INVESTMENT Introduction:

The money a person earns is partly spent and the rest saved for meeting future
expenses. Instead of keeping the savings idle he may like to use savings in order to
get return on it in the future. This is called Investment. The term investment refers
to exchange of money wealth into some tangible wealth. The money wealth here
refers to the money (savings) which an investor has and the term tangible wealth
refers to the assets the investor acquires by sacrificing the money wealth. By
investing, an investor commits the present funds to one or more assets to be held
for some time in expectation of some future return in terms of interest or dividend
and capital gain. Definition: “Investment may be defined as an activity that
commits funds in any financial/marketable or physical form in the present with an
expectation of receiving additional return in the future.” For example, a Bank
deposit is a financial asset, the purchase of gold is a physical asset and the
purchase of bonds and shares is marketable asset. “Investment is the commitment
of current funds in anticipation of receiving larger inflow of funds in future, the
difference being the income”.

An investor hopes to be compensated for

(i) forgoing present consumption,

(ii) for the effects of inflation, and
(iii) for taking a risk. Features:
There are three basic features common to all types of investment:
1. There is a commitment of present funds.
2. There is an expectation of some return or benefits from such
commitment in future, and
3. There is always some risk involved in respect of return and the principal
amount invested.

OBJECTIVES OF INVESTMENT:

1. RETURN:
Investors expect a good rate of return from their investments. Return
from investment may be in terms of revenue return or income (interest or
dividend) and/or in terms of capital return (capital gain i.e. difference
between the selling price and the purchasing price). The net return is the
 sum of revenue return and capital return. For example, an investor
purchases a share (Face Value FV Rs.10) for Rs.130. After one year, he
receives a dividend of Rs.3 (i.e. 30% on FV of Rs.10) from the company
and sells it for Rs.138. His total return is Rs.11, i.e., Rs.3 + Rs.8. The
normal rate of return is Rs.11 divided by Rs.130 i.e., 8.46%. In the same
case, if he is able to sell the share only for Rs.128, then his net return is
Re.1 (i.e., Rs.3 – Rs.2) only. The annual rate of return in this case is
0.77% (i.e., 1/130) a) Expected Return: The expected return refers to the
anticipated return for some future period. The expected return is
estimated on the basis of actual returns in the past periods. b) Realised
Returns: The realized return is the net actual return earned by the
investor over the holding period. It refers to the actual return over some
past period.
2. RISK:
Variation in return i.e., the chance that the actual return from an investment
would differ from its expected return is referred to as the risk. Measuring
risk is important because minimizing risk and maximizing return are
interrelated objectives.
2. LIQUIDITY:

Liquidity, with reference to investments, means that the investment is

saleable or convertible into cash without loss of money and without loss of
time. Different types of investments offer different type of liquidity. Most of
financial assets provide a high degree of liquidity. Shares and mutual fund
units can be easily sold at the prevailing prices. An investor has to build a
portfolio containing a good proportion of investments which have relatively
high degree of liquidity.Cash and money market instruments are more liquid
than the capital market instruments which in turn are more liquid than the
real estate investments. For ex, money deposited in savings a/c and fixed
deposit a/c in a bank is more liquid than the investment made in shares or
debentures of a company.

3. SAFETY:
An investor should take care that the amount of investment is safe. The
safety of an investment depends upon several factors such as the
economic conditions, organization where investment is made, earnings
 stability of that organization, etc. Guarantee or collateral available
against the investment should also be taken care of. For ex, ➢ Bonds
issued by RBI are completely safe investments as compared with the
bonds of a private sector company. ➢ Like wise it is more safer to invest
in debenture than of preference shares of a company ➢ Accordingly, it is
more safer to invest in preference shares than of equity shares of a
company, the reason being that in case of company liquidation, order of
payment is debenture holders, preference share holds and then equity
share holders.
4. TAX BENEFITS:
Investments differ with respect to tax treatment of initial investment,
return from investment and redemption proceeds. For example,
investment in Public Provident Fund (PPF) has tax benefits in respect of
all the three characteristics. Equity Shares entails exemption from
taxability of dividend income but the transactions of sale and purchase
are subject to Securities Transaction Tax or Tax on Capital gains.
Sometimes, the tax treatment depends upon the type of the investor. The
performance of any investment decision should be measured by its after
tax rate of return. For example, between 8.5% PPF and 8.5% Debentures,
PPF should be preferred as it is exempt from tax while debenture is
subject to tax in the hands of the investors.

5. REGULARITY OF INCOME:
The prime objective of making every investment is to earn a stable
return. If returns are not stable, then the investment is termed as risky.
For example, return (i.e. interest) from Savings a/c, Fixed deposit a/c,
Bonds & Debentures are stable but the expected dividends from equity
share are not stable. The rate of dividend on equity shares may fluctuate
depending upon the earnings of the company. RISK Investors invest for
anticipated future returns, but these returns can be rarely predicted. The
difference between the expected return and the realized return and latter
may deviate from the former. This deviation is defined as risk. All
investors generally prefer investment with higher returns, he has to pay
the price in terms of accepting higher risk too. Investors usually prefer
less risky investments than riskier investments. The government bonds
are known as risk-free investments, while other investments are risky
investments.

