DD & CE , MANONMANIAM SUNDARANAR UNIVERSITY, TIRUNELVELI

SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT

[Link] – Second Year

Paper – 4

Directorate of Distance and Continuing Education

Manonmaniam Sundaranar University
Tirunelveli – 627 012

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SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT – I INVESTMENT AND SECURITIES MARKETS
Investment – Meaning – Nature and scope of Investment – Investment vs Speculation –
Type of Investors – Investment Avenue – Factors influencing the investment choice –
Portfolio Management: Meaning and significance, Active Vs Passive portfolio
management – Strategic Vs Tactical asset allocation – factors affecting investment
decisions in Portfolio management.
UNIT – II VALUATION OF SECURITIES.
Bond : Introduction – Reasons for issuing Bonds – Features of Bond – Types of Bonds –
Determinants of Bond safety – Bond prices, Yields and Interest Rates – Measuring Price
Volatility of Bonds – Maturity Duration and Modified Duration – Preference Shares:
Introduciton – Features of Preference Shares – Preference Shares Yield – Holding
Period Return – Yield to call – Concept of Present Value – Equity Share Valuation
Models.
UNIT – III FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS
Fundamental Analysis: Objectives - Economic Analysis - Industry Analysis – Company
Analysis - Technical Analysis : Meaning – Assumptions – Pros and cons of technical
analysis – Difference between Fundamental analysis and Technical Analysis – Dow
theory – Type of Charts – Chart Patterns -Trend Analysis – Support Line and Resistance
Line – Volume analysis – Indicators and Oscillatiors – Simple Moving Average –
Exponential Moving Average – Relative Stregth Index – Bollinger Band Elliott Wave
Thoery.
UNIT – IV EFFICIENT MARKET HYPOTHESIS
Efficient Market Hypothesis - Markowitz’s Model, theory, Arbitrage pricing theory -
Sharpe Single Index Portfolio selection method - Capital Asset Pricing model.
UNIT – V PORTFOLIO PERFORMANCE EVALUATION
Portfolio performance evaluation: Meaning – Need for Evaluation – Methods of
Calculating Portfolio return – Sharpe Ratio - Trynor Ratio – Jensens Different Returns –
Portfolio Revision – Need for Portfolio Revision – Formula Plans.
BOOK FOR STUDY:
01 Prasanna Chandra (2021), “Security Analysis and Portfolio Management”, 6 th
edition, McGraw Hill, Noida, UP.
02 Rustagi R.P. (2022), “Security Analysis and Portfolio Management”, 5 th edition,
Sultan Chand & Sons, New Delhi.
03 Bhalla.V.K. (2019), “ Investment Management” 19th edition, S. Chand & Sons, New
Delhi.

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UNIT – I
INVESTMENT AND PORTFOLIO MANAGEMENT
1. 1 INTRODUCTION
Investment is an activity that is engaged in by people who have savings. But all
savers are not investors. Investment is different from savings. It means many things to
many persons; one person may purchase gold in large quantity for the purpose of price
appreciation and consider it as his investment. Another person may take an insurance
policy to avail so many benefits it offers in future. A farmer buying a piece of agricultural
land. A cricket fan betting on the outcome of a cricket match. A government employee
buying mutual fund units. An officer buying 100 shares of TCS Ltd for Rs.1000. That is his
investment yet another person may lend some amount to somebody with an intention to
get interest at a future date and may consider the same as his investment.
In all these cases, one thing is common i.e, the amount is invested with the aim of
achieving some additional income or growth in value or the prospects expected are
always greater than what they invested now. Hence, it involves the commitment of
resources that have been saved in the hope that some benefits will accrue in future.
1.1.1 MEANING OF INVESTMENT
Investment aims at multiplication of money at higher or lower rates depending
upon whether it is a long-term or short-term investment and whether it is risky or risk-free
investment. Investment activity therefore involves creation of assets or exchange of
assets with profit motive.
1.1.2 Definition:
Donald [Link] and Ronald J. Jordan: Investment means “An Investment is a
commitment of funds made in the expectation of some positive rate of returns. If the
investment is properly undertaken, the return will commensurate with the risk the investor
assumes”
[Link]: The term investment means “The purchase by an individual or institutional
investor of a financial or real asset that products a return proportion to the risk assumed
over some future investment period”
From the above definitions, two points are clear i.e
i). Expectation of return is an essential of Investment.
ii). Return will be proportionate to the risk assumed over some future investment
period.
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1.2. CONCEPT OF INVESTMENT

Basically, there are four concepts, which are as follows,
1. Financial Investment.
2. Economic Investment.
3. Business Investment.
4. General Investment.
1. Financial Investment
Allocation of monetary resources to asset that are expected to yield some gain or
positive return over a given period of time is known as financial investment. Purchasing of
Shares, Debentures, Post Office Saving Certificates and insurance policies all are
investment in the financial assts.
These investment rage from safe investment of risky investments such
investments yield return in the form of interest, dividend, rend, premium, pension benefits
or the appreciation of the value of their principal capital. While making investments in
these assets, decisions as to type of investment amount of investment, period of
investment etc, are necessarily to be taken.
2. Economic Investment
According to the economists, investment means the net addition to the economy’s
capital stock, which consists of goods, and services that are used in the production of
other goods and services. Hence, it includes all type of plant and machinery, equipment,
inventory and construction materials as well as all types of services.
3. Business Investment
Putting money in a private business is known as business investment. For
instance, a man is investing Rs. 2,00,000 in his newly started provisional store.
4. General Investment
Some times, some persons invest in the avenues, which do not give any additional
income such as interest, dividend, rent etc., or capital growth. Such people are called
“The man on the Street”

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EXAMPLE:
If a person buys a car or scooter for his personal use, such an investment is called
general investment or personal investment. He will not receive any additional income from
such an investment.
1.3. NATURE OF INVESTMENT / OBJECTIVES OF INVESTMENT /
INVESTMENT PRINCIPLES.
The main investment objectives are increasing the rate of return and reducing
the risk. Other objectives like safety, liquidity, profit, taxation, inflation, government
control, legality, transferability and tangibility can be considered as subsidiary
objectives.
1. Safety Of Investment
The selected investment avenue should be under the legal and regulatory frame
work.
It will not under the legal frame work, it is difficult to represent the grievances, if any
approval of the law itself adds a flavor of safety.
2. Liquidity
Marketability of the investment provides liquidity to the investment. The liquidity
depends upon the marketing and trading facility. If a portion or the investment could be
converted in to cash without much loss of time, it would help the investor meet the
emergencies. Stocks are liquid only if they command good market by providing adequate
return through dividends and capital appreciation.
3. Profit
The main reason we invest our idle funds is for earining a profit. Profit can be
realized in either or both of the following forms.
[Link] Appreciation – Capital Appreciation occurs when an investment is
disposed of at a higher value as compared to price for which it was purchased. The
difference between the net selling price and purchased priced, when positive, denotes
capital appreciation.
ii. Yield – Yield from an investment is derived in the form of interest or dividend.
4. Tax Implications
While planning investment strategy, one should bear in mind the various provisions
of tax laws vis-à-vis investment income and other incomes. Important taxation provisions

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and tax planning possibilities are to be kept in mind while planning an investment
strategy.
5. Inflation: In our country, every year the purchasing power of the rupee declines as we
suffer form a continuing inflation in prices. So our capital is eroded every year to the
extent of the rate of inflation.
6. Government Control
Various government statutes and controls, the Gold Control Act and Urban Land
Ceiling act, affect investment decisions and so need to be considered.
7. Legality
Law relating to Minors, Estates, Trusts, Shares and Insurance should be studied
and all investments should be approved by law.
8. Transferability
Though the investor presumably buys high grade securities and holds for the long
term, the securities must be easily and legally transferable both on monetary and Non-
monetary terms.
9. Tangibility
Tangible assets do not yield an income. Some investors prefer such investments
because intangible assets may have lost their value due to price level changes, regulation
of Law, or social collapse.
1.4. TYPES OF INVESTMENT
Many types of investment media or channels are available for making investments.
Some media are simple and direct, whereas others are complex necessitating detailed
analysis and investigation. Some are popular, whereas others are relatively new. Some
are appropriate for one type of investor, while others may be suitable to rest of the types
of investors. Whatever it is, the ultimate aim of the investor is to derive a variety of
investments that fulfill his preference risk and expected return.

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TYPES OF INVESTMENT

1. Direct Investment Alternatives [Link] Investment Alternatives

1. Fixed Principal Investments 2. Variable Principal Investments

1. Preference Shares.
[Link] 2. Equity Shares
2. Saving Account.
3. Saving Certificates.
3. Non Security Investments
[Link] Bonds.
5. Corporate Bonds.
1. Real Estate 2. Mortgages 3. Commodities
4. Business Ventures 5. Arts, Antiques and Other Valuables

I. Direct Investment Alternatives

Direct investment alternatives are those where the individual makes his own choice
and investment decision. These include the following.
1. Fixed Principal Investments.
2. Variable Principal Investments.
3. Non – Security Investments.
1. Fixed Principal Investments
Fixed Principal Investments are those principal amount and the terminal value are
known with certainty. There will not be any change in the terminal value. These
investments include the following.
a). Cash
Cash has a definite and constant value. It does not earn any return, while in hand.
It is the safest investment. However, only a small portion is to be kept as cash balance, it
does not carry any interest or earn any return.

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b). Saving Accounts

Saving accounts have a fixed return. They differ only in terms of time period.
However, only a very low return can be received from this type of investment. Here the
principal amount is fixed plus interest earned.
c). Saving Certificates
Saving certificates are quite recent, some of the examples of saving certificates are
national saving certificates, bank saving certificates, Postal saving certificates etc. Here
also the principal amount is fixed plus interest earned over time.
d). Government Bonds
State governments and central governments issue government bonds. These
bonds are having a fixed maturity value. They bear a fixed rate of return over time.
e). Corporate Bonds / Debentures
Corporate bonds and debentures also have a fixed maturity value and a fixed rate
of return over time.
2. Variable Principal Investments
The variable principal investments are those whose terminal values are not known
with certainty. They include the following:
a). Preference Shares
Preference Shares are those shares some preferential rights in other class of
shares. Preference share is a share that bears a stated dividend and has priority of claim
over equity shares in the matter of dividend and assets in the event of liquidation of the
company.
b). Equity Shares
Equity share is a security that represents ownership interest in a company. It is
issued to those who have contributed in setting up an enterprise. They have neither fixed
return nor maturity period.
c). Convertible Securities
Convertible Securities such as convertible debentures or preference shares can
convert them in to equity shares according to certain prescribed conditions and thus have
features of fixed principle securities supplemented by the possibility of a variable terminal
value.

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3. Non – Security Investments

Non- security investments are those, which are other than corporate securities.
These include the following:
a). Real Estate: It denotes the ownership of residential as well as commercial
properties. It is less than corporate securities. The terminal value of real estate is
uncertain, but generally there is a price appreciation. However, we can claim depreciation
while filing the income tax returns.
b). Mortgages
Mortgages it denotes the financing of real estate. It has a periodic fixed income
and the principal is recovered at a stated maturity date.
c). Business Ventures
Business ventures denote direct ownership investments in new or growing
business before firms sell securities on a public basis.
d). Commodities
In the process of buying and selling commodities while purchasing the goods we
pay the price for them. That is why this transaction is also bought under investment.
e). Art, Antiques and other Valuables
Art, Antiques and other valuables include silver, gold, jewelers. They are
also another type of specialized investments which offer aesthetic qualities also.
II. Indirect Investment Alternatives
Indirect Investment Alternatives are those in which the individual has no direct hold
on the amount he invests. He contributes his savings to certain organizations such as
LIC, UTI etc. and depends upon them to make investments on his behalf.

1.5. Investment Managers and Portfolio Structures

At the heart of the investment management industry are the managers who invest
and divest client investments. A certified company investment advisor should conduct an
assessment of each client's individual needs and risk profile. The advisor then
recommends appropriate investments.
1 Asset Allocation
The different asset classes and the exercise of allocating funds among these
assets (and among individual securities within each asset class) is what investment
management firms are paid for. Asset classes exhibit different market dynamics, and
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different interaction effects; thus, the allocation of monies among asset classes will have
a significant effect on the performance of the fund. Some research suggested that
allocation among asset classes have more predictive power than the choice of individual
holdings in determining portfolio return. Arguably, the skill of a successful investment
manager resides in constructing the asset allocation, and separately the individual
holdings, so as to outperform certain benchmarks (e.g., the peer group of competing
funds, bond and stock indices).
2 Long-term Returns
It is important to look at the evidence on the long-term returns to different assets,
and to holding period returns (the returns that accrue on average over different lengths of
investment). For example, over very long holding periods (e.g. 10+ years) in most
countries, equities have generated higher returns than bonds, and bonds have generated
higher returns than cash. According to financial theory, this is because equities are riskier
(more volatile) than bonds which are themselves more risky than cash.
3. Diversification
Against the background of the asset allocation, fund managers consider the
degree of diversification that makes sense for a given client (given its risk preferences)
and construct a list of planned holdings accordingly. The list will indicate what percentage
of the fund should be invested in each particular stock or bond. The theory of portfolio
diversification was originated by Markowitz and effective diversification requires
management of the correlation between the asset returns and the liability returns, issues
internal to the portfolio (individual holdings volatility), and cross-correlations between the
returns.
4. Investment Styles
Investment Style selection depends upon risk appetite and return expectation.
There are a range of different styles of fund management that the institution can
implement. For example, growth, value, market neutral, small capitalization, indexed, etc.
Each of these approaches has its distinctive features, adherents and, in any particular
financial environment, distinctive risk characteristics. For example, there is evidence that
growth styles (buying rapidly growing earnings) are especially effective when the
companies able to generate such growth are scarce; conversely, when such growth is
plentiful, then there is evidence that value styles tend to outperform the indices
particularly successfully.

