Course 406FM 02

M.B.
A IV Semester Course 406 FM-02
SECURITY ANALYSIS AND

INVESTMENT MANAGEMENT
LESSONS 1 TO 6
INTERNATIONAL CENTRE FOR DISTANCE EDUCATION

AND OPEN LEARNING HIMACHAL PRADESH UNIVERSITY,
GYAN PATH, SUMMERHILL, SHIMLA-171005
Contents
Sr. No. Topoc Page No.
LESSON-1 STOCK MARKET 1
LESSON-2 NEW ISSUE MARKET 15
LESSON-3 VALUATION OF SECURITIES 26
LESSON-4 FUNDAMENTAL ANALYSIS 37
LESSON-5 TECHNICAL ANALYSIS 58
LESSON-6 PORTFOLIO MANAGEMENT 80

LESSON-1
STOCK MARKET
Structure
1.0 Learning Objectives
1.1 Introduction
1.2 Financial Market
1.3 Components of Financial Market
1.4 Stock Exchange
1.5 Nature and Characteristics of Stock Exchange
1.6 Function of Stock Exchange
1.7 Advantages of Stock Exchange
1.8 Organisation of Stock Exchange in India
1.9 Operational Mechanism of Stock Exchanges
1.10 Listing of Securities
1.11 Self-check Questions
1.12 Summary
1.13 Glossary
1.14 Answers: Self-check Questions
1.15 Terminal Questions
1.16 Suggested Readings
After going through this lesson the learners should be able to:
1. Understand the financial market.
2. Discuss the components of financial market.
3. Understand the function of stock market.
4. Describe the operational mechanism of the stock exchange.
1.1 Introduction
Stock market or secondary market is a place where buyer and seller of listed securities come together.
This market is one of the important components of financial markets. In order to understand stock markets in
detail, we shall understand the structure of financial market in an economy. Sections of this unit explain
briefly the financial markets, components of financial markets, nature and functions of stock market, its
Organization and statutory regulations for listing securities on stock markets.
1.2 Financial Market
All business units have to raise short-term as well as long-term funds to meet their working and fixed
capital requirements from time to time. This necessitates a mechanism with the help of which the fund
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providers (investors/ lenders) can interact with the borrowers/ users (business units) and transfer the funds to
them as and when required. This aspect is taken care of by the financial markets which provide a place
where or a system through which, the transfer of funds by investors/lenders to the business units is
adequately facilitated.
1.3 Components of Financial Markets
Financial markets can broadly be divided into 2 types i.e. capital (long term funds) and money market
(short term funds).
Money market is the financial market for short term funds which is further divided into sub markets.
These are call money market, treasury bills, commercial bills, acceptance houses, commercial paper market
and more.
Capital market on the other hand, is a market dealing in medium and long-term funds. It is an
institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing
and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions,
borrowings from foreign markets and raising of capital by issue various securities such as shares debentures,
bonds, etc.
The capital market has two interdependent and inseparable segments, the primary market and stock
(secondary market).
Primary Market
The primary market provides the channel for sale of new securities. The issuer of Securities sells the
securities in the primary market to raise funds for investment and/ or to discharge. In other words, the market
wherein resources are mobilized by companies through issue of new securities is called the primary market.
These resources are required for new projects as well as for existing projects with a view to expansion,
modernization, diversification and upgradation.
This market id explained in detail in the next unit.
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Secondary (Stock) market
Secondary market refers to a market where securities are traded after being initially offered to the
public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the
secondary market. Secondary market comprises of equity markets and the debt markets.
This market lays an equally important role in mobilizing long-term funds by providing the necessary
liquidity to holdings in shares and debentures. It is an organized market where shares and debentures are
traded regularly with high degree of transparency and security. In fact, an active secondary market facilitates
the growth of primary market as the investors in the primary market are assured of a continuous market for
liquidity of their holdings.
1.4 Stock Exchange
Stock exchange is the term commonly used for a secondary market, which provide a place where
different types of existing securities such as shares, debentures and bonds, government securities can be
bought and sold on a regular basis. A stock exchange is generally organized as an association, a society or a
company with a limited number of members. It is open only to these members who act as brokers for the
buyers and sellers.
The Securities Contract (Regulation) Act has defined stock exchange as an “association, organization or
body of individuals, whether incorporated or not, established for the purpose of assisting, regulating
and controlling business of buying, selling and dealing in securities
1.5 Nature and Characteristics of Stock Exchange:
The stock exchange is an organized market for the purchase and sale of listed securities. They
facilitate, regulate and control the trade in securities. The following are the features of stock markets:
1. Association: Stock market is an association of persons that may be incorporated or not.
2. Mechanism: It provides a place or mechanism through which industrial and government securities
may be bought and sold.
3. Organized market: It is an organized market for securities. It allows trading in securities subject to
certain regulations.
4. Market for old securities: It provides the ready market for old securities that have been already
issued by the companies to public. It does not deal in the fresh shares, debentures and bonds to be
issued by the companies or government agencies to the public. In stock market transactions in old
securities of companies are carried on without the involvement of companies
5. Deals with listed securities: It offers trading facilities only for those securities that are listed by
the companies or issuing agencies with the exchange. It a company has not complied with the
listing procedure of a stock market then its securities are not allowed to be traded on such stock
market.
6. Only the members allowed dealing: These stock markets allow only their members to transact
the business in the market. Outsiders or nonmembers cannot purchase or sale the securities on
these stock exchanges. Membership of a 2 particular stock exchange (say Bombay stock Exchange
or National stock Exchange or Bangalore Stock Exchange) is acquired by individuals and firms
only on payment of the membership fees prescribed by that stock exchange.
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7. Ensures free transferability of securities and securities evaluation: Stock exchange provides a
mechanism for free transfer of industrial securities and also makes continuous evaluation of securities
traded in the market.
1.6 Functions of a Stock Exchange
The functions of stock exchange can be as follow
1. Provides ready and continuous market: By providing a place where listed securities can be
bought and sold regularly and conveniently, a stock exchange ensures a ready and continuous
market for various shares, debentures, bonds and government securities. This lends a high degree
of liquidity to holdings in these securities as the investor can en-cash their holdings as and when
they want.
2. Provides information about prices and sales: A stock exchange maintains complete record of
all transactions taking place in different securities every day and supplies regular information on
their prices and sales volumes to press and other media. This enables the investors in taking quick
decisions on purchase and sale of securities in which they are interested. Not only that, such
information helps them in ascertaining the trend in prices and the worth of their holdings. This
enables them to seek bank loans, if required.
3. Provides safety to dealings and investment: Transactions on the stock exchange are conducted
only amongst its members with adequate transparency and in strict conformity to its rules and
regulations which include the procedure and timings of delivery and payment to be followed. This
provides a high degree of safety to dealings at the stock exchange. There is little risk of loss on
account of non-payment or non delivery. Securities and Exchange Board of India (SEBI) also
regulates the business in stock exchanges in India and the working of the stock brokers.
4. Evaluation of securities: It the stock exchange, the prices of securities clearly indicate the
performance of the companies. It integrates the demand and supply of securities in an effective
manner. It also clearly indicates the stability of companies. Thus, investors are in a better position
to take stock of the position and invest according to their requirements.
5. Mobilizes savings: The savings of the public are mobilized through mutual funds, investments
trusts and by various other securities. Even those who cannot afford to invest in huge amount of
securities are provided opportunities by mutual funds and investment trusts.
6. Healthy speculation: The stock exchange encourages healthy speculation and provides
opportunities to shrewd businessmen to speculate and reap rich profits from fluctuations in security
prices. The price of security is based on supply and demand position. It creates a healthy trend in
the market. Any artificial scarcity is prevented due to the rules and regulations of the market..
7 Mobility of funds: The stock exchange enables both the investors and the companies to sell or
buy securities and thereby enable the availability of funds. By this, the money market also is
strengthened as even short-term funds are available. The banks also provide funds for dealing in
the stock exchanges.
8. Stock exchange helps Capital formation: Stock exchange plays an active role in the capital
formation in the country. Companies are able to raise funds either by issuing more shares through
rights shares or bonus shares. But when a company wants to go in for diversification, they can
issue the shares and raise more funds. Thus, they are able to generate more capital and this
promotes economic growth in the country.
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9. Liquidity in Stock Exchange: Institutions like banks can invest their idle funds in the stock
exchange and earn profit even within a short period. When necessity arises, these securities can
be immediately sold for raising funds. Thus, it is the stock exchange which provides opportunities
for converting securities into cash within a short notice.
10. Economic barometer: The most important function of a stock exchange is that it acts as an
economic indicator of conditions prevailing in the country. A politically and economically strong
government will have an upward trend in the stock market, whereas an unstable government with
heavy borrowings from other countries will have a downward trend in the stock market. So, every
government will adopt policies in such a manner that the stock exchange remains dynamic.
11. Control on companies: One of the major function of stock exchange is that it has control on
companies. The companies listing their securities in the stock exchange have to submit their annual
report and audited balance sheet to the stock exchange. Thus, only genuine companies can function
and have the shares transacted. If not, such companies will be black listed and they will find it
difficult to raise their capital.
12. Attracts foreign capital: Due to its dynamism and higher return on capital, the stock exchange is
capable of attracting more foreign funds. Due to this, the exchange rate of the currency will
improve when there is more trade undertaken by the government.
13. Monetary and fiscal policies: The monetary policy and the fiscal policy of the government have
to be favorable to businessmen and producers. If they are not so, then through the stock exchange
the government may indicate and accordingly suitable steps can be taken.
14. Proper Canalization of Capital: Stock exchange directs the flow of savings into the most
productive and profitable channels.
15. Regulation of Company management: The companies, which want to get their securities listed
in the stock exchange, should have to follow certain rules and fulfill certain conditions. Thus stock
exchanges safeguard the interest of the investing public and also regulate company management.
16. Barometer of Business Progress: Stock exchanges function as a barometer of the business
conditions in the country. Booms and depressions are reflected by the index of prices of various
securities maintained by the stock exchange. By analyzing the ups and downs of the market
quotations, the causes for the changes in the business climate can be ascertained.
1.7 Advantages of Stock Exchanges
The existence of stock exchange is of a vital importance to (a) Companies, (b) Investors and (c) the
Society as a whole. The various advantages can be enlisted as
(a) To the Companies
i. The companies whose securities have been listed on a stock exchange enjoy a better goodwill and
credit-standing than other companies because they are supposed to be financially sound.
ii. The market for their securities is enlarged as the investors all over the world become aware of such
securities and have an opportunity to invest.
iii. As a result of enhanced goodwill and higher demand, the value of their securities increases and their
bargaining power in collective ventures, mergers, etc. is enhanced.
iv. The companies have the convenience to decide upon the size, price and timing of the issue.
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(b) To the Investors:
i. The investors enjoy the ready availability of facility and convenience of buying and selling the securities
at will and at an opportune time.
ii. Because of the assured safety in dealings at the stock exchange the investors are free from any
anxiety about the delivery and payment problems.
iii. Availability of regular information on prices of securities traded at the stock exchanges helps them in
deciding on the timing of their purchase and sale.
iv. It becomes easier for them to raise loans from banks against their holdings in securities traded at the
stock exchange because banks prefer them as collateral on account of their liquidity and convenient
valuation.
(c) To the Society
i. The availability of lucrative avenues of investment and the liquidity thereof induces people to save
and invest in long-term securities. This leads to increased capital formation in the country.
ii. The facility for convenient purchase and sale of securities at the stock exchange provides support to
new issue market. This helps in promotion and expansion of industrial activity, which in turn contributes,
to increase in the rate of industrial growth.
iii. The Stock exchanges facilitate realization of financial resources to more profitable and growing
industrial units where investors can easily increase their investment substantially.
iv. The volume of activity at the stock exchanges and the movement of share prices reflect the changing
economic health.
v. Since government securities are also traded at the stock exchanges, the government borrowing is
highly facilitated. The bonds issued by governments, electricity boards; municipal corporations and
public sector undertakings (PSUs) are found to be on offer quite frequently and are generally successful.
1.8 Organization of Stock Exchange in India
The stock exchanges are the exclusive centers
for trading of securities. At present, there are 21 operative
stock exchanges in India. Most of the stock exchanges
in the country are incorporated as ‘Association of
Persons’ of Section 25 companies under the Companies
Act. These are organized as ‘mutual’ and are considered
beneficial in terms of tax benefits and matters of
compliance.
Organizational structure of stock exchanges can be
studied as under
Figure: Structure of Stock exchange

