). The fundamental analyst should evaluate the prevailing and likely future trends in inflation and their probable impact on the company's performance. However it should be noted that the economists argue that moderate rate if inflation is good and is necessary for industrial growth, as it is a good motivator for higher production, without introducing any serious imbalance between demand and supply in the economy. High inflation rate, say2-digit rate is however associated with dangerous consequences.

Interest Rates

Interest rates reflect the cost and availability of credit to the companies operating in the economy. The interest rate, and the volume as well as direction of the credit supply, in the economy is influenced by monetary policy of the Reserve Bank of India. If the cheap money policy is pursued, the interest rates are likely to be lower and larger volume of money supply is expected to be there in the economy.

A lower rate of interest implies lower costs of financing the company's operations and assures higher profitability. Higher, the rate of interest, higher will be the costs of manufacturing and sale, which

is expected to lead lower profitability to the company. The fundamental analyst therefore, has to examine the trends in money supply, interest rates and monetary policy and their impact on an individual company's performance.

Foreign. Exchange Rate

If a company is major exporter or importer its performance and profitability are likely to be affected considerably by the exchange rate of rupee against other currencies. A depreciation of rupee vis-à-vis U.S. dollar, a major internationally accepted currency, will make Indian products more competitive, pricewise in the foreign markets, thereby stimulating exports from India. However it will make imports more expensive and a company which depends heavily on imports might find that devaluation of rupee has affected its profitability adversely.

The exchange rate or rupee is adversely affected by deficit balance of trade, balance of payment deficit and foreign exchange reserves position. The excess of imports over exports is called deficit balance of trade. To this we add balances on "invisibles" like net tourism receipts and interest payments etc. and get the balance on current account. We then add the balance of payment deficit. Each of these reflects the strength of rupee on external account. If these deficits increase there is high chance that the rupee will depreciate against foreign currencies. Another important indicator is foreign exchange reserves. The balance of payment deficit leads to a decline in these reserves. The size of the foreign exchanges reserves is a measure of strength of rupee on external account. A large foreign exchanges reserve is a measure of strength of rupee on external account. Large foreign exchanges reserves help to increase the value of rupee against other currencies.

Government Budget

The government budget provides detailed information on each of government spending and revenues. The deficit is essentially the excess of government spending on revenues. Budget deficit though often incurred for creating infrastructural facilities in the economy tends to create inflationary pressure. Due to this there is a strong public opinion against the government's creation of deficit without expanding the revenue.

The government spending generates substantial demand for goods and services produced by such industries. For example, if the government makes a large allocation in its budget for malaria eradication and control program, then prospects of industry engaged, in manufacture of mala-thion-a chemical used for mosquitoes' control-would improve. The prospect or cement industry is influenced by the government expenditure, on construction of bridges, dams and similar infrastructure projects. The government expenditure is also great stimulant of the economy by creating employment and generating effective demand. In view of the significance of government expenditure and deficit on the economy, an investor has to evaluate these carefully to assure their impact on his investment.

Savings and Investment

The capital market is a channel through which the savings of households are made available to corporate for investment. Therefore the trends in saving and investment are significant in studying their impact on capital market. A rising trend in investment points to the fact, that economy is on upswings with additional employment and income generation. Under such simulation, the share prices are likely to go up, particularly due to demand for this type of financial assets. Further, a part of the rising savings of the people will find their way to the stocks investment, creating demand for stock, which will in turn push up share prices. Moreover, the pattern of distribution of savings over the various assets like bank deposits, bullion, stocks etc. will give an idea of-relative preference of the investor to various types of assets.

Infrastructure

The availability of infrastructure facilities like power, transportation and communication system, affect the performance of the companies. Inadequate and inefficient infrastructure leads to lower productivity, wastage, delays and higher cost of production. An investor should, therefore, assess the status of infrastructure facilities available in the economy and their impact on a company. Further, the likely trends in infrastructure development having bearing on a specific company or industry must be identified and its impact evaluated.

Economic and Political Stability

A stable political environment is necessary for steady and balanced growth. The stable but long term economic policies are needed for industrial growth. Such stable policies can be maintained only when stable political system exists and economic and political factors are well linked. A stable government will have a clear-cut long term economic policies, which will be conductive to good performance of the economy and industry. An investment analyst cannot afford to lose sight of this crucial factor and its impact on investment decision.

Monsoon

Indian economy is essentially an Agrarian economy. The agriculture accounts for 65% of occupations and 32% of GDP of the country. Agriculture has strong forward and backward linkages to industries like fertilizer, cotton textiles, sugar, and vanaspati and pesticides. Their performance depends heavily on agricultural performance which in turn depends, among other things on monsoons. Moreover, the improved performance of agriculture results in appreciable demand for goods and services by it. The research studies have pointed out that about 55% to 60% of demand for most consume? goods comes from rural sector. Thus the assessment of prospects of monsoon is attached with "significant" tag by an investor in stocks.

Meteorological forecasts of whether the monsoon will be good or bad are available in May. The monsoon lash in Kerala coast first, in early June and advances gradually to northwards. Such advances are reported in T.V and newspapers. Tentative assessments of adequacy of monsoons are available in July and August and a final picture emerges by end of September. Adequacy of monsoon involves a number of parameters like distribution of rainfalls over space and time. The rains should occur uniformly in all districts where agriculture belts are situated and should occur at certain crucial points of agriculture cycle.

ECONOMIC FORECASTING

Economic analysis is the first step in fundamental analysis and it starts with an analysis of historical performance of the economy. But investment is future oriented activity. The investor is more interested in expected future performance of the economy and its various segments. For this purpose, forecasting the future direction of the economy and major macro-economic variables becomes necessary. Hence economic forecasting becomes a key activity in economic analysis. The main theme in economic forecasting is to forecast the national income. The GNP is one of measures of National Income. An investor would be particularly interested in forecasting the GNP and its various components that he is analyzing.

Economic forecasting is generally carried out for short period (up to 1 year) or medium period (1 to 3 periods) or for long period (3 to 5 years). But an investor is more concerned about short-term economic forecasts for period ranging from a quarter to one year. Some of the techniques of such economic forecasting are Anticipatory Survey. Barometric of leading indicator approach, econometric model building or sectoral analysis.

INDUSTRY ANALYSIS

A company belongs to an industry. An industry is generally described as a group of companies manufacturing and supplying similar products, which serve the need of common set of buyers. The industry classification is nothing but he product wise classification of the firms. Thus all companies who manufacture cement belong to cement industry. It is not unusual to find a company which belongs to more than one industry, because it manufactures more than one product. Yet, practically every company can be characterized as belongings to an industry.

The performance of a company would be influenced by the fortunes of industry to which it belongs. Not all industries may perform consistently with performance of the economy as a whole the economy in growing. Similarly recession does not mean that all industries will show a recession of same order. There is a need therefore for examining specific factors, on which performance of the industry depends.

Such industry related factors are:

i. Product life cycle

ii. Demand-supply gap

iii. Market for firm's product

iv. Barrier to entry

v. Supply of input

vi. Government policy towards the industry

PRODUCT LIFE CYCLE

The marketing experts believe that each product has a life cycle. They have identified 4 phases of the product life cycle- introduction stage, growth stage, maturity stage and stagnation and decline stage.

1. Introduction Stage. This is first stage of the cycle of any product. The product and its technology are possibly new, whenever a new product is introduced. During this stage the product has to penetrate into market. For this purpose sizeable amount of promotion efforts and expenditure have to be incurred. The response of sales of product may not be large, but may be that clues of promising future are seen. In this stage profits may be low or at times negative. Thus for the investors who want to have quick returns the shares of such companies may not be

attractive. Bu the genius investors who wish to get long-run returns will find such companies and industries attractive.

