UNIT- 3

SAIM
Fundamental analysis
• It is a method of measuring a security's intrinsic value by examining
related economic and financial factors.

• Fundamental analysts study anything that can affect the security's value,
from macroeconomic factors such as the state of the economy and
industry conditions to microeconomic factors like the effectiveness of the
company's management.
Cont.:

• The end goal is to arrive at a number that an investor can compare with
a security's current price in order to see whether the security is
undervalued or overvalued.
It includes-

• the overall state of the economy

• then the strength of the specific industry

• Then concentrating on individual company performance

to arrive at a fair market value for the stock.

Hence it is also called EIC Analysis.

Analysis of Economy- wide factors:
• Help in predicting future shape of the economy and expected growth of
different industrial sectors.
• Helps in deciding the timing of investment.

It includes:
• Study of macroeconomic aggregates
• Classification of factors into indicators
• Forecast about the economy
1) Study of macroeconomic aggregates
-Tells about the health of the economy.
- Prediction about future outcomes
• Industrial production
• GDP
• Investment in infrastructure
• Foreign trade
• Inflation
• Monsoon
• Business condition
• Government policies
• International environment / events.
A) Timing of investment
B) Identification of the industry which is likely to perform better.

2) Classification of factors into indicators

- Used to make a forecast about the economy
Advance moving indicators
Coinciding indicators
Indicators reflecting happenings
Advance moving indicators:
• Move well in advance before incidence of actual development takes
place in the economy.

Monsoon
Infrastructural development
Industrial growth
Per capita income
Government policies
Inflation
Interest rates.
• Help in identifying those industries that are likely to perform better in
future.
• Also help in making a forecast about the overall development in the
economy.

Coinciding Indicators: move along with the growth in economy.

 stock index
Increasing consumption
Increase in living standard.

• Indicate maximum extent of growth

• Identification of reversal of economy.
Indicators reflecting happenings
• Show a signal after an activity has taken place.
• Used only for academic interests.

• Such as regional imbalances.

• Might help in making identification for the future developmental

allocations by the government.
3. Forecast about the economy- techniques

A) Time series analysis- indicating seasonal and cyclical trends

B) Delphi technique- expert opinion

C) Construction of index using majority of the advance moving indicators.

Conclusion of Economic Analysis

• Appropriate timing of investment

• Selection of industries that might perform better.

Industry Analysis:
• The industries selected in the previous phase are scanned individually at
length in this phase.

• The best industry for investment is selected.

Involves two steps:

 Study of Industry Lifecycle

 Study of Quantitative and qualitative factors.

• The study of these stages help in indicating about the future results of
an industry.

It is better to be cautious at the pioneering or embryonic phase.

Be selective at the growth stage.

Investment position should be synthesized at the maturity stage.

Investment in the industry could be continued if there is scope of

diversification.
Example of Industry Life Cycle Analysis
• There was a boom in social media during the early 2000s due to the success
of Myspace, a social networking site that surpassed Google as the most
visited place on the Internet in 2006.

• Sites like Orkut (a Google venture) and Bebo competed to gain users in a
crowded landscape.

• Facebook, which had started in 2004, was also fast gaining traction among
universities and was considered the second most popular social media site.
There were signs of consolidation when Myspace was acquired by Rupert
Murdoch's Newscorp. Ltd for $580 million in 2005.
• But that valuation turned out to be inflated after Facebook overtook MySpace in
rankings.

• MySpace eventually petered into insignificance after Facebook became a social

media behemoth.

• With the exception of a few, like Twitter, other social media sites also fell by the
wayside.

• The social media sites that survived made a thumping debut on the stock market.

• Their valuations were considered high in comparison to their revenues, mainly

because investors expected significant growth in the future as social media became
popular throughout the world.
• As of May 2019, however, Facebook's valuation has declined and the
company has warned of plateauing growth figures in the future.

• Snap Inc. another social media company, is in a similar situation.

