unit -2 equity valuation sapm

1. UNIT-2
FUNDAMENTAL ANALYSIS

2. INTRODUCTION
• Fundamental analysis is used to determine the intrinsic value of the
share by examining the underlying forces that affect the well being of
the economy, Industry groups and companies.
• Fundamental analysis is to first analyse the economy, then the
Industry and finally individual companies. This is called as top down
approach.

4. • At the economy level, fundamental analysis focus on economic data
(such as GDP, Foreign exchange and Inflation etc.) to assess the
present and future growth of the economy.
• At the industry level, fundamental analysis examines the supply and
demand forces for the products offered.
• At the company level, fundamental analysis examines the financial
data (such as balance sheet, income statement and cash flow
statement etc.), management, business concept and competition.

5. 1. ECONOMIC ANALYSIS:
• Economic analysis occupies the first place in the financial analysis top
down approach. When the economy is having sustainable growth,
then the industry group (Sectors) and companies will get benefit and
grow faster. The analysis of macroeconomic environment is essential
to understand the behaviour of the stock prices. The commonly
analysed macro economic factors are as follows.

6. • Gross domestic product (GDP): GDP indicates the rate of growth of the
economy. GDP represents the value of all the goods and services produced by a
country in one year. The higher the growth rate is more favourable to the share
market.
• Savings and investment: The economic growth results in substantial amount of
domestic savings. Stock market is a channel through which the savings of the
investors are made available to the industries. The savings and investment
pattern of the public affect stock market.
• Inflation: Along with the growth of GDP, if the inflation rate also increases, then
the real rate of growth would be very little. The decreasing inflation is good for
corporate sector.
• Interest rates: The interest rate affects the cost of financing to the firms. A
decrease in interest rate implies lower cost of finance for firms and more
profitability.

7. • Budget: Budget is the annual financial statement of the government,
which deals with expected revenues and expenditures. A deficit
budget may lead to high rate of inflation and adversely affect the cost
of production. Surplus budget may result in deflation. Hence,
balanced budget is highly favourable to the stock market.
• The tax structure: The tax structure which provides incentives for
savings and investments.
• The balance of payment: The balance of payment is the systematic
record of all money transfer between India and the rest of the world.
The difference between receipts and payments may be surplus or
deficit. If the deficit increases, the rupee may depreciate against
other currencies. This would affect the industries, which are dealing
with foreign exchange.

8. • Monsoon and agriculture: India is primarily an agricultural country.
The importance of agricultural in Indian economy is evident.
Agriculture is directly and indirectly linked with the industries. For
example, Sugar, Textile and Food processing industries depend upon
agriculture for raw material. Fertilizer and Tractor industries are
supplying input to the agriculture. A good monsoon leads better
harvesting; this in turn improves the performance of Indian economy.
• Infrastructure: Infrastructure facilities are essential for growth of
Industrial and agricultural sector. Infrastructure facilities include
transport, energy, banking and communication. In India even though
Infrastructure facilities have been developed, still they are not
adequate.

9. •Demographic factors: The demographic data
provides details about the population by age,
occupation, literacy and geographic location. This is
needed to forecast the demand for the consumer
goods.
•Political stability: A stable political system would
also be necessary for a good performance of the
economy. Political uncertainties and adverse change
in government policy affect the industrial growth.

10. ECONOMIC FORECASTING:
• The common techniques used are analysis of key economic
indicators, diffusion index, surveys and econometric model building.
These techniques help him to decide the right time to incest and the
type of security he has to purchase i.e. stocks or bonds or some
combination of stocks and bonds.

11. ECONOMIC INDICATORS
• The economic indicators are statistics about the economy that
indicate the present status, progress or slow down of the economy.
They are capital investment, business profits, money supply, GNP,
interest rate, unemployment rate, etc. The economic indicators are
grouped into leading, coincidental and lagging indicators. The
indicators are selected on the following criteria
• Economic significance
• Statistical adequacy
• Timing
• Conformity

12. The leading indicators:
• The leading indicators indicate what is going to happen in the
economy. It helps the investor to predict the path of the economy.
The popular leading indicators are the fiscal policy, monetary policy,
productivity, rainfall, capital investment and the stock indices. The
fiscal policy shows what the government aims at and the fiscal deficit
or surplus has an effect on the economy.

13. The coincidental indicators
• The coincidental indicators indicate what the economy is. The
coincidental indicators are gross national product, industrial
production, interest rates and reserve funds. GDP is the aggregate
amount of goods and services produced in the national economy. The
gap between the budgeted GDP and the actual GDP attained
indicates the present situation. If there is a large gap between the
actual growth and potential growth, the economy is slowing down.
Low corporate profits and industrial production show that the
economy is hit by recession

14. The lagging indicators:
• The changes that are occurring in the leading and coincidental
indicators are reflected in the lagging indicators. Lagging indicators
are identified as unemployment rate, consumer price index and flow
of foreign funds. These leading, coincidental and lagging indicators
provide an insight into the economy s current and future position.

15. DIFFUSION INDEX
• Diffusion index is a composite or consensus index. The diffusion
index consists of leading, coincidental and lagging indicators. This
type of index has been constructed by the National Bureau of
Economic Research in USA. But the diffusion index is complex in
nature to calculate and the irregular movements that occur in
individual indicators cannot be completely eliminated.