2. Growth Stage. Once the industry has established itself it passes through the stage of growth. The companies in this stage of industry become stronger. The product demand goes on expending. Each company, finds a market for itself and price charged and profits become attractive for investment purposes. The investors can get high return with law risk in this stage. The demand for goods of the industry exceeds the supply. The companies earn increasing profits and pay attractive dividends to the holders of the share.

3. Maturity. During this phase, the growth of the industry slackens. In other words, further rate of growth of sales of industry's product appears to be decelerating. The slowdown of sales growth is because the product has achieved acceptance by most potential buyers. Profits stabilize or decline because of increased competition. The transition of the industry from expansion to maturity stages is often slow. An investor should as far as possible dispose of his holdings in an industry which begins to pass from growth stage to maturity stage, because this stage will soon be followed by decline stage. However a company which faces this stage of maturity may make some technological break-through and introduce new product. Hence, an investor in a company has to monitor the industry's development continuously and diligently. Such technological changes may make a specific company's future performance even more attractive.

4. Decline Stage. After crossing the maturity phase the industry may stagnate for a very short period and decline will begin. This occurs when product of the industry is no longer in demand. New technology and new products have come to the market. The customers have changed their preference and habits. The company which still lives under this stage will be boasting of yester years and will soon be forced to down the shutters. An investor is unlikely to get any return in this stage. Hence, he should get out of such industries before the onset of the decline stage.

Growth stage

An analysis of the product life cycle has important implications for an investor. It gives him an insight into the apparent merits of investment in a given industry at any time. As industry is usually

associated with low profitability in introduction stage, medium but steady profitability in maturity stage and negative profitability in decline stage.

DEMAND SUPPLY GAP

The demand for goods generally changes steadily whereas the change in capacity for the production of goods tends to be lumpy (i.e. change by substantial quantity at irregular interval). As a result of this industry passes through alternative period of under supply and over supply of capacities as different times. Excess capacity tends to reduce profitability of an industry through the decline in the unit price realization. On the contrary inadequate supply (Excess Demand over supply) tends to improve the profitability through higher price realization. The gap between demand-supply of a product is a fair indicator of short term and long term profitability of the firm in the industry. Thus, as part of the industry analysis, an investor has to analysis demand-supply gap.

COMPETITIVE CONDITIONS IN THE INDUSTRY

The competitive conditions prevailing in the industry is a significant factor to be considered in determining the current and future profitability of the firm in the industry.

The competitive factors operating in an industry are higher to entry,

i. Bargaining power of buyers,

ii. Bargaining power of suppliers,

iii. Threat of substitutes and

iv. The rivalry among competitions.

An industry with high profitability attracts new firms. As new entrants come to industry, the industry's capacity grows, hence leading to price depression for products and associated reduction in profit margins. On the other hand, if there are barriers to entry, the new firms will not easily enter the industry. Such barriers to entry may be due to product differentiation, absolute cost advantage, large scale operation resulting in saving in costs, high level of investment required to set up new capacity and intense advertisement made by one firm and creation of a brand image and loyalty. An industry which is well protected from the inroads of new firms would be ideal for investment.

The bargaining power of the buyer is an important factor affecting the competition in the industry. The consumer goods market is widely spread. There are numerous customers and segments. Hence, there is very little scope for consumers to together wield any power to influence prices and profitability, through concerted efforts. On the other hand, the auto ancillary industry supplying most of its output to a few automobile manufactures (buyers) in entirely at the mercy of large buyers. The number of segments in market is another significant factor. If number of segment of market to which the firm caters is large, survival may not be difficult, because when demand may be bad in some segments, it may be good in other segments.

The threat of new substitute the competition in the industry. New investments keep taking place and new better products get introduced. The new substitutes will compete with existing products and finally may replace the existing ones. The prospects of such an industry facing threat of substitutes cannot be considered to be goods.

The competition may be dependent also on the supplier's bargaining power. If one or a new strong suppliers increase the prices of raw material, the cost of production will go up and profitability of the buyer firms will shrink and its competitive advantage will be eroded.

Further, when supply is in excess of demand and there are many firms in industry, the competition among the firms in the industry will be high. This will lead to price cuts and increase in

advertisement and promotional costs of all firms to maintain their relative market share. In such situation, the profitability gets eroded.

INPUT SUPPLY

The continuous availability of inputs at reasonable price is an important factor is determining its healthy performance. Some industries may not have difficulty in getting major raw material as they may be indigenously available. For example, bottling gas industry and salt industry have plenty of inputs. But in case of some other industries, there may be inadequate availability and erratic supply besides high price fluctuations. In case of India's synthetic yarn industry, which depends on a couple of domestic manufacture and imports, find themselves often in fix due to high prices and erratic supply. Industry analysis must take into account the availability of raw material and its impact on industry prospects.

GOVERNMENT POLICY

The attitude of the government towards and industry is an important determinant of its prospects. The government may assist and encourage some industries through favorable policies and legislations. Some other industries may not find favour with the government. The government may impose different kinds of legal hurdles and controls such as price and distribution controls, on such industries. A prospective investor should therefore consider the attitude of the government towards the industry being analyzed.

The analyst must evaluate all the above factors before making an investment decision. If the analysis of above factors indicates that the industry has favorable future prospects, the funds may be committed to shares of such companies in industry.

COMPANY ANALYSIS

The company analysis is the last leg in the analysis of Economy- Industry- Company (EIC) framework of fundamental analysis. The economy analysis provides an investor a broad outline of the prospects of growth in the economy. The industry analysis helps the investor to select the industry in which investment would be rewarding. The investor now has to decide in which of the companies belonging to chosen industries, he should invest he requires the company analysis.

The company analysis has to be made in three different parts:

1. Study of the financial information and assess the financial health of the company.

2. Sizing up the present situation and prospects. This requires an analysis of the present business of the company and its future prospects.

3. Evaluation of management.

STUDY OF FINANCIAL INFORMATION

The financial statements of the company can be used to understand and evaluate the financial performance and health of the company. Ratio analysis helps and investor to determine the financial strength and weakness of the company. Such ratio analysis can be made for a company over several past years, and trends can be understood. Also one can compute ratios and compare with other firms in the same industry over a specific period.

Different ratios measure different aspects of company's health and performances. Such ratios are grouped below, depending on main purpose for which they are used.

1) Liquidity Ratios. This measure indicates the company's ability to fulfill its short term obligations and reflect short term financial strength of liquidity.

The commonly used liquidity ratios are:

a) Current ratio =

current assets current liabilities

A higher current ratio is preferable, as it would enable the company to meet its short term liabilities even if value of current assets declines.

b) Quick Ratio

= current assets

- inventory -

period expenses

current liabilities

This is more rigorous measure as those items which are less liquid are deducted from the numerator of the ratio.

2) Leverage Ratios. The leverage ratios are also known as capital structure ratios and solvency ratios. They measure the company's ability to meet its long-term debt obligations. They reflect company's long * term solvency.

The commonly used leverage, ratios are as follows:

long - term Debt

a) Debt - equity Ratio =

shareholder 's equity

b) Debt to total Asset ratio = total Debt

total Asset

c) Proprietary Ratio = shareholder's equity

total Asset

earnings before interest & taxes (EBIT)

d) Interest coverage Ratio =

interest

The first three ratios stated above indicates relative contribution of shareholders (owners) and creditors/lenders in financing the company's assets. These ratios give an idea as to the safety margin available to the long term creditors. Higher the margin better it is. The last ratio called interest coverage ratio measures the ability of the company to meet its interest payments arising from the debt. Higher this ratio better is the general health and performance of the company.