• Both companies have expanded the scope of their operations to include

other products, such as cameras and drones, in their portfolio.
Qualitative factors:
• Level of competition
• Protection by Government/ Support.
• Entry barriers
• Product differentiation
• Substitution effect
• Demand level
• Supply of Inputs
• Technological changes
• Stability
Helps in knowing about the profit earning capacity, survival chances and
growth prospects.
Healthy competition represents stability
Mushrooming growth indicates instability
Protection by Government/ Support indicates good earning prospects.
Quantitative factors:
• Trends of turnover/ sales
• Trends of Profitability
• Trends of Cost structure
• Trends of margins

• Tells about profit earning capacity of industry.

Conclusion:
• Aim is to identify that industry which has chance of growth, chance of
high profits and low risk if investment is made.
Company Analysis:
To identify the best company in each of the industry selected.

Done through-
Financial performance analysis
Analysis of qualitative parameters.

Financial performance analysis indicate:

• Profitability
• Financial soundness
Financial performance analysis includes:
• Methodical classification of data given in the financial statements
• Comparison of the various interconnected figures with each other by different
tools of financial analysis.

Tools/ Techniques-
• Comparative Financial statements
• Common size financial statements
• Trend percentages
• Fund flow Analysis
• Cash Flow analysis
• CVP Analysis
• Ratio Analysis
Analysis of Qualitative Parameters:
 Technological advancement in the company
Marketing and distribution network
Research and development efforts
Diversification
Disputes/ claims against the company
Ownership structure

Result of Company analysis:

They indicate about the future survival of a company
Assessment of risk
Identification of companies in which investment can be made.
Estimation of intrinsic value:
1. Estimation of expected EPS of the company.
2. Expected risk in the company
3. Estimation of P/E multiplier.

Calculation of P/ E Multiplier:
1.Assumed on the basis of-
• Expectations about future
• Goodwill of the company
• Diversification and modernization.
2. Rate on a 5 or 7 point scale.
3. Add the rated score.
• Intrinsic value= Expected EPS X P/E Multiplier

Decision making:
• Buy if intrinsic value is more than current price
• Sell if intrinsic value less than current price.
Technical Analysis
• Technical analysis is a trading discipline employed to
evaluate investments and identify trading opportunities by analyzing
statistical trends gathered from trading activity, such as price movement
and volume.

• It focuses on patterns of price movements, trading signals and various

other analytical charting tools to evaluate a security's strength or
weakness.
• It can be used for any security with historical trading data.
• This includes stocks, futures, commodities, fixed-income, currencies, and other
securities.
• Technical analysis was first introduced by Charles Dow and the Dow Theory in
the late 1800s.
• Technical analysts believe past trading activity and price changes of
a security can be valuable indicators of the security's future price movements.
• They may use technical analysis independent of other research efforts or in
combination with some concepts of intrinsic value considerations but most
often their convictions are based solely on the statistical charts of a security.
Basic premises/assumptions of TA:
Prices follow a particular movement over the time
Price movement is affected by Demand and supply.
Demand and supply are affected by certain rational ( logical) and irrational (
psychological) factors.
Every kind of price sensitive information is discounted into prices, which is the
base of predicting near future movements.
Prices follow a particular path continuously which gets repeated again and
again , this repetition helps in taking investment/divestment decisions.
Price movement is supported by traded volume.
Line Chart:

• Most commonly used.

• Various movements like support, resistance, uptrend, downtrend etc.

can easily be identified in these.
Tools to predict overall market trends:
1. Dow Jones Theory
2. Advance Decline Index
3. Client account position.
Basic assumptions of Dow’s Theory:

• Markets are efficient with values representing factors that influence a

security’s price- markets are weakly efficient.

• Market price movements are not purely random but move in identifiable

patterns and trends that tend to repeat over time.

Charles Dow Jones used two averages ( indices):

• Dow Jones Industrial average ( DJIA)

• Dow Jones Transport Average ( DJTA)

• They were considered to be representative of the whole economy.