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SEBI (Securities Exchange Board of India) is the regulatory body regulating the functioning of
whole capital market. Its functions and role have been explained in the ext unit.
National Stock Exchanges
Stock exchanges require to get themselves recognized by the SEBI in order to list securities. In India,
there are currently 2 national Stock exchanges
 NSE
 BSE
BSE (Bombay Stock Exchange)
Established in 1875, BSE (formerly known as Bombay Stock Exchange Ltd.) has more than 5500
companies listed and thus making it world’s No. 1 exchange in terms of listed companies. BSE provides an
efficient and transparent market for trading in equity, debt instruments, derivatives, mutual funds. It also has
a platform for trading in equities of small-and-medium enterprises (SME).
It is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was established in
1878.
It is a voluntary non-profit making Association of Persons (AOP) and has converted itself into
demutualised and corporate entity. It has evolved over the years into its present status as the Premier
Stock Exchange in the country’. It is the first Stock Exchange in the Country to have obtained permanent
recognition in 1956 from the Govt. of India under the Securities Contracts (Regulation) Act, 1956.
A Governing Board having 20 directors is the apex body, which decides the policies and regulates
the affairs of the Exchange. The Governing Board consists of 9 elected directors, who are from the broking
community (one third of them retire every year by rotation), three SEBI nominees, six public representatives
and an Executive Director & Chief Executive Officer and a Chief Operating Officer.
NSE (National Stock Exchange)
The National Stock Exchange (NSE) is India’s leading stock exchange covering 364 cities and towns
across the country. NSE was set up by leading institutions to provide a modern, fully automated screen-
based trading system with national reach.
The Exchange has brought about unparalleled transparency, speed & efficiency, safety and market integrity.
It has set up facilities that serve as a model for the securities industry in terms of systems, practices and
procedures.
NSE has played a catalytic role in reforming the Indian securities market in terms of
microstructure, market practices and trading volumes. The market today uses state-of-art information
technology to provide an efficient and transparent trading, clearing and settlement mechanism, and has
witnessed several innovations in products & services viz. demutualization of stock exchange governance,
screen based trading, compression of settlement cycles, dematerialization and electronic transfer of securities,
securities lending and 19 borrowing, professionalization of trading members, fine-tuned risk management
systems, emergence of clearing corporations to assume counterparty risks, market of debt and derivative
instruments and intensive use of information technology.
NSE’s mission is setting the agenda for change in the securities markets in India. The NSE was set-
up with the following objectives:
 establishing a nation-wide trading facility for equities, debt
 instruments and hybrids, ensuring equal access to investors all over the country through an
 appropriate communication network, providing a fair, efficient and transparent securities market to
investors
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 using electronic trading systems, enabling shorter settlement cycles and book entry settlements systems,
 and meeting the current international standards of securities markets.
Regional Stock Exchanges
There are many regional stock exchanges in India which have been given recognized by SEBI. It is
a place outside of a country’s financial sector where equity is publicly held. Companies that cannot meet the
strict listing requirements of national exchanges may qualify to trade on regional exchanges.
Recognized stock exchanges in India are given below in the table:
1. U.P. Stock Exchange Ltd.
2. Jaipur Stock Exchange Ltd.
3. Madras Stock Exchange Ltd.
4. Cochin Stock Exchange Ltd.
5. Bangalore Stock Exchange Ltd.
6. National Stock Exchange of India Ltd.
7. The Guwahati Stock Exchange Limited
8. The Ludhiana Stock Exchange Ltd.
9. The Calcutta Stock Exchange Ltd.
10. Bhubaneshwar Stock Exchange Ltd.
11. The Delhi Stock Exchange Ltd.
12. Vadodara Stock Exchange Ltd.
13. Ahmedabad Stock Exchange Ltd.
14. Madhya Pradesh Stock Exchange Ltd.
15. Pune Stock Exchange Ltd.
16. Bombay Stock Exchange Ltd.
17. Inter connected Stock Exchange of India Ltd.
18. MCX Stock Exchange Ltd
19. United Stock Exchange of India Limited (USE)
20. Coimbatore Stock Exchange Due to pending litigation before the Hon’ble
Madras High Court, Coimbatore Stock
Exchange Ltd. (CSX) has not filed
application for renewal of recognition which
expired on 17.09.06. However, in terms of
order dated 15.09.06 of the Hon’ble Court,
the right of CSX to apply for renewal shall
be subject to further orders of the court and
the stock exchange shall not be entitled to
oppose the renewal solely on the ground of
lapse of time.
Source: SEBI website
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1.9 Operational Mechanism of Stock Exchanges
The leading stock exchanges in India have developed itself to a large extent since its emergence.
These stock exchanges aim at offering the investors and traders better transparency, genuine settlement
cycle, honest transaction and to reduce and solve investor grievances if any.
1. Market Timings: Trading on the equities segment takes place on all days of the week (except
Saturdays and Sundays and holidays declared by the Exchange in advance). The market timings of
the equities segment are:
a) Normal Market Open: 09:55 hours
b) Normal Market Close: 15:30 hours
c) The Post Closing Session is held between 15.50 to 16.00 hours.
2. Automated Trading System’. Today our country has an advanced trading system which is a fully
automated screen based trading system. This system adopts the principle of an order driven market
as opposed to a quote driven system.
a. NSE operates on the ‘National Exchange for Automated Trading’ (NEAT) system.
b. BSE operates on the BSE”s Online Trading” (BOLT) system.
3. Order Management in Automated Trading System: The trading system provides complete flexibility
to members in the kinds of orders that can be placed by them. Orders are first numbered and time-
stamped on receipt and then immediately processed for potential match.
Every order has a distinctive order number and a unique time stamp on it. If a match is not found,
then the orders are stored in different ‘books’.
4. Order Matching Rules in Automated trading system: The best buy order is matched with the
best sell order. An order may match partially with another order resulting in multiple trades. For order
matching, the best buy order is the one with the highest price and the best sell order is the one with
the lowest price.
Members can proactively enter orders in the system, which will be displayed in the system till the full
quantity is matched by one or more of counter-orders and result into trade(s) or is cancelled by the
member. Alternatively, members may be reactive and put in orders that match with existing orders in
the system.
Orders lying unmatched in the system are ‘passive’ orders and orders that come in to match the
existing orders are called ‘active’ orders. Orders are always matched at the passive order price.
5. Order Conditions in Automated Trading System: A Trading Member can enter various types of
orders depending upon his/her requirements.
6. Market Segments The Exchange operates the following sub-segments in the Equities segment:
a) Rolling Settlement: In a rolling settlement, each trading day is considered as a trading period and
trades executed during the day are settled based on the net obligations for the day. At NSE, trades in
rolling settlement are settled on a T+2 basis i.e. on the 2nd working day. For arriving at the settlement
day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are
excluded. Typically trades taking place on Monday are settled on Wednesday, Tuesday’s trades
settled on Thursday and so on.
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b) Limited Physical Market: Pursuant to the directive of SEBI to provide an exit route for small investors
holding physical shares in securities mandated for compulsory dematerialized settlement, the Exchange
has provided a facility for such trading in physical shares not exceeding 500 shares. This market
segment is referred to as ‘Limited Physical Market’ (small window). The Limited Physical Market
was introduced on June 7, 1999.
c) Institutional Segment: The Reserve Bank of India had vide a press release on October 21, 1999,
clarified that inter-foreign-institutional investor (inter-FII) transactions do not require prior approval
or post facto confirmation of the Reserve Bank of India, since such transactions do not affect the
percentage of overall FII holdings in Indian companies.
7. Brokerage and Other Transaction Costs: Brokerage is negotiable. The Exchange has not prescribed
any minimum brokerage. The maximum brokerage is subject to a ceiling of 2.5 percent of the contract
value. However, the average brokerage charged by the members to the clients is much lower.
Typically there are different scales of brokerages for delivery transaction, trading transaction, etc.
8 Transfer of Ownership: Transfer of ownership of securities, if the same is not delivered in demit
form by the seller, is effected through a date stamped transfer-deed which is signed by the buyer and
seller. The duly executed transfer-deed along with the share 33 certificate has to be lodged with the
company for change in the ownership.
9. Listing of Securities: Listing means admission of the securities to dealings on a recognized stock
exchange. The securities may be of any public limited company, Central or State Government, quasi
governmental and other financial institutions/corporations, municipalities, etc.
The Exchange has a separate Listing Department to grant approval for listing of securities of companies
in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956, Securities
Contracts (Regulation) Rules, 1957, Companies Act, 1956, Guidelines issued by SEBI and Rules,
Bye-laws and Regulations of the Exchange.
1.10 Listing of Securities
Listing of securities means admitting the securities’ trading on a recognized stock exchange.
Purchase and sale of a security cannot be conducted on a stock exchange unless it is officially listed in that
stock exchange. Trading in a particular security takes place on a stock exchange only after the company
issuing that security accomplishes the listing procedure.
Listing is compulsory for the company that offers its shares and debentures to the public for subscription
by issue of prospectus. Once the securities of a company are listed on recognized stock exchanges it has to
follow the rules and regulations of the stock 4 exchanges. It has to maintain necessary books; documents etc.
and disclose any information which the stock exchanges call for.
Advantages of Listing: Listing of securities result in the following advantages:
1. Facilities marketing of securities: If a company does the listing of its shares on recognized stock
exchanges its shareholders will be able to release their investment in the shares at market price
whenever they want by selling these shares on stock exchanges. Similarly an investor who wants to
purchase the shares of that company may buy those shares at market price in that stock exchange.
Thus constant marketing facilities are availed to the securities that are listed on stock exchange.
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2. Assures finance to the companies: Whenever a company offers its shares to the public it receives
proper response from the investors only if such shares are listed on recognized stock exchanges.
Because listing enables the investor to release his money in the shares by selling those on stock
exchanges. Thus listing enables the companies to raise the necessary finance by the issue of its
securities to the public.
3. Ensures liquidity: The prices of listed securities are quoted daily in the share markets. Hence the
listed securities can be readily converted into cash at the quoted price. Thus listing ensures liquidity
of securities.
4. Enables the investors to borrow the funds: Banks and other financial institutions accepted the
listed securities as collateral securities against their loans and advances because these listed securities
have a ready market. Thus the people holding the listed securities can raise loan against such securities
without any difficulty.
5. Protection to investors: The companies that have listed their securities on stock Exchange Board of
India (SEBI). They have to maintain transparency in their working and have to disclose their financial
information and policies. All these rules regulations and transparency aim at protection of interest of
small investors who should not be deceived or put to loss.
6. Offers wide publicity: Names of companies whose securities are listed on stock exchanges are
mentioned regularly in stock market reports, T.V., News papers, Radios etc. Thus listed securities
offer wide advertising and publicity to the companies concerned.
Listing Requirements
For a security of a firm to be listed under stock exchange adherence to certain guidelines and also
submission of certain defined forms is required.
Listing in NSE
Listing of securities of an existing company
1. Paid up Capital & Market Capitalization
 The paid-up equity capital of the applicant shall not be less than 10 crores and the market capitalization
of the applicant’s equity shall not be less than 25crore.
 The paid-up equity capital of the applicant shall not be less than Rs.25crores.
 The applicant Company shall have a net worth of not less than Rs.50crores in each of the three
preceding financial years. The Company shall submit a certificate from the statutory auditors in
respect of net worth.
2. Conditions Precedent to Listing:
 The applicant shall have adhered to conditions precedent to listing as emerging from inter-alia, Securities
Contracts (Regulations) Act 1956, Companies Act 1956, Securities and Exchange Board of India
Act 1992, any rules and/or regulations framed under foregoing statutes, as also any circular, clarifications,
guidelines issued by the appropriate authority under foregoing statutes.
 The applicant should have been listed on any other recognized Stock Exchange Listed for at least last
three years or listed on the exchange having nationwide trading terminals for at least one year.
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 The applicant has paid dividend in at least 2 out of the last 3 financial years immediately preceding
the year in which listing application has been made OR The applicant has distributable profits (as
defined under section 205 of the Companies Act, 1956) in at least two out of the last three financial
years (an auditors certificate must be provided in this regard) or The net worth of the applicant is at
least 50crores.
3. The applicant desirous of listing its securities should also satisfy the Exchange on the following:
 No Disciplinary action has been taken by other stock exchanges and regulatory authorities in the past
three years
 Distribution of shareholding: The applicant company/promoting company shareholding pattern on
March 31 of preceding three years separately showing promoters and other groups’ shareholding
pattern should be as per the regulatory requirements.
 Details of Litigation: The applicant, promoters/promoting company, group companies, companies
promoted by the promoters/promoting company litigation record, the nature of litigation, status of
litigation during the preceding three years need to be clarified to the exchange.
 Track Record of Director(s) of the Company: In respect of the track record of the directors, relevant
disclosures may be insisted upon in the offer document regarding the status of criminal cases filed or
nature of the investigation being undertaken with regard to alleged! commission of any offence by
any of its directors and its effect on the business of the company, where all or any of the directors of
issuer have or has been charge-sheeted with serious crimes.
 Change in Control of a Company/Utilization of funds raised from public: In the event of new promoters
taking over listed companies which results in change in management and/or companies utilizing the
funds raised through public issue for the purposes other than those mentioned in the offer document,
such companies shall make additional disclosures (as required by the Exchange) with regard to
change in control of a company and utilization of funds raised from public.
Listing in BS
1. Minimum Listing Requirements for New Companies The following eligibility criteria have
been prescribed for listing of companies on BSE, through Initial Public Offerings (IPOs) & Follow-
on Public Offerings (FPOs):
 The minimum post-issue paid-up capital of the applicant company shall be Rs. 10 crore for IPOs &
Rs.3 crore for FPOs; and
 The minimum issue size shall be Rs. 10 crore; and
 The minimum market capitalization of the Company shall be Rs. 25 crore (market capitalization shall
be calculated by multiplying the post-issue paid-up number of equity shares with the issue price).
The Issuer shall comply with the guidance/ regulations applicable to listing as bidding inter alia from
 Securities Contracts (Regulations) Act 1956
 Securities Contracts (Regulation) Rules 1957
 Securities and Exchange Board of India Act 1992
 And any other circular, clarifications, guidelines issued by the appropriate authority.
 Companies Act 1956
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2. Minimum Requirements for Companies Delisted by BSE seeking Relisting on BSE
Companies delisted by BSE and seeking relisting at BSE are required to make a fresh public offer
and comply with the existing guidelines of SEBI and BSE regarding initial public offerings.
3. Permission to Use the Name of BSE in an Issuer Company’s Prospectus Companies desiring
to list their securities offered through a public issue are required to obtain prior permission of BSE
to use the name of BSE in their prospectus or offer for sale documents before tiling the same with
the concerned office of the Registrar of Companies.
BSE has a Listing Committee, comprising of market experts, which decides upon the matter of
granting permission to companies to use the name of BSE in their prospectus/offer documents.
This Committee evaluates the promoters, company, project, financials, risk factors and several
other aspects before taking a decision in this regard.
Decision with regard to some types/sizes of companies has been delegated to the Internal Committee
of BSE.
4. Submission of Letter of Application As per Section 73 of the Companies Act, 1956, a company
seeking listing of its securities on BSE is required to submit a Letter of Application to all the stock
exchanges where it proposes to have its securities listed before filing the prospectus with the
Registrar of Companies.
5. Allotment of Securities As per the Listing Agreement, a company is required to complete the
allotment of securities offered to the public within 30 days of the date of closure of the subscription
list and approach the Designated Stock Exchange for approval of the basis of allotment.
In case of Book Building issues, allotment shall be made not later than 15 days from the closure of
the issue, failing which interest at the rate of 15% shall be paid to the investors.
6. Trading Permission as per SEBI Guidelines an issuer company should complete the formalities
for trading at all the stock exchanges where the securities are to be listed within 7 working days of
finalization of the basis of allotment.
A company should scrupulously adhere to the time limit specified in SEBI (Disclosure and Investor
Protection) Guidelines 2000 for allotment of all securities and dispatch of allotment letters/share
certificates/credit in depository accounts and refund orders and for obtaining the listing permissions
of all the exchanges whose names are stated in its prospectus or offer document.
7. Requirement of 1% Security Companies making public/rights issues are required to deposit 1%
of the issue amount with the Designated Stock Exchange before the issue opens. This amount is
liable to be forfeited in the event of the company not resolving the complaints of investors regarding
delay in sending refund orders/share certificates, non-payment of commission to underwriters,
brokers, etc.
8. Payment of Listing Fees All companies listed on BSE are required to pay to BSE the Annual
Listing Fees by 30th April of every financial year as per the Schedule of Listing Fees prescribed
from time to time.
1. What is a financial market? Explain its components.
2. Define the term stock exchange.
3. How many stock exchanges are working in India?
13
1.12 Summary
All business units have to raise short-term as well as long term funds to meet their working and fixed
capital requirement from time to time. This necessitates a mechanism with the help of which the fund
providers can interact with the borrowers and transfer the funds to them when required. This aspect is taken
care of by the financial market, which provides a place through which; the transfer of funds by investors/
lenders to the business units is adequately facilitated. A financial market is a combination of capital market
and money market. Money market is the financial market for short term funds which is further divided into
sub markets. Capital market on the other hand, is a market dealing with medium and long term funds.Another
market existing in the financial structure of an economy is the forex market. This market enables the exchange
of foreign currency
113 Glossary
Financial market: An organized institutional structure or mechanism for creating and
exchanging financial assets.
Primary market: Primary market is a market where a newly issued security is first offered.
Secondary market:Secondary market is the market where previously issued securities, such as
stocks and bonds, are traded among investors.
Listing of securities: Listing of securities means admitting the securities trading on a recognized
stock exchange.
1. Seesection no. 1.2 and 1.3, lesson-1
2. Seesection no. 1.4, lesson-1
3. Seesection no. 1.8, lesson-1
1. What are the differences between primary and secondary market?
2. Define stock exchange. What are the major functions of the stock exchange?
3. Discuss the operational mechanism of stock exchange in India.
4. Discuss the structure of financial markets.
1. Benjamin Graham and David L. Dodd. (2008). Security Analysis. McGraw-Hill Education; 6th
edition.
2. S. Kevin (2006). Security Analysis and Portfolio Management. Prentice Hall India Learning
Private Limited.
3. Rohini Singh (2009). Security Analysis and Portfolio Management. Excel Book A-45 Naraina,
phase 1, New Delhi.
4. Shashi K. Gupta & Rosy Joshi (2014). Security Analysis and Portfolio Management Kalyani
Publishers.
*****
14
LESSON-2
NEW ISSUE MARKET
Structure
2.1 Introduction
2.2 Features of New Issue Market
2.3 Functions of New Issue Market
2.4 Methods of Floating Issue in Primary Market
2.5 Pricing of Issue
2.6 Parties Involved in New Issue Market
2.7 Securities Exchange Board in India
2.8 Underwriting of Securities
2.10 Summary
2.11 Glossary
After going through this lesson the learners should be able to:
1. Differentiate between New Issue Market and Secondary market
2. Learn about participants in New Issue Market
3. Describe methods to issue shares in new issue market;
2.1 Introduction:
Primary Market is also known as the new issue market. It is the market for issuing new securities.
In the primary market the securities are purchased directly from the issuer, which is not in the case of the
secondary market.
The primary market is a market for new capital that will be traded over a longer period. A company’s
new offering is placed on the primary market through an initial public offer. When shares are bought in an
IPO it is termed as primary market. The primary market does not involve the stock exchanges.
Stocks available for the first time are offered through new issue market. The issuer may be a new
company or an existing company. After trading in the primary market the securities will entered in the
secondary market.
15
2.2 Features of a New Issue Market
1. One of the reasons it is names as New Issue market is that it is a market where the securities are
sold for the first time.
2. This is the market for new long term capital.
3. In a primary issue, the securities are issued by the company directly to investors.
4. The company receives the money and issue new security certificates to the investors.
5. Primary issues are used by companies for the purpose of setting up new business or for expanding
or modernizing the existing business.
6. The primary market performs the crucial function of facilitating capital formation in the economy.
7. The new issue market does not include certain other sources of new long term external finance, such
as loans from financial institutions. Borrowers in the new issue market may be raising capital for
converting private capital into public capital; this is known as ‘going public’.
2.3 Functions of New Issue Market
There are three major functions performed by new issue market.
Origination / Transfer
In primary market, origination means to investigate, evaluate and procedure new project proposals. It
initiates before an issue is present in the market. It is done with the help of merchant bankers. The merchant
bankers can be banks, financial institutions, private investment firms, etc. In primary market, the preliminary
investigation involves a detailed study of economic, financial, legal, technical aspects to ensure the soundness
of the project.
16
The second function is performed by sponsoring institutions. They provide advisory service.
Advisory service includes:
 Types of issue
 Pricing
 Methods of issue, etc.
Underwriting / Guarantee
In primary market, to ensure success of new issue, there is a need for underwriting firms. The
company needs to appoint underwriters. They can be banks or financial institutions or specialized underwriting
firms.
In primary market, underwriting can be done by a single underwriter or by a group of underwriters. Minimum
subscription is guaranteed by underwriters. If the issue is completely subscribed, no liability would be left for
the underwriters. If by chance any part of the issue remains unsold, afterwards the underwriter has no option,
rather than buying all the unsubscribed shares.
Distribution
In primary market, the success of any grand new issue is hinges on the issue is being subscribed by
the people. The sale of the securities to the supreme or highest investors is termed as distribution.
Distribution Job is given to brokers and dealers. The brokers or agents maintain direct contact with the
supreme investors.
2.4 Methods of floating issue in Primary Market
There are various methods through which a company can enter the new issue market. These are:
New Issue
Market
Public Right Private Book Bonus