3) Profitability Ratios: the profitability of company can be measured by the profitability ratios. These ratios can be calculated by relating the profits either to sales, or to investment, or to equity shares.

Some of the profitability ratios are as follows:

a) Gross profit ratio =

gross profit sales

´100

Gross profit ratio =

sales

- costs of good sold ´100 sales

b) Operating profit ratio =

earnings before interest & tax (EBIT) ´100

sales

c) Net profit ratio =

earnings after tax (EAT) ´100

sales

d) Return on investment = earning after tax(EAT)

total assets

earnings after tax (EAT)

e) Return on equity =

shareholder’s equity

4) Activity or efficiency ratios. These ratios measure the efficiency of management of assets of the company. They reflect the efficiency at which the assets of the company. They reflect the efficiency at which. They-reflect the efficiency at which the assets are employed often they are called as turnover ratios:

Important activity ratios are follows:

a) current asset turnover ratio =

sales current assets

This indicates how fast current assets are turned over in a year. Higher ratio implies that current assets are used more efficiently.

b) Fixed assets turnover ratio =

sales fixed assets

Higher this ratio, greater is the utilization of a given fixed assets of the company. It is also called fixed asset coverage ratio.

c) Inventory turnover ratio =

sales average inventory

This reflects how efficiently inventory is managed. In general, faster the turnover of inventory greater is the contribution to profits of the company.

d) Debtor turnover ratio =

sales average debtor

This ratio shows how good the receivable management in the company is. If this ratio is high it means bills are converted into cash faster, thus enabling the company to have higher sales and profits with a given amount of cash or working funds.

5) Valuation Ratio. These ratios are most relevant for valuation of company's securities. They are as follows:

a) Earnings per share(EPS) =

earning (i.e. profit ) after use number of outstanding equity shares

b) Dividend pay - out ratio = dividend per share(DPS)

earnings per share(EPS)

dividend payment ratio(EAT)

c) Dividend per share(DPS) =

d) Book value per share =

number of outstanding shares

net worth

number of outstanding equity shares

Where, networth = assets - liabilities.

The ratio of book value per share is often seen as a measure of intrinsic value of a share. Generally, we find a share being quoted a certain number of times of its book value (say usually from 5 to 10 times). But, it is not always necessarily right to take this ratio as indicative of intrinsic value of shares as market quoted price is often reflecting the future earning potential of the share, which may not have any relation with the assets of the company. Moreover, the book value of share is based on historical cost of the assets of the firm.

e) Yield Ratio

= dividend + price share

initial price

Price / earnings ratio (P Ratio) = market price per share

E earning per share

g) Earning yield

= earning per share(EPS) market price per share

dividend per share(DPS)

h) Dividend yield =

market price per share

i) Retention ratio

= retained + earnings profit After Tax

j) Return on equity

= Profit After Tax Net worth

k) Price volatility

= market high in the year - market low in the year average market price in the year

From an analysis of past performance, as judged by the ratio analysis, the analyst has to forecast the future prospects of the company. The investment decision would depend on such forecasts. The impacts of some key measures are shown below in the tabular form as favourable or unfavourable. Such an analysis needs to be made by the analyst for wide range of ratios.

KEY MEASURES AND THEIR IMPACTS

Areas of impact

Favorable Factors

Unfavorable Factors

On Earnings Levels

a. High Book Value Per Share

b. High Earning Per Share

c. High Return on Equity

a. Low Book Value Per Share

b. Low Earning Per Share

c. Low Return on Equity

On Growth Rate

a. High growth Rate in Earnings Per Share

b. High Retention Ratioc. High Return on Equity

a. Low growth Rate in Earnings Per Share

b. Low Retention Ratio

c. Low Return on Equity

On Risk Exposure

a. Low Debt. Equity Ratio

b. Low Variability of Earnings Per Share

c. Low Price volatility

a. High Debt: Equity Ratio

b. High Variability of Earnings Per Share

c. High Price volatility index

ANALYSIS OF BUSINESS OF THE COMPANY

Analysis of financial data must be supplemented by an appraisal of the company's business. This is mostly in quantitative terms. The variables and issues which are likely to affect the future prospects of the company must be examined.

In this context analyst must ask a series of questions in the relevant areas of investigation.

1. Company's market share. What is the market share of the company? To which segments of the market the company caters? Does it export?

2. Product portfolio. What are relatives' shares of various products in the portfolio of business of the company? What are the prospects of these goods? How competitive is the position of the company in these products? What are the overall prospects for the company?

3. Marketing and distribution. What is the company's image in the market place? How loyal are the customers? How is the distribution network-is it widespread, old and well established?

4. Procedure Capacity of the firm. What is the productive or installed capacity of the firm? Is it fully utilized? Are these plans of expansion of production capacity? Are there any modernization plans?

5. Order Position. How is the order position of the company? How many months or years production capacity it represents?

6. Availability and cost of inputs. Is the company well placed with respect to the availability of basic raw material, power fuel and other inputs? Are they available at reasonable rates? What are the relative cost advantages and disadvantages in respect of the inputs? Are the supplies monopolists?

7. Regulating Framework. Are there any government regulations on the business that the company conducts? Is there licensing requirement? Are there price controls? Are there stringent environment norms or regulations? In export encouraged? Are there certain supportive polices of the government to the business?

If answer of most of these question are favorable the business of the company appears to be prima facie, attractive and hence the company has a promising prospects.

EVALUATION OF MANAGEMENT

All said and done, the management of the company is an important input contributing to the failure or success of the company. It is therefore, desirable to assess the quality and competence of management. Many financial analyst are of the opinion that management need not be considered as an important factor, as quality of management is reflected in growth of sales profits earned returned on equity and similar performance measures. The Management experts on the other hand argue that such results like profit after tax, sales growth and return on equity are to be considered separately and management has to be viewed independently. Peter Drucker for instance observes that, the performance of business today is largely a result of the performance or lack of it, of earlier management of year past, Good management means doing a good job in preparing today's business for the future. Thus it is important to examine how the present management is giving shape to the company's future.

Thus the analyst should ask the question like:

ü What is the caliber, motivation dynamism and commitment of the top management to the company 'growth and development.

ü Does the management have any specific mission, objective pans and time bound feasible programmes?

ü What emphasis is given to research and development?

ü How are the management planning and control systems pursued by the company?

ü is the management investor-friendly and is committed to maximization of value of the firm?

The answers to this kind of question are hard to come by. Nevertheless and investor or analyst has to gather some ideas in respect of the above by referring to published material, reading annual reports including Director's Reports and attending annual general body meeting.

SELF CHECK EXERCISE

1. Define fundamental analysis.

2. Describe economic forecasting.

3. Explain Industry analysis.

4. Discuss Company analysis.

SUMMARY

A commonly advocated procedure for fundamental analysis involves a 3-step analysis: macro- economic analysis, industry analysis, and company analysis. The analysis of economy, industry and company fundamentals is the main ingredient of the fundamental approach. There are two broad classes of macroeconomic policies, viz. demand side policies and supply side policies. After conducting analysis of the economy and identifying the direction, it is likely to take in the short intermediate and long term; the analyst must look into various sectors of the economy in terms of various industries. An industry is a homogenous group of companies. The company analysis is the last leg in the analysis of Economy-Industry- company framework of fundamental analysis. The economy analysis provides an investor a broad outline of the prospects of growth in the economy. The industry analysis helps the investor to select the industry in which investment would be rewarding and in company analysis investor would decide in which of the companies he should invest.