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5. Performance Measurement
Fund performance is the acid test of fund management, and in the institutional context
accurate measurement is a necessity. For that purpose, institutions measure the
performance of each fund (and usually for internal purposes components of each fund)

1.6. Factors Affecting Investment Decisions in Portfolio Management

Nowadays, banks and Internet Investment businesses provide a diverse range of
investment opportunities for new investors. Whether we choose to make our own
investing selections or to work with a professional, there are a number of considerations
to keep in mind while deciding on which investments to include in our portfolio.
Interest rates
Investment is financed by a combination of internal savings and external
borrowing. Investment decisions are thus heavily influenced by interest rates. Borrowing
money is a costly endeavor when interest rates are high. When interest rates are high,
the rate of return on bank deposits increases. The interest payments you forego while
investing are known as the "opportunity cost.
1. Evaluation
According to the marginal efficiency of capital, an investment's rate of return must
be greater than the interest rate for it to be profitable. A minimum rate of return of 5% is
required for an investment project if interest rates are 5%. If interest rates rise, fewer
investment opportunities will be profitable. If interest rates on loans were reduced, more
potential investment projects would be feasible.
2. Economic Growth
Businesses spend money in preparation for future growth in customer demand. As
demand drops, companies reduce spending. If the economy shows signs of improvement,
companies are likely to ramp up investment in anticipation of a surge in demand.
Investment seems to be cyclical, according to data. Investment levels drop during a
recession and then rise again when the economy improves. Investment, according to the
accelerator hypothesis, is sensitive to the tempo of economic expansion. In other words,
as the economy improves, investment expenditure will rise along with it. This is because a
higher growth rate indicates that the economy is doing better. Investment, according to
the accelerator hypothesis, follows the business cycle.

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3. Confidence
Saving is less risky than investing. Only when businesses are positive about their
cost structure, demand, and economic outlook can they make investments. Keynes
believed that businessmen's "animal spirits" were a major factor in investing decisions.
Keynes observed irrational assurance often accompanied confidence. Growth and
interest rates are important factors in determining consumer confidence, but the overall
economic and political atmosphere also plays a role. Uncertainty about the future might
limit or even stop business investment.
4. Inflation
Inflation is a potential threat to long-term investment gains. Because inflation is
both high and volatile, it hinders one's ability to plan ahead financially. If companies have
doubts about the sustainability of the economy and the effects of inflation, they may be
unwilling to make investments. Countries that have had low and stable inflation for an
extended period of time tend to increase their investment levels.
5. Productivity of Capital
The allure of a long-term investment might be affected by technological changes.
Around the end of the nineteenth century, developments like Bessemer steel and
enhanced steam engines gave businesses a compelling reason to invest in cutting-edge
technology. If technical advancement stalls, businesses will spend less since their profits
will decrease.
6. Availability of Finance
As a result of the liquidity crisis that began in 2008, numerous financial institutions
reduced their lending to customers. Investment loans from banks were very hard to come
by. As a result, companies who wanted to invest were unable to do so despite historically
low loan rates. One such factor that might effect long-term investment is the ability to
save money. If savings rates are high, more money might be directed toward
investments. The more money people deposit in banks, the more money they can give
out. A decrease in national savings reduces the quantity of money available for
investment.
7. Government Policies
Investing might be made more challenging by some government rules. Strict
zoning regulations, for instance, might put off investors. Yet, government subsidies and
tax cuts may encourage investment.
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8. Investment Knowledge
The level of expertise and experience of the investor is a critical consideration.
While weighing their investment possibilities, no shady investor will consult their circle of
friends and relatives. Investors with more expertise generally make their own choice on
which possibilities to pursue.
1.7 TYPES OF INVESTORS
Generally Investors are classified into the following three categories. They are as
follows.
Types of Investors

1. Conservative Investors. 2. Speculative Investors.

3. Enterprising Investors.

1. Conservative Investors
Conservative investors buy the securities with a view to invest their savings in
profitable income earning securities. They generally retain the security for a considerable
length of time and care much about the safety of their investment. They will sell their
holdings only when they are assured of a profit and that too for cash only. Hence, they
are also called genuine investors.
2. Speculative Investors
Speculative investors are popularly known as speculators. They buy securities with
a hope to sell them in future at a profit. They are not interested in holding the securities
for longer period. Hence, their objective of buying the securities is to sell them and not to
retain them. They are interested only in price differentials.
3. Enterprising Investors
They assume risks very boldly as well as willingly. They aim at earning income as
well as enjoying capital appreciation.

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1.8. SPECULATION
Speculation means taking up the business risk in the hope getting short term gain.
Speculation essentially involves buying and selling activates with the expectation of
getting profit from the price fluctuations.
Speculation means the purchase or sale in the present followed by a sale or
purchase in the future in the expectation of making a profit from a price change in the
meantime.

Types of Speculators
The Speculators are classified in to following four categories.
Types of Investors

1. Bull Speculator
2. Bear Speculator.
3. Stag Speculator.
4. Lame Duck Speculator.
1. Bull / Tejiwala Speculator
This type of speculator expects a rise in the price of the securities in which he
deals. Therefore, he enters in to purchase transactions with a view to sell them at a profit
in the future. If his expectation becomes a reality he shall get the price difference without
actually taking delivery of the securities.
2. Bear Speculator
A bear is a pessimistic speculator who expects a sharp fall in the prices of certain
securities. He inters in to selling contracts in certain securities of a future date. If the price
of the security falls as he expects, he shall get the price difference. A bear usually
presses its victim down the ground.
3. Stag Speculator
A stag is considered as a cautious investor when compared to the bulls or bears.
He is a speculator who simply applies for fresh shares in new companies with the sole
objective of selling them at a premium or profits as soon as he gets the shares allotted.

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4. Lame Duck Speculator

When a bear is unable to meet his commitment immediately, he is said to be
struggling like a lame duck. For instance, the bear who enters into a selling contract
should sell the contacts, securities on the date fixed. If the buyer instead of accepting the
price difference demands the actual delivery, the bear should also arrange for their
supply.

1.9. Difference between Investment and Speculation

INVESTMENT SPECULATION
[Link] of Return Expected. Speculation also involves purchase of an
Investment involves purchase of an asset asset but with the expectation of profit on
to enjoy the return on it. sale on account of its price change.
2. Length of Commitment.
In investment the length of commitment is In speculation, investment is always held
comparatively long term. for a short term.
3. Amount of Risk.
Investments is considered to involve Speculation is considered to involve
minimum risk Maximum risk.
4. Purpose of Investment
The purpose of investment is to receive a The purpose of speculation is to enjoy
stable as well as regular return. capital gain
5. Type of Contract
In case of investment the type of contract is It is of Ownership nature in speculation.
that of creditor nature.
6. Sources of Income
The sources of income are the earnings of Here it is change in the market price for a
enterprises for an investor. speculator
7. Type of Analysis
The investor Constantly evaluates the Speculator is interested in market action
securities through a scientific analysis of and price movements.
intrinsic value.

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1.10 QUESTIONS FOR DISCUSSION

1. Describe in detail about different types of Investment.
2. State the Objectives of Investment.
3. List out a Concepts of Investment.
4. Explain in detail about factors influencing in Investment Decisions.
5. Distinguish between Investment and Speculation.
6. State the Types of Investors.
7. Describe in detail about types of Speculators.

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UNIT – II
Valuation of Securities
2.1 Debenture
A debenture is an instrument acknowledging a debt issued under the common seal
of the company and is a contract for the repayment of the principle sum at a specified
date and for the payment of interest at a specified rate per cent till the time the principle
sum is repaid. Under section 2 (12) of the Companies Act 1956,
Debenture have been defined as “Debenture includes debenture stock, bond and
any other securities of the company whether constituting a charge on the company’s
asset or not”
2.2 Features of Debenture
(i) A debenture is a document or certificate which acknowledges the debt of a company.
(ii) Mode and period of repayment of principle and interest is fixed.
(iii) It is considered as external equity or long term borrowing.
2.3 Types of Debentures / Bonds
Debentures can be divided into various categories on different basis
(A). On the basis of Security
(B). On the basis of Redemption
(c). On the basis of Records
(D). On the basis of Coupon rate
(E). On the basis of convertibility
(A). On the basis of Security
1. Mortgage or Secured debentures
Those debentures which are secured either by fixed charge or a floating charge
on the asset of the company. A regular mortgage deed of trust deed is entered into the
company and the debenture holder.
2. Unsecured debentures.
Those debentures which are not secured by a fixed charge, are known as
unsecured debentures

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(B). On the basis of Redemption

[Link] debenture.
Those debentures which are repaid by the company at the end of the period or at a
specified period in lump sum or in installments, as called as redeemable debentures
2. Irredeemable debenture.
Those debentures which are not repayable during lifetime of the company, are
know as irredeemable debentures.
(C ). On the basis of coupon rate:
1. Specified coupon rate.
These debentures are issued with a specified rate of interest, which is called
coupon rate. The rate may be fixed or floating. Different debentures may have different
rates of interest.
2. Zero coupon rate.
These debentures do not carry a specific rate of interest. In order to compensate
the investors such debentures are issued at a substantial discount.
(D). On the basis of records
i. Registered debentures.
Those debentures in respect of which the names, addresses, and particulars of
debenture holder are kept in a register of the company.
2. Bearer debentures.
These debentures keep no record of debenture holder. Payment of the interest is
made on the production of coupon attached to the debenture.
(E). On the basis of Convertibility:
1. Convertible debentures.
Debentures which have the option of exchanging the whole or part of the amount
of their debenture for shares after a specified time period are called convertible
debentures.
2. Non-convertible debentures.
Those debentures which have no option of converting the value of debenture into
equity share.
2.4. Valuation of bonds and debenture
Basically, the value of a bond is the present value of all the future interest
payments and maturity value, discounted at the required return on bond commensurate
with the prevailing interest rate and risk.
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𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡1 / (1 + 𝑟) 1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡2 / (!+ 𝑟) 2 + ⋯ + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖 + 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒

/ (1 + 𝑟) 𝑛
Where, Interest 1 to n= interest in period 1 to n.
Unless otherwise mentioned, the maturity value of the bond is the face value.
Different situations
(i) When the required rate of return is equal to the coupon rate, the bond value becomes
equal to the par value.
(ii) When the required rate of return is more than the coupon rate, the bond value be less
than its par value. The bond in this case would be sold at a discount.
(iii) When the required rate of return is less than the coupon rate, the bond value would be
more than its par value. Therefore, in this case, bond would be sold at a premium.

Example: 1
Let us assume the face value of the bond is Rs 1,000, coupon rate is 10% payable
semi annually. Yield to maturity is 9%. It matures in 5 years. What is the value of the
bond?
Solution:
Interest = 100/2 = Rs.50 semi annually N= 10 years Yield to maturity= 9%,
therefore, semi annual yield= 4.5%
Bond value= 50 / (1+0.045)2 + 50 / (1+0.045)2 +………………….+ 50 / (1+0.045)10
Solving the above equation, we get Bond value = Rs. 1,040 approx Method of Valuation
2.5 Valuation method can be categorized into two ways:
(1) Convertible Debenture
(2) Non-convertible Debenture
(1) Valuation of Convertible Debenture
Valuation of bonds with the maturity period when a bond or debenture has reached
maturity, its value can be determined by considering annual interest payment plus its
terminal or maturity and this is done using the present value concept to discount the cash
flows and the result will be compared the market value of the bond to ascertain whether it
is overvalued or undervalued.
Example: 2
K is thinking of purchasing a 3 year bond worth 40,000 rs carrying a nominal
coupon rate of 10%. K’s required rate of return is 6%. How much he should be willing to
pay now to purchase the bond if it matures at par?
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Solution:
Interest = 10% *40,000= 4,000 p.a
N = 3 years, kd= 6% M = 40,000
Vd = 4,000* PVAF (6%, 3) + 40,000* PVIF (6%,)
= (4,000* 2.673) + (40,000*0.840)
= Rs 44,292
[Link] of Non - convertible bonds and debentures
This type of bond or debenture has a maturity of greater than 10 years and holder
has an option to convert it into security. To compensate for having value through the
option to convert the bond into stock, a convertible bond has a coupon rate lower than
that of similar non-convertible debt.
The key benefit of raising money by selling convertible bonds is a reduced interest
payment. The advantage for companies issuing convertible bonds is that, if the bonds are
converted to stock, company’s debt vanishes. However, in exchange of the benefit of
reduced interest payment, the value of shareholders equity is reduced due to stock
dilution which is expected when bondholders convert their bonds into new shares. An
option price to value a convertible bond is:
Price convertible bond = price straight bond + price stock call option – price bond
call option+ price bond put option
Example: 3.
Bond ABC matures in 5 years with a coupon rate of 7% and maturity value is Rs.
1,000. The rate of discount is 5% and interest is paid annually.
Solution:
1 st year’s cash flow = 70 to year four is also 70 Year five = 1,070 The PV is as follows:-
Year one = 70/(1.05)1 = 66.67
Year two = 70/(1.05) 2 = 63.49
Year three = 70/(1.05)3 = 60.47
Year four = 70/(1.05)4 = 57.59
Year five = 1070/(1.05)5 = 838.37
Now, value of bond = 66.67+63.49+60.47+57.59+838.37
= Rs. 1086.59.