Issue Issue Placement Building Issue
IPO
FPO
17
2.5 Public issue
When an issue/offer of shares or convertible securities is made to new investors for becoming part
of shareholders’ family of the issuer it is called a public issue.
Public issue can be further classified into Initial public offer (IPO) and Further public offer (FPO).
(i) Initial public offer (IPO): When an unlisted company makes either a fresh issue of shares or
convertible securities or offers its existing shares or convertible securities for sale or both for the
first time to the public, it is called an IPO. This paves way for listing and trading of the issuer’s
shares or convertible securities on the Stock Exchanges.
(ii) Further public offer (FPO) or Follow on offer: When an already listed company makes either
a fresh issue of shares or convertible securities to the public or an offer for sale to the public, it is
called a FPO
Rights issue (RI):
When an issue of shares or convertible securities is made by an issuer to its existing shareholders
as on a particular date fixed by the issuer (i.e. record date), it is called a rights issue. The rights are offered
in a particular ratio to the number of shares or convertible securities held as on the record date.
Composite issue
When the issue of shares or convertible securities by a listed issuer on public cum-rights basis,
wherein the allotment in both public issue and rights issue is proposed to be made simultaneously, it is
called composite issue.
Bonus issue
When an issuer makes an issue of shares to its existing shareholders without any consideration
based on the number of shares already held by them as on a record date it is called a bonus issue. The
shares are issued out of the Company’s free reserve or share premium account in a particular ratio to the
number of securities held on a record date.
Private placement
When an issuer makes an issue of shares or convertible securities to a select group of persons not
exceeding 49, and which is neither a rights issue nor a public issue, it is called a private placement.
In this method the issue is placed with a small number of financial institutions, corporate bodies and
high net worth individuals.
The financial intermediaries purchase the shares and sell them to investors at a later date at a suitable price.
2.6 Pricing of Issue
Pricing of the public issue has to be carried out according to the guidelines issued by SEBI. Two
major approaches are:
18
Fixed Price
In this approach prices are fixed by the company itself
• At Premium:
Companies are permitted to price their issues at premium in the case of the following:
 First issue of new companies set up by existing companies with the track record.
 First issue of existing private/closely held or other existing unlisted companies with three-year track
record of consistent profitability,
 First public issue by exiting private/closely held or other existing unlisted companies without three-
year track record but promoted by existing companies with a five year track record of consistent
profitability,
 Existing private/closely held or other existing unlisted company with three-year track record of
consistent profitability, seeking disinvestments by offers to public without issuing fresh capital
(disinvestments),
 Public issue by existing listed companies with the last three years of dividend paying track record
• At Par Value
In certain cases companies are not permitted to fix their issue prices at premium. The prices of the share
should be at par. They are for:
 First public issue by existing private, closely held or other existing unlisted companies without three-
year track record of consistent profitability and
19
 Existing private/closely held and other unlisted companies without three- year track record of consistent
profitability seeking disinvestments offer to public without issuing fresh capital (disinvestments).
Book Building
Book Building may be defined as a process used by companies raising capital through Public Offerings-
both Initial Public Offers (IPOs) and Follow-on Public Offers (FPOs) to aid price and demand discovery.
It is a mechanism where, during the period for which the book for the offer is open, the bids are
collected from investors at various prices, which are within the price band specified by the issuer.
The process is directed towards both the institutional investors as well as the retail investors. The
issue price is determined after the bid closure based on the demand generated in the process
Parties Involved in the New Issue market
In the sixties and seventies, public issue was managed by the company and it’s personal. But, at
present public issue involves a number of agencies also the intermediaries. The rules and regulations, the
changing scenario of the capital market necessitated the company to seek for the support of many agencies
to make the public issue a success. The main parties involved in the NIS are
 Managers to the issue
 registrars to the issue
 underwriters o bankers
 advertising agencies
 financial institutions and
 Government /statutory agencies.
Managers to the Issue
Lead managers are appointed by the company to manage the public issue programs. Their main
duties are
(a) Drafting of prospectus
(b) Preparing the budget of expenses related to the issue
(c) Suggesting the appropriate timings of the public issue
(d) Assisting in marketing the public issue successfully
(e) Advising the company in the appointment of registrars to the issue, underwriters, brokers, bankers
to the issue, advertising agents etc.
(f) Directing the various agencies involved in the public issue.
Many agencies are performing the role of lead managers to the issue. The merchant banking division
of the financial institutions, subsidiary of commercial banks, foreign banks, private sector banks and private
agencies are available to act as lead managers. Some of them are SBI Capital Markets Ltd., Bank of Baroda,
Canara Bank, DSP Financial Consultant Ltd. ICICI Securities & Finance Company Ltd., etc. The company
negotiates with prospective mangers to its issue and settles its selection and terms of appointment. Usually
companies appoint lead managers with a successful background...
20
Registrar to the Issue
After the appointment of the lead managers to the issue, in consultation with them, the Registrar to
the issue is appointed. Quotations containing the details of the various functions they would be performing
and charges for them are called for selection.
Among them the most suitable one is selected. It is always ensured that the registrar to the issue has
the necessary infrastructure like computer, Internet and telephone.
The Registrars normally receive the share application from various collection centers.
They recommend the basis of allotment in consultation with the Regional Stock Exchange for approval.
They arrange for the dispatching of the share certificates.
They hand over the details of the share allocation and other related registrars to the company.
Usually registrars to the issue retain the issuer records at least for a period of six months from the
last date of dispatch of letters of allotment to enable the investors to approach the registrars for redressed of
their complaints.
Underwriters
Underwriting is a contract by means of which a person gives an assurance to the issuer to the effect
that the former would subscribe to the securities offered in the event of non subscription by the person to
whom they were offered. The person who assures is called an underwriter. The underwriters do not buy and
sell securities. They stand as back-up supporters and underwriting is done for a commission. Underwriting
provides an insurance against the possibility of inadequate subscription. Underwriters are divided into two
categories
(i) Financial institutions and banks
(ii) Brokers and approved investment companies.
Some of the underwriters are financial institutions, commercial banks, merchant bankers, members
of the stock exchange, Export and Import Bank of India etc.
Bankers to the Issue
Bankers to the issue have the responsibility of collecting the application money along with the application
form. The bankers to the issue generally charge commission besides the brokerage, if any. Depending upon
the size of the public issue more than one banker to the issue is appointed. When the size of the issue is large,
3 to 4 banks are appointed as bankers to the issue.
The advertising agencies
Take the responsibility of giving publicity to the issue on the suitable media. The media may be
newspapers/magazines/hoardings/ press release or a combination of all.
Government and Statutory Agencies
The various regulatory bodies related with the public issue are:
1. Securities Exchange Board of India
2. Registrar of companies
3. Reserve Bank of India (if the project involves foreign investment)
4. Stock Exchange where the issue is going to be listed
5. Industrial licensing authorities
6. Pollution control authorities (clearance for the project has to be stated in the prospectus)
21
2.7 Securities Exchange Board of India
The Securities and Exchange Board of India was established on April 12, 1992 in accordance with
the provisions of the Securities and Exchange Board of India Act, 1992. SEBI is headquartered in the popular
business district of Bandra-Kurla complex in Mumbai, and has Northern, Eastern, Southern and Western
regional offices in New Delhi, Kolkata, Chennai and Ahmadabad. SEBI was formed in consideration with
major objective-
1. To protect the interests of investors in securities.
2. To Form rules and regulation for the security market to function
3. To promote efficient services by the financial intermediaries involved in trading e.g. brokers, merchants
bankers etc.
The Preamble of the Securities and Exchange Board of India describes the basic functions of the
Securities and Exchange Board of India as “...to protect the interests of investors in securities and to promote
the development of, and to regulate the securities market and for matters connected therewith or incidental
thereto”.
SEBI itself enlists its basic functions as-
1) Registration- SEBI also entails certain procedures involved in the registration of stock exchanges
and any other securities markets, stock brokers, sub-brokers, share transfer agents, bankers to an
issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers,
investment advisers, self regulatory organizations and such other intermediaries who may be associated
with securities markets in any manner.
2) Protection- It shall be the duty of the Board to protect the interests of investors in securities and to
promote the development of, and to regulate the securities market, by such measures as it thinks fit.
3) Supervision- One of the major function of SEBI is to track, monitor and supervise the functioning of
the capital markets (primary and secondary) and all its components such as intermediaries, organizations
and individuals that are involved in trading in capital markets.
4) Regulation- Business in stock exchanges and any other securities markets
a) The working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of
trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment
advisers and such other intermediaries who may be associated with securities markets in any manner.
b) The working of the depositories, custodians of securities, foreign institutional investors, credit rating
agencies and such other intermediaries as the board may notify.
c) the working of venture capital funds and collective investment schemes including mutual funds
d) self-regulatory organizations
e) substantial acquisition of shares and take-over of companies
5) Record- Another major role of SEBI is to keep track record of all the components and organization
and services that are involved in the trading activities and also to maintain the record of all the
changes in the capital marked for e.g. Listing and delisting of stocks, registration on new organizations.
6) Amend- In order to adopt to the changing environment and also in reaction to the various activities
and problems faced in the capital markets SEBI has to amend its rules and regulation from time to
time and also notify these changes in public issue documents.
22
7) Control- SEBI functions to control the prices rigging activities in order to protect the investors’
interest from any fraudulent activities taking place.
8) Maintain transparency- SEBI ensures transparency across all trading activities and functions of
the intermediaries and organizations by establishing certain rules and regulations such as that in
which broker is asked to show the their prices, brokerage, service tax etc. separately in contract
notes and their accounts.
9) Inspect and audit-SEBI generally performs its regulatory functions by undertaking inspection,
conducting inquiries and audits of the intermediaries and self- regulatory organizations in the securities
market thus ensuring proper and clean function.
10) Prohibition- SEBI also functions to prohibit fraudulent and unfair trade practices relating to securities
markets by promoting investors’ education and training of intermediaries of securities markets and
by prohibiting insider trading in securities.
2.8 Underwriting of Securities
Underwriting may be defined as contract entered into by the company with the persons or institutions,
called underwriters, who undertake to take the whole or a part of such of the offered shares or debentures,
as may not be subscribed by the public, in consideration of remuneration, called “Underwriting
Commission”.
Thus, the underwriting is an undertaking or guarantee given by the underwriters to the company that
the shares or debentures offered to the public will be subscribed in full, in case the response of the public is
poor the underwriters will take the balance of the shares or debentures not subscribed by the public and will
pay for them.
Types of Underwriting: - Underwriting may be of three types:-
1. Complete Underwriting: - If the whole of the issue of shares or debentures of a company is
underwritten, it is to be said as “complete underwriting”. In such a case the whole of the issue of
shares or debentures may be underwritten by firm or person who has agreed to take the risk.
2. Partial Underwriting: - If only a part of the issue of shares or debentures of a company is
underwritten, it is to be said as “partial underwriting”. In such a case the part of the issue of shares
or debentures may be underwritten by firm or person who has agreed to take the risk.
3. Firm Underwriting: - It refers to a definite commitment by the underwriter to take a specified no.
of shares, irrespective of the no. of the shares subscribed by the public. Finn” underwriting signifies
a definite commitment to take a specified number of shares, irrespective of the number of shares
subscribed by the public.
In case of firm underwriting, underwriters take the agreed no. of shares in addition to the unsubscribed
shares, if any, whether the issue is fully subscribed or oversubscribed. In such a case, unless it has been
otherwise agreed, the underwriter’s liability is determined without taking into account the number of shares
taken up „firm” by him, i.e. the underwriter is obliged to take :
 The number of shares he has applied for firm; and
 The number of shares he is obliged to take on the basis of the underwriting agreement.
Underwriting Commission: - The consideration payable to the underwriter for underwriting the
issue of shares or debentures of a company is called as “Underwriting Commission”
23
In general it can be paid with the following limits