16. ECONOMETRIC MODEL BUILDING
• For model building several economic variables are taken into consideration. While
using the model, the analyst has to think clearly all the inter-relationship between
the variables. When these inter-relationships are specified, he can forecast not only
the direction but also the magnitude. But his prediction depends on his
understanding of economic theory and the assumptions on which the model had
been built. The models mostly use simultaneous equations.
• Factors affecting Economic Forecasting
• ¸ GDP ( Gross Domestic Product)
• ¸ Inflation
• ¸ Interest rates
• ¸ Government revenue, expenditure and deficits
• ¸ Exchange rates
• ¸ Infrastructure
• ¸ Monsoon
• Economic and political stability

17. Surveys:
• It is a method of short term forecasting. It is broadly used to convey
the future course of events in the economy. The method to do this is
approximate "because it is based on beliefs, notions and future
budgeting of the government. It, however, broadly indicates the
future of events in the economy.

18. Opportunistic Model Building:
• This method is the most widely used economic forecasting method.
This is also sectoral analysis of Gross National Product Model
Building. This method uses the national accounting data to be able to
forecast for a future short-term period. It is a flexible and reliable
method of forecasting. The method of forecasting is to find out the
total income and the total demand for the forecast period.

19. Industry Analysis
• The industry has been defined as a homogeneous group of people
doing a similar kind of activity or similar work. But industry broadly
covers all the economic activity happening in a country to bring
growth. A broad concept of industry would include all the factors of
production, transportation, trading activity and public utilities.
Usually, the industry is classified in processes and in stages. It may
also be classified according to work group that it identifies to.

20. • Industry analysis involves reviewing the economic, political and
market factors that influence the way the industry develops. Major
factors can include the power wielded by suppliers and buyers, the
condition of competitors and the likelihood of new market entrants.

22. Classification of industries
• In India asset based industry grouping used to exist under MRTP Act
and FERA Act. However, since economic reforms in 1991 onwards,
there is no limit to the asset growth and the classification of MRTP
and non MRTP companies has since disappeared. Nowadays, even
multinational firms can operate in India through their subsidiaries or
directly by having a majority stake in a company

23. The size wise classification of industries is as
follows:
• Small scale units: These industries are not listed and those which
have a minimum paid up capital of Rs 30 lakhs can be listed on OTCEI.
• Medium Scale Industries: The units having paid up capital of Rs 5
crores and above can be listed on regional stock exchanges.
• Large scale Industries: Industrial units with paid up capital of Rs 10
crores or more can be listed on major stock exchanges like BSE.

24. Proprietary Based Classification
• The industries can be classified on the basis of ownership into :
• (a) private sector industries which are open to the general public for
investment
• (b) public sector (Government and semi-government ownership)
• (c) and in joint sector

25. Use Based Classification
• (a) Basic Industries: These are in the core sector in India and
constitute the infrastructure industries which are mostly in the public
sector but are now kept open to the public sector. The examples are
fertilizers, chemicals, coal, cement, steel etc.
• b) Capital Goods Industries: These are both in the private and public
sectors. These are highly capital intensive industries and are used to
produce inputs of other industries such as machine tools, agricultural
machinery, wires, cables etc.

26. (c) Intermediate goods: These are goods in the intermediate stage of
production, having undergone some processing already but will be
used for further production examples are tyres, synthetic yarn, cotton
spinning, automobile parts etc.
(d) Consumer goods industries: These are of two categories, namely,
consumer durables and consumer non durables. These are final
products for the consumption of households. Durables are fans, bulbs,
Automobiles, Cycles, Two wheelers, Telephone equipment etc. Non
durables are food products, Agro based products, tobacco, woollen
and jute textiles etc.

27. Input based Classification
• (a) Agro based products like jute, sugar cotton, tobacco,
groundnuts etc.
• (b) Forest based products like plywood, paper, wood, ivory,
resin honey etc.
• (c) Marine based products like fisheries, prawns, etc.
• (d) Metal based products like engineering products,
aluminium, copper, gold etc.
• (e) Chemical based products like fertilizers, pesticides, drugs
paints etc.

28. Industry Life Cycle
• An insightful analysis when predicting industry sales and trends in
profitability is to view the industry over time and divide its
development into stages similar to those that humans progress
through. The number of stages in the industry life cycle analysis can
be based on a five stages model, which includes:
• 1. Pioneering Development
• 2. Rapid accelerating growth
• 3. Mature growth during this period is very small or negative profit
margins and profits.
• 4. Stabilization and market maturity
• 5. Deceleration of growth and decline.

29. Industry Life Cycle

30. 1. Pioneering Development:
• During this start up stage, the industry experiences modest sales
growth and very small or negative profit margins and profits. The
market for the industry’s product or service during this time period is
small, and the firms involved incur major development costs.

31. 2. Rapid Accelerating Growth:
• During this stage a market develops for the product or service and
demand becomes substantial.
• The limited number of firms in the industry faces little competition
and individual firms can experience substantial backlogs.
• The profit margins are very high. The industry builds its productive
capacity as sales grow at an increasing rate as the industry attempts
to meet excess demand.
• High scales growth and high profit margins that increase as firms
become more efficient cause industry and firm profits to explode.
• During this phase profits can grow at over 100% a year as a result of
the low warning base and the rapid growth of scales and net profit
margins.