RISK

Systematic Unsystematic Or Or Uncontrollable controllable

1. Market risk
2. Business risk
3. Interest rate risk
4. Financial risk
5. Purchasing power risk

SYSTEMATIC RISK
It affects the entire market. It indicates that the entire market is moving
in particular direction. It affects the economic, political, sociological
changes. This risk is further subdivided into:
1. Market risk
2. Interest rate risk
3. Purchasing power risk

1. Market risk:
Jack Clark Francis defined market risk as “portion of total variability in
return caused by the alternating forces of bull and bear markets. When
the security index moves upward for a significant period of time, it is
bull market and if the index declines from the peak to market low point
is called troughs i.e. bearish for significant period of time. The forces
that affect the stock market are tangible and intangible events. The
tangible events such as earthquake, war, political uncertainty and fall in
the value of currency. Intangible events are related to market
psychology. For example – In 1996, the political turmoil and recession in
the economy resulted in the fall of share prices and the small investors
lost faith in market. There was a rush to sell the shares and stocks that
were floated in primary market were not received well.
2. Interest rate risk:
It is the variation in single period rates of return caused by the
fluctuations in the market interest rate. Mostly it affects the price of the
bonds, debentures and stocks. The fluctuations in the interest rates are
caused by the changes in the government monetary policy and changes in
treasury bills and the government bonds. Interest rates not only affect the
security traders but also the corporate bodies who carry their business
with borrowed funds. The cost of borrowing would increase and a heavy
outflow of profit would take place in the form of interest to the capital
borrowed. This would lead to reduction in earnings per share and
consequent fall in price of shares. EXAMPLE –In April 1996, most of
the initial public offerings of many companies remained under
subscribed, but IDBI & IFC bonds were over subscribed. The assured
rate of return attracted the investors from the stock market to the bond
market.
3. Purchasing power risk:
Variations in returns are due to loss of purchasing power of currency.
Inflation is the reason behind the loss of purchasing power. The inflation
may be, “demand-pull or cost-push “. • Demand pull inflation, the
demand for goods and services are in excess of their supply. The supply
cannot be increased unless there is an expansion of labour force or
machinery for production. The equilibrium between demand and supply
is attained at a higher price level. • Cost-push inflation, the rise in price is
caused by the increase in the cost. The increase in cost of raw material,
labour, etc makes the cost of production high and ends in high price
level. The working force tries to make the corporate to share the increase
in the cost of living by demanding higher wages. Hence, Cost-push
inflation has a spiraling effect on price level.

UNSYSTEMATIC RISK
Unsystematic risk stems from managerial inefficiency, technological
change in production process, availability of raw materials, change in
consumer preference and labour problems. They have to be analysed by
each and every firm separately. All these factors form Unsystematic risk.
They are
1. Business risk
2. Financial risk

1. BUISNESS RISK: It is caused by the operating environment of the

business. It arises from the inability of a firm to maintain its
competitive edge and the growth or stability of the earnings. The
variation in the expected operating income indicates the business risk.
It is concerned with difference between revenue and earnings before
interest and tax. It can be further divided into: • Internal business risk
• External business risk Internal business risk - it is associated with
the operational efficiency of the firm. The efficiency of operation is
reflected on the company’s achievement of its goals and their
promises to its investors. The internal business risks are: • Fluctuation
in sales • Research and development • Personal management • Fixed
cost • Single product External business risk –It is the result of
operating conditions imposed on the firm by circumstances beyond its
control. The external business risk are, • Social and regulatory factors
• Political risk • Business cycle.

2. FINANCIAL RISK:

It is the variability of the income to the equity capital due to the debt
capital. Financial risk is associated with the capital structure of the
firm. Capital structure of firm consists of equity bonds and borrowed
funds. The interest payment affects the payments that are due to the
equity investors. The use of debt with the owned funds to increase the
return to the shareholders is known as financial leverage. The
financial risk considers the difference between EBIT and EBT. The
business risk causes the variation between revenue and EBIT. The
financial risk is an avoidable risk because it is the management which
has to decide how much has to be funded with equity capital and
borrowed capital.

INVESTMENT & SPECULATION:

In speculation, there is an investment of funds with an expectation of
some return in the form of capital profit resulting from the price
change and sale of investment. Speculation is relatively a short term
investment. The degree of uncertainty of future return is definitely
higher in case of speculation than in investment. In case of
investment, the investor has an intention of keeping the investment
for some period whereas in speculation, the investor looks for an
opportunity of making a profit and “exit- out” by selling the
investment.
DIFFERENCES IN INVESTMENT & SPECULATION:

FACTOR INVESTEMENT SPECULATION

Degree of risk Relatively lesser Relatively higher
Basis of return Income and capital Change in market
gain price

Basis for decision Analysis of Rumors, tips, etc

fundamentals
Position of investor Ownership Party of an agreement
Investment period Long term Short term

INVESTMENT ALTERNATIVES

Physical assets like real estate, gold/jewelry, commodities etc. and/or

Financial assets /Non-Marketable financial assets such as fixed
deposits with banks, small saving instruments with post offices,
insurance/provident/pension fund etc.
Marketable financial assets - securities market related instruments
like shares, bonds, debentures, derivatives, mutual fund etc.
REAL ASSETS FINANCIAL ASSETS
1. Real Estate • Residential Apartments • Office Buildings • Land
2. Gems and Metals • Diamonds • Gold • Silver
3. Antiques • Art Pieces • Stamps • Coins etc
1. Equity Claims • Equity Shares • Mutual Funds • Convertible
Debentures • Convertible Preference Shares 2. Redeemable
Preference Shares 3. Creditors Claims • Debt Securities • Commercial
Paper • Loans and Deposits • Savings Account Intangible Alternative
Investments : Hedge funds Private equity Venture capital Derivatives
Cryptocurrency