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2.7 Preference share

Preference shares represent a stock with dividends that are paid to shareholders
before common stock dividends are paid out. In the event of a company bankruptcy,
preferred stock shareholders have a right to be paid company assets before equity
shareholders. Preference shares typically pay a fixed dividend, whereas common stocks
do not. And unlike common shareholders, preference share shareholders usually do not
have voting rights.
The preference shares are different from the equity shares in the sense that
preference shares enjoy these two preferences over the equity shares:
(i) The dividend is paid to preference shareholders before any dividend is to paid to
equity shareholders,
(ii) At the time of winding up, preference shareholders are paid prior to equity
shareholders.
Thus, preference shares are considered as a hybrid security with both features of
the bonds and the share ownership.
2.8. Features of Preference Share
Preferred stock is a special class of shares which may have any combination of
features not possessed by common stock. The following features are usually associated
with preferred stock:
 Preference in dividends
 Preference in assets, in the event of liquidation
 Convertibility to common stock.
 Call ability, at the option of the corporation
 Restricted voting rights
 Claims on income and assets
 Fixed Dividend
 Cumulative dividend
 Sinking fund
 Call feature
 Participation feature

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2.9 Types of Preference Shares

The following way classified preference shares.
a). Cumulative Preference Shares.
b). Non- Cumulative Preference Shares.
c). Redeemable Preference Shares.
d). Irredeemable Preference Shares.
e).Participating Preference Shares.
f). Non-participating Preference Shares.
g).Convertible Preference Shares.
h).Non-Convertible Preference Shares.
a). Cumulative Preference Shares
Cumulative preferences shares are those shares, the arrear dividend of these
shares go on accumulating till they are paid. These arrear dividends are to be paid first
out of profits before any amount is paid to any other types of shareholders.
b). Non- Cumulative Preference Shares: In case of these preference shares, the
unpaid dividend of any year does not accumulate, that is dividend of a particular year, is
paid only out of the profits made during the particular year.
c). Redeemable Preference Shares
These shares are repaid, after a fixed period or after giving prior notice under
certain conditions made clear at the time of their issue. They are redeemed only out of
excess profits or out of the proceeds of a new issue of shares.
d). Irredeemable Preference Shares
Irredeemable preference shares can be redeemed only upon the company goes
for liquidation or winding up of the company.
e). Participating Preference Shares
Participating preference shares also get a share out of the surplus profits
remaining after paying dividend to the equity shareholders at a fixed rate as determined
by the company articles.
f). Non- Participating Preference Shares: These kinds of preference shares get only
their fixed rate of dividend. They do not enjoy the right to participate in the surplus profit.
g). Convertible Preference Shares
The holders of these shares have a right to convert their shares in to equity shares
within a specified period of time. The right of conversion must be authorized by the
Articles of association.
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h). Non-Convertible Preference Shares

These types of preference shares cannot be converted in to equity shares.
2.10 Valuation of Preference Shares
Preference Shares are issued by corporations or companies with the primary aim
of generating funds. A preference share usually carries a fixed stated rate of dividend.
The dividend is payable only upon availability of profits. In case of cumulative preference
shares, arrears of dividends can be accumulated and in the year of profits common stock
holders can be paid dividend only upon settlement of all the arrears of cumulative
preference dividends.
Preference share holders have preference right over payment of dividend and
settlement of principal amount upon liquidation, over common share holders. A
preference share can be irredeemable or redeemable. Redeemable preference shares
have a fixed maturity date and irredeemable preference shares have perpetual life with
only dividend payments. periodically upon profit availability. Preference shares can also
be cumulative and non-cumulative.
Assumptions
Following two assumptions are relevant while ascertaining the value of preference
shares:
(1) The dividend on preference shares is received once a year and that the first dividend
is received at the end of one year from the date of acquisition or date of purchase.
(2) The company intends to pay the dividend to preference shareholders so that the
stream of preference dividend is considered to be known with certainty.
For valuation purpose, preference shares are divided into two categories:
(i) Redeemable preference shares
(ii) Irredeemable preference shares
(i) Valuation of Redeemable Preference Shares
Basically, the value of redeemable preference shares represents the present value
of the future cash flows. The future cash flows associated with a redeemable preference
shares includes the stream of dividends at a fixed rate of dividend and the maturity
payment at the time of redemption.
These future cash flows are discounted at an appropriate rate to find out the value
of redeemable preference share as follows:

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(𝑃𝑜) = Dividend1 / (1+r) 1 + Dividend2 / (1+r) 2 + ⋯ + Dividendn+Maturity value /

(1+r) n
Where, Po= Value of a preference share Dividend 1 to n = Annual fixed dividends
in periods 1 to n. N= Life of the preference share
r= required rate of return of the preference shareholders
Example : 4
The face value of the preference share is 500$. And the rate of dividend is 12%.
The shares are redeemable after 5 years. Calculate the value of preference shares if the
required rate of return is 13%.
Solution:
Annual preference dividend= Rs 500*12%= Rs 60
P0, value of redeemable preference share = Rs. 60 1 / (1+.13)1 + Rs602/(1+.13)2 + ⋯ +
Rs605 + Rs.500 /(1+.13)5
After solving this equation, we get value of the preference shares as Rs. 482
approximately.
Example: 5
XYZ Ltd. issues 15% preference shares of the face value of 100 Rs each at a
floatation cost of 4%. Find out the cost of capital of preference shares if the preference
shares are redeemable after 10 years at a premium of 10%.
Solution:
using the formula given above,
Po= ∑10 i=1 15/(1+k)i +110/(1+k)10
At kp= 16%, the R.H.S. of the equation may be written as:
= 15(PVAF(16%,10))+110(PVF(16%,10)) = 15(4.833)+110(.227) = Rs 97.76
At kp= 17%, the R.H.S. of the equation may be written as:
=15(PVAF(17%,10))+110(PVF(17%,10)) = 15(4.659)+110(.208) = Rs 92.76
By interpolating between 16% and 17% the value of Kp comes to 16.31 % as follows:
Kp= 16%+(97.46-96)*1 /(17%-16%) (97.46-92.76)
where 1 represents the difference
(ii) Valuation of Irredeemable Preference Shares
The value of irredeemable preference shares may be defined as the present value
of the perpetuity of fixed dividends on preference shares. Symbolically, it is defined as:

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Irredeemable preference share value : Dividend / Required return on Preference

Share.
or
Kp= PD/Po
Where, PD= Annual preference dividend
Po= Net proceeds on issue of preference shares
Kp= Cost of capital of preference shares
Example : 6
A company issues 10% irredeemable preference shares. The face value per share
is 100 Rs, but the issue price is 95 Rs. What is the cost of preference share? What is the
cost if the issue price is 105 Rs.
Solution:
When issue price is 95 Rs.
Kp= preference dividend/ issue price = 10/95= 0.1053 or 10.53% When issue price is 105
Kp= preference dividend/ issue price = 10/105= 0.0952 or 9.52%
Example: 7
XYZ Ltd. issues 15% preference shares of the face value of 100 Rs each at a floatation
cost of 4%. Find out the cost of capital of preference shares if the preference shares are
irredeemable.
Solution:
Kp= PD/Po
= 10/(100-4) = 15/96= 0.1563 or 15.63%
2.11 Equity Shares
Every company needs a lot of funds to do business. For this company takes the
help of public. Issuing shares to public is one of the ways to generate funds from public
for doing business. Whenever someone buys shares from a company he gets a share
certificate in return. There are basically two kinds of shares namely Equity shares and
Preference shares. Section 43 of the companies act 2013 explains that there are two
kinds of shares issued by companies:
(A) Equity shares
The act defines equity shares for a company limited by shares to be shares which
are not preference shares. They are of following types

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1) Equity shares with voting rights

2) Equity shares with differential rights
These differential rights can be with respect to dividend, voting or in accordance
with such rules as may be prescribed.
2.12. Valuation of Equity Shares.
There are different approaches to find out the value of equity shares on the basis of the
earnings of the company. These are
1. Gordon model
2. Walter Model
3. Price Earnings Ratio approach
1. Gordon model
One very popular model clearly relating the market value of the firm to dividend
policy is developed by Myron Gordon. He explained that either company will distribute
its profit as dividends or it will retain them for investing purpose on the basis of
availability of projects in future.
Assumptions of Gordon Model:
Following are the assumptions on which the Gordon’s model is based:
1. All the financing needs of the firm are met by issue of equity shares.
2. There are no loans and debentures. In short there is no external financing through
borrowed funds.
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K e) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. There are no corporate taxes to be paid by the firms.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K e is always greater than br. (i.e. K e > br = g) if this condition is not fulfilled, we
cannot get a meaningful value for the share.
According to Gordon’s dividend capitalization model, the market value of a
share (P0) is equal to the present value of an infinite stream of dividends to be
received by the share. Thus:
P0 = EPS (1-b)/ (k e – br)
The above equation explicitly shows the relationship of following in the
determination of the value of the share (P0):
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Current earnings (EPS,),

Retention ratio (b),
Rate of return on reinvestment (r) and The all-equity firm’s cost of capital (k e)
Example: 8
A firm has earnings per share of Rs [Link] retention ratio is 80%.The return on investment
is 25%. The cost of equity is 15%.find the value of share.
Solution:
P0 = EPS (1-b)/ (k e – br)
Here Current earnings (EPS) = 10
Retention ratio (b) = 80%
Rate of return on reinvestment (r) = 25%
cost of capital (k e) = 15%
P0 = 10 (1-.80)/ (.15 – (.80 x .25)) = Rs 40
2. Walter Model
Professor James E. Walter gave a model that supports that the value of share is
found by adding the value of infinite stream of dividends and return from retained
earnings. His model shows clearly the importance of the relationship between the firm’s
internal rate of return (r) and its cost of capital (k) in wealth of shareholders.
Walter’s model is based on the following assumptions:
1. All the financing of the firm is done through retained earnings. There is no debt or new
issue of equity.
2. The firm’s internal rate of return (r) and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. EPS and dividend per share remain constant.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/k e +(r (E-D)/k e)/k e
Example: 9
ABC ltd has cost of capital (k e) of 10%.Earnings per share (E) = Rs10 and the
rate of return on investments (r) = 8%.The Dividend payout ratio50%. Calculate the
market price of the shares.

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Solution:
The market price of the share can be found by applying the following formulae:
D/P ratio = 50% EPS = Rs10
Therefore, according to D/P ration of 50%, Dividend per share i.e.
D = 10 x 50% = Rs5.
So price of the share is: P = 5 + [0.08 / 0.10] [10 -5] 0.10 = Rs90

3. Price Earnings Ratio approach

The price earnings ratio can be understood as the price for a stock that an investor
is paying for Rs1 of a company's profit.
In other words, if a company is reporting that the earning per share is of Rs2 and
the stock is selling at a price of Rs20 per share, the price earnings ratio is 10 (Rs20 per
share divided by Rs2 resulting in earnings per share = 10 p/e).The price earnings ratio is
usually written as P/E Ratio. To find out the value of an equity share we have to multiply
the EPS (earning per share) with the P/E multiplier or the price earnings ratio. But here it
becomes important to understand how P/E ratio is determined. Generally it is computed
by dividing the current stock price by earnings per share for the most recent 12 months. It
is followed so closely because it relates the market’s expectation of investors about the
performance of the company in future, embedded in the price component of the equation,
to the company’s actual recent earnings performance. The greater the expectation, the
higher a multiple of current earnings investors is willing to pay for the promise of future
earnings. Thus the value of share can be determined if we know the following:
 EPS i.e. earnings per share
 P/E ratio or price earnings ratio
Value = EPS X P/E ratio.
Example: 10
A company has EPS of Rs [Link] price earnings ratio is [Link] the value of the equity in
this case.
Solution:
Value = EPS X P/E ratio. = 20 x 2 = Rs.40

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2.13 QUESTIONS FOR DISCUSSION

1. Write on the three-step valuation process.
2. Write on features of bonds and explain them in detail
3. What are the reasons for issuing Bonds?
4. Define a bond and also explain the different types, in detail.
5. What are some of the general characteristics found in preference shares?
6. Explain preference shares in detail.
7. State the features of Equity Shares.
8. Describe in detail about different approaches to Valuation of Equity Shares.

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UNIT - III

FUNDAMENTAL ANALYSIS

3.1 SECURITY ANALYSIS

The aim of the Security analysis is to find out intrinsic value of a security. The
intrinsic value also called as the real value of a security is the true economic worth of a
financial asset. The real value of the security indicates whether the present market price
is overpriced or under priced in order to make a right investment decision. The actual
price of the security is considered to be a function of a set of anticipated capitalization
rate.
Security analysis refers to analyzing the securities from the point of view of the
scrip prices, intrinsic value of shares, return and risks. The analysis will help in
understanding the behavior of security prices in the market for investment decision
making.

3.2. APPROACHES TO SECURITY ANAYSIS

There are various approaches to security analysis, which are as follows:

Approaches To Security Anaysis

1. Fundamental Analysis II. Technical Analysis [Link] Market Theory

1. Economic Analysis. 2. Industry Analysis.

3. Company Analysis

3.3. FUNDAMENTAL ANAYLSIS

The investor, while buying stock, has the primary purpose of gain. If he invests for
a short period of time, it is speculative but when he holds it for a fairly long period of time,

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the anticipation is that he would receive some return on his investment. Fundamental
analysis is a method of finding out the future price of a stock which an investor wishes to
buy. The method of for forecasting the future behavior of investments and the rate of
return on them is clearly through an analysis of the broad economic forces in which they
operate, the kind of industry to which they belong and the analysis of the company’s
internal working through statements like income statement, balance sheet and statement
of changes of income.
Fundamental Analysis is really a logical and systematic approach for
estimating the future dividends and share price. It assumes that share price is
determined by a number of fundamental factors regarding Economy, Industry and
Company. Fundamental analysis is in other words, a detailed analysis of the
fundamental factors affecting the performance of companies.
3.4 STAGES IN FUNDAMENTAL ANALYSIS
Fundamental Analysis thus involves three stages are as follows:

FUNDAMENTAL ANALYSIS

1. ECONOMIC ANALYSIS [Link] ANALYSIS

3. COMPANY ANALYSIS

3.5. ECONOMIC ANALYSIS.

The performance of a company depends much on the performance of the
company. If the economy is boom, the industries and companies in general trend to be
prosperous. On the other hand, if the economy is in recession, the performance of
companies will be generally poor.
Investors are interested in studying those economic variables, which affect
the performance of the company in which they proposed to invest. Analysis of
these economic variables would give an idea about future corporate earnings and
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the payment of dividends and interest to investors. Hence, analysis of

macroeconomic environment is essential to understand the behavior of the stock prices.

3.5.1 ECONOMIC VARIABLES / MICROECONOMIC FACTORS

The following Macroeconomic or Economic variables affecting the performance of
the company.

ECONOMIC VARIABLES / MICROECONOMIC FACTORS

1. Gross Domestic Product.

2. Saving and Investment.
3. Inflation / Rate of inflation.
4. Interest Rates
5. Budget.
6. Balance of Payment.
7. Tax Structure.
8. Monsoon and Agriculture.
9. Infrastructure Facilities.
10. Demographic Factors.
11. Research and Development Facilities

1. Gross Domestic Product.

The GDP indicates the growth rate of the economy and it represents the total value
economy and it represents the total value of goods and services produced in the country
The growth of GDP reflects the growth of various sectors, companies and per capita
income. If the GDP growth rate increases certainly the return available for investors also
will increase.
2. Saving and Investment.
The savings made by the large number of people and various sectors determine
the Growth of economy. If the people save a part of their earnings and make investments
in various shares and securities then corporate can easily make investments in expansion
and Modernization programmes and this will fuel their earning capacity.