32. 3. Mature Growth:
• The success in stage two has satisfied most of the demand for the
industry goods or service. Thus, future scales growth may be above
normal but it no longer accelerates.
• for example, if the over all economy is growing at 8% scale for this
industry might grow at an above normal rate of 15% to 20% a year.
Also the rapid growth of scales and high profit margins attract
competitors to the industry which causes an increase in supply and
lower prices which means that the profit margins begin to decline to
normal levels.

33. 4. Stabilization And Market Maturity:
• During this stage which is probably the longest phase the industry
growth rate declines to the growth rate of the aggregate economy or
its industry segment.
• During this stage investors can estimate growth easily because scales
correlate highly with an economic series.
• Although scales grow in line with the economy profit growth varies
by industry because the competitive structure varies by industries
and by individual firms within the industry because the ability to
control costs differs among companies.
• Competition produces tight profit margins and the rates of return on
capital eventually become equal to or slightly below the competitive
level.

34. 5. Declaration of Growth and Decline:
•At this stage of maturity the industry sales growth
declines because of shifts in demand or growth of
substitutes.
•Profit margins continue to be squeezed and some
firms experience low profit or even losses. Firms
that remain profitable may show very low rates of
return on capital.
•Finally, investors begin thinking about alternative
uses for the capital tied up in this industry.

35. Assessing the Industry Life Cycle
• The industry life cycle classification of industry evolvement helps
investors to assess the growth potential of different companies in an
industry. Based on the stage of industry, they can better assess the
potential of different companies within an industry. However, there
are limitations to this type of analysis.
• First, it is only a generalization, and investors must be careful not to
attempt to categorize every industry, or all companies within a
particular industry, into neat categories that may not apply.
• Second, even the general framework may not apply to some
industries that are not categorized by many small companies
struggling for survival.
• Finally, the bottom line in security analysis is stock prices, a function
of the expected stream of benefits and the risk involved.

36. • The industry life cycle tends to focus on sales and share of the market
and investment in the industry. Although all of these factors are
important to investors, they are not the final items of interests. Given
these qualifications to industry life cycle analysis, what are the
implications for investors?
• The pioneering stage may offer the highest potential returns, but it
also poses the greatest risk. Several companies in an industry will fail
or do poorly. Such risk may be appropriate for some investors, but
many will wish to avoid the risk inherent in this stage.

37. • Investors interested primarily in capital gains should avoid the
maturity stage. Companies at this stage may have relatively high pay-
outs because they have fewer growth prospects. These companies
will often offer stability in earnings and dividend growths.
• Clearly, companies in the fourth stage of the industrial life cycle,
decline, are usually to be avoided. Investors should seek to spot
industries in this stage and avoid them.
• It is the second stage, expansion that is probably of most interest to
investors. Industries that have survived the pioneering stage often
offer good opportunities for the demand for their products and
services is growing more rapidly than the economy as a whole.
Growth is rapid but orderly an appealing characteristic to investors.

38. Industry forecasting Methods
• 1. Market profile: no of establishments, geographical locations, value
if sales etc.,
• 2. Cumulative methods: based on statistical measurements.
• a. Surveys: Carried by researchers, consultants
• b. Correlation and regression analysis: Demand measurements
• 3. Time series:
• a. Trend(T): Result of basic development in population, capital
formation and technology
• b. Cycle(C ): Helps in intermediate range forecasting( wave like
movement of sales)
• c. Seasons( S): Sales movement within a year
• d. Erratic Events: Unpredictable events as strikes, riots, floods etc.,

39. COMPANY OR CORPORATE ANALYSIS
• Company analysis is a study of variables that influence the future of a
firm both qualitatively and quantitatively. It is a method of assessing
the competitive position of a firm, its earning and profitability, the
efficiency with which it operates its financial position and its future
with respect to earning of its shareholders.
• The fundamental nature of the analysis is that each share of a
company has an intrinsic value which is dependent on the company's
financial performance. If the market value of a share is lower than
intrinsic value as evaluated by fundamental analysis, then the share is
supposed to be undervalued.

40. • The basic approach is analysed through the financial statements of an
organisation. The company or corporate analysis is to be carried out
to get answer for the following two questions.
• 1 How has the company performed in comparison with the similar
company in the same Industry?
• 2 How has the company performed in comparison to the early years?
• Before making investment decision, the business plan of the
company, management, annual report, financial statements, cash
flow and ratios are to be examined for better returns.

41. • Fundamental analysis is the method of analysing companies based on
factors that affect their intrinsic value. There are two sides to this method:
• The Quantitative And The Qualitative.
• The Quantitative: The Quantitative side involves looking at factors that can
be measured numerically, such as the company’s assets, liabilities, cash flow,
revenue and price to- earnings ratio. The limitation of quantitative analysis,
however, is that it does not capture the company’s aspects or risks
unmeasurable by a number - things like the value of an executive or the risks
a company faces with legal issues.
• The Qualitative : the qualitative side or non-number side. Although relatively
more difficult to analyse, the qualitative factors are an important part of a
company. Since they are not measured by a number, they more represent an
either negative or positive force affecting the company.