Return
Return can be defined as the actual income from a project as well as
appreciation in the value of capital. Thus there are two components in
return—the basic component or the periodic cash flows from the
investment, either in the form of interest or dividends; and the change
in the price of the asset, com-monly called as the capital gain or loss.
The term yield is often used in connection to return, which refers to
the income component in relation to some price for the asset. The
total return of an asset for the holding period relates to all the cash
flows received by an investor during any designated time period to
the amount of money invested in the asset.
Computation of Return 1.Grow More Ltd. Is evaluating the rate of
return on two of its Assets, I and II. The Asset I was purchased a year
ago for Rs.4,00,000 and since then it has generated cash inflows of
Rs. 16,000. Presently, it can be sold for a price of Rs.4,30, 000.Asset
II was purchased a few years ago and its market price in the
beginning and at the end of the current year was Rs.2,40,000 and
Rs.2,36,000 respectively. The Asset II has generated cash inflows of
Rs.34,000 during the year. Find out the rate of return on these assets.
Solution: The rate of return on these assets can be ascertained with
the help of the above equation: For Asset I R= 16000+(430000-
400000) = 11.5% 400000 11.5% For Asset II R= 34000+(236000-
240000) =12.5% 240000 2. A had purchased a bond at a price of
Rs.800 with a coupon payment of Rs.150 and sold it Rs.1000.i)What
is his holding period return and ii)If the bond is sold is sold for
Rs.750 after receiving Rs.150 as coupon payment then what is his
holding period return? i) R= 150+(1000-800) X 100 = 43.75% 800 ii)
R= 150+(750-800) X 100 = 12.5% 800 Expected rate of Return The
expected return is the profit or loss that an investor anticipates on an
investment that has known historical rates of return (RoR). It is
calculated by multiplying potential outcomes by the chances of them
occurring and then totaling these results. Expected returns cannot be
guaranteed. The expected return for a portfolio containing multiple
investments is the weighted average of the expected return of each of
the investments. Expected return calculations are a key piece of both
business operations and financial theory, including in the well-known
models of the modern portfolio theory (MPT) For example, if an
investment has a 50% chance of gaining 20% and a 50% chance of
losing 10%, the expected return would be 5% = (50% x 20% + 50% x
-10% = 5%). What is Expected Return? The expected return on an
investment is the expected value of the probability distribution of
possible returns it can provide to investors. The return on the
investment is an unknown variable that has different values
associated with different probabilities. Expected return is calculated
by multiplying potential outcomes (returns) by the chances of each
outcome occurring, and then calculating the sum of those results (as
shown below).
Computation of Expected Return.

1.Compute expected return on security X from the particulars given:

Return Probability

20% .15
21% .20
22% .50
23% .10
24% .05

Return(X) Probability(P) PX 20% *.15 + 21% *.20 + 22% *.50 +

23% *.10+ 24%* .05 Expected return R = 21.8%

RISK

Risk is defined in financial terms as the chance that an outcome or

investment's actual gains will differ from an expected outcome or
return. Risk includes the possibility of losing some or all of an
original investment. Investing money into the markets has a high
degree of risk and you should be compensated if you're going to take
that risk. If somebody you marginally trust asks for a Rs.500 loan and
offers to pay you Rs.600 in two weeks, it might not be worth the risk,
but what if they offered to pay you Rs.1000? The risk of losing
Rs.500 for the chance to make Rs.1000 might be appealing.
Calculation of Risk The market price of an equity share is
Rs.100.Following information is available respect of dividends.
market price and expected market condition after one year Market
Condition Probability Market Price Dividend Good 25 Rs.115 9
Normal 50 107 5 Bad 25 97 3 Find out the expected return and
variability of return of the equity share.

SECURITY ANALYSIS FUNDAMENTAL ANALYSIS:

Fundamental analysis is the study of economic factors, industrial
environment and the factors related to the company. The earnings of
the company, the growth rate and the risk exposure of the company
have a direct bearing on the price of the share. These factors in turn
rely on the host of other factors like economic development in which
they function, the industry belongs to, and finally companies’ own
performance. The fundamental school of thought appraised the
intrinsic value of shares through
• Economic Analysis
• Industry Analysis
• Company Analysis
ECONOMIC ANALYSIS: The state of the economy determines the
growth of gross domestic product and investment opportunities. An
economy with favorable savings, investments, stable prices, balance
of payments, and infrastructure facilities provides a best environment
for common stock investment. If the company grows rapidly, the
industry can also be expected to show rapidly growth and vice versa.
When the level of economic activity is low, stock prices are low, and
when the level of economic activity is high, stock prices are high
reflecting the prosperous outlook for sales and profits of the firms.
The analysis of macro economic environment is essential to
understand the behavior of the stock prices. The commonly analyzed
macro economic factors are as follows:
❖ Gross domestic product (GDP): GDP represents the aggregate
value of goods and services produced in the economy. It consists of
personal consumption expenditure, gross private domestic investment
and government expenditure on goods & services and net export of
goods & services. It indicates rate of growth of economy. The
estimate on GDP available on annual basis.
❖ Business Cycle: Business cycles refer to cyclical movement in the
economic activity in a country as a whole. An economy marching
towards prosperity passes through different phases, each known as a
component of a business cycle. These phases are: a. Depression:
Demand level in the economy is very low. Interest rates and Inflation
rates are high. These affect profitability and dividend pay out and
reinvestment activities. b. Recovery: Demand level starts picking up.
Fresh investment by corporate firms shows increasing trend. c. Boom:
After a consistent recovery for a number of years, the economy starts
showing signs of boom which is characterized by high level of
economic activities such as demand, production and profits. d.
Recession: The boom period is generally not able to sustain for a long
period. It slows down and results in the recession.
❖ Savings & investment: The growth requires investment which in
turn requires substantial amount of domestic savings. Stock market is
a channel through which the savings of investors are made available
to the corporate bodies. Savings are distributed over various assets
like equity shares, deposits, mutual fund unit, real estate and bullion.
The saving and investment pattern of the public effect the stock to
great extent.
❖ Inflation: The inflation is raise in price, where its rate increases,
than the real rate of growth would be very little. The demand is the
consumer product industry is significantly affected. The industry
which comes under the government price control policy may lose the
market. If the mild level of inflation, it is good to the stock market but
high rate of inflation is harmful to the stock market.
❖ Interest rates: The interest rate affects the cost of financing to the
firms. Higher interest rates increase the cost of funds and lower
interest rates reduce the cost of funds resulting in higher profit. There
are several reasons for change in interest rates such as monetary
policy, fiscal policy, inflation rate, etc,
❖ Monetary Policy, Money supply and Liquidity: The liquidity in
the economy depends upon the money supply which is regulated by
the monetary policy of the government. RBI regulate the money
supply and liquidity in the economy. Business firms require funds for
expansion projects. The capacity to raise funds from the market is
affected by the liquidity position in the economy. The monetary
policy is designed with an objective to maintain a balance in liquidity
position. Neither the excess liquidity nor the shortage are desirable.
The shortage of liquidity will tend to increase the interest rates while
the excess will result in inflation.
❖ Budget: The budget draft provides an elaborate account of the
government 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 favorable to the stock market.
❖ Tax structure: Every year in March, the business community
eagerly awaits the government’s announcement regarding the tax
policy. Concessions and incentives given to the certain industry
encourage investment in particular industry. Tax relief given to
savings encourages savings. The minimum alternative tax (MAT)
levied by finance minister in 1996 adversely affected the stock
market. Ten years of tax holiday for all industries to be set up in the
northeast is provided in the 1999 budget. The type of tax exemption
has impact on the profitability of the industries.
❖ Monsoon and agriculture: Agriculture is directly and indirectly
linked with the industries. For example, sugar, cotton, textile and food
processing industries depend upon agriculture for raw material.
Fertilizer and insectide industries are supplying inputs to agriculture.
A good monsoon leads to higher demand for input and results in
bumper crop. This would lead to buoyancy in the stock market. When
the monsoon is bad, agricultural and hydro power production would
suffer. They cast a shadow on a share market.
❖ Infrastructure facilities: Infrastructure facilities are essential for the
growth of industrial and agricultural sector. A wide network of
communication system is a must for the growth of the economy.
Good infrastructure facilities affect the stock market favourably. The
government are liberalized its policy regarding the communication,
transport and power sector.
❖ Demographic factors: The Demographic data provides details
about the population by age, occupation, literacy and geographic
location. This is needed to forecast the demand of customer goods.
The population by age indicates the availability of able work force.
❖ Economic forecasting: To estimate the stock price changes, an
analyst the macro economic environment and the factor peculiar to
industry concerned to it. The economic activities affect the corporate
profits, Investors, attitude and share prices.
❖ Economic indicators: The economic indicators are factors 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.
❖ Diffusion index: Diffusion index is a composite index or consensus
index. The diffusion index consist of leading, coincidental and
lagging indicators. This type of index has been constructed by the
National Bureau of Economic Research in USA. But it is complex in
nature to calculate and the irregular movements that occur in
individual indicators cannot be completely eliminated.
❖ Econometric model building: For model building several economic
variables are taken into consideration. The assumptions underlying
the analysis are specified. The relationship between the independent
and dependent variables is given mathematically. While using the
model, the analyst has to think clearly all inter-relationship between
the variables. This model use simultaneous equations. Other factors:
a. Industrial growth rate b. Fiscal policy of the Government c. Foreign
exchange reserves d. Growth of infrastructural facilities e. Global
economic scenario and confidence f. Economic and political stability.
INDUSTRY ANALYSIS
An industry is a group of firms that have similar technological
structure of production and produce similar products. E.g.: food
products, textiles, beverages and tobacco products, etc. These
industries can be classified on the business cycle i.e. classified
according to their relations to the different phases of the business
cycle. They are classified into
▪ Growth industry
▪ Cyclical industry
▪ Defensive industry
▪ Cyclical Growth industry