• Their study helps in predicting the near future movement of the whole
market.
• According to him, the share prices show three kinds of movements all
moving at the same time.
 Daily movements- lasting for about one week
Secondary movements- which continue for about 2- 3 weeks
Primary movements- which continue for about a year or more.

Primary movements are used to for making predictions about the near future
for overall markets.
Both the averages should be moving in the same direction.
The price movements should be supported by traded volume.
Only then it can be confirmed that the market is going to move in the
direction of price index.

Buying Signal/ Bullish market

Selling signal/ Bearish market
Signal of Indifference
Advance Decline Index:
• By advance decline it means a difference between the number of shares
whose prices have increased and the number of shares whose prices
have declined on a particular day.
• Also called Net advances
• A series of such values over a period of time is called Advance Decline
Index.
• The movement of this index can be used to confirm the signals
generated by the general price index of the market.
• Advance decline Line is plotted along the general price index and a
combined movement of both these indices helps in confirming the
signals about the market.
• If the price index as well as Advance decline index both rising, signifies
uptrend

• If the price index as well as Advance decline index both falling, signifies
downtrend.

• If they are not moving in same direction, it indicates divergence in the

price trend in future.
• Tools to predict for individual share trends:
• Moving average analysis
• Oscillators
 MACD
ROC
RSI
• Chart patterns
Moving average analysis:
• It is simply a rolling average of past prices.
• Daily or weekly prices are taken and every time an average is calculated
by dropping the oldest and a new value is calculated.
• It is plotted along with price line.
• Helps in generating buying and selling signals.
Buying signal:
• Whenever the price line is moving above the MA line, it moves towards
the MA line but does not cross it but moves upward and the MA line is
moving upward too.
• When the price line is below the MA line, crosses it and both move
upwards.
• When the price line is above the MA line and both are moving upward.
Selling signal:
• When price line is below MA line, moves upward but fails to cross, instead
starts declining supported by a downward movement of MA line.
• When price line is above the MA line, crosses it moves downward
supported by downward movement of MA line.
• When price line is below the MA line, both move downward continuously.

• For long term prediction 200 days MA is used

• Medium term 70 days
• Short term movement 21 days or 10 days MA
Oscillators:
• It means a movement of certain item again and again on the same path
with the same frequency, like a pendulum in a wall clock.
• Used in predicting future movements much before such movements
takes place hence a sufficient time gap is there to take decision.

• MACD- moving average convergence and divergence

• ROC- Rate of change
• RSI- Relative strength index
MACD=Short period moving average- long period moving average

When MACD is in positive zone it gives a buy signal

When MACD is in negative zone it gives a sell signal.

In order to generate advanced signals MA of MACD is also calculated

and both the line are drawn on a graph to get buying and selling signals.
Generally 7 or 10 period moving average is calculated.
Buying signal:
• Whenever the MACD line is moving above the MA line, it moves towards
the MA line but does not cross it but moves upward and the MA line is
moving upward too.
• When the MACD line is below the MA line, crosses it and both move
upwards.
• When the MACD line is above the MA line and both are moving upward.
Selling signal:
• When MACD is below MA line, moves upward but fails to cross, instead
starts declining supported by a downward movement of MA line.
• When MACD line is above the MA line, crosses it moves downward
supported by downward movement of MA line.
• When MACD line is below the MA line, both move downward
continuously
ROC:
• In calculating ROC, the current days price is divided by the price which
prevailed a few days ago.
• Helps in identifying overbought and oversold markets.
• Generally 10 days ROC is calculated on a rolling basis, that is the 11th day
price is divided by 1st day price and 12th day by 2nd day price and so on.