GLOSSARY

Erratic Events: It refers to the unpredictable sales caused by unforeseen events like strikes, riots, Notes war scares, floods, and other disturbances.

Growth Industry: This is an industry that is expected to grow consistently and its growth may exceed the average growth of the economy.

Cyclical Industry: In this category of the industry, the firms included are those that move closely with the rate of industrial growth of the economy and fluctuate cyclically as the economy fluctuates.

Net Asset Value: Net asset value (NAV) is a term used to describe the value of an entity's assets less the value of its liabilities.

ANSWERS TO SELF CHECK EXERCISE

1. For answer refer to section 5.2

2. For answer refer to section 5.3

3. For answer refer to section 5.4

4. For answer refer to section 5.5

TERMINAL QUESTIONS

1. Why should a security analyst carry out industry analysis?

2. Why does portfolio manager do the industry analysis?

3. What is the need of company analysis? Do we need the company analysis?

TECHNICAL ANALYSIS

Introduction

Assumptions of Technical Analysis

Technical Vs Fundamental Analysis

Tools and Techniques of Technical Analysis

Evaluation of Technical Analysis

Self Check Exercise

Summary

Glossary

Answers to Self Check Exercise

Terminal Questions

LEARNING OBJECTIVES

After reading this chapter, you will be able to:-

· Describe the various tools of technical analysis.

· Plot technical charts using software available

· Identify trends and patterns and indicators in charts

· Understand stock market news reports

· Interpret technical signals and decides whether to use them or not

INTRODUCTION

Fundamental analysis and technical analysis are two main approaches to security analysis. Technical analysis is frequently used as a supplement to fundamental analysis rather than as a substitute to it. Fundamental analysis forecasts stock prices on the basis of economic, industry and company analysis. The stock value is judged with the help of a risk return framework based upon earning power and economic environment. However, according to technical analysis, the price of stock depends on demand and supply in the market place. It has little correlation with the intrinsic value. All financial data and market information of a given stock is already reflected in its market price. Technical analysts have developed tools and techniques to study of markets only. Technical analysts study the technical characteristics which may be expected at mayor market turning points and their objective assessment. The previous turning points are studied with a view to develop some characteristics that would help in identification of major market tops and bottoms. Human reactions are, by and large consistent in similar though not identical reaction; with his various tools, the technician attempts to correctly catch changes in trend and take advantage of them.

"Technical analysis is directed towards predicting the price of a security. The price at which a buyer and seller settle a. deal is considered to be the one precise figure which synthesizes, weighs and finally expresses all factors, rational and irrational quantifiable and non-quantifiable and is the only figure that counts". Thus, the technical analysis provides a simplified and comprehensive picture of what is happening to the price of a security. Like a shadow or reflection it shows the broad outline of the whole situation and it actually works in practice.

ASSUMPTIONS OF TECHNICAL ANALYSIS

There are some basic assumptions underlying the technical analysis. These assumptions are discussed as follows:

1. The market value of a security is solely determined by the interaction of demand and supply factors operating in the market.

2. The demand and supply factors of a security are surrounded by numerous factors; these factors are both rational as well as irrational.

3. The security prices move in trends or waves which can be both upward or downward depending upon the sentiments, psychology and emotions of operators or traders.

4. The present trends are influenced by the past trends and the projection of future trends is possible by an analysis of past price trends.

5. Expect minor variations, stock prices tend to move in trends which continue to persist for an appreciable length of time.

6. Changes in trends in stock prices are caused whenever there is a shift in the demand and supply factors.

7. Shifts in demand and supply, no matter when and why they occur, can be detected through charts prepared specially to show market action.

8. Some chart trends tend to repeat themselves. Patterns which are projected by charts record price movements and these patterns are used by technical analysis for making forecast about the future patterns.

TECHNICAL VS FUNDAMENTAL ANALYSIS

The major differences between the technical and fundamental analysis are as follows:

I. Technical analysis tries to predict short term price movements whereas fundamental analysis tries to establish long term values.

II. The focus of technical analysis is mainly or internal market data, particularly price and volume data whereas the focus of fundamental analysis is on the factors relating to the economy, industry and the company.

III. Speculators who want to make quick money mostly use results of technical analysis whereas investors who invest on long term basis use the results of fundamental analysis.

IV. Fundamental analysis involves completion and analysis of huge amount of data and is therefore, complex, time consuming and tedious in nature. On the other hand, technical analysis is a simple and quick method on forecasting behavior of stock prices.

V. According to the technical analyst, their method is for superior than the fundamental analysis, because fundamental analysis is based on financial statements which themselves are plagued by certain deficiencies like subjectivity, inadequate disclosure etc.

VI. Fundamental analysis is a longer term approach. Even if an analyst identifies an under period security, market may take time to bid its price up. Technical analyst feels that their own techniques and charts are quicker and superior to fundamental analysis.

Thus, technical and fundamental analysis provide exactly opposite approaches to valuation. But in practice, generally, a judicious combination of both these approaches is used to arrive at better results.

These two approaches are not used as substitutes but as complementary to each other.

TOOLS AND TECHNIQUES 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:

1. Price: whenever there is change in prices of securities, it is reflected in the changes in investor attitude and demand and supply of securities.

2. 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.

3. Volume: the intensity of price changes is reflected in the volume of transactions that accompany by a small change in transactions, it implies that the change is not strong enough.

4. 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.

In terms of the above dimensions various tools and techniques of technical analysis are discussed as follow:

6.4.(1) DOW THEORY

The Dow Theory, originally proposed by Charles Dow in 1900 is one of the oldest technical methods still widely followed. The basic principles of technical analysis originate from this theory.

According to Charles Dow "The market is always considered as having three movements, all going at the same time. The first is the narrow movement from day to day. The second is the short swing, running from two weeks to a month or more and third is the main movement, covering at least four years in its duration”.

The theory advocates that stock behavior is 90% psychological and 10% logical. It is mood of the crowd which determines the way in which prices move and the move can be gauged by analyzing the price and volume of transactions.

The Dow Theory only describes the direction of market trends and does not attempts to forecast future movements or estimate either the duration or the size of such market trends. The theory uses the behavior of the stock follow the underlying market trend, most of the times. Therefore, the postulates of the theory were farmed with reference to market indices, specifically constructed to measure market trends.

Basic tenets of Dow Theory: the basic tenets of Dow Theory are few and simple and are as follows:

1. The average (index numbers) discounts everything except acts of god, because they reflect the combined market activities of thousands of investors and brokers. Thus, the aggregate judgement of all stock market participants regarding both the current and potential changes in the demand- supply relationships of stocks, is reflected in the share prices.

2. The 'market' meaning the price of shares in general, swings in trends which may be primary, secondary and minor. Primary movements which last from a year to several years, represent the major market trends it can be either a rising (bull) trend or a falling (bear) trend. Movements in the direction of primary trend are interrupted at intervals by secondary swings in the opposite direction. The secondary trends usually last from several weeks to several months in length. This trend acts as a restraining force on the primary trend trending to correct deviations from its general boundaries. The minor trends are day to day fluctuation in the market. These have little analytical value because of their short duration and variations in amplitude.

3. So long as each successive price advance reaches a higher level than the one before it and each secondary reaction or price decline, stop at a higher level than the previous one, the primary trend is up. This is called a "bull market”.

4. When each intermediate decline carries prices to successively lower levels and each intervening advance fails to bring them back up to the top level of the preceding advance, the primary trend is down and that is called 'bear market'.