Growth industry: The growth industry has special features of high

rate of earnings and growth in expansion, independent of the business
cycle. The expansion of the expansion of the industry mainly depends
upon the technological change.
➢ Cyclical industry: The growth and the profitability of industry
move along with the business cycle. During the boom period they
enjoy the growth and during depression they suffer set back.
➢ Defensive industry: Defensive industry defies the movement of
business cycle. The stock of defensive industries can be held by the
investor for income earning purpose. They expand and earn income in
the depression period too, under the government’s of production and
are counter-cyclical in nature.
➢ Cyclical Growth industry This is a new type of industry that is
cyclical and at the same time growing. The changes in technology and
introduction of new models help the automobile industry to resume
their growth path.
INDUSTRY LIFE CYCLE
The life cycle of the industry is separated into four well defined
stages such as o Pioneering stage o Rapid growth stage o Maturity
and stabilization stage o Declining stage Fig.5 Pioneering stage: The
prospective demand for the product is promising in this stage and the
technology of the product is low. The demand for the product attracts
many producers to produce the particular product. There would be
severe competition and only fittest companies this stage. The
producers try to develop brand name, differentiate the product and
create a product image. This would lead to nonprice competition too.
The severe competition often leads to the change of position of the
firms in terms of market shares and profit. In this situation, it is
difficult to select companies for investment because the survival rate
is unknown. Rapid growth stage: This stage starts with the
appearance of surviving firms from the pioneering stage. The
companies that have withstood the competition grow strongly in
market share and financial performance. The technology of the
production would have improved resulting in low cost of productions
and good quality products. The companies have stable growth rate in
this stage and they declare dividend to the share-holders. It is
advisable to invest in the shares of these companies. Maturity and
stabilization stage: In the stabilization stage, the growth rate tends to
moderate and the rate of growth would be more or less equal to the
industrial growth rate or the gross domestic product growth rate.
Symptoms of obsolescence may appear in the technology. To keep
going, technological innovations in the production process and
products should be introduced. The investors have to closely monitor
the events that take place in the maturity stage of the industry.
Declining stage: In this stage, Demand for the particular product and
the earnings of the companies in the industry decline. The specific
feature of the declining stage is that even in the boom period; the
growth of the industry would be low and decline at a higher rate
during the recession. It is better to avoid investing in the shares of the
low growth industry even in the boom period. Investment in the
shares of these types of companies leads to erosion of capital.
KEY FACTORS IN INDUSTRY ANALYSIS:
1. The past performance of the industry.
2. The performance of the product and technology of the industry.
3. Role of government in the industry.
4. Labour conditions relating to the industry.
5. Competitive conditions in the market
6. Inter-linkages with other industries
DETERMINING THE SENSITIVITY OF THE INDUSTRY:
1. Sensitivity to sales.
2. Operating leverage
3. Financial leverage.
SWOT ANALYSIS FOR THE INDUSTRY
Strength: Strength of the industry refers to its capacity and
comparative advantage in the economy. For example, the existing
research and development facilities and greater dependence on
allopathic drugs are two elements of strength to the pharmaceutical
industry in India. Weakness: Weakness refers to the restrictions and
inherent limitations in the industry, which keep the industry away
from meeting its target. For example, Lack of infrastructure facility,
rail-road links, etc., are weakness of the tourism industry in India.
Opportunities: Opportunities refers to the expectation of favourable
situation for an industry. For example, with increase in purchasing
power with the people, demand for pharmaceutical industry will
increase and likewise, changing preference from gold to diamond
jewellary has brought a lot of opportunities for the diamond industry.
Threats: Threat refers to an unfavourable situation that has a potential
to endanger the existence of an industry. For example, after
liberalization of import policy in India, import of Chinese goods has
threatened many industries in India, such as toys, novelties, etc.
III. COMPANY ANALYSIS
Effect of a business cycle on an individual company may be different
from one industry to another. Here, the main point is the relationship
between revenues and expenses of the firm and the economic and
industry changes. The basic objective of company analysis is to
identify better performing companies in an industry .These companies
would be identified for investment. The processes that may be taken
up to attain the objective are as follows: a. Analysis of management
of the company to evaluate its trust-worthiness, capacity and
efficiency. b. Analyse the financial performance of the company to
forecast its future expected earnings. c. Evaluation of long-term
vision and strategies of company in terms of organizational strength
and resources of company. d. Analysis of key success factor for
particular industry.
SOURCES OF INFORMATION: Information and data required for
analysis of earnings of a firm are primarily available in the annual
financial statements of the firm. It include,
➢ Balance sheet or Position statement
➢ Income statement or Profit & Loss account.
➢ Financial statement analysis (Ratio analysis)
➢ Cash flow statement, the statement of sources and uses of cash and
also
➢ Top level management people in the company.
I.BALANCE SHEET (BS): It is the most significant and basic
financial statement of any firm. It is prepared by a firm to present a
summary of financial position at a given point of time, usually at the
end of financial year. It shows the state of affairs of the firm at a point
of time. In fact, the total assets must be equal to the total claim
against the firm and this can be stated as, Total assets =Total claim
(Debt +Share holders) =Liabilities +Share holders equity The
different items contained in BS can be grouped into,
1. Assets
2. Liabilities
3. Shareholder’s funds.
a. ASSETS: An asset of the firm represents the investments made by
the firm in order to generate earnings. It can be classified into
(a).Fixed Asset (b).Current assets. i. FIXED ASSET – Those which