 In case of Shares, 5 % of the issue price or such lower rate as provided by the Articles of the
company.
 In case of Debentures, 2.5 % of the issue price or such lower rate as provided by the Articles of the
company
Marked and Unmarked Applications: - When the issue of the shares of a company is underwritten
by two or more underwriters, it is usual that the applications for shares sent through the underwriters should
bear a stamp of the respective underwriter, otherwise it would be very difficult for the company to determine
that how many applications have been received from a particular underwriter.
Thus, the applications bearing the stamp of the respective underwriters are called as “Marked Applications”
and the applications received directly by the company which do not bear any stamp of the underwriters are
called as “Unmarked Applications”
Marked Applications: - The application forms bearing the stamp of the underwriter, are termed as
“Marked Applications”
The benefit of marked applications is given to the concerned underwriters in whose name application
forms have been marked.
Unmarked Applications: - The application forms which do not bear the stamp of the underwriter,
are termed as “Unmarked Applications”
The benefit of unmarked applications is given first to the company to the extent of issue not underwritten
by underwriters.
In case there is surplus, benefit of surplus will be given to the underwriters in the ratio of their gross liability.
Note: - If the entire issue of the shares is underwritten by only one underwriter, there is no
question of marked and unmarked applications, as one underwriter will be given credit for all the
applications, whether received through him or directly.
1. Explain the function of the new issue market.
2. Define the term underwriting of securities.
3. What is Right issue.
4. Discuss the major parties involved in new issue market.
2.10 Summary
In the new issue market stocks are offered for the first time. The functions and organization of the
new issue market are different from the secondary market. In the new issue the lead managers manage the
issue, the underwriters assure to take up the unsubscribed portion according to his commitment for a commission
and the bankers take up the responsibility of collecting the application form and money. The new issues are
offered through prospectus. The prospectus is drafted according to SEBI guidelines disclosing the needed
information to the investing public. Book building involves firm allotment of the instrument to a syndicate
created by the lead managers. The book runner manages the issue. Norms are given by SEBI to price the
issue. Proportionate allotment method is adopted in the allocation of shares. Project appraisal, disclosure in
the prospectus and clearance of the prospectus by the stock exchanges protect the investors in the primary
market along with the active role played by the SEBI.
24
2.11 Glossary
Origination: Origination refers to the work of investigation, analysis and review, rendering relevant
consultative services, authenticating and processing of new issue proposals by issue houses/merchant bankers/
originators, who act as sponsors of issues.
Distribution: Distribution is the sale of securities to the ultimate investorss. It is a specialised
actively rendered by brokers, sub-brokers and dealers in securities.
Private Placement: Private placement is method of acquiring securities by the issuing houses
directly from the issuing company at an agreed price, and then these are placed only with their investor-
clients, both individual and institutional investors, at a higher price.
Underwriter/guarantees: Underwriter guarantees that he would buy the portion of issue in case of
under subscription. This service is known as underwriting for which a commission is charged called underwriting
commission.
Book Building: Book building is a process of issuing shares based on floor price which is indicated
before the opening of the bidding process.
Registrars: Registrars to the issue normally receive the share application from various collection
centres and recommend the basis of allotment in consultation with the Regional Stock Exchange for approval.
1. See the section no. 2.3, lesson 2
2. See the section no. 2.8, Lesson 2
1. Explain the nature of New Issues Market (NIM). How does NIM differ from secondary market?
2. What are the parties involved in the issue of shares in the stock market?
3. What are the different functions of the lead managers, registrars and underwriters?
4. Explain the functions of the primary market.
5. Discuss the various methods of floating the new issue.
6. Explain the nature of book-building process. What are the objectives of Book-building? Has the
process really taken-off in India?
1. M. Ranganathan and R. Madhumathi (2010).Investment Analysis and Portfolio Management.
Pearson Education, New Delhi.
2. Punithavathy Pandian (2009)Security Analysis and Portfolio Management. Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Bharti V. Phathak (2019).Indian Financial System. Pearson Education, Delhi.
*****
25
LESSON - 3
VALUATION OF SECURITIES
Structure
3.1 Introduction
3.2 Basic Valuation Model
3.3 Bond Valuation
3.4 Bond Valuation Behaviour
3.5 Valuation of Perference Shares
3.6 Valuation Equity Shares
3.8 Summary
3.9 Glossary
After going through this lesson the learners will be able to:
1. Understand the main characteristics of fixed income instruments.
2. Discuss the time value concept
3. Describe basic discounted cash flow valuation model and its application to bonds.
4. Learn valuations of preference and equity instruments
3.1 Introduction
Investment process invariability requires the valuation of securities in which the investments are
proposed. The value of a security may be compared with the price of the security to get an idea as to
whether a particular security is overpriced, under-priced or correctly priced.
The valuation process requires the estimation of:
Expected Cash Flows Required Rate of return
1
Assistant Professor, Govt. College of Commerce and Business Administration Sector-50, Chandigarh.
26
 The stream of expected Cash flows: An estimate of the expected return depends upon following:
 Form of returns: the form of return for any investment may include earnings, cash flows, dividends,
interests or capital gains during the period.
 Time Pattern and growth rate of return: Since money has time value of money, time pattern and
growth rate of return shall be determined for an investment.
 Required rate of return: It is determined by three components:
 Real risk free rate of return
 Expected inflation rate
 Risk premium
This required rate of return is used as the discount rate to find out the present value.
3.2 Basic Valuation Model
The valuation model can be presented in terms of the cash flows, their timings and the required rate
of return. The value of a security is determined by discounting the expressed cash flows to their present value
at a discount rate commensurate with the risk-return prospective of the investor.
So utilizing the present value technique, the value of financial asset can be expressed as follows:
V = [cf2/(l+k)1] + [cf2/(l+k)22] + [cf3/(l+k)n ]
Where
v = value of the security
cf = cash flows expected at the end of year
i k = appropriate discount rate and
n = expected life of the asset
Thus the value of a security is the sum of discounted values of expected future cash inflows.
3.3 Bond Valuation
A bond or debenture is a debt security issued by a borrower and subscribed/purchased by a lender/
investor. Bond is a usual form of long-term financing used by the firms, which upon issuing a bond, promise
to make certain cash flows in future (in the form of interest and/or repayment) under clearly defined terms
and conditions. In order to understand the valuation of bonds, the understanding of the following basic terms
is required:
1. Par value. The par value (also called the face value or nominal value) of a bond is the principal
amount of a bond and is stated on the face value of the bond is stated on the face of the bond
security. The par value of a bond may be Rs.100, Rs.1000 or any amount. The issue price, however,
may be less than, equal to or more than the par value.
2. Coupon rate. This is the rate at which interest on the par value of the bond is payable as per the
payment schedule. The interest may be paid annually or even monthly. The coupon rate is usually
described as % rate and is applied to the par value to find out the periodic interest amount.
3. Maturity. The maturity of a bond refers to the period from the date of issue, after the expiry of
which the redemption repayment will be made to the investor by the borrower firm. -
27
The value of a bond may be defined as the sum of the present values of the future interest
payments plus the present value of the redemption repayment. The appropriate discount rate to find out
the present value would be the required rate if the return kd, which depends upon the prevailing risk-free
interest rate and the risk premium.
The valuation model may be modified to find out the value of a bond as follows:
B = i=1 I1/(l+ kd)i + RV/ (1 + kd)n
B = value of bond at present.
I = Annual interest payment starting one year from now till the end of the year n.
RV = redemption repayment at the end of the year n.
kd = appropriate discount rate.
In short, valuation of bond consists of two components:
For Example:
A bond of Rs. 1000 bearing a coupon rate 12% is redeemable at par in 10 years. Find out the value of the
bond if:
1. Required rate of return is 12% or 10% or. 14%
2. Required rate of return is 14% and the maturity period is 8 years or 12 years; and
3. Required rate of return is 12% and redeemable at Rs.950 or Rs.1050 after 10 years.
Solution:
The value of the bond can be ascertained by the equation:
B = i=1I1/(l+kd)i + RV/(l+kd)n
Or B = I (PVAFi.n) + RV (PVFi.n)
Where
(PVAFi.n) = present value annuity factors at the rate of interest i, and number of years n.
(PVFi.n) = present value factor for a given rate of interest I, and number of years n.
Now the value of the bond under different situations can be ascertained as follows: 1. Basic information -
Coupon rate 12% Redeemable at par Maturity 10 years.
28
If required rate of return is 12%
B = 120(5.650) + 1000(0.322)
= 678 + 322 = Rs.1000
B = 120(6.145) + 1000(0.386)
= 737.4 + 386 = Rs. 1123.40
B = 120(5.216) + 1000(0.270)
= 625.92 + 270
= Rs.895.92
2. Basic Information-Coupon rate 12% Redeemable at par Maturity 8/12 years. Required rate of
return 14%
If maturity period is 8 years
B = 120(4.639) + 1000(0.351)
= 556.68 + 351
= 907.68
If required period is 12 years
B = 120(5.660) + 1000(0.208)
= 679.20 + 208
= 887.20
3. Basic information - Coupon rate 12% Required rate of return 12% Maturity 10 years.
If redemption amount is Rs.950
B = 120(5.65) + 950(0.322)
= 678 + 305.90
= Rs.983.90
If redemption amount is Rs.1050
B = 120(5.650) + 1000(0.322)
= 679.2 + 338.1
= Rs.1016.10
3.4 Bond Valuation Behavior: On the basis of the above calculation, certain conclusions regarding the
behavior of the valuation of bond can be arrived as follows:
1. Relating to the required rate of return: If the required rate of return and the coupon rate are
equal then the value will be equal to par value. Whenever the required rate of return differs
from the coupon rate, the bond value also differs from the par value.
When the required rate of return is less than the coupon rate, the bond has a premium value
here as if the required rate of return is more than the coupon rate, the bond has a discounted
value.
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2. Relation to maturity period: Whenever the required rate of return is different from the coupon
rate, the time to maturity also affects the value of the bond. In this respect the conclusion can be
drawn with the reference to the remaining period of maturity.
When the required rate of return is different from the coupon rate and assumed constant until
maturity, the value of the bond will approach its par value as the remaining period approaches its
maturity. Of course, when the approach rate of return is equal to the coupon rate, the bond value
will remain the same at par until it matures.
Further, the longer the time to maturity of bond, the greater its value changes in response to a given
change in the required rate of return.
3. Yield to maturity (YTM): it is already stated that the cash flows in relation to a bond are consisting
of a regular interest payments and the redemption repayment. The rate of return kd, which
makes the discounted values of these cash flows equal to the bond’s market value, is known
as the YTM of the bond.
So, a bond’s YTM may be defined as the Internal Rate of Return (IRR) for a given level of risk.
When an investor evaluates bonds in order to make a buy or not to buy decision, the evaluation is often
done by fading out the IRR of the bond.
3.5 Valuation of Preference Shares
Preference share is a share which entitles the shareholder to receive a dividend at a fixed rate for a
given period and a redemption amount at the time of preference share (in case of redeemable preference
share) OR a dividend at the fixed rate perpetually till the liquidation of the company (in case of irredeemable
preference share)
Assumptions: Two assumptions are relevant while ascertaining the value of preference shares
are as follows:
1. The dividend on preference share are received once a year and that the first dividend is received at
the end of one year from the date of acquisition / purchase.
2. The company always intends to pay the preference dividend so that the stream of preference
dividend is concerned to be known with certainty.
Redeemable preference share. The value of redeemable preference share may be defined as the
present value of the cash flows expected from the company. The future cash flows associated with a
redeemable preference share are:
 The stream of future dividends at a fixed rate of dividend
 The maturity payment at the time of redemption.
These future cash flows are discounted at an appropriate rate to find out the value of the redeemable
preference shares as follows:
P = i=l [d l /(1+kp)i] + [RV/(l+kp)n]
Where
P = value of preference share
D = annual fixed dividend
RV = redemption value of preference share
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n = life of the preference share
kp = required rate of return of the preference shareholders
Irredeemable preference share. The value of irredeemable preference share may be defined as
the present value of the perpetuity of the fixed dividend on the preference shares.
Symbolically, it may be defined as:
P = D/kp
Where
P = value of the irredeemable preference share
D = fixed annual dividend
kp = required rate of return of preference shareholders
3.6 Valuation of Equity Shares
Conceptually, the valuation of the equity share is the most typical because of its residential ownership
character. The equity shareholders receive the residential profit and also the residual assets in case of
liquidation.
From the point of view of calculation also, the valuation of equity share is difficult for
(i) The rate of dividend is not given,
(ii) Unlike rate of interest or rate of preference dividend which remains constant over the life of the
security, the rate of dividend on equity share may be varying over the years. .
Broadly the value of equity share may be found by following either of the two approaches:
1. Valuation based on dividends
2. Valuation based on earnings
Figure: Approaches to Equity Valuation