42. • The conclusions of qualitative analysis either reconfirm or raise
questions about the conclusions of quantitative analysis.
Fundamental analysis is not as simple as looking at numbers and
computing ratios; it is also important to look at influences and
qualities that do not have a number value. The present and future
values are affected by the following factors (Figure-1):

43. • 1) Competitive Edge: Many industries in India are composed of
hundreds of individuals companies. The large companies are
successful in meeting the competition and some companies rise to
the position of eminence and dominance. The companies who have
obtain the leadership position; have proven his ability to withstand
competition and to have a sizable share in the market. The
competitiveness of the company can be studied with the help of:
• a) Market share: The market share of the company helps to
determine a company’s relative position with in the industry. If the
market share is high, the company would be able to meet the
competition successfully. The size of the company should also be
considered while analysing the market share, because the smaller
companies may find it difficult to survive in the future.

44. • b) Growth of annual sales: Investor generally prefers to study the
growth in sales because the larger size companies may be able to
withstand the business cycle rather than the company of smaller size.
The rapid growth keeps the investor in better position as growth in
sales is followed by growth in profit. The growth in sales of the
company is analysed both in rupee terms and in physical terms.
• c) Stability of annual sales: If a firm has stable sales revenue, other
things being remaining constant, will have more stable earnings.
Wide variation in sales leads to variation in capacity utilization,
financial planning and dividends. This affects the company’s position
and investor’s decision to invest.

45. • 2) Earnings: The earning of the company should also be analysed
along with the sales level. The income of the company is generated
through the operating (in service industry like banks- interest on
loans and investment) and non-operating income (ant company,
rentals from lease, dividends from securities). The investor should
analyse the sources of income properly. The investor should be well
aware with the fact that the earnings of the company may vary due
to following reasons:
• • Change in sales.
• • Change in costs.
• • Depreciation method adopted.
• • Inventory accounting method.
• • Wages, salaries and fringe benefits.
• • Income tax and other taxes.

47. • 3) Capital Structure: Capital structure is combination of owned capital and
debt capital which enables to maximize the value of the firm. Under this, we
determine the proportion in which the capital should be raised from the
different securities. The capital structure decisions are related with the
mutual proportion of the long term sources of capital. The owned capital
includes share capital
• a) Preference shares: Preference shares are those shares which have
preferential rights regarding the payment of dividend and repayment of
capital over the equity shareholders. At present many companies resort to
preference shares. The preference shares induct some degree of leverage in
finance. The leverage effect of the preference shares is comparatively lesser
than that the debt because the preference shares dividend are not tax
deductible. If the portion of preference share in the capital is large, it tends
to create instability in the earnings of equity shares when the earnings of the
company fluctuate.
• b) Debt: It is an important source of finance as it has the specific benefit of
low cost of capital because interest is tax deductible. The leverage effect of
debt is highly advantageous to the equity shareholders. The limits of debt
depend upon the firm’s earning capacity and its fixed assets.

48. • 4) Management: The basic objective of the company is to attain the
stated objectives of the company for the good of the equity holders,
the public and employees. If the objectives of the company are
achieved, investor will have a profit. Good management results in
high profit to investors. Management is responsible for planning,
organizing, actuating and controlling the activities of the company.
The good management depends upon the qualities of the manager.
• 5) Operating Efficiency: The operating efficiency of the company
directly affects the earnings capacity of a company. An expanding
company that maintains high operating efficiency with a low break
even point earns more than the company with high break even point.
If a firm has stable operating ratio, the revenues also would be stable.
Efficient use of fixed assets with raw materials, labour and
management would lead to more income from sales. This leads to
internal fund generation for the expansion of the firm.

49. 6) Financial Performance:
• Balance Sheet: The level, trends, and stability of earnings are powerful forces in
the determination of security prices. Balance sheet shows the assets, liabilities
and owner’s equity in a company. It is the analyst’s primary source of
information on the financial strength of a company. Accounting principles dictate
the basis for assigning values to assets. Liability values are set by contracts.
When assets are reduced by liabilities, the book value of share holder’s equity
can be ascertained. The book value differs from current value in the market
place, since market value is dependent upon the earnings power of assets and
not their cost of values in the accounts.
• Profit and Loss account: It is also called as income statement. It expresses the
results of financial operations during an accounting year i.e. with the help of this
statement we can find out how much profit or loss has taken place from the
operation of the business during a period of time. It also helps to ascertain how
the changes in the owner’s interest in a given period have taken place due to
business operations. Last of all, for analyzing the financial position of any
company following factors need to be considered for evaluating present situation
and prospects of company.
•

50. COMPANY ANALYSIS: THE STUDY OF FINANCIALS
STATEMENTS
• Financial statement means a statement or document which explains
necessary financial information. Financial statements express the
financial position of a business at the end of accounting period
(Balance Sheet) and result of its operations performed during the
year (Profit and Loss Account). In order to determine whether the
financial or operational performance of company is satisfactory or
not, the financial data are analysed. Different methods are used for
this purpose. The main techniques of financial analysis are:
• 1. Comparative Financial Statements
• 2. Trend Analysis
• 3. Common Size Statement
• 4. Fund Flow Statement
• 5. Cash Flow Statement
• 6. Ratio Analysis

51. 1) Comparative Financial Statements:
• In comparative financial statement, the financial statements of two
periods are kept by side so that they can be compared. By preparing
comparative statement the nature and quantum of change in
different items can be calculated and it also helps in future estimates.
By comparing with the data of the previous years it can be
ascertained what type of changes in the different items of current
year have taken place and future trends of business can be
estimated.