5. The secondary trends are the intermediate declines or corrections which occur in bull market and the intermediate advances or recoveries which occur in bear markets or recoveries which occur in bear markets. Normally, these last from three weeks to as many months and generally retrace from 1/3^rd to 2/3^rd of the gain or loss in prices recorded in the previous swing, in the primary direction.

6. The minor trends are the brief fluctuations lasting usually for six days but rarely for three weeks. These are meaningless but go to make up secondary trend. In theory, this is the only trend that can be manipulated.

7. At times a line can substitute for the secondary trend. A line in Dow Theory is a sidewise movement which lasts for two or three weeks, may before as many months and in the course of its formation, prices fluctuate within a range of 5% or less of their mean figures.

8. A trend should be assumed to continue in effect until such time as its reversal has been definitely signalled. The end of a bull market is signaled when a secondary reaction of decline carries prices lower than the level recorded during the earlier reaction and the subsequent advance fails to carry prices above the top level of the preceding recovery. The end of a bear market is signaled when an intermediate recovery carries prices to a level higher than the one registered in the previous advance and the subsequent decline halts above the level recorded in the earlier reaction.

The following figure gives an example of a bull market trend.

This figure shows a bull market interrupted by reactions. The following figure shows a bear market trend.

This figures shows a bear market interrupted by recoveries.

Dow Theory's Shortcomings: the Dow Theory is widely applied by technical analysis and has stood the test of time. However, the theory has been criticized on the following grounds:

1. The Dow Theory provides a single of change in the trend, often too late. The end of a bull market is signaled only when the nearest intermediate button is penetrated by more than 3% of the level and the subsequent advance fails to carry prices on the index above the earlier top. It is estimated that the theory confirms a reversal in trend often 20 to 25% after a peak or trough has occurred. But then there is no other way of forecasting that the change of trend has taken place at the top and it is better to be late than to be wrong.

2. The Dow Theory depends on interpretation and is subject to all the hazards of human ability to interpret. Experience has shown that the theory is usually more nearly right and the faults lies with the persons interpreting it.

6.4.(2) CHARTING

Charting is the basic tool in technical analysis, which provides visual assistance in defecting changing pattern of price behavior. The technical analysis is sometimes called the Chartist because of the importance of this tool. The Chartist 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 demand-supply changes. Chartists also believe that generally volume and trend go hand in hand. When a major uptrend 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 behavior 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:

a) Line chart

b) Bar chart

c) Point and figure chart

a) 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. The following figure presents a typical line chart.

Bar charts: it is a simple charting technique. In this chart, prices are indicted 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 the 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. The following figure shows a bar chart:

c) Point and figure Chart (PFC): though the point 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 fells, a circle is plotted in the next column and this is contained downward while continues to fell. When it rises again, a new vertical line of crosses is plotted in the next column and so on. A point and figures 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 mat be a price change of say one rupee). The following figure shows a point and figure chart:

PRICE

POINT AND FIGURE CHART TIME

6.4.(3) 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.

If the succession of peaks and troughs occurs at increasingly higher prices, then the market is clearly up trend. This trend is bullish indicating a good time to buy securities. If the peaks and troughs occur at successively lower prices. The market is in down trend which signals to the time to sell securities. The upward and downward trends are shown in the following figures.

A sideway trend is characterized by stock prices trading in a range where successive peaks occur at the same level and successive troughs occur at the same level and successive troughs occur at the same level. The two levels create parallel trend lines. During this time the investor should be

extra careful and wait for more definite indicators of the future market movement. The following figure shows the sideway trend.

Trend lines encompass advances and declines by joining successive tops and bottoms. Sometimes, it is useful to trap trends by drawing trend lines on both the sides of an upward or downward trend. These parallel lines drawn to encompass trends from both the sides are called channels.

6.4.(4) MOVING AVERAGE ANALYSIS

The statistical method of moving averages is also used by the technical analysis 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 average has to be first 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 a 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 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 pries 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 analysis can use three types of moving averages-simple weighted or exponential.

6.4.(5) ADVANCE DECLINE THEORY

The advance decline theory takes into consideration the total number of securities traded called the width of the market. The greater the number of securities traded compared to the number ofsecurities listed, greater will be the width of the market. This theory takes into consideration the total number of issues traded during a session and compares the number of stocks whose prices advanced with those whose prices declined. The basic idea behind all this is to determine what the majority of stocks are going. The daily net difference between the number of shares whose prices have advanced in a stock exchange and the number of those whose prices have declined is calculated. The net difference is added to next day's difference and so on to form a continuous cumulative index. The index is plotted in a line form on the graph and compared with the index of that stock exchange. The key signals occur when there is divergence between the two, when they diverge, the advance-decline line will show the truer direction of the market because the index of the stock exchange cannot move contrary to the market as a whole, at least not for long.

For example, suppose in Bombay stock exchange, 1600 securities were traded on a particular day. Of the total securities traded 1000 advanced in price, 400 declined and 200 were unchanged. Using the data, the technical analysis will calculate the percentage of the advance or the decline by subtracting the number of declining stocks from the number of advancing stocks and then dividing the difference by the total number of securities traded.

æ +1000 - 400 ö = +600 = 37.5%

ç 1600 ÷ 1600

è ø

Continued positive and high percentages indicate negative percentages indicate a technically weak market.

Advance-decline theory focuses on the width of the market instead of selected securities. This theory has been widely used as the basis for developing more complex technical measures and theories about the market movement.

6.4.(6) NEW HIGHS AND NEW LOWS

A supplementary measure to the width of the market is the high-low differential or index. A rising market is accompanied by a healthy number of new highs. A graph of new highs can be plotted to be read along with a market index. If net new highs trace a series of declining peaks while the index continues to rise, a reversal in imminent. Similarly a graph of net new lows can be expected to signal the end of a bear market, when it does not confirm the new trough reached by the market index. This is because a declining number of stocks reaching new lows implies that large number of stocks resisting the downtrend in the market index and thus, signifies the end of a bear market.

This method can be used to know the trend of the market and plan the investment strategy accordingly.

6.4.(7) SHORT SELLING THEORY

Short selling is viewed as a sentiment indicator by the technical analysis. Short selling refers to selling shares that are not owned. Investors sell short when the expect the market price of a security to decline. They hope to purchase the security at a later date below the selling price and reap a profit. The short sellers eventually cover their positions resulting in an increase in the potential demand for the security. Therefore, rising short sales foretell future demand for the security and thus, increments in future price. Large outstanding short interest is, therefore, considered to be a long term bullish indicator. Small or moderate amounts of short interest are considered to have little potential impact on a stock's price. Technical analysis consider the short interest ratio to be a more useful measure of the market's potential movement.

Short Interest Ratio

= Short Interest Position Average Daily Trading Volume

This ratio indicates how many days of trading it will take to cover total short interest. The ratio does not represent a hard and fast indicator of a bullish or bearish sentiment, but there are some rule of thumb norms against which the ratio is compared. Generally, a short interest ratio is considered to be high when it is greater than 2. This is a bullish indicator because there are a large number of investors in the market who will have to buy back the shares that were sold short.

Short sales cannot be an exact indicator and is only general in essence. The technical analysts also believe that it is a sophisticated technique and it is difficult for an average investor to understand it.

6.4.(8) REVERSAL EFFECT

Reversal effect is a tendency for poorly performing stocks of one time period i.e. a week or a month to perform well in the subsequent time period and vice versa. This effect can be used by the investors in planning their investment strategy of maximizing the returns. The strategy should be to buy stocks that have recently done poorly and sell shares that have done very well.