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3. Rate of Inflation.
The rate of inflation prevailing in the country determines the real economic growth.
If money supply increases without increase in production of goods and services then
inflation rises. During inflationary conditions more money chasing few goods. When
inflation is high the cost of living and cost of business operations are increasing. The
returns available from stock market investments will be declining.
4. Interest Rates.
The interest rate affects the cost of financing of the firms. A decrease in interest
rate of implies lower cost of finance for firms and more profitability. More money is
available at a lower rate for the borrowers. Availability of cheap fund encourages
speculation and rise in the price of shares.
5. Budget.
The annual budget proposals submitted by the State and Central Governments
affects the economic growth. When budget deficit increases the economic growth will
slow down and inflation starts rising. Surplus budget may result in deflation. Hence,
balanced budget is highly favorable to the stock market.
6. Balance of Payment.
The balance of payment is the record of a countries money receipts from and
payment abroad. The difference between receipts and payments may be surplus or
deficit. Balance of payment is a measure of the strength of rupee on the external account.
If the deficit increases, the rupee may depreciate against other currencies, the rupee may
depreciate against other currencies, thereby affecting the cost of imports. The industries
involved in the export and import are considerably affected by the changes in foreign
exchange rate.
7. Tax Structure.
The various taxes imposed by the Central and State Government on individuals
and corporate affects their purchasing ability. High corporate tax leaves the companies
with fewer surpluses which will be inadequate to pay dividend to shareholders and to
meet business development expenditures.
8. Monsoon and Agriculture.
In India around 79% of the people lives in rural areas and engaged in agriculture
and allied activities. The agriculture mainly depends on monsoon. Moreover many
sectors get raw materials from agriculture. Therefore the monsoon and agricultural output
influences the stock market.
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9. Infrastructure Facilities / Resources.

Natural resources are very much important for the economic growth of the country.
Water, oil, mines resources are the backbone of any economy. Technological discoveries
in recycling of materials, nuclear and solar energy and new synthetics offers lot of
potential for growth of economy.
10. Demographic Factors / Population of the country.
Analyzing the population of the country gives a complete picture about the kind of
labour force. Increase in population results in increase in demand for many goods and
services and at the same time the availability of manpower also increases. If the
population explosion is strategically used by the country certainly it is an asset.
11. Research and Development Facilities.
The economic growth mainly depends on the emphasis given on research and
development and the infrastructure development. The investor should select the industry
based on the above issue. For example the Government is focusing on the development
of infrastructure, telecommunication and power sector. These sectors future growth rate
in very high.
3.5.2 ECONOMIC FORECASTING OR ECONOMETRIC FORECASTING.
To estimate the stock price changes, an analyst has to analyses the
macroeconomic environment and the factors peculiar to the industry. The economic
activities affect the corporate profits, investors’ attitude and the share prices. For the
purpose of economic analysis, an analyst should be familiar with the forecasting
techniques.

Forecasting Techniques of Economic Analysis

1. Anticipatory Survey. 2. Barometric Approach or Indicators.

3. Diffusion Index. 4. Economic Model Building.

5. Opportunistic Model Building.

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1. Anticipatory Surveys.
The Survey method of economic forecasting involves getting the concerned
peoples Opinion about the current development and outlook of the economy and specific
sector. It is very difficult to meet all the concerned people and a sample can be taken and
a questionnaire or interview schedule can be administered with the selected sample.
Thus survey involves the collection of first hand information from the concerned
respondents and this method is more reliable. However the survey method is a time
consuming and costly method.
2. Barometric Approach or Indicators.
The economic forecasting can be done with the help of analyzing the economic
indicators. The factors like GDP, capital investments, corporate profits, liquidity, rate of
interest, forex level, currency value, unemployment rate, percapita income etc, gives lot
of insight and indicate the direction of the economic growth.
a).The economic indicators may be classified as Leading Indicator, Coincidental
Indicator and Lagging Indicator. The Leading Indicators give a hint about what would
happen to economy. This indicates the future direction of the economy. The examples of
Leading Indicator are fiscal policy, Monitory Policy, Productivity, Monsoon and Stock
market indices.
b).The coincidental indicator indicates the current condition of the economy. For
example GNP, GDP, Industrial production and interest rate etc. shows the current
developments of economy.
c).Lagging indicators is the charges that are taking place in leading and
coincidental indicators are reflected in the lagging indicators. For example unemployment
rate, inflation, and forex level are the outcome of leading and coincidental indicators.
Lagging indicators provide an insight in to the economy is current and future position.
3. Diffusion Index.
The Diffusion Index is considered as a composite index and consensus index. The
diffusion index includes the futures of leading indicators, coincidental indicator, and
lagging indicator. Under diffusion index both micro as well as macro factors are analyzed.
However this complex statistical method is very difficult to understand and apply.
4. Economic Model Building.
Under Economic Model Building technique of economic forecasting relationship
between two variables are found to draw some conclusions so as to predict the future

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direction of the economy. One independent variable and dependent variable are taken
and their relationship is measured. Like this many variables are compared to draw some
meaningful inferences and to know to the future direction of the economy. However, to
apply this model one has to have the computer, necessary software and accurate data.
5. Opportunistic Model Building: The Opportunistic Model Building is also known as
sectoral analysis of Gross National Product Model Building and this is widely used
economic forecasting technique. This method is based on the national accounting data
and helps to find out the total income and total demand for various goods and services.
The forecast is made for the Central Government Sectors, State Government Sectors,
Private Sectors, and the Consumption Sector. The expenses and income of all the above
sectors are carefully analyzed. This method is very reliable and highly flexible in
forecasting the economic conditions and future directions.
3.6. INDUSTRY ANALYSIS.
Under fundamental analysis the next focus area is Industry Analysis. When the
investor is ensured about the growth of economy he has to evaluate various industries
and select the most promising industry for identifying investment opportunities. Industry
analysis it indicates to an investor whether the industry is a growth industry or not. It gives
an investor a choice of the industry in which the investments should be made or not.
Industry analysis, which refers to an evolution of the relative strengths and
weakness of particular industries, can be divided into five categories of Industry analysis.

Industry Analysis

1. Classification of Industry. 2. Industry Life Cycle Analysis.

3. Analysis of the Structure and Charactertics of an Industry

4. Michael Porters Profit Potential Analysis. 5. Other Factors.

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1. CLASSIFICATION OF INDUSTRY.
An industry means a group of firms doing similar business. An industry is a group
of firms that have similar technological structure of production and produce similar
products. Classification of industry further classified by Product and Business Cycle.
A). Classification by Product.
The companies in a particular industry are almost using similar materials,
technology manpower skill and distribution system. They target the same customer
segment. Following is the industry wise classification given by the Reserve Bank of India.

Types of Industries

i) Banking Industry
ii) Software Industry
iii) Automobile Industry
iv) Cement Industry
v) Steel Industry
vi) Paper Industry
vii) Aluminum Industry
viii) Textiles Industry
ix) Rubber Industry
x) Leather Industry
xi) Chemical Industry
xii) Pharmaceutical Industry

B). Classification According to Business Cycle.

Industries can also be classified on the basis of the business cycle or
classified according to their reactions to the different phases of the Business Cycle.
a). Growth Industry.
b). Cyclical Industry.
c). Defensive Industry.
d). Cyclical Growth Industry.
a) Growth Industry.
The industry which is growing at faster rate is termed as growth industry. This
industry is growing at high rate when compared to other industry and to certain extent

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independent of the economy life cycle. In other words the growth industry growth rate is
high when compared to the growth rate of economy and other sectors. For instance the
Indian Software and Information technology enabled services industry and Infrastructure
industry is considered as growth industry.
b) Cyclical Industry.
The Cyclical Industries’ growth depends on the growth of economy. For example
the consumer goods industry such as consumer white goods industry ( colour television,
washing machine, fridge etc.,) growth rate depends on the growth of general economic
conditions such as Boom period and Depression period.
c) Defensive Industry
The Defensive industry to certain extend is independent from the ups and downs of
the other sectors. For example the growth of industry which is producing consumer
essential goods such as food, cloth and basic requirements of the consumer are steady
always.
d) Cyclical Growth Industry
This is a new type of industry that is cyclical and at the same time growing. For
example the automobile industry experience periods of stagnation and decline but they
grow tremendously. The changes in technology and introduction of new models help the
automobile industry to resume their growth path.
2. INDUSTRY LIFE CYCLE ANALYSIS.
Many industrialist economists believe that the development of almost every
industry based four stages or every industry has to undergo various stages due to
changes in technology, consumer behavior and innovations. The length of each and
every stage may be different from Industry to industry. The cost, profitability and demand
are influenced mainly by the stages of the industry life cycle.
a). Pioneering Stage.
b). Growth Stage.
c). Maturity and Stabilization Stage.
d). Decline Stage.
a). Pioneering Stage.
This is the first stage of the industry life cycle and at this stage a new product is
introduced and the demand is created by educating the consumers about the product.
The number of players at the stage is less and the sales are also less. No company can
operate at its full capacity. The cost of production, marketing and distribution are very
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high. Many companies enter into market and complete with each other vigorously. Large
number of companies attempts to capture their share of the market. So at this stage weak
firms are eliminated and survival for the few firms.
b). Growth Stage.
In this stage, these companies grow further and become a stronger. Each
company finds a market for itself and develops its own strategies to sell and thereby
maintain its position in the market. Improved products are brought out lower prices due to
competition. Companies, which are in the expansion stage of an industry, are quite
attractive for investment purpose. Investors can get high returns become demand
exceeds supply.
c). Maturity and Stabilization Stage.
In this stage, the growth of the industry stabilizes sales increases at a slower rate,
change in social habits and development of improved technology are the causes of such
change. An investor should dispose of his holding in an industry, which begins to pass
from the expansion stage to the stagnation stage. Otherwise, he will have to suffer loss.
d). Decline Stage.
This is last life cycle of the industry and at this stage the demand for the product
starts declining. Thus causes of declining stage may be changes in raw material,
technology, consumer behavior or Government policy. Under declining stage the
companies’ production is declining whereas the cost is high and above all the profitability
is severely affected and ultimately it results in loss. An investor should dispose of his
holdings in such industry before the onset of the decay stage.
The industry life cycle approach provides a useful frame work for industry analysis
by the investor. The life of an industry may extend after the stagnation and decay stage
through appropriate adaptation to changes in the investment careful analysis is needed to
detect such expectations

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3. ANALYSIS OF THE STRUCTURE AND CHARACTERTICS OF AN INDUSTRY.

Since each industry is unique, a systematic study of its specific features and
Charactertics must be an integral part of security analysis. Industry analysis should focus
on the following structure and Charactertics of industry.

Charactertics of an Industry

a). Structure of the industry and

Nature of Competition. b). Nature and Prospectus of Demand.

c). Cost, Efficiency and Profitability. D). Technology and Research.

a). Structure of the industry and Nature of Competition.

Analyzing the structure and Charactertics of an industry the following factors to be
considered.
 The Number of firms in the industry and the market share of top few ( four to
five) firms in the industry.
 Licensing policy of the government.
 Entry barriers and pricing policy of the firm.
 Degree of homogeneity or differentiation among products.
 Competition from foreign firms.
 Comparison of the products of the industry with substitutes in terms of
quality, price, appeal and functional performance.
b). Nature and Prospectus of Demand.
 Major customers and their requirements.
 Key determinants demand.
 Degree of cyclicality in demand.
 Expected rate of growth in the foreseeable future.
c). Cost, Efficiency and Profitability.
 Proportions of the key cost elements, namely, raw materials, labour , utilities
and fuel.
 Productivity of Lobour.
 Turnover of inventory, receivables and fixed assets.

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 Control over prices of outputs and inputs.

 Behaviors of prices of inputs and outputs in response to inflationary
pressures.
 Gross profit, Operating profit and net profit margins.
 Return on assets, earning power and return on equity.
D). Technology and Research.
 Degree of technological stability.
 Important technological changes on the horizon and their implications.
 Research and development outlays as a percentage of industry sales.
 Proportion of sales growth attributable to new products.

4. MICHAEL PORTERS PROFIT POTENTIAL ANALYSIS.

Michael Porters has argued that the profit potential of an industry depends on the
following five forces.
Profit Potential of an Industry.
a). Threat of New Entrants.
B). Competition among Existing Firms.
C). Pressure from Substitute Products.
d). Bargaining Power of Buyers.
e). Bargaining Power of Sellers.
a). Threat of New Entrants.
Industry threat of new entrants is greater; its profit potential would be limited. In
some industries, it may not be economical to set up small capacities. An industry, which is
well protected from the entry of new firms, would be ideal for investment.
b). Competition among Existing Firms: Many firms are operating in an industry. They
complete with each other on the basis of price, quality, promotion, service, warranties and
so on. The rivalry in an industry is high when the following conditions prevail in the
market:
 There are a large number of competitors in the industry.
 There is a sustained competitive battle.
 The level of fixed cost is high.
 The industry growth is dull.
 There is over capacity in the industry continuing for a long time.

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 The industries product is considered as a commodity, which stimulates

strong competition.

c). Pressure from Substitute Products.

Each firm in an industry faces competition from other firms in the same industry
producing substitute products. Substitute products may affect the profit potential of the
industry badly. The pressure from the substitute products is found to be high under
following circumstances:
 When the price of product is attractive.
 When the cost for the prospective buyers to switch over to a substitute
product is minimum.
 When the substitute products are earning greater profits.
d). Bargaining Power of Buyers.
Buyers can bargain for price reduction, ask for better quality and better service.
They may induce competition among competitors. They can even reduce the profitability
of the supplier industry. The bargaining power of a buyer group is said to be high under
the following conditions:
 If its capacity to buy is more than the capacity of the seller to sell.
 If the cost of switch over to a substitute products is low.
 If it poses a threat of backward integration strongly.
e). Bargaining Power of Sellers.
Sellers also can expect a competitive force in an industry and bargain for rise in
lower quality, curtail some of the free services they offer etc. Powerful suppliers can affect
the profitability of the buyer industry badly. Suppliers are said to be powerful under the
following circumstance:
 Few suppliers dominate the entire market.
 There is no viable substitute for the products supplied.
 The switching poses a strong threat of forward integration.
 Suppliers also pose a strong threat of forward integration.

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5. OTHER FACTORS.
The following are some of the factors that are to be analyzed as part of industry
analysis;

Other Factors.

a). Growth of the Industry

b). Profitability of the Industry
c). Nature of the Industry
d). Degree of competition
e). Government policy
f). Manpower
h).Research and development

a). Growth of the Industry.