are intended to be for a longer period .These are permanent in nature,
relatively less liquid and are not easily converted into cash in short
run. Fixed asset include, plant & machinery, furniture & fixtures,
buildings, etc. The value of fixed asset is known as book value, which
may be different from market value or replacement cost of the assets.
The amount of depreciation is anon-cash expense and does not
involve cash out flow. It is taken as an expense item and is included
in the cost of goods sold or indirect expense. ii.
CURENT ASSET - It is the liquid asset of the firm and is convertible
into cash within a period of one year. It includes cash and bank
balance, receivables, inventory (raw material, finished goods, etc),
prepaid expenses, loan, etc.
b. LIABILITIES: It is also called as debts. It is claimed by the
outsiders against the assets of the firm. The liabilities refer to the
amount payable by the firm to the claim holders. The liabilities are
classified into long term and short term liabilities.
i. LONG TERM LIABILITIES: It is the debt incurred by the firm,
which is not payable during the period of next one year. It represents
the long term borrowings of the firm. ii. CURRENT LIABILITITES:
It is the debt which the firm expects to pay within a period of one
year. It is related to the current assets of the firm in the sense that
current liabilities are paid out of the realization of current assets. 3.
SHAREHOLDERS EQUITY (SE): It represents the ownership
interest in the firm and reflects the obligations of the firm towards its
owners. It the direct contribution of the shareholders to the firm.The
retained earnings on the other hand reflects the accumulated effect of
the firms earnings. SE is also called as net worth. The liabilities and
the SE must be equal to the total assets of the firm. I
I.INCOME STATEMENT OR PROFIT & LOSS ACCOUNT (IS): It
shows the result of the operations of the firm during a period. It gives
detail sources of income and expenses; Income statement is a flow
report against the balance sheet which is a stock report or status
report. It helps in understanding the performance of the firm during
the period under consideration. It can be grouped into three classes.
(i) Revenues (ii) Expenses & (iii) Net profit or loss REVENUES- It is
the inflow of resources\cash that arise because of operation of the
firm. The revenue arises from the sale of goods and services to the
customer and other non-operating incomes. The firm may also get
revenue from the use of its economic resources elsewhere. E.g. –
some of the funds might have been invested in some other firm. The
income by way of interest or dividend is also a revenue. EXPENSES-
The cost incurred in the earning the revenues is called the expenses.
Expenses like, salaries, general expenses, repairs, etc. It occurs when
there is a decrease in assets or increase in liabilities
III.CASH FLOW STATEMENT AND FUND FLOW
STATEMENT: The balance sheet and the income statement are the
two common financial statements and are also known as traditional
financial statements. It is essential to know the movement of cash
during the period. It is a historical record of where the cash came
from and how was it used. IV. FINANCIAL STATEMENT
ANALYSIS: Financial statement analyses are ratio like: a.
Profitability ratios b. Liquidity ratios c. Solvency ratios TECHNICAL
ANALYSIS It is a process of identifying trend reversal at earlier
stages to formulate the buying and selling strategy. With the help of
various indicators they analyse the relationship between price&
volume, supply & demand, etc. An investor who does this analysis is
called technician. ASSUMPTIONS: 1. The market value is
determined by the interaction of supply and demand. 2. The market
discounts everything. The information regarding the issuing of bonus
shares and right issues may support the prices. These are some of the
factors which cause shift in demand & supply and change in direction
of trends. 3. The market always moves in trend, except for certain
minor deviations. The trend may either be increasing or decreasing. It
may continue in same manner or reverse. 4. In the rising market,
many purchase shares in greater volume. When the market moves
down, people are interested in selling it. The market technicians
assume that past prices predict the future.
THEORIES USED IN THIS ANALYSIS:
1. Dow theory
2. Elliot wave theory
DOW THEORY: This theory was developed by Charles H Dow. He
did research and published in journal in 1984 mainly for trend
analysis. According to his theory, the price patterns do not move just
like that and it follows some trend. There are 3 types of trend. •
Primary trend – It is broad upward or downward movement which
last for a year or two. • Secondary trend or Correction trend – It last
for 3 weeks to some months. • Minor trend. –It refers to the day to
day price. Its also knows as fluctuations These 3 trends are compared
to tide, waves and ripples of the sea.
The security price may be either increasing or decresing.When market
exhibits increasing trend, its called bull market..The revival period
encourages more and more investors to buy scripts,their expectation
about the future is high.In the next phase, increased profits or
corporate would result in further price rise.In the final phase,the price
advance due to inflation and speculation. Fig.8 the above graph
depicts bear market.The contrary of bull market happens here .In the
first phase ,the prices are coming down,this would result in lowering
of profit in second phase.The final phase is characrterised by distress
sale of share
In the bull market the secondary trend results in fall of about 33-66%
of earlier rise. In bear market, it carries the price upward and corrects
the main trend. It provides breathing space to market. MINOR
TREND : Its also called as random wiggles. They are the daily price
fluctuations. It tries to carry the secondary trend movement. It’s better
for the investors to carry primary or secondary than this trend.
ELLIOT WAVE THEORY- Fig.10 The above graph depicts bullish
wave, 1,3,5 – impulsive waves 2,4 - correction waves In starting
wave, only few people invest and the waves keep moving high. It
indicates the prices of shares are moving high and hence they sell it.
As they get more profit they will again invest in the same company
and there will be few more investors. This makes the wave to move
higher. Same process keeps going everyday. In the 5th wave investors
will be more interested in investing and to gain profit. Since people
buy lot of shares here, it is called as buying wave. After these five
waves get over A,B,C waves or correction waves will occur. It these
8 waves get over and if the same trend occur, again we may face
bully’s wave or else we have beary’s wave. TYPES OF PRICES 1.