52. 2) Trend Analysis:
• In order to compare the financial statements of various years trend
percentages are significant. Trend analysis helps in future forecast of
various items on the basis of the data of previous years. Under this
method one year is taken as base year and on its basis the ratios in
percentage for other years are calculated. From the study of these
ratios the changes in that item are examined and trend is estimated.
Sometimes sales may be increasing continuously and the inventories
may also be rising. This would indicate the loss of market share of a
particular company’s product. Likewise sales may have an increasing
trend but profit may remain the same. Here the investor has to look
into the cost and management efficiency of the company.

53. 3) Common Size Statement:
• Common size financial statements are such statements in which
items of the financial statements are converted in percentage on the
basis of common base. In common size Income Statement, net sales
may be considered as 100 percent. Other items are converted as its
proportion. Similarly, for the Balance sheet items total assets or total
liabilities may be taken as 100 percent and proportion of other items
to this total can be calculated in percentage.

54. 4) Fund Flow Statement:
• Income Statement or Profit or Loss Account helps in ascertainment of
profit or loss for a fixed period. Balance Sheet shows the financial
position of business on a particular date at the close of year. Income
statement does not fully explain funds from operations of business
because various non-fund items are shown in Profit or Loss Account.
Balance Sheet shows only static financial position of business and
financial changes occurred during a year can’t be known from the
financial statement of a particular date.
• Thus, Fund Flow Statement is prepared to find out financial changes
between two dates. It is a technique of analysing financial
statements. With the help of this statement, the amount of change in
the funds of a business between two dates and reasons thereof can
be ascertained. The investor could see clearly the amount of funds
generated or lost in operations. These reveal the real picture of the
financial position of the company.

55. 5) Cash Flow Statement:
• The investor is interested in knowing the cash inflow and outflow of
the enterprise. The cash flow statement expresses the reasons of
change in cash balances of company between two dates. It provides a
summary of stocks of cash and uses of cash in the organization. It
shows the cash inflows and outflows. Inflows (sources) of cash result
from cash profit earned by the organization, issue of shares and
debentures for cash, borrowings, sale of assets or investments, etc.
The outflows (uses) of cash results from purchase of assets,
investment redemption of debentures or preferences shares,
repayment of loans, payment of tax, dividend, interest etc. With the
help of cash flow statement the investor can review the cash
movement over an operating cycle. The factors responsible for the
reduction of cash balances in spite of increase in profits or vice versa
can be found out.

56. 6) Ratio Analysis:
• Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for
the purpose of comparison. Ratio analysis is a technique of analysing
financial statements. It helps in estimating financial soundness or
weakness. Ratios present the relationships between items presented
in profit and loss account and balance sheet. It summaries the data
for easy understanding, comparison and interpretation. The ratios are
divided in the following group:

57. • Ratio analysis is useful when converting raw financial statement
information into a form that makes easy to compare firms of different
sizes. The analysis includes the examination of the main financial
ratios:
• 1. Profitability ratios, which measure the earning power of the firm.
• 2. Liquidity ratios, which measure the ability of the firm to pay its
immediate liabilities.
• 3. Debt ratios, which measure the firm’s ability to pay the debt
obligations over the time.
• 4. Asset – utilization ratios, which measure the firm’s ability to use
its assets efficiently.
• 5. Market value ratios are an additional group of ratios which reflect
the market value of the stock and the firm.

60. • Book value per share: This ratio indicates the share of equity
shareholders after the company has paid all its liabilities, creditors,
debenture holder and preference shareholders. It is calculated as
follows:
• Book value per share =
• Paid up Equity share capital + Reserves & Surplus
Total number of equity shares outstanding

61. • Earnings per share (EPS): This ratio measures the earnings per share
available to ordinary shareholders. Equity shareholders have the right
to all profits left after payment of taxes and preference dividend. This
ratio is calculated by dividing the profits available for equity
shareholders by the number of equity shares issued.
• EPS = Equity Earnings or EAT
Number of equity shares outstanding

62. TECHNICAL ANALYSIS
• Technical analysis involves a study of market-generated data like
prices and volumes to determine the future direction of price
movement. It is a process of identifying trend reversal at an earlier
stage to formulate the buying and selling strategy. With the help of
several indicators, the relationship between price –volume and
supply-demand is analysed for the overall market and individual
stocks.

63. Technical Analysis
• In other words, technical analysis attempts to understand the
emotions in the market by studying the market itself, as opposed to
its components. If you understand the benefits and limitations of
technical analysis, it can give you a new set of tools or skills that will
enable you to be a better trader or investor.