The rate of growth in terms of sales and profitability is very important factor to be
analyzed. The growth rate of industry has a significant impact on the profitability and
growth rate of the companies in the industry.
b). Profitability of the Industry.
The profit margin of the industry determines the return available for investors. The
asset structures (fixed and current assets) and the operating expenses influence the
profitability.
c). Nature of the Industry.
The nature of the industry that is whether consumer goods, industrial goods, or
service sector influences the profitability. If the particular industry directly depends on
other industry
then that industry also should be analyzed. For example the demand for type industry
depends on the growth of automobile industry.
d). Degree of competition.
The level of competition is an important factor to be analyzed for sound investment
decision. If the competition level is very high the profit margin of this company will be
very low. The growth prospects also will be very less.
e). Government policy

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The Government policy over a particular industry determines the profitability. The
Taxation policy, price control, environmental norms etc., affects directly the performance
of the companies.
f). Manpower
The availability of skilled manpower and its cost structure are very important issues
to be analyzed. When the required skilled manpower is available at reasonable cost then
the cost of recruitment, training and development will be low. Otherwise the employee
cost will be very high and in turn it will affect the profitability of the industry.
h).Research and development
The investment on Research and Development and the facilities available will help
the Industry to achieve high growth rate.
3.7. COMPANY ANALYSIS.
The company analysis is the major part in fundamental analysis. For taking
prudent investment decision, the investor has to analyze economic conditions and select
the most Promising industry. However it doesn’t mean that all the companies in the
selected industry will be really growth oriented. Therefore it becomes necessary to
identify the best company from the selected industry for investment. For this purpose the
investor has to carefully analyze various important fundamental factor which influences
the valuation and growth Prospects of the company.
Company analysis involves a close investigative scrutiny of the company’s
financial and non financial aspects with a view to identifying it strengths, weakness and
future business prospects. The following factor to be evaluated by the analyst.

COMPANY ANALYSIS.

1. Analyzing the competitive edge of the company.

2. Analyzing the Earnings of the Company.

3. Financial Analysis.

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1. Analyzing the Competitive Edge of the Company.

Each and every company has its own competitive edge when compare to others.
For example Unilever, Colgate Palmolive Ltd., and P&G are having lot of powerful brands
in their product portfolio. This competitive edge helps the companies to retain and
increase their customer base and market share. This competitive edge ensures stable
earnings for the company.
The competitive edge of the company can be studied with the help of:
a). The Market Share.
b). Growth in sales.
c). Stability of Sales.
d). Sales Forecast.

a). The Market Share.

The market share enjoyed by a company facilitates strong earnings growth.
For example
Tata motor’s significant market share in automobile industry enables the company to have
consistent profitability. When a company has high market share in its product it acts as
price dictation. It dominates in various marketing activities. This dominant certainly
guarantee high profit margin.

b). Growth in sales.

The Growth of the sales of the company should be steadily increasing, so that it’s
financial results really improves. The growth of sale indicates the increasing market
share, increasing number of loyal customers. Such growth results in optimum utilization
of the resources of the company.
c). Stability of Sales.
If a firm has stable sales revenue, other things remaining constant, will have more
stable earnings and it ensures constant dividend for equity shareholders.
d). Sales Forecast.
A company may be in a superior position commanding more sales both in
monetary terms and physical term but the investor should have an idea whether it will
continue in the future or not. For this purpose, forecast of sales has to be done and it
used some forecasting methods such as: Trend line, Simple Least square methods,

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demand for substitute and complementary products and sales growth can be compared
with macro economic variables like GDP, per capital income etc.
2. Analyzing the Earnings of the Company.
Sales alone do not increase the earnings but the cost and expenses of the
company also influence the earnings of the company. Earnings do not always increase
with the increase in sales. The company’s sales might have increased but its earnings per
share may decline due to rise in costs. Sometimes, the volume of sales may decline but
the earrings may improve due to rise in the unit price of the product. Hence, the investor
should not depend only on the sales, but should analyze the earnings of the company.
The investor has to predict the future earnings of the company, so as to know the
returns on his investment. The cost structure changes in sale and provisions etc. will
influence the profitability. To predict earnings in the following factors should be carefully
analyzed
a) The cost and sales
The cost structure that is the proposition of variable cost and fixed cost and the
pattern of sales affects the profitability of the company. When the fixed cost proportion is
very high the company can earn more profit by increasing volume. Therefore growth in
sale under the circumstances will yield maximum benefit to the company.
b) Depreciation
The provision for depreciation and other reserve determine the profitability of the
company. If the company follows a conservative approach then the amount of
depreciation and other reserve will be very high and leaves share holders with very less
cash dividend. From such companies the shareholders can get only less immediate
return. However the book value of the share may increase and in turn the market value of
the equity shares gets increased. If the company changes the method depreciation it will
have an impact on the profitability.
c). Depletion of resources
If the company is in oil, mining, gas and forest based business the depletion of
such natural resources will pull down the profitability of the company. Therefore the
resources available and the rate of depletion will give a hint about the future profitability of
the company.
d). Employee cost
If the company is in manpower intensive industry and if the manpower cost is
increasing then the future profitability of the business is doubtful. For example there is a
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consistent increasing employees cost in Indian IT Sectors and the profit margin is
affected.
e). Currency Value
If the company is in export or import business the currency value against overseas
currencies determine the profitability. For instance for the last one year the Indian
currency appreciate against U.S $ benefiting the importers and affecting the exporters.
Therefore the trends of currency value can give better idea about the future profit margin
of the companies.
f). Capital Structure
The capital structure that is the source of long term capital employed by a
company influences the ultimate profit available for the equity share holders. By
employing debt capital the company can reduce the cost of capital since the payment of
interest is made before payment of corporate tax and results in tax savings. Above all the
company promises to pay interest to the debenture holders irrespective of the profitability
of the company Thus the debenture holders are on safer side and they expects only a
reasonable interest. Thus the after tax cost of debt capital is always less. So the capital
structure indicates in future returns available for the equity share holders.
g). Efficiency of management
If the board of directors consists of highly experienced, efficient and dedicated
people then the company can be really successful. The efficiency of the management will
be reflected in terms of; introduction of new products, financial discipline, good corporate
governance and taking strategic decision.
3. Financial Analysis.
The investor has to go through the financial statements and analyze the profitability
and financial position of the company. The various accounting policies and accounting
standards adopted by the company for preparation of the financial statement should be
understood so that the real financial health of the company is known. In this regards the
following areas should be carefully analyzed.
1. Analysis of Financial Statement
The Trading, Profit and Loss account and Balance sheet are the basic financial
statement of a company. The Trading, Profit and Loss account shows the results of one
year business operation that is profit or loss. The Balance sheet shows the financial
position of the company. Following are the techniques of financial statement analysis.

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a). Comparative Financial Statement

The figures of financial statement for more than one period are presented in a table
for analysis. The increase or decrease of various items such as expenses, income,
liabilities and assets over two years period are calculated and shown in terms of actual
amounts and percentage. Such analysis helps the investor which items is increasing or
decreasing and the percentage of increase or decrease.
b). Common Size Statement
The common items in the financial statements are taken as hundreds and the rest of the
items are converted as a percentage of the common item. For example in common size
income statement the sale figure is taken as hundred and all the expenses are converted
as a percentage of sales. Similarly in common size balance sheet the total liabilities are
taken as hundred and all the liabilities are shown as a percentage of the total liabilities.
When come to assets side of the balance sheet the total asset is taken as hundred and all
the assets are converted as percentage of total assets. This exercise simplifies lengthy
accounting figures and facilitates easy and quick understanding of the importance of each
and every accounting figure.
c). Trend Analysis
The Trend analysis considers more than two years figures. For example a
company’s five years balance sheet can be shown in the form of table by taking the first
year figure as base data. The base data is taken as hundred and the subsequent years
figures are converted as a percentage of the based data. This Trend Analysis helps to
understand the movement of the trend of the profitability and the financial position of the
company.
d). Funds Flow and Cash Flow Analysis
The funds flow and cash flow analysis shows the various sources of funds and
applications of funds of a company. It shows changes in the financial condition of the
company over two years period. This statement also shows funds earned from core
business or funds lost in the core business. The Cash flow statement shows the route
causes of changes in cash position over two years period.
e). Ratio Analysis
Ratio is a relationship between two accounting figures expressed mathematically.
Calculating ratio and analyzing the same will give a better picture about the turn over
efficiency, profitability and financial position of a company. There are many ratios but the
ratios under the following classifications will be immense useful to the investors.
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1. Liquidity Ratios: a). Current Ration. B). Quick Ratio.

2. Leverage Ratios: a). Debt – Equity Ratio. B). Property Ratio.
c). Interest Coverage Ratio.
3. Profitability Ratios: a). Gross Profit Ratio. b). Operating Profit Ratio.
c). Net Profit Ratio.
4. Activity Ratios: a). Debtors Turnover Ratio. b). Creditors Turnover Ratio.
c). Stock Turnover Ratio. d). Current Asset Turnover Ratio.

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3.8. TECHNICAL ANALYSIS

The fundamental analysis focus on the analysis of the economy, industry and
company for investment decisions. The decisions are based on fundamental facts but the
fundamental analysis ignores the importance of market timings ie…entry and exit timings.
The technical analysis focus on the price movements and volume so as to give signals to
the investor to identify the right entry and exit timings.
The shares and securities price movements are analyzed broadly by two key
approaches, namely Fundamental approach and Technical approach. The Fundamental
approach emphasis much on the growth prospects of economy, stability of government,
the prospects of the specific industry and the specific company where as the technical
approach emphasis much on the price and volume movement of the stock. Based on the
price and volume movements of stock the buying and selling decisions are taken.
The technical approach is the oldest approach to equity investment, dating back to
the late 19th century. The Technical analysis continues to flourish in modern times as well.
It is widely used by institutional investors, operators and a large number of retail
investors. In fact the investor analyses both fundamentals and technical so that he can
buy the right Stock at right time.
The Technical approach to investing is essentially a reflection of the idea that
prices move in trends, which are determined by the changing attitudes of investors
towards a verity of economic, monetary, political and psychological forces. The Technical
analysis helps the investor to identify the trend reversals at an earlier stage to formulate
the buying and selling strategy and any corrections made on the existing investment
avenue.
3.9. TECHNICAL ANALYSIS – MEANING
The technical analyst believes that the market is in a trend and they try to predict
the trend well in advance so that the investor can take buying and selling decisions at
appropriate timings. With the help of several indicators the analyze the relationship
between Price – Volume and supply demand for the overall market and their individual
stock. They examine these, patterns with the help of charts and graphs and predict
whether prices are moving higher or lower and even by how much.

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3.10 TOOLS / TECHNIQUES USED FOR TECHNICAL ANALYSIS.

The following important tools are used for technical analysis for predicting the price
movement of overall market.

TECHIEQUES OF TECHNICAL ANALYSIS.

1). Basic Premises of Technical Analysis. 2). General Market Analysis.

3). Individual Stock Analysis

3.10.1. BASIC PREMISES OF TECHNICAL ANALYSIS /

ASSUMPTIONS OF TECHNICAL ANALYSIS.
Before, we embark on the actual methods themselves; let us review the basic and
necessary assumptions regarding the technical analysis.
a) The market price of a stock is basically determined by the demand and supply
forces.
b) Various rational and irrational factors influence the demand and supply of stocks.
c) The market discounts everything. The good news and bad news will cause the
Shift in demand and supply forces.
d) Stock prices tend to move in fairly persistent trends.
e) Changes in demand and supply bring out changes in trends.
f) Shifty in demand and supply can be detected with help of charts as to market
action.
g) The technical analyst analyze the past price behavior of the market / stock to
Predict the future trend.

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3.10.2. FUNDAMENTAL ANALYSIS VS TECHNICAL ANALYSIS .

There are two primary schools of thought regarding security analysis –
fundamental and technical analysis. Fundamental analysis utilizes a much wider range of
information than does technical analysis and relies on traditional financial statement
analysis. Technical analysis, on the other hand, concerns itself with attempting to identify
patterns in past price movements. Both consider macro economic trends to differing
degrees, but emphasize the use of firm specific microeconomic data. Basically, technical
analysis and fundamental analysis aim at good return on selected investment.

FUNDAMENTAL ANAYLSIS TECHNICAL ANALYSIS

a).The fundamental analysis is based on The technical analysis is based on analysis
Analysis of information relating to the of price movements and the volume or
economy, industry and company. internal market data.
b).The Fundamental analysis helps the The technical analysis helps to predict the
investor to find out the intrinsic value of the trend of price movements.
stock
c).The fundamental analysis uses the The technical analysis used tools like
accounting tools like Ratio, fund flow and technical indications and charting methods.
cash flow analysis.
d).The fundamental analysis mainly The technical analysis mainly focuses on
focuses on long term investments the short term investment prospects
prospectus.
e).The fundamental analysis is mainly used The technical analysis is mainly used by
by long term investors. speculators.
f).The fundamental analysis not used any The technical analysis used by many
assumptions to find out the intrinsic value assumptions to predict the trend of predicts
of the stock. movements.
h).The fundamental analysis considers The technical analysis considers the factors
economic factors, population and natural like price of securities, its demand and
resources etc. supply and return on investment.

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3.10.3. General Market Analysis.

Out of variety of tools employed by technical analysis to assess the overall market
movement, the two important tools are:

GENERAL MARKET ANALYSIS

1. Dow Theory. 2. Breadth of Market Analysis.

1. Dow Theory.
 Dow Theory developed by Charles H. Dow.
 Generally Stock Performance is Classified in two Categories:
a).Bullish Trend.
A). Bullish Trend.
Bull market has three phases. In the first phase, the prices would advance with the
revival of confidence in the future of business. This will encourage investors to buy share
of companies. During the second phase, price would advance due the improvements in
corporate earnings. In the third phase, prices advance due to inflation and speculation.
The following chart shows the three phases of bullish market.
Phases of Bullish / Bull Market:

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b). Bearish Trend.