The open price. 2. The close price. 3. The high price. 4. The low
price. TOOLS AND TECHNIQUES USED IN TECHNICAL
ANLYSIS CHARTS What are stock charts It is a graphical
representation of how a stock’s price or trading volumes have
changed over time. This relationship can be presented in a number of
ways, through the use of different types of charts. It is your job, as a
technical analyst, to identify the type that will bring out a hidden
trend most effectively. Stock charts, like all other charts, have two
axis—the vertical axis and the horizontal axis. The horizontal axis
represents the historical time periods for which a technical chart has
been constructed. The vertical axis displays the stock price or the
trading volume corresponding to each period. There are many types
of charts that are used for technical analysis. However, the four types
that are most common are—line chart, bar chart, point and figure
chart and candlestick chart. We will discuss these technical charts
extensively later. However, we have illustrated three types of stock
charts below. The bar chart looks a lot like the candlestick chart. All
the charts displayed below are stock price charts. The nature of the
input may, however, have to be altered when you move from one
chart type to another. Line charts: A line chart is the figure that,
perhaps, automatically comes to mind when you think of a chart. The
line chart has the stock price or trading volume information on the
vertical or y-axis and the corresponding time period on the horizontal
or x-axis). Trading volumes refer to the number of stocks of a
company that were bought and sold in the market on a particular day.
The closing stock price is commonly used for the construction of a
line chart. Once the two axes have been labelled, preparation of a line
chart is a two-step process. In the first step, you take a particular date
and plot the closing stock price as on that date on the graph. For this,
you’ll put a dot on the chart in such a way that it is above the
concerned date and alongside the corresponding stock price. Let’s
suppose that the closing stock price on December 31, 2014 was Rs
120. For plotting it, you’ll put a dot in such a way that it is
simultaneously above the marking for that date on the x-axis, and
alongside the mark that says Rs 120 on the y-axis. You will do this
for all dates. In the second step, you will connect all the dots plotted
with a line. That’s it! You have your line chart below: Fig. Line Chart
Fig.11 Point and figure charts: A point and figure chart essentially
displays the volatility in a stock’s price over a chosen period of time.
On the vertical axis, it displays the number of times stock prices rose
or fell to a particular extent. On the horizontal axis, it marks time
intervals. Markings on the chart are exclusively in the form of X’s
and O’s. X’s represent the number of times the stock rose by the
specified limit, while O’s represent the number of times it fell by it.
The specified amount used is called box size. It is directly related to
the difference between markings on the y-axis. Fig. Point and Figure
Chart Fig.12 • Bar charts: A bar chart is similar to a line chart.
However, it is much more informative. Instead of a dot, each marking
on a bar chart is in the shape of a vertical line with two horizontal
lines protruding out of it, on either side. The top end of each vertical
line signifies the highest price the stock traded at during a day while
the bottom point signifies the lowest price at which it traded at during
a day. The horizontal line to the left signifies the price at which the
stock opened the trading day. The one on the right signifies the price
at which it closed the trading day. As such, each mark on a bar chart
tells you four things. An illustration of the marks used on a bar chart
is given below: A bar chart is more advantageous than a line chart
because in addition to prices, it also reflects price volatility. Charts
that show what kind of trading happened that day are called Intraday
charts. The longer a line is, the higher is the difference between
opening and closing prices. This means higher volatility. You should
be interested in knowing about volatility because high volatility
means high risk. After all, how comfortable would you be about
investing in a stock whose price changes frequently and sharply? Fig.
Bar Chart Fig.13 • Candlestick charts: Candlestick charts give the
same information as bar charts. They only offer it in a better way.
Like a bar chart is made up of different vertical lines, a candlestick
chart is made up of rectangular blocks with lines coming out of it on
both sides. The line at the upper end signifies the day’s highest
trading price. The line at the lower end signifies the day’s lowest
trading price. The day’s trading can be shown in Intraday charts. As
for the block itself (called the body), the upper and the lower ends
signify the day’s opening and closing price. The one that is higher of
the two, is at the top, while the other one is at the bottom of the body.
What makes candlestick charts an improvement over bar charts is that
they give information about volatility throughout the period under
consideration. Bar charts only display volatility that occurs within
each trading day. Candles on a candlestick chart are of two shades-
light and dark. On days when the opening price was greater than the
closing price, they are of a lighter shade (normally white). On days
when the closing price was higher than the opening price, they are of
a darker shade (normally black).A single day’s trading is represented
by Intraday charts. Higher the variation in colour, more volatile was
the price during the period. The appearance of candles on a
candlestick chart is as follows: Fig. Candle stick chart Fig.14 PRICE
PATTERNS Price Patterns are formations which appear on stock
with the help of charts which have shown to have a certain degree of
predictive value. Some of the most common patterns include: Head &
Shoulders (bearish), Inverse Head & Shoulders (bullish), Double Top
(bearish), Double Bottom (bullish), Triangles, Flags.
CONTINUATION PATTERNS A price pattern that denotes a
temporary interruption of an existing trend is known as a continuation
pattern. A continuation pattern can be thought of as a pause during a
prevailing trend – a time during which the bulls catch their breath
during an uptrend, or when the bears relax for a moment during a
downtrend. While a price pattern is forming, there is no way to tell if
the trend will continue or reverse. As such, careful attention must be
placed on the trendlines used to draw the price pattern and whether
price breaks above or below the continuation zone. Technical analysts
typically recommend assuming a trend will continue until it is
confirmed that it has reversed. In general, the longer the price pattern