6.4.(9) RELATIVE STRENGTH

The empirical evidence shows that certain securities perform better than other securities in a given market environment and this behavior remains constant overtime. Relative strength is the technical name given to such securities by the technical analysis because these securities have stability and are able to withstand both are the 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 stocks and bonds. The relative strength can be calculated by:

i. Measuring the rate of return of securities

ii. Classifying securities

iii. Finding out the high average return of securities

iv. Using the technique of ratio analysis to find out the strength of an individual security.

Technical analysis 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 market (bear). These securities will rise and fall faster than the market. Technical analysis explains 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.

6.4.(10) CREDIT BALANCE THEORY

The technical analysts predict that when cash balances build up with the brokers, it represents high potential for the market advancing and vice versa when investors sell their securities, they receive credit balances in their accounts at their brokerage houses. At that time they have two choices-either to take their money or to leave it in the account. The reason for leaving the money in the account will be for investment in the near future, it is believed that a rise in these cash balances represents large reservoirs of potential buying power. The investors leave their money with the brokers only when they anticipate a fall in security prices and thus, buying opportunity. On the other hand, a drop in credit balance suggests that prices of securities will go up in future and investors will not like to buy.

6.4.(11) THE FILTER RULES

The filter rules many a times, defined the mechanical trading schemes. Filters are minor price changes arising from random factors. If the price of a security moves up at least X% from a low point, it

should be bought and held until its price moves down at least X% from a subsequent high, at which time it could be sold. The security is not repurchased until it moves up again at least X% from the subsequent low point. The following figure illustrates the filter rule.

The major problem with this technique is deciding on the size of the filter. If x is small, it will result in larger number of transactions and therefore larger transaction costs. If x is large, much of the price movement has taken place before the investor acts. So called "Hatch System" is basically a 10% filter. In general, these rules can be effectively used if the transactions costs are very low. Since these rules can be easily mechanized, they are widely used for computerized trading.

6.4.(12) RESISTANCE AND SUPPORT LEVELS

The peak price of the stock is called the resistance area. Resistance level is the price level to which the stock market rises and then falls from 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 cause the price fell.

Support level shows the previous low price of the stock. It is a price level to which a stock or market price fells 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 preventing it from going lower.

The figure shows that if the share price persistently fails to rise above a certain level this is known as a resistance level. This perhaps because at this price people who purchased previously, but then saw the share prices fell, took the opportunity to sell at the price they previously paid. Likewise, a

support level is a price at which buyers constantly seem to some forward to prevent the share prices dropping any further.

The support and resistance levels are important tools in confirming a reversal, in forecasting the course of prices, and in making appropriate price moves.

6.4.(13) BREAKOUT THEORY

Break out is also "confirmation". This is indicated by drawing a line, which is a period of consolidation, when the share prices move sideways within a range of about 5% of the share price. Eventually a break out will occur and it is often suggested that the longer the period of consolidation, the greater will be extent of ultimate rise or fall.

6.4.(14) HEAD AND SHOULDERS PATTERN

The Head and Shoulders pattern is by far the most reliable and widely used of all reversal patterns. This pattern indicates a reversal of an uptrend. This pattern occurs at the end of a bull market and is characterized by two smaller advances flanking a higher advance just as the head lies in between two shoulders. A typical head and shoulder formation is shown in the following figure:

In reality, the shoulders are not always symmetrical. This does not in any way alter the signals provided by the pattern. The important requirement is that the shoulders should be at lower levels than

the head. The left shoulder is seen during the time when there is a lull in the trading market followed by heavy purchases. The quiet time in trading called lull is such to raise the price by pushing to a new peak. The head faces with the time when there are heavy purchases in the market that it raises it and then it fells back to indicates that it is far below the top of the left shoulder. The right shoulder indicated that the price raises moderately by the activity in the price raises moderately by the activity in the market but it does not rise in such a manner that it reaches higher than the top of the head while it is reaching is top, it begins to fell again and decline is indicated. The formation is easily discernible once the right shoulder is formed. The line that joins the points from where the final advance begins and ends is called the neckline. A trend reversal almost always occurs when the neckline is penetrated by the price line.

The head and shoulders pattern may be formed over short period of a Tew weeks or take even years to emerge. This pattern is the most reliable indicator of the onset of a bear market. The method also provides scope for measuring the extent of fall in prices. The prices are expected to decline after the penetration of the neckline by the price line, at least as much as the distance between the head and the neckline.

6.4.(15) DOUBLE TOP FORMATION

The double top occurs as an uptrend is about to reverse itself. A double top is formed when prices reach the previous high and react immediately, the two highs reached being almost at the same level. Two peaks at comparable heights are seen, with a reaction forming a valley in between them. The prices breakout into a bearish phase, once they penetrate the neckline drawn across the bottom of the intervening reaction. The measuring implication is similar as for the head and shoulder formation. If the price line falls below the neckline by a distance equal to the distance between the peak and the trough the indication is to sell. Volume is found to be distinctly low at the second top. The following figure shows the double top formation:

6.4.(16) DOUBLE BOTTOM FORMATION

A double pattern is just the reverse of a double top and occurs at the end of a downtrend in prices. In the double bottom, the second decline is supported by substantially more volume, indicating the price about to rise. The following figure shows the double bottom formation.

Sometimes, the tops and bottoms are not found exactly at equal levels, but still these provide valid reversal signals. Sometimes the patterns extend to triple tops or triple bottoms. It must be remembered that longer it takes for the second top (bottom) to appear and deeper the intervening valley (peak) more reliable will be the reversal:

6.4.(17) ODD-LOT TRADING

Small investors who often buy in odd lots (no tradable lot) are known as odd lotters. Odd lots are generally groups of less than 100 shares. The odd-lot theory suggests that it is important to find out information about odd lots because such investments are not made by professional investors. This theory reflects the views of common man on daily basis. For finding out the daily record of lots, information must be gathered about the number of shares purchased every day, the number of shares sold every day and also the number of shares which are sold short. By charting out the ratio of odd purchases to odd sales. It is possible to find out the direction of prices because it indicates the buying activity of the common man. If the odd purchases are less than the odd sales, then there is a positive purchase otherwise there can be negative purchase also. The technical analysts emphasis that a fall in the market price is reflected if the net purchases made by the common man are positive. If the net purchases are negative then it reflects that the bear markets are at a close. Similarly, an increasing ratio of odd lot short sales to total odd sales suggests increasing bearishness. The theory has been opposed by the odd lotters because according to them they buy low and sell high and make profits, which is contrary to the theory.

6.4.(18) MUTUAL FUND ACTIVITY

The mutual funds always keep ready cash and take advantage of favorable market conditions and/ or to provide for redemption of shares by holders. Mutual fund cash is expressed as a percentage of net assets on a daily, monthly or annual basis. A low cash ratio indicates a reasonably fully invested position, with the implication that not much reserve buying power is remaining in the hands of the mutual fund. Low ratios are frequently associated with market heights. At market troughs the cash ratio would be high. Such a buildup of cash reserves is an indication of potential purchasing power that can be injected into the market to push it upward.

6.4.(19) CONFIDENCE INDEX

Securities market can be analyzed through a calculation of confidence index. The confidence index is supposed to reveal how willing the investors are to take chance in the market. Confidence index is the ratio of high grade bond yields to low grade bond yields. When investors grow more confident about the economy, they shift their holdings from high grade to low grade bonds in order to

obtain higher yields. High grade bonds are higher in equity but do not yield high returns. Low grade bonds while risky will offer a higher yield. When the investor makes the change from high grade to low grade bonds the prices of low grade bonds rise. This lowers their yield relative to high grade bonds and increases the confidence index.