64. The Basic Assumptions
• The field of technical analysis is based on three assumptions:
• 1. The market discounts everything.
• 2. Price moves in trends.
• 3. History tends to repeat itself.

65. 1. The Market Discounts Everything
• A major criticism of technical analysis is that it only considers price
movement, ignoring the fundamental factors of the company.
However, technical analysis assumes that, at any given time, a stock's
price reflects everything that has or could affect the company -
including fundamental factors.
• Technical analysts believe that the company's fundamentals, along
with broader economic factors and market psychology, are all priced
into the stock, removing the need to actually consider these factors
separately. This only leaves the analysis of price movement, which
technical theory views as a product of the supply and demand for a
particular stock in the market.

66. 2. Price Moves in Trends
• In technical analysis, price movements are believed to follow trends.
This means that after a trend has been established, the future price
movement is more likely to be in the same direction as the trend
than to be against it. Most technical trading strategies are based on
this assumption.

67. 3. History Tends To Repeat Itself
• In technical analysis is that history tends to repeat itself, mainly in
terms of price movement. The repetitive nature of price movements
is attributed to market psychology; in other words, market
participants tend to provide a consistent reaction to similar market
stimuli over time. Technical analysis uses chart patterns to analyse
market movements and understand trends. Although many of these
charts have been used for more than 100 years, they are still believed
to be relevant because they illustrate patterns in price movements
that often repeat themselves.

68. CHARTING TECHNIQUES
• Technical analyst use a variety of charting techniques. The most
popular one are :
• Dow theory
• Bar and Line charts
• The point and figure chart
• The moving average line
• The relative strength line

69. BASIC CONCEPT UNDERLYING CHART ANALYSIS
• The basic concept underlying chart analysis are:
• Persistence of Trends
• Relationship between volume and trend
• Résistance and support levels

70. Trends
• The key belief of the chartist is that stock prices tend to move in fairly
persistent trends. Stock price behaviour is characterized by inertia:
the price movement continues along a certain path (up, down or
sideways) until it meets an opposing force, arising out of an altered
supply demand relationship.

73. Relationship between Volume and Trends:
• Chartists believe that generally volume and trend of hand in hand.
When a major upturn begins, the volume of trading increases as the
price advances and decreases as the price declines. In a major
downturn, the opposite happens: the volume of trading increases as
the price declines and decreases as the prices rallies.

74. • Volume is used to confirm strength in current trend and is an
indicator to identifytrend reversal. Any price trend supported with
volume movement is considered as reliable. The higher the volume
the bigger market participation is which means a larger mass is
validating price movement and it will take much stronger news to
change the direction of the trend.

75. • Volume is calculated by the number of shares that have exchanged
hands between buyers and sellers. Lots of technical analyst
use volume as their main indicator because it reveals the level of
interest for a particular stock.

77. Support and Resistance Levels:
• Chartists assume that it difficult for the price of a share to rise above
a certain level called the resistance level and fall below a certain level
called a support level. If investors find that prices fall after their
purchases, they continue to hang on to their shares in the hope of
recovery. And when the price rebounds to the level of their purchase
price, they tend to sell and heave a sigh of relief as they break even.
Such a behavioural tendency on the part of investors stimulates
considerable supply when the price rebounds to the level at which
substantial purchases were made by the investors .As a result, the
share is not likely to rise above this level, the resistance level.

78. Support and resistance level

80. Bar and Line Charts
• Line charts are created by plotting a line between the closing prices
for each period set on the chart. On a daily chart, a line is plotted
between the daily closing prices. Line charts are useful to help
visualize the direction of prices. The extent of rallies and reactions in
trends can also be quickly deduced.
A line chart is plotted by default when only end-of-day (closing) prices
are available for a symbol. Examples of such symbols include all mutual
funds and some market indices. However, weekly and monthly price
bars can be charted for ticker symbols with only end-of-day (EOD)
quotes.

82. BAR CHARTS
• The most basic tool of technical analysis is the bar chart. This chart
displays basic market price data over a defined period of time. Daily
bar charts note the open, high, low and closing price of an asset.
Rising vertically, the bar marks the high and the low of a given time
period, with the starting price marked by a horizontal line, or tick, to
the left and the ending or closing price marked by a tick to the high

85. Candlestick Charts

87. • Another type of chart used in technical analysis is the
candlestick chart, so called because the main component
of the chart representing prices looks like a candlestick,
with a thick body, called the real 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 represents 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 signify a reversal of the trend.

88. • The top and bottom of the real body represents the opening
and closing prices. Whether the top represents the opening
or closing price depends on the color of the real body—if it
is white, then the top represents the close; black, or some
other dark color, indicates that the top was the opening
price.
• The length of the real body shows the difference between
the opening and closing prices. Obviously, white real bodies
indicate bullishness, while black real bodies indicate
bearishness, and their pattern is easily observable in a
candlestick chart.