takes to develop, and the larger the price movement within the
pattern, the more significant the move once price breaks above or
below the area of continuation. If price continues on its trend, the
price pattern is known as a continuation pattern. Common
continuation patterns include: • Pennants, constructed using two
converging trendlines • Flags, drawn with two parallel trendlines •
Wedges, constructed with two converging trendlines, where both are
angled either up or down FLAGS & PENNANTS Flags and Pennants
are short-term continuation patterns that represent a consolidation
following a sharp price movement before a continuation of the
prevailing trend. Flag patterns are characterized by a small
rectangular pattern that slopes against the prevailing trend, while
pennants are small symmetrical triangles that look very similar.
Figure – Pennant Example – Source: StockCharts.com Fig.15 The
short-term price target for a flag or pennant pattern is simply the
length of the ‘flagpole’ or the left vertical side of the pattern applied
to the point of the breakout, as with the triangle patterns. These
patterns typically last no longer than a few weeks, since they would
then be classified as rectangle patterns or symmetrical triangle
patterns. Fig.16 TRIANGLES Triangles are among the most popular
chart patterns used in technical analysis since they occur frequently
compared to other patterns. The three most common types of triangles
are symmetrical triangles, ascending triangles, and descending
triangles. These chart patterns can last anywhere from a couple weeks
to several months. Figure Symmetrical Triangle Example – Source:
StockCharts.com Fig.17 Symmetrical triangles occur when two trend
lines converge toward each other and signal only that a breakout is
likely to occur – not the direction. Ascending triangles are
characterized by a flat upper trend line and a rising lower trend line
and suggest a breakout higher is likely, while descending triangles
have a flat lower trend line and a descending upper trend line that
suggests a breakdown is likely to occur. The magnitude of the
breakouts or breakdowns is typically the same as the height of the left
vertical side of the triangle. REVERSAL PATTERNS A price pattern
that signals a change in the prevailing trend is known as a reversal
pattern. These patterns signify periods where either the bulls or the
bears have run out of steam. The established trend will pause and then
head in a new direction as new energy emerges from the other side
(bull or bear). For example, an uptrend supported by enthusiasm from
the bulls can pause, signifying even pressure from both the bulls and
bears, then eventually giving way to the bears. This results in a
change in trend to the downside. Reversals that occur at market tops
are known as distribution patterns, where the trading instrument
becomes more enthusiastically sold than bought. Conversely,
reversals that occur at market bottoms are known as accumulation
patterns, where the trading instrument becomes more actively bought
than sold. As with continuation patterns, the longer the pattern takes
to develop and the larger the price movement within the pattern, the
larger the expected move once price breaks out. When price reverses
after a pause, the price pattern is known as a reversal pattern.
Examples of common reversal patterns include: • Head and
Shoulders, signaling two smaller price movements surrounding one
larger movement • Double Tops, representing a short-term swing
high, followed by a subsequent failed attempt to break above the
same resistance level • Double Bottoms, showing a short-term swing
low, followed by another failed attempt to break below the same
support level HEAD AND SHOULDERS The Head and Shoulders is
a reversal chart pattern that indicates a likely reversal of the trend
once it’s completed. A Head and Shoulder Top is characterized by
three peaks with the middle peak being the highest peak (head) and
the two others being lower and roughly equal (shoulders). The lows
between these peaks are connected with a trend line (neckline) that
represents the key support level to watch for a breakdown and trend
reversal. A Head and Shoulder Bottom – or Inverse Head and
Shoulders – is simply the inverse of the Head and Shoulders Top with
the neckline being a resistance level to watch for a breakout higher.
Figure Head and Shoulders – Source: StockCharts.com Fig.18
DOUBLE TOPS AND BOTTOMS The Double Top or Double
Bottom pattern are both easy to recognize and one of the most reliable
chart patterns, making them a favorite for many technically-orientated
traders. The pattern is formed after a sustained trend when a price
tests the same support or resistance level twice without a
breakthrough. The pattern signals the start of a trend reversal over the
intermediate- or long-term. Figure – Double Top Example – Source:
StockCharts.com Fig.19 MARKET INDICATORS Market indicators
are a subset of technical indicators used to predict the direction of
major financial indexes or groups of securities. Most market
indicators are created by analyzing the number of companies that
have reached new highs relative to the number that created new lows,
known as market breadth, since it shows where the overall trend is
headed. • Market Breadth indicators compare the number of stocks
moving in the same direction as a larger trend. For example, the
Advance-Decline Line looks at the number of advancing stocks
versus the number of declining stocks. • Market Sentiment indicators
compare price and volume to determine whether investors are bullish
or bearish on the overall market. For example, the Put Call Ratio
looks at the number of put options versus call options during a given
period. MOVING AVERAGES Moving averages "smooth" price data
by creating a single flowing line. The line represents the average price
over a period of time. Which moving average the trader decides to use
is determined by the time frame in which he or she trades. For
investors and long-term trend followers, the 200-day, 100-day and
50-day simple moving average are popular choices. There are several
ways to utilize the moving average. The first is to look at the angle of
the moving average. If it is mostly moving horizontally for an
extended amount of time, then the price isn't trending, it is ranging. If
the moving average line is angled up, an uptrend is underway.
Moving averages don't predict though; they simply show what the
price is doing, on average, over a period of time. Crossovers are
another way to utilize moving averages. By plotting a 200-day and
50-day moving average on your chart, a buy signal occurs when the
50-day crosses above the 200-day. A sell signal occurs when the 50-
day drops below the 200-day. The time frames can be altered to suit
your individual trading time frame.