• ROC value is plotted on a graph and this moves above or below a central
value, 1/0.
• 1/0 is considered as a bench mark value.
• Buying signal
when ROC is more than one and moving upward continuously , it
indicates that market is likely to move upward.
When ROC is less than one but moving upward continuously it indicates
that market has come out of the red and in near future it is expected to
have a upward movement.
When ROC is moving downward but the pace of decline has decreased ,
it indicates that the market is likely to reach Over sold level and after
that it will start rising. Opportunist can consider it as a buy signal.
Selling signal:
• When ROC is increasing but at a slower rate , it indicates that the
market has reached the overbought zone. After which it is going to
decline.
• When ROC reached a peak, one should sell.
• When ROC is more than one but declining it indicates that market is
going to decline in future.
• RSI
• The gains and losses of the prices over the immediate previous day’s price
for a certain period is calculated.
• RSI value calculated and plotted on the graph to identify Over bought and
oversold market.
• RS= Average of n days advance/ Average of n days declines
• RSI= 100- 100/ (1+RS)

• Value 50 is the bench mark

• Value 70 is used to identify overbought market
• Value 30 is used to identify oversold market.
Buying signal:
• When RSI is more than 50 and moving upward continuously, it indicates
that market is likely to move upward.
• When RSI line is less than 50 and moving upward continuously, it
indicates that market has come out of the red and in the near future it is
expected to have an upward movement.
• When RSI is moving downside below 50 mark, but the pace of decline
has decreased it indicates that market is likely to reach oversold level
and after that it will start rising, an opportunist who can take a risk can
buy at this level.
Selling signal:
• When RSI is more than 50 and declining continuously, it indicates that
market is likely to move downward.
• When RSI line is increasing above 50 but pace of increase has declined,
it indicates that the market is about to reach the over bought zone after
which it is likely to move downward.
• When RSI has made a peak at around 70 level it shows overbought
market and market is likely to move downward.
Chart Patterns:
Head and shoulder-
• A Head and Shoulders pattern forms after an uptrend, and its completion
marks a trend reversal.
• The pattern contains three successive peaks, with the middle peak (head)
being the highest and the two outside peaks (shoulders) being low and
roughly equal.
• The reaction lows of each peak can be connected to form support, or
a neckline.
Inverse Head and Shoulder-
• the Head and Shoulders Inverse/Bottom forms after a downtrend, with
its completion marking a change in trend.
• The pattern contains three successive troughs with the middle trough
(head) being the deepest and the two outside troughs (shoulders) being
shallower.
• Ideally, the two shoulders would be equal in height and width.
• The reaction highs in the middle of the pattern can be connected to form
resistance, or a neckline.
• Advantages:
Used in Trading Activities.
1. Market news reflects the stock prices
• The stock price is a reflection of all fundamental news.
• The crowd market psychology is identified using the patterns.
• It’s used for price forecasting. This helps investors make informed investment
decisions.
2. Trend identification
• The direction of the stock market trend is identified using technical analysis.
• The stock may be in an uptrend, a downtrend, or a sideways trend.
• The trend direction is useful when you’re investing and trading in stock markets.
3. Entry and exit recommendations
• Entry and exit strategy is recommended for short and long-term trading in
technical analysis.
• Fundamental analysis is used for the long-term entry and exit point.
Limitations:
Technical indicators’ mixed signals
• In some cases, one of the technical indicators will show a buy signal and another
indicator will show a sell signal.
• This causes confusion in trading decisions.
• This is one of the disadvantages of technical analysis.
• So, some traders use a combination of technical indicators, patterns, volume, and
moving averages to determine the entry and exit point.
Accuracy
• Technical analysis is used to forecast stocks.
• All of the technical indicators give possible entry and exit points.
• The forecasting accuracy isn’t 100%.
• For example, when a possible entry or exit point for a stock is suggested, it doesn’t
guarantee a successful trade.
• Stock may decrease after the entry. Stock can also rise after the exit.
Biased opinion
• One technical analyst’s opinion may contradict another analyst’s opinion
for the same stock.
• The technical methods that are used to analyze stocks can vary from one
analyst to another.
Elliot Wave Principle:
• Given by R. N. Elliot in 1930s. Popularized by Hamilton Bolton.
• Major moves take place in 5 successive steps that resemble a tidal wave.
• In a major bull market the first move is upward, the second downward, the
third upward, the fourth downward and fifth and final phase upward.
• The waves have a reverse flow in bear market.
• Helps the investors in developing important marketing strategies.