89. Point-and-figure charts
• It list only significant price information as columns of X's and O's
without regard to time, so that trends, resistance and support levels
are more apparent. Although time is depicted on the horizontal axis,
the units of time are determined by when the trend changes.
• There are several ways of constructing point-and-figure charts, but all
are based on box size, which is the minimum price differential
necessary before a price is recorded as an X or an O. Columns of X's
show an uptrend, and O's show a downtrend. Generally, closing price
differentials are used

91. Dow Theory
• The theory is named after Charles Dow who was editor of The Wall
Street Journal. He is not its creator. SA Nelson and W. Hamilton who
were using his research and written articles created this theory.
Although it was written more than 100 years ago, it is still base of
research of every technician.
• In 1884, Dow created the first index which was calculated using
prices of the shares of 11 companies. Later, in 1897 he came to the
conclusion that it is better to use two indices: index of 12 shares of
industrial companies (Dow Jones Industrial Index) and Index of 20
shares of railway companies (Dow Jones Rail Index). By the 1928 the
industrial index grown up to include 30 stocks. On that number it
stands today.
•

92. Basic principles
• The basic principles of the theory are:
• (1) The averages discount everything
• Price changes on stock exchange include all knowledge of Wall Street.
So it's enough to analyse price.
• This principle is identical to the first axiom of technical analysis
(everything is included in price), just this principle is applied to the
entire exchange not only to specific stock. The principle is the same
whether it is applied on one or more stocks.

93. (2) Prices are moving in trends
• Dow defined uptrend as a situation in which each successive rally closes
higher then previous rally high and each successive rally low closes higher
than previous rally low. This means that the uptrend consisting of rising
peaks and troughs. For downward opposite logic is applied.
• Dow believed that every trend consists of three parts: primary, secondary
and minor. He compared the trend with the movement of the sea.
• The primary trend is tide, secondary waves make up the tide, and the minor
trend is a small wave. The observer can see the tide if each successive wave
comes further than it did in prior movement. If the farest point of the
coming waves begins to move towards the sea, it means that the tide
disappears.
• The secondary trend is a correction of the primary and usually lasts from
three weeks to three months. Typically, retracements are between a third
and two thirds of previous trend and often that value is 50% of previous
trend.
• Minor trend usually lasts less than 3 weeks and represents the fluctuations
of the secondary trend.

95. (3) Primary trend has three phases
• Uptrend or bullish trend has three phases: accumulation, phase of growth
and market expansion phase. Accumulation phase is characterized by
extreme pessimism. News is bad as the estimates of market movement. At
this stage, investors are able to buy stocks that nobody wants and can
become rich. It can be considered that this is an ideal time to buy. The
second phase is the longest and it is characterized by growth and optimism.
In the third phase there are signs of inflation. A volume of trading is high and
traders have high confidence in market.
• Downward trend or bearish trend also consists of three phases: distribution,
panic and phase of dissapointment. Distribution phase is the beginning of
the price declining. There is nothing in the media to indicate the beginning
of this phase and people are still buying stocks. After corrections prices are
rising, but they stabilize on lower level than they were before the fall. If the
price falls below the previous bottom, a downtrend is confirmed and next
phase begins. In phase of panic stocks are soled massively and the prices are
falling quickly. The last phase is characterized by pessimism, no one wants to
buy although prices are low. Until all bad news do not incorporate in the
price, falling continues. After that, the cycle starts from the beginning.

96. (4) The averages must confirm each other
• Dow believed that the signal for growth or decline in the market can
not be identified on the basis of one index. Both of the indices, Dow
Jones Industrial and Dow Jones Rail must give a signal. Of course
signals do not have to occur simultaneously, they can occur in a short
period of time.

97. (5) The trend should be confirmed by volume
• If the price changes with a small trading volume, there are various
explanations for that: for example, presence of aggressive sellers. But
the right picture of the market is seen only when the price changes
with large volume. Dow believed that volume is secondary indicator
and that volume has to grow in the direction of the primary trend.
Thus, in an uptrend volume should increase when prices rise and fall
as well as prices fall. For downtrend the opposite statement is true.

98. (6) It is considered that the trend remains in force until it
gives definite signals that it has reversed
• This principle is basic rule of technical analysis. Practically if it is not
true, the entire technical analysis would not make sense. The
principle is linked to the law of motion in general: anything that
moves is likely to continue to move until an external force does not
prevent it.
•

99. Charting: The Dow Theory
The Dow Theory:
•Uses price and volume trends to predict
stock prices.
•Identifies primary, secondary, and tertiary
trends.
•Predicts support and resistance price levels.

100. Figure 19-2 Dow Theory Trends

101. Moving averages
• Moving averages are popular and versatile for identifying price
trends. They smooth out fluctuations in market prices, thereby
making it easier to determine underlying trends. Their other function
is to signal significant changes in direction as early as possible.
• The two most popular types of moving averages are the Simple
Moving Average (SMA) and the Exponential Moving Average (EMA).
• SMA is formed by computing the average (mean) price of a security
over a specified number of periods. While it is possible to create
moving averages from the Open, the High, and the Low data points,
most moving averages are created using the closing price.
• EMA in order to reduce the lag in simple moving averages,
technicians often use exponential moving averages (also called
exponentially weighted moving averages).

102. Elliott Wave
• Elliott Wave theory is developed by Ralph Nelson Elliott (1871-1948)
and is successfully being used by market participants to analyse stock
market to forecast market trends. Elliot Wave theory is based on the
hypothesis that stock prices move between optimism and pessimism
of all market participants’ psychology and wide swings in the
participants’ psychology makes stock prices move in a certain
patterns/trends.