The confidence index has an upper limit of unity; since the yields on high quality bonds will never rise above the yields on similar low quality bonds. In the period of economic boom when investors grow optimistic and their risk aversion diminishes, the yields difference between high and low quality bonds narrows and the confidence index rises. A rising confidence index is interpreted by technical analysis as an indication that institutional investors are optimistic/ an upturn in confidence index foretells rising optimism and rising prices in the stock market.

Contrary to the rising index, a fell in the confidence index represents the feet that low grade bond yields are rising fester or felling more slowly than high grade yields. Thus movement is supposed to reflect increasing risk aversion by institutional investors who foresee an economic downturn and rising bankruptcies and defaults/ empirical evidence shows that confidence index is not always positively correlated with the stock market. Although it gives some indications and signals about the stock market trend, yet the signals which are formed by it show errors. However, according to technical analysis, signals always show some errors and complete accuracy can never be predicted.

6.4.(20) TRADING VOLUME INDICATORS

Most of the technical analysis believes that volume changes are always a prerequisite to a price change. Historical data analysis of price and volume movements indicates that in a normal market, the price rise is accompanied by an expanding volume. During bull market, volume increases with price advance and decrease with price declines. In a major downward price trend, the reverse will hold true. Further, volume generally fells in advance of major decline in the stock price averages and rises sharply during market bottoms. These indications are to be studied carefully before a final decision is taken on the state of the market, whether bullish or bearish, the phase the uptrend or downtrend and look for buy and sell signals at the start of the reversal trends.

Volume is a function of the demand for and supply of stocks and can signal turning points for the market as well as for individual stocks, in the short run, on a day today basis, the demand and supply for each scrip is based on a host of fundamental, technical and other factors.

6.4.(21) FIBONACCI NUMBERS

The technical analyses use a number of techniques in predicting the resistance and support levels of the stock market and individual scrips. One of the set of numbers they often use are "Fibonacci numbers". Leonardo Fibonacci, a renowned medieval mathematician identified a sequence of numbers while studying the reproductive behavior of rabbits. The sequence was named after him. The Fibonacci sequence of number is as follows:

1,1, 2, 3, 5, 8, 13, 21, 34, 55,89, 144, 233....

After the initial pair of one, each succeeding number is simply the sum of the previous two

e.g. 2+3 = 5 3+5 = 8 5+8-13

8 +13 = 21 and so on

Another feature of these numbers is that after the first few numbers, the ratio of each Fibonacci number to its successor is 0.618 e.g. .

21/34 = 0.618

34/55 = = 0.618

55/89 = = 0.618

89/144 = = 0.618 and so on.

Likewise, Fibonacci number of its predecessor is = 0.618 e.g.

34/55 = = 0.618

55/89 = = 0.618

89/144 = = 0.618

144/89 = = 0.618 and so on.

The advocates of Fibonacci numbers use the ratio 0.382 and = 0.618 to compute the retracement level of the stock movement. For instance, a stock that fells from Rs.100 to Rs.70 (a 30% drop) will encounter resistance to further advances after it recoups 38.2% of its loss (i.e. it rises to Rs.81.46) some technical analysis keep close watch on the resistance and support levels as predicted by the Fibonacci ratios.

6.4.(22) COPPOCK INDICATOR

The Coppock indicator is based on wave theory predicting long term changes in investment sentiment and sudden changes cannot be accurately predicted. The indicator may be regarded as a general measure of underlying investor confidence. The Coppock's indicator is calculated as follows:

i. Take this month's average share price index and subtract the index for the same month twelve months ago. Multiply the result by ten.

ii. Repeat this arithmetic for last month and multiply the result by nine. Repeat this sequence for a total often months, multiplying each successive result by eight, seven, six, and so on down to one.

iii. Add up all the figures calculated in steps (1) and (2). The result may be positive or negative. Divide the result by ten. The figure so obtained is the coppock indicator for this month.

An average indicator value of zero is taken as the base line. If the coppock value is above zero, a bull market exists, while a figure below zero indicates the existence of a bear market. The start of a bull market is predicted when the points plotted below zero first start to become less bad. Thus, if the figures of January, February, march and April was -100, -110, -112 and -110, then April would give the first indication of a new bull market.

6.4.(23) BLOCK UPTICK DOWNTICK RATIO

Trading in the equity market has become dominated by institutional investors who tend to trade in large blocks. It is possible to determine the price change that accompanied a particular block transaction. If it is above the prior price, it is an uptick and if it is below^ it is downtick. It is assumed that the price change indicates whether the transaction was initiated b a buyer (in which case you would expect an uptick) or a seller (in which case you would expect a downtick). This line of reasoning led to the development of the uptick-downtick ratio as indicator of institutional investor sentiment. The ratio has generally fluctuated in the range of 70 (a bearish sentiment) to about 130 (a bullish sentiment).

6.4.(24) ELLIOT WAVE THEORY TIME Wave5 1 1 1 2 4 A B C C

Elliot wave theory was established in the 1936s by R.N. Elliot and later popularized by Hamilton Bolton. This theory attempts to develop a rational for a long term pattern in the stock price movements. This theory is difficult to grasp and somewhat intimidating. The principle behind the theory is actually relatively simple.

In its most basic form the theory states that the stock market follows a repetitive rhythm of waves. A wave is a movement of the market price from one change in the direction to the next change in the direction. The waves are the result of buying and selling impulses emerging from the demand and supply pressures on the market. If the demand exceeds the supply, there is pressure of overbought position in the market leading to rising trend in the prices. On the other hand, if the supply exceeds demand, there is an oversold position in the market leading to a downward trend in the prices. Depending on the pressure of the oversold and overbought position, the waves are generated in the prices.

The stock market, generally, follows a repetitive rhythm of a five wave advance followed by a three wave decline. If we count the waves, we find that one complete circle has eight waves, five up and three down. In the advancing portion of the cycle, the waves are numbered as shown in the following figure:

Waves 1, 3 and 5 are rising waves these are also called impulse waves. Wave z and y move against the uptrend. Waves 2 and 4 correct waves 1 and 3 and are thus called corrective waves. After the five waves numbered advance has been completed, a three wave correction binges, identified by waves A and B and C.

This theory has been accepted as one of the important tools of technical analysis for the investor and trader to decide on the timing of investment and for developing important market strategies. However the wave theory has two basic limitations:

i. It is difficult to identify the turning point in each stage.

ii. Investors cannot distinguish between a major and minor five stage movement because the rhythm as well as the count numbers of waves may not be consistent.

6.4.(25) OSCILLIATORS (RATE OF CHANGE)

The rate of change index is a widely used tool of technical analysis to measure the momentum of price changes. Oscillators refer to the velocity of price change reflecting the market momentum which is measured by the rate of change of prices. The rate of change may be over a very short period (i.e. 5 to 10 days) or a longer period (i.e. 3 to 6 months). Most of the oscillators move in the same direction either positive or negative, depending on the trends of the market. An overbought market is reflected by a positive reading and a oversold market is respected by a negative reading. The shape of the oscillator when plotted on the graph will depend on the period for which it is calculated. Oscillator will have a smoother curve, if it is for a long period, but if it is compiled on a daily basis, it will be widely fluctuating.