The bear market also has three phases. In the first phase, prices begin to fall due
to abandonment of hops. Investors begin to sell their shares. In the second phase,
companies start reporting lower profits and lower dividends. In the third phase, prices fall
still further due to distress selling. The following chart shows the phases of Bearish:
Phases of Bearish Trend:

 Stock market movement is classified in the following trends:

a). Primary Market Trend.
The primary market trend, which can often last a year or more.
b). Secondary or Intermediate Trend.
Secondary or intermediate trend, which can move against the primary trend for one
to several months.
c). Minor Trend.
Minor movements lasting only for hours to a few days. The determination of the
market trend is the most important decision to the Dow believer.
 Stock prices demonstrate patterns over four to five years.
The Dow Theory asserts that stock prices demonstrate patterns over four to five years
and these patterns are mirrored by indices of stock prices. The Dow Theory employs
two Jones Averages.
a). Industrial Average.
b). Transportation Average.

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 If the Dow Jones Industrial Average rises, the Transportation Average should also
rise. Such simultaneous price movements suggest a strong bull market.
 Decline in both the Industrial Average and Transportation Average suggests that
the market is uncertain or bearish trend market.
 If one of the averages starts to decline after a period of rising stock prices, then the
two are at odds. This suggests that the other average may not continue to rise but
may soon start to fall. Hence, the investor will use this signal to sell securities and
convert them in to cash.
 One of the averages start to rise while the other continues to fall the converse
occurs, suggests that, this phase is over and that security prices in general will
soon start to rise.
Dow theory, finally suggest that the, investor use this above signals of stock market
movements and Dow Jones averages and made it quality decision regarding that buy and
sale of securities.

2. Breadth of Market Analysis or Market Breadth.

The market breadth is an important technical indicator and widely used by

technical Analyst to predict the future trend. The market breadth is the difference
between numbers of stocks advanced and number of stocks declined.
If the day’s closing price of a stock is more than the previous day’s closing price
then it is said to be advanced. If the day’s closing price of a stock is less than the
previous day’s closing price then it is said to be declined. The cumulative index of net
differences of number of stocks advanced and number of stocks declined measures the
market breadth.
When the market breadth is positive and consistently increasing it indicates the bull
market. Instead if the market breadth is reducing then it is the signal of bear market. The
market breadth can be shown in the form of chart also.

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Market Breadth or Breadth of Market Analysis.

3. Individual Stock Analysis.

Analyzing the individual stocks, the technical analysis primarily uses the
following tools:

Individual Stock Analysis.

[Link]. 2. Chart Patterns.

a). Line Chart. a). [Link].

b). Bar Chart. b). Tops and Bottoms Formation.
c). Point and Figure Chart. i). Double Top Formation.
d). Japanese Candlestick Chart. ii). Double Bottom Formation.
c). Head and Shoulder Formation.

3. Moving Average Analysis d). Triangle.

i). Symmetrical Triangle.
ii). Ascending Triangle.
iii). Descending Triangle.
e). Flags.
i). Up Flag.
ii). Down Flag.
f). Pennant.

4. Relative Strength Index (RSI).

5. Rate of Change.(ROC). 6. Oscillators.

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1. CHARTS.
Technical analysis uses charts as important tool to predict the future trend of share
price movement. The price movements of a stock presented in the form of charts enable
investor to easily understand and predict the price movements. The graphical
presentation helps the investor to understand the past and present price movements.
The charts indicate the main support and resistance levels of the stock.
Uses of Charts.
 Spots the current trend for buying and selling.
 Indicates the probable future action of the market by projection.
 Shows the past historic movement.
 Indicates the important areas of support and resistance.

Types of Charts.

a). Line Chart c). Point and Figure Chart.

b). Bar Char d). Japanese Candlestick Chart

A). LINE CHART

The line chart is the simple presentation of price movement of a stock over a
specified period. The period is represented by “ X” axis and the price movement is
represented by “ Y” axis. The closing price of the stock for various period are plotted in
the chart with dots and then all the dots are joined by a line and the line is called variable
line.
Line charts can be prepared by considering daily closing price, weekly closing
price or monthly closing price. To predict short term movements’ daily closing price can
be used to prepare line charts. To predict medium term and long term movements the
weekly and monthly closing price can be considered. Traders in the stock market prepare
intra – day line charts by considering every ten minutes / 1/2 hr price movements.
The line chart can be prepared for volume of a stock, index numbers or total
volume of the stock exchange.
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Line Chart.

B). BAR CHART

The bar chart is based on the statistical technique. The bar chart shows the
complete Price movements of a stock. It reveals the day’s opening price, low price, high
price, closing price and the volume of a stock. The closing price and opening price are
marked in between the high price and low price by marking a tick on the vertical bar. The
volume of transactions is shown as separate vertical bars in the bottom portion of the bar
chart.

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Bar Chart

C). POINT AND FIGURE CHART.

The Point and figure chart is useful to predict the change of price direction. The
point and figure chart is drawn on the ruled paper. The price interval of the stock is
entered on the left side of the chart. For high priced scrip the price intervals are high and
for less priced scrip e price intervals are less. When the price of the scrip moves up to
the next price interval then it is marked up with “X” symbol and as long as the share price
increases the “ X “ symbols are plotted in the vertical column. When the share price
declines by the price intervals then the chart is plotted with “O” symbols in the next
column. The price movements are analyzed and interpreted by reading the ‘X” and “O”
symbols on the chart.
The point and figure chart have the price interval of Rs.3 whenever the price rises
by Rs.3 then the chart is plotted “X” symbols vertically and when price declines by Rs.3
then the chart is plotted with “O” symbol in the next column. The point and figure chart
shows the support and resistance levels and also indicates the buy and sells signals.
However the point and figure chart fails to show the intra – day price movements and
minor fluctuations below the selected price intervals. The chart does not show the
volume which is very important aspect of technical analysis.

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Point and Figure Chart.

D). JAPANESE CANDLE STICK CHART

The candle stick chart shows the price movements of the stock in vertical form.
The top and bottom points of the stock passes through the candle. A clear candle without
any shading indicates increase in price and a shaded candle indicate decrease in price.
When the day’s closing price is higher than the opening price then it is considered as
increase in price and the candle is kept clear.
When the day’s closing price is less than the opening price it is considered as
decrease in price and the candle is shaded. The candle stick chart shows the day’s
opening price, low Price, high price and closing price and the price movements. The
candle stick charts can prepared for weekly or monthly.

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Japanese Candle Stick Chart.

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2. CHART PATTERNS.
Chart reveals certain patterns that are of predictive value. Chart patterns are used as
a supplement to other information and confirmation of signals provided by trend lines.
Some of the most widely used and easily recognizable chart is given below:

Types of Chart Patterns.

a). [Link].

b). Tops and Bottoms Formation. c). Head and Shoulder Formation.
i). Double Top Formation.
ii). Double Bottom Formation.

d). Triangle e). Flags.

i). Symmetrical Triangle. i). Up Flag
ii). Ascending Triangle. ii). Down Flag
iii). Descending Triangle.

f). Pennant.
ii). Down Flag.

a). [Link].
The name itself indicates that in the ‘V’ Formation there is a long share decline and
a fast reversal. The ‘V’ pattern occurs mostly in popular stocks where the market interest
changes quickly from hope to fear and vice – versa. In the case of inverted ‘ ’ the rise
occurs first and declines.
V – Shaped Reversal

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b). Tops and Bottoms Formation.

Top and bottom formation is interesting to watch but what is more important, is the
middle portion of it. The investor has to buy after up trend has started and exist before the
top is reached. Generally tops and bottoms are formed at the beginning or end of the new
trends. The reversal from the tops and bottoms indicate sell and buy signals.
i). Double Top Formation.
It represents a bearish development, signaling that the price is expected to fall. Its
pattern resembles the letter ‘M’. The double top may indicate the onset of the bear
market. But the results should be confirmed with volume and trend.

Double Top Formation.

ii). Double Bottom Formation.

In double bottom, the price of the stock falls to a certain level and increase with
diminishing activity. Then it falls again to the same or to a lower price and turns up to a
higher level. The double bottom resembles the letter ‘W’. Technical analysts view double
bottom as a sign for bull market.

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Double Bottom Formation

C). Head and Shoulder Formation.

The most popular reversal pattern is the head and shoulder formation. Head and
Shoulder formation occurs at the end of a long up trend. it shows a top followed by a still
higher top and then another lower top. Such a formation resembles the head and two
shoulders of a man. So it is called as head and shoulder formation.
The first hup i.e. the left shoulder is formed when the prices reach the due to a
strong buying impulse. Then there is a short downward suing due to the less volume of
trade. The second top known as head is formed when the volume of trade increases still
further. This is followed by less volume, which takes the price down to a bottom near to
the earlist downward Suring. A third top i.e, right shoulder occurs taking the price to a
height less then the head but equal to the left shoulder. A horizontal line joining the
bottom of this formation is called neckline. Price penetrates this neck line. So the
formation of the head and shoulder pattern is completed. After breading the neck line, the
price is expected to decline sharply.

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Head and Shoulder Formation.

d). Traingles.
The triangle formation is easy to identify and popular in technical analysis.

Types of Triangles.

i). Symmetrical Triangle ii). Ascending Triangle.

iii). Descending Triangle.

i). Symmetrical Triangle.

The Pattern is made up of series of fluctuations, each fluctuations smaller than the
previous one. Tops do not attain the height of the previous tops. Likewise bottoms are
higher than the previous bottoms. Connecting the lower tops that are slanting downward
forms a symmetrical triangle. Connecting the rising bottom, which is slanting upward,
becomes the lower trend line. It is not easy to predict the breakaway either way. The
symmetrical triangle does not have any bias towards the bull and bear operators. It
indicates the slow down or temporary halt in the direction of the original trend.

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Symmetrical Triangle.

ii). Ascending Triangle.

Here, the upper trend line is almost a horizontal trend line connecting the tops and
the lower trend line is a rising trend line connecting the rising bottoms. When the demand
for the scrip overcomes the supply for it, then there will be a break out. The break will be
in favour of the bullish trend. This pattern is generally spotted during an up move and the
probability of the upward move is high here.
Ascending Triangle.

iii). Descending Triangle.

Here, connecting the lower tops forms the upper trend line. The upper trend line
would be a falling one. The lower trend line would be almost horizontal connecting the
bottoms. The lower line indicates the support level. The possibility for a downward
breakout is high in the pattern. The pattern indicates that the bear operators are more
powerful than the bull operators. This pattern is seen during the down trend.

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Descending Triangle.

e). Flags.
Flag pattern is commonly seen on the price charts. These patterns emerge either
before a fall or rise in the value of the scrip’s. These patterns show the market corrections
of the over bought or oversold situations. The time taken to form these patterns is quick.
Each rally and set back may last only three to four days. If the pattern is wider it may take
three weeks to complete the pattern.

Types of Flags

i). Up Flag. ii). Down Flag

A flag resembles a parallelogram. A bullish flag is formed by two trend lines that
stoop downwards. The bread-out would occur on the upper side of the trend line. In a
bearish flag both the trend lines would be stooping upwards. The bread out in the
downward trend line.

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i).Up Flag

ii). Down Flag.

f). Pennant.
Pennant looks like a symmetrical triangle. Here also there is bullish and bearish
pennant. In the bullish pennant, the lower tops from the upper trend line. The lower trend
line connects the rising bottoms. The bullish trend occurs when the value of scrip moves
above the upward trend line.

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Pennant

3. Moving Average Analysis.

Technical Analysts are using indicators like Chart and Chart Patterns. These
indicators are used to predict the direction of the price movements of scrip and the
direction of the market in future.
The Moving averages are considered as most reliable and better indicator of the
future direction. Most of Technical analysts use the Moving average since it is very simple
and gives reliable signal about the forth coming bull / bear trend. The word moving means
that the body of data moves ahead to include the recent observation. If it is 10 days
Moving averages, on the 11th day the body of data moves to include the 11 th day
observation eliminating the first day’s observation likewise it continues.
For the Moving average calculation the closing price of the stock is considered,
because the day’s closing price gives better indication about the next day’s movements
than the intra day’s high low price. The Moving average can be calculated for the
individual scripand for the Index and it indicates the underlying trend in the scrip (or) the
market as the case may be. To predict short-term trend 10 – 30 days, to predict medium
term, 50 – 125 days and to predict the long – term 200 days Moving averages can be
applied.
USES OF MOVING AVERAGES
There are many advantages of Moving averages. It is possible to identify the trend
and confirm the trend. There are three ways to identify the direction of the trend with
Moving averages; i) direction, ii) location and iii) crossovers.
The first trend identification techniques use the direction of the moving average to
Determine the trend. If the Moving averages are rising, the trend is considered up. If the
Moving average is declining, the trend is considered down.

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The location of the price relative to the Moving average can be used to determine
the Basic trend; if the price is above the Moving average the trend is considered up if the
price is below the Moving average the trend is considered down.
The third technique for crossovers or trend identification is based on the
location of the Short-term Moving average relative to the Long term Moving average and
if it is above the Long-term Moving average the trend is considered up. If the Short term
Moving average is below the Long-term Moving average then the Long term Moving
average trend is considered down.
Another important use of Moving average is the identification of support and
resistance levels. It helps the investor to find out the Support and Resistance Level for the
market as well as for individual stock. Support and resistance level identification through
Moving averages works best in trending market.
Types of Moving Average Analysis.
i). Index and Stock Price Moving Averages.
ii). Stock Price and Stock Prices Moving Average.
Eg: Calculation Of Five – Day Moving Average for Tata Motors.
Day Price Moving Average.
Feb 4, 2013 255 -
Feb 6, 2013 261 -
Feb 7, 2013 269 266.2
Feb 8, 2013 8273 270.8
Feb 9, 2013 273 272.8
Feb 11, 2013 278 273.8
Feb 12, 2013 271 274.0
Feb 13, 2013 271 273.8

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Moving Average – 5 Days

i). Moving Average Convergence and Divergence (MACD)

MACD is another indicator used for disinvestment and investment process. It

measures the convergence and divergence between two exponential or simple moving
averages. Two series of closing price data – one for short term moving average of say 12
day and the other for 26 days of long-term moving average. The MACD should reflect the
absolute differences between these two moving averages. With differences shown the Y-
axis
and days represented on the X-axis the chart can be drawn with a MACD line oscillating
across the zero line.
As long as the MACD line moves above the zero line but likely to cross it, we have
to select a point for disinvestment. Care has to be taken to see that some false signals
are not pursued, but disinvestment may be based on some confirmation of likely trend to
cross the zero line from above. This means that the short-term moving average is above
the longer one, and the MACD is positive and in the opposite case, it is negative and falls
below the zero line. This is seen from the above chart of MACD.
One can see many sell signals in the above chart, namely, A, B, C and D but after
D the line started falling continuously and crossed the zero line and thus the point of ‘D’ is
the last chance for disinvestment with advantage. If the market is in the overbought zone
one can sell but not in the cover sold zone. A daily chart prices will first give preliminary
indications, which are to be confirmed by the oscillators or the MACD lines. Even with
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confirmation, one cannot be certain that the disinvestment has taken place at the right
time. Experimentation and research through stimulation is the only guide to expertise and
experience in the field of technical analysis to act as an aid for disinvestment
management.