103. • Elliott Wave theory suggests that stock prices move in clear trends.
These trends can be
• classified in two parts i.e.
• A. Dominant trend (Five wave pattern)
• B. Corrective trend (Three wave pattern)

104. A. Dominant Trend (Five wave pattern)
• Basically Dominant Trend consists of five waves. These five waves can
be in either direction, up or down. When five waves directions is up
then advancing waves are known as impulsive waves and declining
waves are known as corrective waves.
• Similarly when five waves directions is down then declining waves
are known as impulsive waves and advancing waves are known as
corrective waves.

107. ABC corrective sequence after market declined in a basic five wave sequence.
Here entire move is clearly up after Wave 5 is formed. Hence Wave A and C are
impulse waves and wave B is a corrective wave.

108. Characteristic of Corrective Waves after market rallies
in a basic five wave sequence
• Each individual Wave of the corrective trend has its own
characteristic. One should understand these characteristics which is
the key to practical application of Elliott Theory. These are described
as-
• Wave A: Wave A is the beginning of a new bear market, fundamental
news is still positive and nobody is ready to accept the fact that
markets can decline.
• Wave B: Wave B is basically a small rally which gives the feeling that
Bull Run has again started but prices fail to make new high and typical
volume characteristic here is that Volume in Wave B is lesser than
Wave A.
• Wave C: Here prices again starts declining and volume also pick up
and it’s in Wave C that everyone realizes that market decline is likely
to continue and hence market participation on the sell side increases.

109. Characteristic of Corrective Waves after market
declines in a basic five wave sequence
• Wave A: Wave A is the beginning of a new bull market, fundamental
news is still negative and nobody is ready to accept the fact that
markets could rally
• Wave B: Wave B is basically a small decline which gives the feeling
that decline has again started but prices fail to make new low and
typical volume characteristic here is that Volume in Wave B is lesser
than Wave A.
• Wave C: Here prices again starts rising and volume also pick up and
it’s in Wave C that everyone realizes that market rally is likely to
continue and hence market participation on the buy side increases.
• Combining five wave dominant sequences with a three wave
corrective sequence completes basic fundamental concept behind
Elliott Theory.

110. • Elliott Wave theory suggests that irrespective of size of the wave, all
impulse waves are subdivided into five smaller waves and all
corrective waves are subdivided into three smaller waves. Hence
Elliot Wave is a fractal (Fractal is typically a self similar patterns
appearing at every degree of trend where self similar means they are
“the same from near as from far”).

112. THE EFFICIENT MARKET HYPOTHESIS (EMH)
• The efficient markets hypothesis (EMH), popularly known as the
Random Walk Theory, is the proposition that current stock prices
fully reflect available information about the value of the firm, and
there is no way to earn excess profits, (more than the market over
all), by using this information. It deals with one of the most
fundamental and exciting issues in finance – why prices change in
security markets and how those changes take place.

113. • Fama identified three distinct levels (or ‘strengths’) at which a market
might actually be efficient.
• Strong-form EMH
• In its strongest form, the EMH says a market is efficient if all information
relevant to the value of a share, whether or not generally available to
existing or potential investors, is quickly and accurately reflected in the
market price.
• For example, if the current market price is lower than the value justified by
some piece of privately held information, the holders of that information
will exploit the pricing anomaly by buying the shares. They will continue
doing so until this excess demand for the shares has driven the price up to
the level supported by their private information. At this point they will
have no incentive to continue buying, so they will withdraw from the
market and the price will stabilise at this new equilibrium level. This is
called the strong form of the EMH.
• It is the most satisfying and compelling form of EMH in a theoretical
sense, but it suffers from one big drawback in practice. It is difficult to
confirm empirically, as the necessary research would be unlikely to win the
cooperation of the relevant section of the financial community – insider
dealers.

114. • Semi-strong-form EMH
• In a slightly less rigorous form, the EMH says a market is efficient if all
relevant publicly available information is quickly reflected in the market
price. This is called the semi-strong form of the EMH. If the strong form is
theoretically the most compelling, then the semi-strong form perhaps
appeals most to our common sense. It says that the market will quickly
digest the publication of relevant new information by moving the price to
a new equilibrium level that reflects the change in supply and demand
caused by the emergence of that information. What it may lack in
intellectual rigour, the semi-strong form of EMH certainly gains in
empirical strength, as it is less difficult to test than the strong form.
• One problem with the semi-strong form lies with the identification of
‘relevant publicly available information’. Neat as the phrase might sound,
the reality is less clear-cut, because information does not arrive with a
convenient label saying which shares it does and does not affect. Does the
definition of ‘new information’ include ‘making a connection for the first
time’ between two pieces of already available public information?

115. • Weak-form EMH
• In its third and least rigorous form (known as the weak form), the
EMH confines itself to just one subset of public information, namely
historical information about the share price itself. The argument runs
as follows. ‘New’ information must by definition be unrelated to
previous information, otherwise it would not be new. It follows from
this that every movement in the share price in response to new
information cannot be predicted from the last movement or price,
and the development of the price assumes the characteristics of the
random walk. In other words, the future price cannot be predicted
from a study of historic prices.