By properly reading the graph, the investors can make use of oscillators for making their investment decisions. As a general rule, if the oscillator reaches the extreme lower end, it is advisable to buy, but if it reaches the extreme upper end, it is advisable to sell. The crossing of the zero line can be taken as an indication of buy and sell decisions. The market is said to be overbought when the oscillator is at the upper extreme, thus it is advisable to sell. On the other hand, if the oscillator is at the lower extreme, the market is oversold and it is advisable to buy. A study of oscillator is very useful to confirm the conclusion arrived at by the trend analysis and the use of charts.

6.4.(26) STOCHASTICS

Stochastic is a price-velocity technique. It is based on the theory that as price increase, closing prices have a tendency to be nearer to the peaks reached during the period. Similarly when prices fell, closing prices have a tendency to be nearer to the troughs reached during that period. George C. Laire had developed the stochastic technique. Thus technique is based on a single formula:

%K =

C-L × 100 H-L

Where %K = Stochastic

C = Latest closing price

L = Low price during the last N periods H = High price during the last N periods

N can be any number of periods % K is then smoothened to derive % D by using the simple moving average technique. For interpreting stochastic, divergence analysis is used.

1. A bearish divergence occurs when the security's price makes a high then corrects moving lower and subsequently reaches a higher high. At the same time, corresponding dealers of the % D line make a high followed by a lower high.

The above figures clarify the principle method of interpreting stochastics.

2. A bullish divergence occurs when the security's prise makes a low, then corrects moving higher and subsequently reaches a lower low. At the same time corresponding bottoms of the %D line makes a low followed by a higher bottom-

3. In the final analysis, in bearish divergence, a sell signal occurs when %K line move below %0 line. In a bullish divergence a high signal occurs when %K line moves above the %D line. Sometimes %K line touches 0% or 100%. This only suggests great weakness or great strength of the scrip.

EVALUATION OF TECHNICAL ANALYSIS

Critics have pointed out that technical analysis is not by itself, the road to be richer. Despite assertions by technical analysis, the technical analysis is an art. Like any other art, its successful use requires talent, experience intuition and above all commonsense. This tool must be used along with fundamental analysis, only then it can convert the modest profits to good profit. There are some inherent limitations of technical analysis as follows:

1. Technical analysis is based on the past and historical data. Unexpected future events are not taken into consideration by it.

2. To earn more profit, the technical analysts have to cleverer and luckier tan others. In a stock market, profits are always realized at the expense of others who are trying to earn profits at their terms.

3. False signals can always occur in the stock markets. If the technical analysis acts without confirmation, they would make mistakes and would suffer unnecessary expenses and losses.

Technical analysts have been in existence for quite a long period of time now and they are unlikely to disappear. For doing their work in a better way they require improved quantitative methods coupled with improved behavioral research.

SELF CHECK EXERCISE

1. Discus the assumptions of Technical Analysis.

2. Explain Dow Theory.

3. Explain Charting.

4. Describe Short selling theory.

SUMMARY

The term technical analysis is used to mean a fairly wide range of techniques; all based on the concept that past information on prices and trading volume of stocks gives the enlightened investor a picture of what lies ahead. It attempts to explain and forecast changes in security prices by studying only the market data rather than information about a company or its prospects, as is done by fundamental analyst. Fundamentalists make their decisions on quality, value and depending on their specific investment goals, the yield or growth potential of the security. Technical analysts use three basic types of charts. These are Line Charts, Bar Charts, Point and Figure Charts

GLOSSARY

Confidence Index: It is the ratio of a group of lower-grade bonds to a group of higher-grade bonds.

Indicators: Indicators are calculations based on the price and the volume of a security that measure such things as money flow, trends, volatility and momentum.

Odd Lots: Stock transactions of less than, close to 100 shares.

Trend line: A charting technique that adds a line to a chart to represent the trend in the market or a stock.

ANSWERS TO SELF CHECK EXERCISE

1. For answer refer to section 6.2

2. For answer refer to section 6.4(1)

3. For answer refer to section 6.4(2)

4. For answer refer to section 6.4(7)

TERMINAL QUESTIONS

1. What is technical analysis? Describe the assumptions of technical analysis.

2. Distinguish between technical and fundamental analysis.

3. What are tools and techniques of technical analysis? Describe in brief.

fundamental and technical analysis

FUNDAMENTAL ANALYSIS AND VALUATION

Structure:-

LEARNING OBJECTIVES

INTRODUCTION

MEANING OF FUNDAMENTAL ANALYSIS

The multitude of factors affecting a company's profitability can be broadly classified as:

ECONOMY-WIDE FACTORS

Growth rate of National Income & Related Measures:

Growth Rate of Industrial Sector

Interest Rates

Foreign. Exchange Rate

Government Budget

Savings and Investment

Infrastructure

Economic and Political Stability

Monsoon

ECONOMIC FORECASTING

INDUSTRY ANALYSIS

Such industry related factors are:

PRODUCT LIFE CYCLE

The marketing experts believe that each product has a life cycle. They have identified 4 phases of the product life cycle- introduction stage, growth stage, maturity stage and stagnation and decline stage.

Growth stage

DEMAND SUPPLY GAP

COMPETITIVE CONDITIONS IN THE INDUSTRY

The competitive factors operating in an industry are higher to entry,

INPUT SUPPLY

GOVERNMENT POLICY

COMPANY ANALYSIS

STUDY OF FINANCIAL INFORMATION

Different ratios measure different aspects of company's health and performances. Such ratios are grouped below, depending on main purpose for which they are used.

The commonly used liquidity ratios are:

Some of the profitability ratios are as follows:

Important activity ratios are follows:

ANALYSIS OF BUSINESS OF THE COMPANY

EVALUATION OF MANAGEMENT

Thus the analyst should ask the question like:

SELF CHECK EXERCISE

SUMMARY

GLOSSARY

ANSWERS TO SELF CHECK EXERCISE

TERMINAL QUESTIONS

SUGGESTED READINGS

TECHNICAL ANALYSIS

LEARNING OBJECTIVES

INTRODUCTION

ASSUMPTIONS OF TECHNICAL ANALYSIS

TECHNICAL VS FUNDAMENTAL ANALYSIS

TOOLS AND TECHNIQUES OF TECHNICAL ANALYSIS

6.4.(1) DOW THEORY

6.4.(2) CHARTING

6.4.(3) TRENDS

6.4.(4) MOVING AVERAGE ANALYSIS

6.4.(5) ADVANCE DECLINE THEORY

æ +1000 - 400 ö = +600 = 37.5%

è ø

6.4.(6) NEW HIGHS AND NEW LOWS

6.4.(7) SHORT SELLING THEORY

6.4.(8) REVERSAL EFFECT

6.4.(9) RELATIVE STRENGTH

6.4.(10) CREDIT BALANCE THEORY

6.4.(11) THE FILTER RULES

6.4.(12) RESISTANCE AND SUPPORT LEVELS

6.4.(13) BREAKOUT THEORY

6.4.(14) HEAD AND SHOULDERS PATTERN

6.4.(15) DOUBLE TOP FORMATION

6.4.(16) DOUBLE BOTTOM FORMATION

6.4.(17) ODD-LOT TRADING

6.4.(18) MUTUAL FUND ACTIVITY

6.4.(19) CONFIDENCE INDEX

6.4.(20) TRADING VOLUME INDICATORS

6.4.(21) FIBONACCI NUMBERS

6.4.(22) COPPOCK INDICATOR

6.4.(23) BLOCK UPTICK DOWNTICK RATIO

6.4.(25) OSCILLIATORS (RATE OF CHANGE)

6.4.(26) STOCHASTICS

EVALUATION OF TECHNICAL ANALYSIS

SELF CHECK EXERCISE

SUMMARY

GLOSSARY