Suffers from two major limitations:

- difficult to identify turning point of each stage.
- Investors cannot frequently distinguish between major and minor movement.
• Difference between TA and FA:
Purpose:
Fundamental Analysis: It seeks to forecast stock prices on the basis of
economic, industry and company statistics. However, the most important
variables considered in deciding stock prices are earnings and dividends.
Technical Analysis: It mainly focuses on internal market data.

Long-term & Short-term Price Movement:

• Fundamental analysis: It seeks to predict long-term values of securities.
Technical Analysis: The technical analysis determines the short-term price
movements of the securities. The technician is a trader who buys and sells
securities for short-term profits.
Value of Share
Fundamental Analysis: The fundamental analyst estimates the intrinsic value of
shares and purchases them when their market price is less than the intrinsic
value. He sells the shares when the market value of shares is more than the
intrinsic value and earns profit. Thus, he works on long-term basis.
Technical Analysis: The technician believes that there is no real value to any
stock. According to him, stock prices depend on demand and supply forces
which in turn are governed by rational and irrational factors.
Finding the trend
• Fundamental Analysis: In fundamental analysis, there is no scope for finding
out the past trend of share and also the fluctuations in the price trend.
• Technical Analysis: Technicians believe that past trend will be repeated again
and the current movements can be used for studying the future trend.
Assumptions
Fundamental Analysis: There are no assumptions in fundamental analysis.
Technical Analysis: Technical analysis works on the basis of various
assumptions which have been outlined earlier.
Decision Making
Fundamental analysis: The fundamental analysis carefully studies the
financial statements, demand forecasts, quality of management, earnings
and growth. Then they judge the prices of securities. Thus, the
fundamental analysts are making decisions based on their own (subjective)
opinions.
Technical Analysis: It listen to what the market has to say. So, the view of
the market is the most important factor in determining stock prices.
Usefulness
Fundamental analysis: It helps identify undervalued or overvalued shares.
Technical analysis: It is useful in timing a buy or sell order.
Efficient Market Theory: propounded by Eugene Fama
• The Efficient Market Hypothesis, or EMH, is an investment theory
whereby share prices reflect all information and consistent alpha
generation is impossible.

• Theoretically, neither technical nor fundamental analysis can produce

risk-adjusted excess returns, or alpha, consistently and only inside
information can result in outsized risk-adjusted returns.
• According to the EMH, stocks always trade at their fair value on stock
exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices.

• As such, it should be impossible to outperform the overall market

through expert stock selection or market timing, and the only way an
investor can possibly obtain higher returns is by purchasing riskier
investments.
• There are three variations of the hypothesis –

• the weak,

• semi-strong

• strong forms – which represent three different assumed levels of market

efficiency.
Weak Form
• It assumes that the prices of securities reflect all available public market information but may
not reflect new information that is not yet publicly available.

• It additionally assumes that past information regarding price, volume, and returns is
independent of future prices.

• The weak form EMH implies that technical trading strategies cannot provide consistent excess
returns because past price performance can’t predict future price action that will be based on
new information.

• The weak form, while it discounts technical analysis, leaves open the possibility that superior
fundamental analysis may provide a means of outperforming the overall market average
return on investment.

•
Semi-strong Form
• The semi-strong form of the theory dismisses the usefulness of both
technical and fundamental analysis.

• The semi-strong form of the EMH incorporates the weak form

assumptions and expands on this by assuming that prices adjust quickly
to any new public information that becomes available, therefore
rendering fundamental analysis incapable of having any predictive power
about future price movements.
Strong Form
• The strong form of the EMH holds that prices always reflect the entirety of
both public and private information.
• This includes all publicly available information, both historical and new, or
current, as well as insider information.
• Even information not publicly available to investors, such as private
information known only to a company’s CEO, is assumed to be always already
factored into the company’s current stock price.
• So, according to the strong form of the EMH, not even insider knowledge can
give investors a predictive edge that will enable them to consistently
generate returns that outperform the overall market average.