Moving Average Convergence and Divergence (MACD)

ii). Exponential Moving Average (EMA)

A type of moving average that is similar to a simple moving average, except that
more Weight is given to the latest data. Also known as “exponentially weighted moving
average This type of moving average reacts faster to recent price changes than a simple
moving average. The 12- and 26-day EMAs are the most popular short-term averages,
and they are used to create indicators like the moving average convergence divergence
(MACD) and the percentage price oscillator (PPO). In general, the 50- and 200-day EMAs
are used as signals of long-term trends
Exponential Moving Average Calculation
Parameters: n - number of days

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Note:
Exponential moving average is related to simple moving average. In other words it
is a weighted simple moving average putting more weight on the today’s closing price. It
may be measured in percentage, which is the percentage that is applied to today’s
closing price weighting yesterdays simple moving average. The formula to convert
exponential percentage into simple moving average number of span days is as following:

For example, let’s say you were calculating a 10-day exponential moving average. To
the previous exponential moving average figure you would add the weighting of 2 / (10 +
1), or 2/11, or .1818 times the current closing price. If you were working with a 20-day
moving average, then the calculation would be 2/21 or .095 times the current close added
to the previous exponential moving average. The longer the period for which you
calculate the moving average, the less of an impact the exponential weighting has on the
most recent data.
Moving averages are lagging indicators, and therefore, by definition, will give late
signals. By weighting recent price data more heavily, exponential moving averages
attempt to speed up the signal given. The disadvantage of doing this, of course, is that
this more rapid signal can sometimes be premature and therefore give the swing trader a
false indication to trade.
1. Relative Strength Index or Relative Strength Analysis (RSI).
The Relative Strength Index was developed by ells wilder. The RSI is used to find
out the relative strength of a stock.
The Relative Strength analysis based on the assumption that prices of some
securities rise reputedly during the Bull phase but fall slowly during the Bear phase in
relation to the market as a whole. But differently such securities possess grater relative
strength and hence outperform the market.
RSI is calculated with the help of the following formula;

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100
RSI = 100 – ———
1 + Rs

Average Gain per day

Rs = ——————————————
Average loss per day

The RSI can be calculated for one week or two weeks. If it is calculated for two
Weeks period the probability of getting wrong indications is minimum.
Relative Strength Index.

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Relative Strength Index or Relative Strength Analysis (RSI).

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
year year year year

4. Rate of Change (ROC).

The Rate of Change (ROC) indicates the rate of change in price of a stock
between two periods. The ROC shows the change between the current price and the
price “n” number of days in the past. The ROC indicates the overbought and oversold
positions of a stock. The ROC also shows the trend reversals. ROC can be calculated
by considering the closing price and it can be prepared weeks or months. ROC can be
calculated by using the following formula:

Today’s price
ROC = —————————————— X 100
Price ‘n’ days back

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The ROC can be calculated and shown in a chart form.

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
year

5. Oscillators
Oscillators are widely used by technical analyst to know the overbought and
oversold Positions of a particular scrip or market. The oscillators show the trend reversal
and the rise or decline in the momentum. The Oscillators shows the share price
movements across a reference point from one extreme to another extreme.
The Oscillators are indicators that we use when viewing charts that are no
trending. Moving averages and trends are paramount when studying the direction of an
issue. A technician will use oscillators when the charts are not showing a definite trend in
either direction. Oscillators are thus most beneficial when a company’s stock either is in a
horizontal or sideways trading pattern, or has not been able to establish a definite trend in
a choppy market.
When the stock is in either an overbought or oversold situation, the true value of
the oscillator is exposed. With oscillators a chartist can see when the stock is running out
of steam on the upside, the point at which the stock moves into an overbought situation.
This simply means that the buying volume has been diminishing for a number of trading
days; traders will then start to think about selling their shares. Conversely, when an issue
has been sold by a greater number of investors for a period of time (from one to two
weeks to three to six months or longer), the stock will enter an oversold situation.

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3.11 QUESTIONS FOR DISCUSSION

1. Explain in detail about Economic Analysis.
2. Explain in detail about Industry Analysis.
3. Explain in detail about Company Analysis.
4. Explain in detail about various ratios are used analysis of the Company financial
performance.
5. Explain in detail about various techniques used in Technical Analysis.
6. Discuss in detail about Assumptions of Technical analysis.
7. Explain in detail about Dow Theory.
8. “Chart patterns are helpful in predicting the Stock Price Movement” – Comment.
9. What are the different types of charts used by the Security Analysis?
10. Explain the techniques of Moving Average Analysis?

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UNIT – IV
EFFICIENT MARKET HYPOTHESIS
4.1 Efficient Market Hypothesis
The efficient market hypothesis emphasizes that it would be difficult for an investor
to regularly beat the market which reveals the combined decision of lots of participants in
an atmosphere regarded as by many contending investors who have similar objectives
and access to the same information. An efficient market is the market which is actually
capable of swiftly taking inane kind of new information or any fact or data relating to the
economy, an industry or it may be relating to the company and then such information is
precisely impounded in the price of the securities.
According to Fama (1970), efficient markets are those markets where “there are
large numbers of rational profit maximizes actively competing, with each trying to predict
future market values of individual securities, and where important current information is
almost freely available to all participants”.
In this type of markets participants cannot expect to earn any more than a fair
return for the risks undertaken. In an efficient market it is assumed that as and when any
information comes to the knowledge of investors it will be quickly and accurately
assessed by the combined actions of millions of investors and thus will be immediately
reflected in the price of the stock.
For example suppose a company announces an increase in their annual profit.
Now this information will be quickly assessed by the investors. The ultimate effect of this
efficiency is that whether an investor buys this particular company’s shares before, after
or during the time when such announcement regarding company’s profit were made or
whether another stock is purchased, only a fair market rate of return can be expected on
these shares which will be enough to match with the risk of buying or holding such
company’s security.
Also for example if a mutual fund companies manager can increase the fund’s
return after transaction cost then Efficient market hypothesis asserts that the cost of
transaction will become equal to the advantage gained by such transaction and research
cost. Therefore no one in the market can outperform or earn better results of investing
than others.

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4.2 Assumptions of an Efficient Market

The efficient market hypothesis is based on certain assumptions. The following are the
main assumptions for a market to be efficient:

 There are large numbers of buyers or investors for the security

 There are large numbers of sellers for the security
 These large number of investors trade in securities for profit.
 All investors act rationally.
 If some investors are not rational then they cancel the irrational behavior of each
other.
 New information comes to the market randomly. This information is costless and
available to all the market participants.
 Prices of securities adjust quickly to the newly available information.
 Stock prices should reflect all the available information.
4.3 Forms of Efficient Market Hypothesis
Efficient market is the one which promises only fair return to the investors. But in
no case we meant that the efficient market doesn’t give any return. It only states that the
returns to an investor from investing in any type of securities in a market which is highly
competitive will be fair on an average.
Eugene Fama classified the market into three categories on the basis of the kind of
information that is available to the investors in a market. There can be three sets of
information that can be available to investors and market participants. These are as
follows:
 Information about past prices of the securities.
 Information that is made available to public at large likes announcements by
company about its financial result etc.
 Information that is not available to public at large i.e. .insider information.
On the basis of the availability of this information or the basis of absorption of such
information in the market the markets can be classified into three forms of efficiency. The
following are the three forms of efficiency given by efficient market hypothesis:
1. Weak form of efficiency
2. Semi strong form of efficiency
3. Strong form of efficiency.

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1. Weak form of efficiency

In this form of market only one set of information that is information about historical
prices of shares is publicly available. It is asserted that in this form of market it is
assumed that any movement in future prices of shares cannot be predicted from the
previous prices of shares. Any development or changes in price is referred as random
walk. In short this weak form of efficiency says that future prices of shares cannot be
predicted from the past prices of shares.
2. Semi strong form of efficiency
In this form of efficient market hypothesis it is assumed that a market is efficient if
all the relevant and openly or publicly available information is swiftly reflected in the
market price of the securities. This is called the semi-strong form of the efficient market
hypothesis. In semi strong form of market securities prices are assumed to be fully
reflecting the all the publicly available information.
In this form of market prices of securities not only reflect the information relating to
past price behavior or data but also the information relating to the profits made by the
company, any announcement relating to the dividends paid or to be paid by the company,
any information relating to the issue of bonus shares or the right shares by the company,
any information regarding the merger of the company, acquisition or amalgamation of the
company, the financial situation of company’s competitors, expectation regarding various
economic factors such as inflation employment etc.
In this form of market a few investors might earn profit in the short run due to
availability of insider information to them. Semi strong form of efficiency of a market is
quite easy to understand and interpret. It says that the market will speedily digest the
publication of all the relevant new information by causing the prices of a share to move to
a new equilibrium level. Whenever any new information reaches the public they react to it
causing a change in demand and supply of shares.
3. Strong form of efficiency
The strong form of market efficiency states that the stock prices integrate all sort of
information that is obtainable about the stock including the public as well as private
information. So, if a market is strong form efficient, then even the traders with insider
information cannot take advantage of their information to make more profits than other
investors with no private information in the stock market. As in this form of efficient market
share prices all kinds of information whether public or private or some insider information
so no investor gets a chance to earn any kind of excess returns. In such a form of market
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there are no legal barriers for the private information becoming public news. All kinds of
insider information are reflected very quickly in the share prices.
So here we have learnt about the three forms of market but what the market
efficiency hypothesis implies is that securities prices should be reflecting the proper
indication about its fair value because it has already incorporated all available information.
In spite of that it does not mean that an investor’s preferences about the choice of
securities are totally irrelevant in making their investment decision. An investor’s choice
about a security may be affected by many reasons. It may be about someone’s family
issue, the age at which he is trading, the risk preference of individual, beliefs of an
individual investor etc. Thus, everyone has a need to optimize their portfolio so that they
can be successful in reaching their objectives.
4. 4 Markowitz Risk-return Optimization
Dr. Harry Markowitz is credited with developing the first modern portfolio analysis
model since the basic elements of modern portfolio theory emanate from a series of
propositions concerning rational investor behaviour set forth by Markowitz, then of the
Rand Corporation, in 1952, and later in a more complete monograph sponsored by the
Cowles Foundation. It was this work that has attracted everyone’s perspective regarding
portfolio management. Markowitz used mathematical programming and statistical
analysis in order to arrange for the optimum allocation of assets within portfolio. To reach
this objective, Markowitz generated portfolios within a reward-risk context.
In other words, he considered the variance in the expected returns from
investments and their relationship to each other in constructing portfolios. In so directing
the focus, Markowitz, and others following the same reasoning, recognized the function of
portfolio management as one of composition, and not individual security selection – as it
is more commonly practiced. Decisions as to individual security additions to and deletions
from an existing portfolio are then predicated on the effect such a manoeuvre has on the
delicate diversification balance. In essence, Markowtiz’s model is a theoretical framework
for the analysis of risk return choices. Decisions are based on the concept of efficient
portfolios.
A portfolio is efficient when it is expected to yield the highest return for the level of
risk accepted or, alternatively, the smallest portfolio risk for a specified level of expected
return. To build an efficient portfolio an expected return level is chosen, and assets are
substituted until the portfolio combination with the smallest variance at return level is

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found. As this process is repeated for other expected returns, a set of efficient portfolios is
generated.
Assumptions
The Markowitz model is based on several assumptions regarding investor
behaviour.
1. Investors consider each investment alternative as being represented by a probability
distribution of expected returns over some holding period.
2. Investors maximize one period’s expected utility and progress along the utility curve,
which demonstrates diminishing marginal utility of wealth.
3. Individuals estimate risk on the basis of the variability of expected returns.
4. Investors base decisions solely on expected returns and variance (or standard
deviation) of returns only.
5. For a given risk level, investors prefer high returns to lower returns. Similarly, for a
given level of expected return, investor prefer less risk to more risk.
4.5 CAPITAL ASSET PRICING MODEL (CAPM)
William F. Sharpe and John Linter developed the Capital Asset Pricing Model
(CAPM). The model is based on the portfolio theory developed by Harry Markowitz. The
model emphasises the risk factor in portfolio theory is a combination of two risks,
systematic risk and unsystematic risk. The model suggests that a security’s return is
directly related to its systematic risk, which cannot be neutralised through diversification.
The combination of both types of risks stated above provides the total risk. The total
variance of returns is equal to market related variance plus company’s specific variance.
CAPM explains the behaviour of security prices and provides a mechanism whereby
investors could assess the impact of a proposed security investment on the overall
portfolio risk and return.
CAPM suggests that the prices of securities are determined in such a way that the
risk premium or excess returns are proportional to systematic risk, which is indicated by
the beta coefficient. The model is used for analysing the risk-return implications of holding
securities. CAPM refers to the manner in which securities are valued in line with their
anticipated risks and returns. A risk-averse investor prefers to invest in risk-free
securities.
For a small investor having few securities in his portfolio, the risk is greater. To
reduce the unsystematic risk, he must build up well-diversified securities in his portfolio.
The asset return depends on the amount for the asset today. The price paid must ensure
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that the market portfolio’s risk/return characteristics improve when the asset is added to
it. The CAPM is a model, which derives the theoretical required return (i.e. discount
rate) for an asset in a market, given the risk-free rate available to investors and the risk
of the market as a whole.
The CAPM is usually expressed:
E(Ri) = Rf + bi(E(Rm) – Rf)
b (Beta), is the measure of asset sensitivity to a movement in the overall market;
Beta is usually found via regression on historical data. Betas exceeding one signify more
than average “riskiness”; betas below one indicate lower than average.
E(Rm) – (Rf) is the market premium, the historically observed excess return of the
market over the risk-free rate. Once the expected return, E(ri), is calculated using CAPM,
the future cash flows of the asset can be discounted to their present value using this rate
to establish the correct price for the asset. (Here again, the theory accepts in its
assumptions that a parameter based on past data can be combined with a future
expectation.) A more risky stock will have a higher beta and will be discounted at a higher
rate; less sensitive stocks will have lower betas and be discounted at a lower rate. In
theory, an asset is correctly priced when its observed price is the same as its value
calculated using the CAPM derived discount rate. If the observed price is higher than the
valuation, then the asset is overvalued; it is undervalued for a too low price.
Assumptions to Capital Asset Pricing Model
Because the CAPM is a theory, we must assume for argument that:
1. All assets in the world are traded.
2. All assets are infinitely divisible.
3. All investors in the world collectively hold all assets.
4. For every borrower, there is a lender.
5. There is a riskless security in the world.
6. All investors borrow and lend at the riskless rate.
7. Everyone agrees on the inputs to the Mean-STD picture.
8. Preferences are well described by simple utility functions.
9. Security distributions are normal, or at least well described by two parameters.
10. There are only two periods of time in our world.
This is a long list of requirements, and together they describe the capitalist’s ideal
world. Everything may be bought and sold in perfectly liquid fractional amounts even
human capital! There is a perfect, safe haven for risk-averse investors i.e. the riskless
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asset. This means that everyone is an equally good credit risk! No one has any
informational advantage in the CAPM world.