1. Valuation of equity shares based on dividends: An investor buys or acquires an equity share in
expectation of
(i) a stream of future dividends from the company
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(ii) Resale price of the equity share after some time when he is no longer interested in holding the
share.
The owner of share receives the shares as a compensation for investing the firm. So, as long as the
firm is operating profitably and the investor holds the shares, he would be expecting to receive a dividend
from the company
Assumption: Valuation of equity share based on dividends requires the following assumptions:
1. The dividends are paid annually
2. The first dividend is paid after one year from the date of acquisition/purchase.
3. Sale of the equity share, if any, occurs only at the end of a year and at the ex-dividend terms.
The value of equity share is the sum of the present values of future cash flows (in the form of
dividends) discounted at the required rate of return of the investors.
The valuation of equity shares may be ascertained with the help of equation:
P = [d1/(l+ke) 1] + [d2(l+ke)2] …………. [dn/(l+ke)n
Where
P = value of the equity share
Di = expected dividend over the year
ke = required rate of return of the equity investors
As per the equation, the value of a share depends on the expected stream of dividends. However,
the future dividend from the company may show different patterns. The company may pay dividends at
a constant rate or otherwise. This uncertainty regarding the pattern of dividend is what makes the valuation
of equity shares of a typical job.
These three assumptions of dividend patterns are:
1. Zero growth in dividend or constant dividends
2. Constant growth in dividend
3. Variable growth in dividends
Zero growth in dividend or constant dividends. This is the simplest type of dividend pattern in
which the dividend amount remains constant over years. The value of equity share under constant dividend
assumption by dividing yearly dividend by the required rate of return of equity investor as follows:
P = D/ke
Where
P = value of equity share
D = annual constant dividend
ke = required rate of return of equity investor
This model requires no estimation of future dividends and no forecast of future selling price and,
therefore, is simple to operate.
Constant growth in dividends:- The assumption is that the dividends will grow constantly at a rate
g, every year. If a firm pays a dividend of Do at present then dividend at the end of year 1 will be D 1, i.e D0
(1+g) and dividend at the end of year 2 will be D2 — D0 (1+g)2 , and so on.
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Under constant growth model, the value of a share will be found with the help of equation
P = D1/(ke-g)
Where
P= value of equity share
D1 = expected dividends at the end of year 1
g = The projected growth rate
ke = The expected rate of return of investors
Variable growth in dividends. The zero growth rate and constant growth rate assumptions of
dividend patterns are extreme assumptions. In a practical situation, the dividend from a company may show
one growth rate for few years, followed by another growth rate for next few years and then yet another
growth rate for next few years, and so on.
For example, for five years the growth rate in dividends may be 2% then it may be 3% for next 5
years then it may stick to 4% growth rate in infinitely. This means that the dividends will grow at 2% annually
for years 1 to 5 at 3% annually for years 6 to 10 and at 4% annually from the year 11 onwards.
Following equation takes care of such growth situations to find out the value of the equity shares.
P = [d0 (l+g1)i /(1+ke) i] + = [d6 (1+g2)i-5/ (1+ke)i-5] +  [dl0 (l+g3)i-10/ (1+ke)i-10]
Where
P = value of equity share,
gl, g2 and g3 = different growth rates for different periods, and
ke = required rate of return of equity investors
To find out the value of equity shares under varying growth rates as per Equation, the following
procedure may be adopted:
Step 1. Find the value of cash dividend at the end of each year during the period over which the
growth rate is changing. In the above eg., the growth rate is changing over 10 years ( 2% growth rate for 1st
five years & 3% growth rate for next 5 years).
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Step2. Find out the present values of these cash dividends for different years by discounting at the
required rate of return, ke. For this purpose, the cash dividend is to be multiplied by the respective discounting
factor to find out the present value. Add up all these present values.
Step 3. Find out the value of the equity share at the end of the last year of the varying growth period,
i.e., the 10th year as follows: P10= D11 / (ke — g3) This value P10 represents the present value of all expected
dividends from year 10 onwards at a constant growth rate in dividends, g3. Find out the present value of this
year by discounting to period 0.
Step 4. Sum of the figures arrived in steps no. 2& 3 is the value of the equity share. If there are more
breaks in the growth rates, then the similar procedure may be adopted.
2. Valuation of Equity Shares based on Earnings
Some firms have extensive growth opportunities and require funds to take up new projects. So these
firms may retain profits (wholly or partially).This reduce the amount of dividends to the shareholders. The
retained earnings are reinvested internally to generate higher profits in future. Investors are willing to
forego cash dividends today in exchange for higher earnings and expectation of higher dividends in
future. The value of an equity share in such a case, may be determined on the basis of the earnings of
the firm.
The earnings of the firm may be expressed as earnings as per share (EPS) which is ascertained from
the accounting information of the firm. There are different approaches to find out the value of the equity
share on the basis of the earnings of the firm. These include :
 Gordon valuation model
 Walter’s Model
 P/E ratio approach and the explicit resale price model.
The Gordon ’s Model. This valuation model presupposes that earnings of the firm are either
distributed among the shareholders or are reinvested within the business. The growth in dividends in
future would therefore depend upon the profits retained and the rate of return on these retained profits.
The golden valuation model can be represented as follows
P = EPS1 (1 -b)/ ke - br
Where
P = price of a share
EPS1 = EPS at the end of year 1
b = retention rate, i.e., % of earnings being retained
r = rate of return on reinvestments, i.e., ROI
ke = required rate of return of the equity investors.
Waller’s Model - The waiter’s model supports the view that the market price of a share is the sum of:
(i) present value of an infinite stream of dividends
(ii) present value of an infinite stream of returns from retained earnings.
Depending upon the relationship between r and ke, the investors will value the expected capita! gains
and will thus value the share.
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The Walter’s Model can be presented as follows:
P = [D/ ke] + (ke/r)(E-D)/ ke
Price earnings ratio(P/E ratio):- The P/E ratio is the most common earnings valuations Model.
The P/E ratio between the price of a share & it is EPS.
P/E Ratio — Current market price/ Expected earnings
For e.g., if a share whose EPS is Rs. 10 is having market price of Rs.250, then its P/E ratio is 250/10
=25 It means that the mp of the share is 25 times that of the EPS.
As per P/E ratio approach the value of the share is expressed as
Value = EPS * P/E ratio
Investment decision:
If above value > M.P, then Buy the share; and if Value < M.P., then sell the share.
1. Define the term valuation of securities
2. What are fixed income securities?
2. Discuss valuation of bond.
3. Explain different approaches of valuation of equity shares.
3.8 Summary
Bonds, do have risk. Changes that occur in the market interest rate affect the value of the bond. It is
known as interest rate risk. Other than this, there are default risk, marketability risk and scallability risk.
Equity shares carry with them ownership rights. They give voting rights to the holders. They have a face
value (in monetary terms) at the time of issue and are evaluated at their market value when they are listed on
a stock exchange. Equity valuation is a complex procedure since there is no consistent definition regarding
what constitutes the intrinsic value of a share. Different valuation approaches and models with different
assumptions and implications are available to investors to assess the true worth of a share. These include
earnings approach, cash flow approach and dividend discount approach.
3.9 Glossary
Par Value:Par Value is the value stated on the face of the bond.
Share Valuation: Share valuation is the process of assigning a value to a specific share.
Price Earnings Ratio: Price/Earnings (P/E) ratio relates the market price of a share with its
earnings per share.
Coupon Rate:Coupon Rate and Interest bond carries a specific interest rate which is called the
coupon rate.
Time value:Time value concept of money is that the rupee received today is more valuable than a
rupee received tomorrow.
Economic Value Added: Economic value added (EVA) is another modification of cash flow that
considers the cost of capital and the incremental return above that cost.
Current yield:Current yield is the coupon payment as a percentage of current market prices.
Expectation theory:Expectation theory according to the this theory, the shape of the yield curve
can be explained by the expectations of the investors about the future interest rates.
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1. How would you assess the present value of a bond? Explain the various bond value theorems with
examples.
2. Discuss the term structure of the interest rate? How do theories explain the term structure of the
interest rate?
3. Discuss the assumptions and implications of earnings approach to equity valuation.
4. What are the quantitative models of equity valuation? What are their limitations?
edition.
Private Limited.
phase 1, New Delhi.
Publishers.
*****
36
LESSON-4
FUNDAMENTAL ANALYSIS
Structure
4.1 Introduction
4.2 Foundation of Fundamental Analysis
4.3 Process of Fundamental Analysis
4.4 Economics Analysis
4.5 Industry Analysis
4.6 Company Analysis
4.7 Appraisal of Fundamental Analysis
4.8 Self Check Questions
4.9 Summary
4.10 Glossary
1. Understand the fundamental aspects affecting stock’s values such as economic outlook and market
conditions.
2. Process and foundational aspects of fundamental analysis.
4.1 Introduction
Fundamental analysis is the study of the various factors that affect a company’s earnings and
dividends. Fundamental analysis studies the relationship between a company’s share price and the
various elements of its financial position and performance.
Fundamental analysis is forward looking even though the data used is by and large historical. The
objective of fundamental analysis is to determine a company’s intrinsic value or its growth prospects. This
intrinsic value can be compared to the current value of the company as measured by the share price. If the
shares are trading at less than the intrinsic value then the shares may be seen as good value.
In simple words, fundamental analysis gives the answer to “which security to buy”. It studies how
lucrative that security is and hence decision of holding or buying of security is made.
4.2 Foundation of Fundamental Analysis - Intrinsic Value
Before understanding the three elements of fundamental analysis, it is of paramount importance to
understand the concept of intrinsic value. The whole process of fundamental analysis is based on the
intrinsic value.
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The intrinsic value is the actual economic value of a company or an asset based on an underlying
perception of its true value including all aspects of the business, in terms of both tangible and intangible
factors. This value may or may not be the same as the current market value.
This value indicates whether stocks are undervalues, overvalued or correctly valued.
Criteria for investment decision
i. If intrinsic value > Market price, Buy the security
ii. If intrinsic value < Market price, Sell the security
iii. If intrinsic value = Market price, No Action
4.3 Process of Fundamental Analysis
Elements of fundamental analysis are:
Fundamental Analysis
Figure: Elements of fundamental Analysis
Regardless of the qualities or capabilities of a firm, the economy and industry environment will have
a major influence on the success of a firm and a realized rate of return on stock. For this, factors affecting
these three elements are studied and analyzed to take the investment decision.
The three phase examination of fundamental analysis is also called as an E1C (Economy-
Industry-Company analysis) framework or a top-down approach.
Here the financial analyst first makes forecasts for the economy, then for industries and finally for
companies. The industry forecasts are based on the forecasts for the economy and in turn, the company
forecasts are based on the forecasts for both the industry and the economy. Also in this approach, industry
groups are compared against other industry groups and companies against other companies. Usually, companies
are compared with others in the same group.
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For example, a telecom operator (Spice) would be compared to another telecom operator not to an oil
company.
These phases of Fundament analysis can be tabulated as follow:
PHASE NATURE PURPOSE INDICATORS
FIRST EconomicAnalysis To access the general economic situation of the nation.
Economic indicators
SECOND Industry Analysis To assess the prospects of Various industry groupings
Industry life cycle analysis, Competitive analysis of industries etc.
THIRD CompanyAnalysis To analyse the Financial and Non-financial aspects of a company to
determine whether to buy, sell or hold the shares of a company. Analysis of Financial Aspects:
Sales, Profitability, EPS etc. Analysis of Non- financial aspects: management, corporate image, product,
quality etc.
These phases are elaborates in the further lecture.
4.4 Economic Analysis
First and foremost step in top down approach of top down approach is evaluation of general economic
conditions. Economic indicators are taken into the account to analyze overall attractiveness of the economy.
These factors help analysts to develop a sound understanding of the overall economic conditions. While doing
economic analysis, investors need to analyze these factors in three scenarios: Past, Current and Future. Key
factors to be considered by investors while analyzing the economy are given in the following diagram.
PHASE NATURE PURPOSE INDICATORS
FIRST Economic To access the general economic Economic indicators