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4.6. QUESTIONS FOR DISCUSSION

1. Explain in detail about Efficient Market Hypothesis.
2. Describe in detail about Markowitz model approach.
3. Explain in detail about Arbitrage Pricing Theory.
4. Enumerate the Capital Asset Pricing Model.

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UNIT – V
PORTFOLIO PERFORMANCE EVALUATION
5.1 Portfolio Management
Portfolio Management is defined as the art and science of making decisions about
the investment mix and policy, matching investments to objectives, asset allocation for
individuals and institutions, and balancing risk against performance. It is mainly
concerned with allocating assets while downsizing risk.
“Never put all your eggs in one basket” is what is meant by diversification. Instead
of investing all funds in one asset, the funds be invested in a group of
[Link] helps in reducing the risk of investing. Total risk of one investment
is the sum of the impact of all the factors that might affect the return from that investment.
However, investors need not suffer risk inherent with individual investments as it could be
reduced by holding a diversity of investments.
For example, return from a single investment in a cold drink company is subject to
weather conditions. This investment is a risky investment. However, if a second
investment can be made in an umbrella company, which is also subject to weather
changes, but in an opposite way, the return from the portfolio of two investments will have
a reduced risk-level. This process is known as diversification. Portfolio is the combination
of securities or diversified investment in securities.
Portfolio management may be defined as the process of construction,
maintenance, revision and evaluation of a portfolio. The objective of portfolio
management is to build a portfolio which gives a return commensurate with the risk
preference of the investor.
Portfolio management specifically deals with security analysis, analysis and
selection of portfolio, revision of portfolio and evaluation of portfolio.
5.2 Objectives of Portfolio Management
a). Capital appreciation
b). Maximizing returns on investment
c). To improve the overall proficiency of the portfolio
d). Risk optimization
e). Allocating resources optimally
f) .Ensuring flexibility of portfolio
g). Protecting earnings against market risks.

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5.3 Types of Portfolio Management

1. Active portfolio management
In this type of management, the portfolio manager is mostly concerned with
generating maximum returns. Resultantly, they put a significant share of resources in the
trading of securities. Typically, they purchase stocks when they are undervalued and sell
them off when their value increases
2. Passive portfolio management
This particular type of portfolio management is concerned with a fixed profile that
aligns perfectly with the current market trends. The managers are more likely to invest in
index funds with slow but steady returns which may seem profitable in the long run.
3. Discretionary portfolio management
In this particular management type, the portfolio managers are entrusted with the
authority to invest as per their discretion on investors’ behalf. Based on investors’ goals
and risk appetite, the manager may choose whichever investment strategy they deem
suitable.
4. Non-discretionary management
Under this management, the managers provide advice on investment choices. It is
up to investors whether to accept the advice or reject it. Financial experts often
recommended investors to weigh in the merit of professional portfolio managers’ advice
before disregarding them entirely.
5.4 Portfolio Management Process
Typically, professionals use these following ways to manage investment portfolio –
1. Asset allocation
Essentially, it is the process wherein investors put money in both volatile and non-
volatile assets in such a way that helps generate substantial returns at minimum risk.
Financial experts suggest that asset allocation must be aligned as per investor’s financial
goals and risk appetite.
2. Diversification
The said method ensures that an investors’ portfolio is well-balanced and
diversified across different investment avenues. On doing so, investors can revamp their
collection significantly by achieving a perfect blend of risk and reward. This, in turn, helps
to cushion risks and generates risk-adjusted returns over time.

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3. Rebalancing
Rebalancing is considered essential for improving the profit-generating aspect of
an investment portfolio. It helps investors to rebalance the ratio of portfolio components to
yield higher returns at minimal loss. Financial experts suggest rebalancing an investment
portfolio regularly to align it with the prevailing market and requirements. Once investors
have selected a suitable strategy, they must follow a thorough process to implement the
same so that they can improve the portfolio’s profitability to a great extent.
5.5. Determinants of Portfolio Performance
Performance of the portfolio depends on certain critical decisions taken by a
portfolio manager. An evaluation of these decisions helps us to determine the activities
that need efficiency for better portfolio performance. The popular activities associated in
this regard are:
1. Investment policy
2. Stock Selection
3. Market Timing
The risk-adjusted performance measures discussed earlier primarily provide an
analysis on the overall performance of a portfolio without breaking it up into sources or
components. Eugene Fama has given a framework towards this purpose. Let us see it
now. As we know that Security Market Line (SML) is likely to provide a relationship
between the systematic risk (B) and return on an Asset, Fama used this framework to
break the actual realized return into two parts. A part of the return may be due to the size
of risk that the asset carries and the remaining due to the superior selectivity skills of the
portfolio manager. The excess returnform of SML can be used to estimate the expected
returns. If actual return is more or less than such expected returns, it can be attributed to
superior or inferior stock selection.
Then, total excess return on a portfolio (say A) = Selectivity + Risk
5.5.1 Risk Taking
To earn excess return, portfolio managers bear additional risk. By using the Capital
Market Line (CML) we can determine the return commensurate with risk as measured by
the standard deviation of return.
5.5.2 Market Timing
A portfolio manager’s performance has been seen so far in the context of stock
selection for superior performance. Managers can also generate superior performance
from a portfolio by planning the investment and disinvestment activities by shifting from
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stocks to bonds or bonds to stocks based on good market timing sense. Positioning of a
portfolio is to be adjusted by correctly adjusting the direction of the market, either in the
bull or bear phases. Managers with a forecast of a declining market can position a
portfolio either by shifting resources from stocks to bonds, or restructure the component
stocks in such a way that the beta of the equity portion of the portfolio comes down.
One way of finding the performance of a portfolio in this regard is to simply look directly
at the way the fund return behaves, relative to the return of the market.
This method calls for calculating the returns of the portfolio and the market at
different intervals and plot a scatter diagram to see the direction of relationship between
these two. If a portfolio is constructed by concentrating on stock selection rather than
keeping the market timing in mind, the average beta of the portfolio stands fairly constant
and if we plot such a portfolio’s returns and market returns, we observe a linear
relationship.
On the other hand, if a manager was able to successfully assess the market
direction and reshuffle the portfolio accordingly, we would observe a situation of high
portfolio betas at times of rise in market and low portfolio beta at times of decline in the
market. Portfolio managers can also achieve superior performance by picking up high
beta stocks during a market upswing and moving out of equity, one could calculate the
quarterly returns for a fund and for the market index like Bombay Stock Exchange’s
National Index of a 5-year period.
[Link] EVALUATION
Portfolio evaluation is the process of measuring and comparing the returns
(actually) earned on a portfolio with returns (estimates) for a benchmarks. Evaluation
factors:
1. Risk-return Trade-off
The performance evaluation should be based on risk and return not on either of
them. Risk without return and return without risk level are impossible to be interpreted.
Investors are risk-averse. But it does not mean that they are not ready to assume risk.
They are ready to take risk provided the return is commensurate. So, in the portfolio
performance evaluation, risk-return trade-off be taken care of.
2. Appropriate Market Index
The performance of one portfolio is benchmarked either against some other
portfolio (for comparative position) or against some market index.

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3. Common Investment Time Horizon

Investment period horizon of the portfolio being evaluated and the time horizon of
the benchmark must be same. Suppose, a mutual fund scheme announces that it has
earned the highest return, it must be verified before accepting whether the highest return
has been earned during current year or during last 3 years or 5 years, etc.

5.7. Measures of Portfolio Performance

There are several measures for evaluation of portfolio performance. They are
I. Return per unit of risk
The return earned over and above the risk-free return is the risk-premium and is
earned for bearing risk. The risk-premium may be divided by risk factor to find out the
reward per unit of risk undertaken. This is also known as reward to risk ratio. There are
two methods of measuring reward to risk ratio:
a) Sharpe Ratio (Reward to Variability Ratio)
The Sharpe Index measures the risk premium of the portfolio relative to the total
amount of risk in the portfolio. The larger the index value, the better the portfolio has
performed.
RP – IRF
Sharpe Ratio = ------------
σP
b) Treynor Ratio(Reward to Volatility Ratio)
The Treynor Index measures the risk premium of the portfolio related to the
amount of systematic risk present in the portfolio.
RP – IRF
Treynor Ratio = -----------
βP
II. Differential Return:
c) Jensen Ratio:
Michel Jensen has developed another method for evaluation of performance of a
portfolio. This measure is based on differential returns. The Jensen’s Ratio is based on
the difference between the actual return of a portfolio and required return of a portfolio in
view of the risk of the portfolio.

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α
Jensen’s Index = -----
β
αP = RP - RS
RP = Acutal Return on portfolio
RS = Expected Return on portfolio
RS = IRF + (RM – IRF) β

5.8. Formula Plans

Investment technique is based on a predetermined timing or asset allocation model
that eliminates emotional decisions. One type of formula investing, called dollar cost
averaging, involves putting the same amount of money into a stock or mutual fund at
regular intervals, so that more shares will be bought when the price is low and less when
the price is high.
Another formula investing method calls for shifting funds from stocks to bonds or
vice versa as the stock market reaches particular price levels. If stocks rise to a particular
point, a certain amount of the stock portfolio is sold and put in bonds. On the other hand,
if stocks fall to a particular low price, money is brought out of bonds into stocks.
Somewhat similar to the constant-dollar plan is the constant-ratio formula. It is one
of the oldest formulas in existence, having been used as long as 20 years ago. More
important, it still stands up today, and is widely used, despite the drastic changes, which
have taken place in the market. It fulfils, perhaps, better than any other formula, the basic
theoretical requirements of formula investing. It permits the investor to participate to some
extent in bull markets, while at the same time protecting him from serious price declines.
And because it is not married to a fixed-dollar amount in stocks (as in the constant-dollar
plan) or a ‘norm’ (as in the variable-ratio plans to be discussed in the next chapter), the
method has a high degree of flexibility. One reason for its durability and its effectiveness
is that no forecast whatsoever is made about the character of future markets, other than
that they will continue to fluctuate, which is hardly a hazardous assumption.
Because of the clear-cut advantages of this plan, it has been widely used by
institutions, such as trust, endowment and pension funds. Its first use, as will be seen
later, was in a college endowment fund. In past years, however, its popularity with some

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institutional investors has waned (although others are still quite satisfied), and it has been
adopted more and more by individuals.
Here is how it works: The total investment fund is divided into two equal portions,
one half to be invested in stocks, the other in bonds. As the market rises, stocks are sold
and bonds are bought to restore the 50-50 relationship. If the market goes down, the
reverse procedure is followed, bonds being sold and stocks bought to return to the 50-50
ratio.
5.9 Basic Assumptions and Ground Rules of Formula Plan
The formula plans are based on the following assumption:
 the stock prices move up and down in cycle.
 the stock prices and the high-grade bond prices move in the opposite directions.
 the investors cannot or are not inclined to forecast direction of the next fluctuations
in stock prices, which may be due to lack of skill and resources or their belief in
market efficiency or both.
The use of formula plans call for the investor to divide his investment funds into two
portfolios, one aggressive and the other conservative or defensive. The aggressive
portfolio usually consists of stocks while conservative portfolio consists of bonds. The
formula plans specify predesignated rules for the transfer of funds from that aggressive
into the conservative and vice-versa such that it automatically causes the investors to sell
stocks when their prices are rising and buy stocks when their prices are falling.
5.10 Techniques of Formula Plan
1. Constant Dollar-Value Plan
An investment strategy designed to reduce volatility in which securities, typically
mutual funds, are purchased in fixed dollar amounts at regular intervals, regardless of
what direction the market is moving. Thus, as prices of securities rise, fewer units are
bought, and as prices fall, more units are bought also called constant dollar plan, also
called dollar cost averaging.
2. Dollar Cost Averaging
Periodic investment of a fixed dollar amount, as in a particular stock or fund or in
the market as a whole, on the belief that the average value of the investment will rise over
time and that it is not possible to foresee the intermediate highs and lows.

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It is a technique of buying a fixed dollar amount of a particular investment on a

regular schedule, regardless of the share price. More shares are purchased when prices
are low, and fewer shares are bought when prices are high. Also referred to as “constant
dollar plan”.
3. Constant-Ratio Plan
This is an investment strategy in which the portfolio’s composition by asset class is
maintained at a certain level through periodic adjustments. When the balance is upset, it
is periodically restored by moving money from over-performing assets to under
performing ones. This system prevents one asset class from dominating the portfolio.
This is one way to maintain a desirable asset allocation.
4. Variable-Ratio Plan
Variable-ratio plan is a more flexible variation of constant ratio plan. Under the
variable ratio plan, it is provided that if the value of aggressive portfolio changes by
certain percentage or more, the initial ratio between the aggressive portfolio and
conservative portfolio will be allowed to change as per the pre-determined schedule.
Some variations of this plan provide for the ratios to vary according to economic or market
indices rather than the value of the aggressive portfolio.

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5.11 QUESTIONS FOR DISCUSSION

1. Explain in detail about Portfolio Performance Evaluation.
2. Describe in detail about objectives of Portfolio Management.
3. Explain in detail about stages in Portfolio Management.
4. Discuss in detail about Formula Plans.
5. Explain in detail about techniques of Performance Evaluation.

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