Analysis situation of the nation.
SECOND Industry Analysis To assess the prospects of Industry life cycle analysis,
Various industry groupings. Competitive analysis of industries
etc.
THIRD Company To analyse the Financial and Analysis of Financial Aspects:

Analysis Non-financial aspects of a Sales, Profitability, EPS etc.
company to determine whether Analysis of Non- financial aspects:
to buy, sell or hold the shares of management, corporate image,
a company. product, quality etc.
Figure: Factors Affecting Economic Analysis

1. Gross Domestic Product. GDP is the total value of goods produced and services provided in a country
during one year. It is the broadest quantitative measure of country’s economic activity. It acts as a basis on
which investment climate of the country can be gauged. Components of GDP are as follow:
39
 Consumption spending: Represents those goods and services which are consumed by the people.
 Investment Spending: Represents the capital expenditure incurred for future production purposes,
 Government expenditure: Represents the spending done by Government on goods and services
like infrastructure, school, roads, etc.
 Exports: Represents the goods and services purchased by foreign companies in exchange of the
foreign currency.
40
All these components help investors to calculate the GDP of that economy and thus make a decision
as to how strong or weak that economy is.
2. Inflation: It is a sustained increase in the general price level of goods and services in an economy
over a period of time. When the price level rises, each unit of currency buys fewer goods and
services. Inflation impacts the capital market in numerous ways:
 It reduces the value of fixed income securities
 Increases the uncertainty in economy
 Cost of production increases and thus profits can also shrink for the businesses.
All these factors can impact the stock market and future investment patterns in the country.
3. Interest Rates: Interest rates keep on changing in an economy due to various reasons and can
have an effect on the stock market. Higher interest rates mean that money becomes more expensive
to borrow. To compensate for the higher interest costs, companies may have to cut back spending
or lay off workers. Higher interest rates also mean that a company cannot borrow as much as it
used to, and this has an adverse affect on company earnings. All of this adds up to a drop in the
stock market. Falling interest rate on the other hand leads to growing stock market.
4. Saving and Investment: Investors shall know the portion of GDP being saved and invested in an
economy. They shall be aware of what are the investment patters of that economy, i.e, in which
alternatives public is investing their money saved. Higher saving and investment, other things being
equal, is more favorable tor stock markets.
5. Industrial Production: overall growth in industrial production also affects the economy and hence
put an impact on the stock market of the country. If industrial sector is booming, it benefits stock
market as well. Higher the growth rate of the industrial production, other things being equal, more
favorable is the stock market for the investment.
6. Fiscal and Monetary Policies: Collection of revenue and payment of expenditure by Government
is called fiscal policies. Policy incorporating the actions of central bank to control money supply in
the economy is called monetary policy. There are various elements of fiscal and monetary policy
may have favorable or unfavorable impact on the economy. These elements can be: Nature of
budget, Balance of payment position, Tax structure, money supply, etc.
7. Infrastructural Facilities: Infrastructural facilities are regarded as the backbone of an economy.
Well established connectivity through robust transportation facilities is of paramount importance for
any economy to develop. Good network of communication system in the form of telecommunication
facility is also required to enhance the overall growth of an economy. Proper infrastructural facilities
along with communication network also attract foreign direct investments. Therefore, good
infrastructural facilities are the indicator of economic growth.
8. Economic and Political Stability: Political environment of a country have an impact on the economic
environment of the economy. A stable political scenario boosts up the investor’s confidence and on
the other hand, destabilized political system creates an atmosphere of uncertainties I the mind of
investors. The investor thus shall keep in the mind the current state of economic - political environment
of the economy.
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9. Agriculture: In country like India monsoon and agriculture play a vital role in determining the
economic condition of the country. This is because almost 70% of Indian population is dependent
upon the agriculture. Also, good monsoon gives impetus to agricultural income, which in turn gives
boost to the industrial sector. Many industries are dependent upon agriculture for the raw material
being used by them. Thus monsoon and agriculture are the main indicators of economic growth and
stock market growth.
10. Business Cycle: In an economy there are many ups and downs known as growth and recession.
This phenomenon of recurring ups and downs is known as business cycle. A typical business cycle
has four stages:
Peak
Recession
Trough
Recovery
The period and intensity of these stages may vary from one economy to another, but certainly exist
in all economies. On the basis of these stages investors make the decision regarding investment in
that particular economy.
11. Exchange Rate: It is the rate at which one currency can be exchanged for another currency.
Exchange rate if often considered to the barometer of economy. If exchange rate changes, it will
impact the export and import of that particular economy as well. This will in turn have an impact on
the stock market
Economic Forecast models
Economic forecasting is the prediction of any of the elements of economic activity. In any case, they
describe the expected future behaviour of all or part of the economy and help form the basis of economic
analysis in investment.
Over the years it has become necessary for an investor to forecast the stock market trend. It helps
investor in taking the decision at the right time in order to maximize its returns. There are several techniques
which can be used by the investor to forecast the economic trends. These are based on the premise that past
data is available to forecast the future performance.
Some of the techniques are discussed further in the notes.
Surveys Indicators Diffussion
Economic Oportunistic
Model Model
Building Building
Figure : Economic Forecasting Techniques
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1. Surveys:
One of the methods of short-term forecasting is to make a survey of the type of business that one is
interested in. The method to do this is approximate because it is based on beliefs, intentions and future
budgeting of the government.
The method to forecast through surveys is either through personal contact or questionnaire. Personal
contact is to meet the people and to record conversations about their intention to invest money by type of
product, and by type of industry in future, and make analysis of it.
The other method of survey is through the means of detailed questionnaire which may either be filled
in by meeting people personally or the respondent may fill the form himself. The basic use of this method is
to have insight of the kind of activity in the economy.
These surveys may be based on statistical sample method but after processing and tabulation of
these questionnaires an analysis should be made.
The limitation of this form of forecasting is that it is based on the observations of a particular
person and on an intention of the future. The intention may not be carried into reality by the respondents.
2. Barometric Indicators:
The second approach behaves like a barometer. It gives indication of the economic process through
cyclical timings. This method helps in finding out the leading, lagging and coincidental indicators of economic
activity. Although, a very accurate estimate is not possible, the barometers indicate the level of economic
activity. Three types of indicators are:
 Leading indicator: These are indicators that usually, but not always, change before the economy as
a whole changes. They experience troughs and peaks before the troughs and peaks of economy.
 Lagging Indicators: They experience troughs and peaks after those of the economy.
 Coincident Indicators: Their troughs and peaks roughly coincide with the troughs and peaks of
economy.
These Indicators help us in forecasting the trend of the overall economy, depending upon the
nature of these indicators.
3. Diffusion Indexes: -
The diffusion index is a method which combines the different indicators into one total measure
and it gives weaknesses and strengths of a particular time series of data.
The diffusion index is also called a census or a composite index. The method adopted in this economic
reading of the future, is to take the leading, the coincidental and the lagging factors together to summarize
them and then to draw out and infer a particular composite answer.
This is a complex statistical method and the combination of various factors in this technique
makes it extremely difficult to draw out a proper understanding of the forecasting methods.
4. Economic Model building:-
This is a mathematical and statistical application to forecast the future trend of the economy.
This technique can be used by trained technicians and it is used to draw out relationships between two or
more variables.
43
This is a process technique as it specifies a particular system and calculates the results through the
simultaneous equations taking both endogenous variables and exogenous variables. The endogenous
variables are usually predetermined and one equation is usually needed to find out the forecast value of the
endogenous variables.
The advantage of this method is the precise nature of the answers and the accuracy in the
forecast made. This system may be applied in those advanced economics where the facilities of a computer
are not difficult to arrange for.
5. Opportunistic Model building
This method is the most widely used economic forecasting method. This is also called sectoral
analysis of Gross National Product Model Building. This method uses the national accounting data to
be able to forecast for a future short-term period. It is a flexible and reliable method of forecasting.
The method of forecasting is to find out the total income and the total demand for the forecast
period. To this are added the environment conditions of political stability, economic and fiscal policies of the
government, policies relating to tax and interest rates.
GNP is calculated by taking following sectors:
 The forecast has to be broken down first by an estimate of the government sector which is to be
divided again into State Government and Central Government expenses.
 The gross private domestic investment is to be calculated by adding the business expenses for
plan, construction and equipment changes in the level of business.
 The third sector which is to be taken is the consumption sector relating to the personal consumption
factor. This sector is usually divided into components of durable goods, non-durable goods and
services.
When data has been taken of all these sectors, these are added up to get the forecast for the
Gross National Product. They are then tested for consistency.
This method of is very reliable and it is often used for forecasting the economic conditions of
an economy.
4.5 Industry Analysis
Once an investor has made an analysis of the economic factors of the country taking into consideration
the leading, lagging and coincidental indicators and also taking into consideration the monetary, fiscal policies
of the country together with the demographic factors to find out the change of direction through indicators,
the next step is to analyses the industry and more firmly the company in which he wishes to invest.
The analysis of this nature will indicate to an investor whether the industry is a growth industry or
it is an expanding industry or there is obsolescence in industry. It is important for the investor to put the
value of his money in the right kind of industry so that he may benefit from his investments. An insight
to industrial analysis will give the investor a choice of the industry in which the investments should be made.
Need For Industry Analysis
Investors perform industry analysis because they believe it helps them isolate investment opportunities
that have favorable risk-return characteristics. Following are the major reasons we go through industry
analysis to make the investment decisions.
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 Cross sectional performances - Different industries show different rates of returns for specific
time period.
 Industry performance over time- For each different time period, different analysis has to be done.
Industry performing well today might not be giving the same results in the future as well
 Differences in industry risk — different industries have different kind of risks attached to them in
accordance to their nature.
 Performance of companies within industry - Even all companies of a particular industry might not
show similar returns.
Industry analysis can be studied under five parts.
Business Cycle and Industry sector

There are mainly four phases of economic cycle:
 Full Recession
 Early Recovery
 Late Recovery
 Early Recession
Different industries are preferred during these four phases, depending upon their sensitivity to the business
cycle
45
 Full Recession
This is not a good time for businesses. GDP has been retracting, quarter-over-quarter, interest rates
are falling, consumer expectations have bottomed and the yield curve is normal.
Sectors that have historically profited most in this stage include:
 Transports (near the beginning)
 Technology
 Industrials (near the end)
 Early Recovery
This is when things start to pick up. Consumer expectations are rising, industrial production is growing,
interest rates have bottomed and the yield curve is beginning to get steeper.
Historically, successful sectors at this stage include:
 Industrials (near the beginning)
 Basic materials
 Energy (near the end)
 Late Recovery
In this stage, interest rates can be rising rapidly, with a flattening yield curve. Consumer expectations
are beginning to decline, and industrial production is flat.
Historically profitable sectors in this stage include:
 Energy (near the beginning) o Staples
 Services (near the end)
 Early Recession
This is where things start to go bad for the overall economy. Consumer expectations are at their
worst, industrial production is falling, interest rates are at their highest, and the yield curve is flat or even
inverted.
Historically, the following sectors have found favor during these rough times:
 Services (near the beginning)
 Utilities
 Transports (near the end)
The investor shall make the investment decision keeping in mind the current phase of business
cycle and its impact on the prospective industry.
Structural characteristics
• Since each industry is unique, a systematic study of its features and characteristics must be an
integral part of the investment decision process. At this stage Industry analyst normally focuses on
the following:
 Structure of industry and nature of competition: Here the attention is on the number of competing
firms, industry leaders, entry barriers, pricing policies of firms, product differentiation, competition
from foreign firms, product features of substitutes available etc.
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 Nature and prospects of demand: In order to understand the nature and prospects of demand for
products in an industry one should identify the major customers and their requirements, key determinants
of demand, degree of cyclicality in demand, expected rate of growth in the future etc.
 Cost structure and profitability of industry: This could be measured by proportion of key cost
elements, labor productivity, liquidity conditions, profit margins, return on investments and earning
power etc.
 Technology and research: Importance shall be given to degree of technological stability, technological
changes, Research and Development expenses as a industry sales, the proportion of sales growth
attributable to new products etc
Industry’s competitiveness
In order to assess the level of competition in an industry Porter’s Five forces model is applied.
Michael Porter (1985) provided a framework for analyzing the competitive conditions, prevailing in
an industry and its relation with the industry’s profitability. In his model Porter has identified five competitive
forces those altogether can drive competition or determine the profit potential or strength of an industry.
The forces identified by Porter in his study include-
Figure: Forces Driving Industry’s competitiveness

1. Threat of New Entrants:
New entrants to an industry put pressure on price and profits. Even if a firm has not entered an
industry, the potential for it to do so places pressure on prices, because high prices and profit margins will
encourage entry by new competitors. Therefore barriers to entry can be a key determinant of industry
profitability.
Barriers to entry arise from several sources:
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 Sometimes government creates barriers by restricting competition through the granting of monopolies
and through regulation.
 Ideas and knowledge that provide competitive advantages are treated as private property when
patented, preventing the others from using the knowledge and thus creating a barrier to entry.
 When an industry requires highly specialized technology or plants and equipment, potential entrants
are reluctant to commit to acquiring specialized assets that cannot be sold or converted in to other
uses if the venture fails.
2. Rivalry among the existing players
When there are several competitors in an industry, there will generally be more price competition
and lower profit margins as competitors seek to expand their share of the market. Slow industry growth
contributes to this competition because expansion must come at the expense of rival’s market share.
Industries producing relatively homogeneous goods are also subject to considerable price
pressure, because firms cannot compete on the basis of product differentiation.
When the customers of the industry can freely switch from one product to another there is a
greater struggle to capture customers which increases rivalry.
3. Pressure from substitute products
Pressure from substitute products means the industry faces competition from firms in related
industries. To the economist, a threat of substitutes exists when a product’s demand is affected by the price
change of a substitute product. The availability of substitutes limits the prices that can be charged to
customers.
4. Bargaining power of buyers
The bargaining power of buyers is the influence that the customers have on a producing industry.
If a buyer purchases a large fraction of an industry’s output, it will have a considerable bargaining
power and can demand price concessions. Sometimes the buyers possess a credible backward integration
net thereby can threaten to buy the producing firm or its rival.
But when the products are not standardized the switching cost to buyer will be very high which
constraints the buyer to switch from one product to another frequently.
5. Bargaining power of supplier
A producing industry requires materials, labor and other supplies. This requirement leads to buyer
supplier relationships between the industry and the firms that provide it the supplies used to create products.
If the suppliers of a key input has monopolistic control over the product or they supply critical portions of
buyers input, then the supplier can demand higher prices for the goods supplied and squeeze profits out of
the industry.
Life cycle Analysis
Every industry passes through different stages in its life cycle. Many industrial economics believe
that the development of almost every industry may be analysed in terms of its life cycle.
The life of an industry can be separated into:
 Pioneering stage
 Expansion stage
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 Stagnation stage
 Decline stage.
This approach will also be useful in analyzing the past and forecasting the future of an industry
1. Pioneering stage
The early stages of an industry are often characterized by a new technology or product. In this
beginning phase the product or industry starts with sales of zero and operates at a loss. Thereafter its demand
not only grows but grows at an increasing rate. A security analyst will have a difficult task at this stage
selecting those firms that will be on top for some time to come. Even if the analyst can recognize an emerging
industry in the pioneering stage, he will probably not invest at this point in the industry’s development because
of the great risks involved
2. Expansion / Growth Stage
Sales of these companies grow rapidly and consistent annual profits usually begin to emerge during
this stage. Their competition in the expansion stage brings about improved products at a lower price. These
firms continue to expand but at a moderate rate of growth than that experienced in the pioneering stage.
These now stronger, steadier, more efficient firms become more attractive for investment purposes.
3. Stagnation / Maturity Stage
Following years of rapid growth during which the firms in an industry tend to acquire stable market
shares, come years of slower growth which comprise the third stage. Mature growth companies may be
large corporations, they may begin to pay consistent cash dividends and they repay any excessive debt they
acquired during their period of rapid expansion.
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4. Decline Stage
In this stage, the industry might grow at less than the rate of the overall economy, or even it might
even shrink. This could be due to obsolescence of the product, competition from new products, or competitions
from new low cost suppliers. The investors should disinvest when signals of decline are evident.
SWOT Analysis
SWOT analysis is a strategic planning method used to evaluate the Strengths, Weaknesses,
Opportunities and Threats of a particular industry. It involves specifying and identifying the internal and
external factors that are favorable and unfavorable to a particular industry.
Every Industry has its own strengths and weaknesses which shall be analyzed by the investor before making
its decision to invest.
4.6 Company Analysis
Once an investor determines the economy and industry to invest in, next step in fundamental analysis
is to perform company analysis. Company analysis assesses the competitive position of a firm, its earnings
and profitability, the operating efficiency, its financial position and the future prospect in regards to
the earnings to the shareholder.
Within an industry, different companies might be performing differently. This makes it necessary to
analyze the companies within the selected industry or industries.
Need of company analysis
 Industry factors alone cannot explain all the price movements of a common stock. Even if all
indications are that the industry has very favorable future prospects, this does not necessarily imply
that funds should be committed to it immediately.
 Although all the firms in most industries tend to be somewhat similar, they are not homogeneous.
Differences in the factors can result in significant variations among firms which are all competing in
an industry to manufacture a similar product.
Company analysis can be studied under two heads:
Figure: Indicators for Company Analysis
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1. Financial Indicators
The investor shall conduct a in depth analysis of the financial health of the selected company (s). A
financially strong company can indicate the good future returns. Financial analysis can be done through
various tools. These can be:
Figure: Tools for financial analysis

A. Ratio Analysis
Financial ratios are mathematical calculations using figures mainly from the financial statements, and
they are used to gain an idea of a company’s valuation and financial performance. Each valuation ratio uses
different measures in its calculations.
Investors might use different ratios depending upon their requirement.
Some of the ratios can be categorized as follow:
Figure: Categories of Financial Ratios

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(i) Liquidity Ratios: Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt
obligations. This is done by comparing a company’s most liquid assets to its short-term liabilities. Some of the
liquidity ratios are:
 Current Ratio: Ascertain whether a company’s short-term assets (cash, cash equivalents, marketable
securities, receivables and inventory) are readily available to pay off its short-term liabilities
Current Assets
Current Ratio =
Current Liabilities
 Quick Ratio: The quick ratio is more conservative than the current ratio because it excludes
inventory and other current assets, which are more difficult to turn into cash.
Cash Equivalents + Short - term Investments + Accounts Receivable
Quick Ratio =
Current Liabilities
(ii) Profitability Indicator: These ratios give users a good understanding of how well the company utilized
its resources in generating profit and shareholder value. Some of these ratios are:
• Profit Margin Analysis: The amount of profit (at the gross, operating, pretax or net income level) generated
by the company as a percent of the sales generated. The objective of margin analysis is to detect consistency
or positive/negative trends in a company’s earnings.
Net Income
Net Profit Margin =
Net Sales (Revenue)
Operating Profit
Operating Profit Margin =
Net Sales (Revenue)
Net Income
Net Profit Margin =
Net Sales (Revenue)
• Return on Assets: This ratio indicates how profitable a company is relative to its total assets. The return
on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a
profit. The higher the return, the more efficient management is in utilizing its asset base.
Net Income
Return on Assets =
Average Total Assets
• Return on Equity: This ratio indicates how profitable a company is by comparing its net income to its
average shareholders’ equity.
Net Income
Return on Equity =
Average Shareholders’ Equity
(iii) Leverage Ratios: These ratios give investors a general idea of the company’s overall debt load as well
as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a
company and its shareholders face. Some of these ratios are:
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• Debt Ratios: It compares a company’s total debt to its total assets, which is used to gain a general idea as
to the amount of leverage being used by a company. A low percentage means that the company is less
dependent on leverage.
Total Liabilities
Debt Ratio =
Total Assets
• Debt - Equity Ratio: Compares a company total liabilities to its total shareholders’ equity. This is a
measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus
what the shareholders have committed.
Total Liabilities
Debt -Equity Ratio =
Shareholders’ Equity
• Capitalization Ratio: Measures the debt component of a company’s capital structure, or capitalization to
support a company’s operations and growth. Long-term debt is divided by the sum of long-term debt and
shareholders’ equity.
Long-term Debt
Capitalization Ratio =
Long - term Debt + Shareholders’ Equity
• Interest Coverage ratio: The interest coverage ratio is used to determine how easily a company can
pay interest expenses on outstanding debt. The ratio is calculated by dividing a company’s earnings before
interest and taxes (EBIT) by the company’s interest expenses for the same period. The lower the ratio, the
more the company is burdened by debt expense.
Earnings Before Interest and Taxes (EBIT)
Interest Coverage Ratio =
Interest Expense
(iv) Investment Valuation Ratios: Ratios that can be used by investors to estimate the attractiveness of a
potential or existing investment and get an idea of its valuation. These ratios attempt to simplify this evaluation
process by comparing relevant data that help investors gain an estimate of valuation. Some of the ratios are:
 Price/Book Value Ratio: The price-to-book value ratio, expressed as a multiple (i.e. how many
times a company’s stock is trading per share compared to the company’s book value per share), is an
indication of how much shareholders are paying for the net assets of a company.
Stock Price per Share
Price Book Value Ratio =
Shareholders’ Equity per Share
• Price / Earnings Ratio (P/E): The price/earnings ratio (P/E) is the best known of the investment valuation
indicators. The financial reporting of both companies and investment research services use a basic earnings
per share (EPS) figure divided into the current stock price to calculate the P/E multiple (i.e. how many times
a stock is trading (its price) per each dollar of EPS).
Price/Earnings Ratio =
Earnings per Share (EPS)
• Price / Sales Ratio: A stock’s price/sales ratio (P/S ratio) is another stock valuation indicator similar to the
P/E ratio. The P/S ratio measures the price of a company’s stock against its annual sales, instead of earnings.
Price/Sales Ratio =
Net Sales (Revenue) per Share
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• Dividend Yield: A stock’s dividend yield is expressed as an annual percentage and is calculated as the
company’s annual cash dividend per share divided by the current price of the stock. The dividend yield is
found in the stock quotes of dividend-paying companies.
Annual Dividend per Share
Dividend Yield =
Income investors value a dividend-paying stock, while growth investors have little interest in dividends, preferring
to capture large capital gains.
b. Income Statement Analysis
When it comes to analyzing fundamentals, the income statement lets investors know how well the
company’s business is performing - or, basically, whether or not the company is making money. Generally
speaking, companies ought to be able to bring in more money than they spend or they don’t stay in business
for long. Those companies with low expenses relative to revenue - or high profits relative to revenue - signal
strong fundamentals to investors.
c. Balance Sheet Analysis
The balance sheet highlights the financial condition of a company and is an integral part of the
financial statements. It is also known as the statement of financial condition and offers a snapshot of a
company’s health. It tells you how much a company owns (its assets), and how much it owes (its liabilities).
The difference between what it owns and what it owes is its equity, also commonly called “net assets” or
“shareholders equity”.
The balance sheet tells investors a lot about a company’s fundamentals: how much debt the
company has, how much it needs to collect from customers (and how fast it does so), how much cash and
equivalents it possesses and what kinds of funds the company has generated over time.
Three major components of balance sheet analysis are:
Assets
Liabilities
Revenues
d. Cash Flow Statement Analysis
The cash flow statement shows how much cash comes in and goes out of the company over the
quarter or the year. Because it shows how much actual cash a company has generated, the statement of cash
flows is critical to understanding a company’s fundamentals. It shows how the company is able to pay for its
operations and future growth.
2. Non - Financial Indicators
Apart from financial indicators, Company analysis shall also take into consideration various non
financial indicators. Some of these indicators are:
 Nature of business:
Even before an investor looks at a company’s financial statements or does any research, one of the
most important questions that should be asked is: What exactly does the company do? This is referred to as
a company’s business model — it’s how a company makes money.
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 Competitive Advantage
Another business consideration for investors is competitive advantage. A company’s long -term
success is driven largely by its ability to maintain a competitive advantage - and keep it.
 Management
A company relies upon management to steer it towards financial success. Some believe that
management is the most important aspect for investing in a company. It makes sense - even the best business
model is doomed if the leaders of the company fail to properly execute the plan.
 Corporate Governance
Corporate governance describes the policies in place within an organization denoting the relationships
and responsibilities between management, directors and stakeholders. These policies are defined and determined
in the company charter and its bylaws, along with corporate laws and regulations. The purpose of corporate
governance policies is to ensure that proper checks and balances are in place, making it more difficult for
anyone to conduct unethical and illegal activities.
4.7 Appraisal of Fundamental Analysis
Strengths of Fundamental Analysis
 Long-term Trends
Fundamental analysis is good for long-term investments based on very long-term trends. The ability
to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient
investors who pick the right industry groups or companies.
 Value Spotting
Sound fundamental analysis will help identify companies that represent a good value. Some of the
most legendary investors think long-term and value. Fundamental analysis can help uncover companies with
valuable assets, a strong balance sheet, stable earnings, and staying power.
 Business Acumen
One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a
thorough understanding of the business. After such painstaking research and analysis, an investor will be
familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can
be potent drivers of equity prices.
 Knowing Who’s Who
Stocks move as a group. By understanding a company’s business, investors can better position
themselves to categorize stocks within their relevant industry group. Knowing a company’s business and
being able to place it in a group can make a huge difference in relative valuations.
Weaknesses of Fundamental Analysis
• Time Constraints
Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming.
Time-consuming models often produce valuations that are contradictory to the current price prevailing in the
stock market.
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 Industry/Company Specific
Valuation techniques vary depending on the industry group and specifics of each company. For this
reason, a different technique and model is required for different industries and different companies. This can
get quite time-consuming, which can limit the amount of research that can be performed.
 Subjectivity
Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the
ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a
base-case valuation, an average-case valuation and a worst-case valuation.
4.8 Self Check Questions
1. Define fundamental analysis.
2. What is Company Analysis?
3. What is industry life cycle?
4. What do you meant by P/E ratio? What is the logic of using this concept in investment decisions?
4.9 Summary
The earnings potential and riskiness of a firm are linked to theprospects of the industry to which it
belongs. The prospects of variousindustries, in turn are largely influenced by the development of macro
economy. The macro economy is the overall economic environment in which all firms operate. The key
variables describe the state of macro economy are- GDP, savings and investments, industrial growth rate etc.
Many economists believe that the development of almost every industry may be analyzed in terms of its life
cycle. The systematic study of specific features and characteristics are also important for making the investment
decisions. The competitive edge of the company could be measured with the help of company market share,
growth and stability of its annual sales. The financial statement of the company reveals the needed information
to the investor to make investment decision. Analysis of the financial statistics must be supplemented with an
appraisal, mostly of a qualitative nature, of the company present situation and prospects. Based on how the
company has done in the past and how it is likely to do in future, the investment analyst use different ratios
4.10 Glossary
Fundamental analysis: Fundamental analysisis primarily concerned with determining the intrinsic
value or the true value of a security.
Competitive edge: Competitive edgeis said to be enjoyed by the companies which have obtained
the leadership position; have proven ability to withstand competition and to have a sizable share in the market.
PEST Analysis:PEST refers to all political, economic, social and technological factors affecting any
industry.
Dividend Payout Ratio (D/P ratio): Dividend Payout Ratiois the ratio which establishes the
relationship between the earnings available for ordinary shareholders and the dividend paid to them. Book
value per share is the ratio which indicates the share of equity shareholders after the company has paid all its
liabilities, creditors, debenture holder and preference shareholders.
Liquidity Ratios: Liquidity Ratiosindicate the ability of the company to pay the short term debts in
time. Trend analysis helps in future forecast of various items on the basis of the data of previous years.
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1. Define Fundamental Analysis. What is the importance of economic variables in such analysis?
2. What is industry life cycle? Bring out its relevance in security analysis.
3. What is Company Analysis? What is its objective? Bring out the relevance of such analysis in
investment decisions.
4. What are the significant factors to be considered for Company Analysis?
5. What are the methods adopted to analyze the financial statements of a company?
edition.
Private Limited.
phase 1, New Delhi.
Publishers.
5. V.A. Avadhani, Security Analysis and Portfolio Management. Himalyana Publication.
*****
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LESSON-5
TECHNICAL ANALYSIS
Structure
5.1 Introduction
5.2 Basic Tenants
5.3 Co-Existence of Fundamental and Technical Analysis
5.4 Theories of Technical Analysis
5.5 Charts-Technical Analysis
5.6 Technical Idicators
5.7 Evaluation Technical Analysis
5.9 Summary
5.10 Glossary
1. Define technical analysis to predict the price behaviour of securities.
2. Describe the techniques of technical analysis.
3. Evaluate technical analysis
5.1 Introduction
In fundamental Analysis, the investment decision was made on the basis of the “intrinsic value” of,
compared to the current market price. In contrast to it, technical analysis decisions are made on the basis of
various trends and techniques. These trends are based on the historical information regarding prices and
volume of the security being evaluated. On these trend patterns, various techniques are employed to evaluate
as to what lies ahead.
Technical analysis deals in quantum of data relating to chart market and thus requires charts to
represent that data in a systematic manner. Various forms of charts can be used by the analyst depending
upon his objective. Once the charts are prepared, various techniques are applied to them in order to gauge the
trend they follow. Interpretation of these trends helps us in taking “sell” or “buy” decision and earn above risk
— adjusted returns with the help of market timing.
In simple words, fundamental analysis provides investors with the answer for “Which share to
buy”, and Technical Analysis provides answer for, “When to buy.
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The most important factor that matters is a security’s past trading data and what information this
data can provide about where the security might move in the future.
5.2 Basic Tenants
There are certain assumptions made regarding the working of technical analysis. These are:
1. Price is product of demand and supply: Technical theory views prices of stock as a product of
the supply and demand for it in the stock market.
2. Various factors govern demand and supply for security: Supply and demand are governed by
numerous factors both rational and irrational. The market continually and automatically weighs all
these factors.
3. Market acts like a barometer. In technical analysis, market discounts every information available.
Each known information about a market is reflected in the price itself. Well informed buyer and
sellers work as soon as the requisite information in floated in the market.
4. Price trends are formed in market: Disregarding minor fluctuations in the market, stock prices
tend to move in trends which persist for an appreciable length of time. Changes in trend are caused
by shifts in demand and supply. These shifts no matter why they occur can be detected sooner or
later in the action of the market itself.
5. History Tends To Repeat Itself: Another important idea in technical analysis is that history
tends to repeat itself, mainly in terms of price movement. Technical analysis uses chart patterns to
analyze market movements and understand trends. On the basis of repeated trends and pattern,
decision regarding investing in the stock is made.
5.3 Co-Existence of Fundamental and technical analysis
Although technical analysis and fundamental analysis are seen by many as polar opposites many
market participants have experienced great success by combining the two.
For example, some fundamental analysts use technical analysis techniques to figure out the best time
to enter into an undervalued security. Oftentimes, this situation occurs when the security is severely
oversold. By timing entry into a security, the gains on the investment can be greatly improved.
Alternatively, some technical traders might look at fundamentals to add strength to a technical
signal. For example, if a sell signal is given through technical patterns and indicators, a technical trader might
look to reaffirm his or her decision by looking at some key fundamental data.
Oftentimes, having both the fundamentals and technicals on your side can provide the best-
case scenario for a trade.
While mixing some of the components of technical and fundamental analysis is not well received by
the most devoted groups in each school, there are certainly benefits to at least understanding both schools of
thought.
5.4 Theories of Technical Analysis
Different theories have been propounded by different researchers in the field of technical analysis.
These theories have given various trends and patterns which exist in the market while using technical analysis.
Some of the commonly studied theories are:
1. Dow Theory
2. Elliot Wave Theory
3. Kondratev wave theory
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4. Chaos theory
5. Fibonacci Numbers
Two major theories, Dow and Elliot wave, are explained in this section
1. Dow Theory:
The Dow Theory is one of the oldest technical method still being used and was proposed by Charles
Dow. It was further refined by William Hamilton and articulated by Robert Rhea.
There are various version of this theory, but the crux is that:
“The market is always considered as having three movements, all going at the same time. The
first is the narrow movement (daily fluctuations) from day to day. The second is the short swing
(secondary movements) running from two weeks to a month and the third is the main movement
(primary trends) covering at least four years in its duration. “
Main Assumptions:
1. Market discounts ever information being floated in the market. Thus, prices reflect all the
information available in the market.
2. Market Indexes must confirm each other: If one index (Sensex) is confirming primary downward
trend, the other index (Nifty) shall also be reflecting the same. They both can’t be contradictory to
each other.
3. Volume must confirm the ongoing trend: It follows that volume must increase when price move in
the direction of trend and shall decrease when prices move in the opposite direction of trend.
4. Investors can identify the facts associated with price movements.
Explanation of theory
The theory states that stock market is influenced by three distinct cyclic trends. Trends are formed
when price of a particular share under the study starts moving in a specific direction and this direction persists
for a period of time.
According to Dow Theory, three trends represent market movements. These trends are:
1. Primary trend
2. Secondary trend
3. Minor trend
Before understanding these market trends we shall know what are trends and its major types.
Trends are constituted of the movement of the highs and lows. The trend line is nothing more than a
straight line drawn between at least three points.
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Types of trends
Dow Theory has recognized following two general trends:
 Downward Trends (Bearish market)

For a downward trend, peaks are connected. High point of each rally is lower than high point of
preceding rally and low point of each decline is lower than the low point of proceeding decline.
 Upward trend (Bullish market)
For an upward trend, lows are connected, High point of each rally is higher than high point of
preceding rally and low point of each decline is higher than the low point of proceeding decline.
This was how Dow Theory defines trends in general. Now as we understand the same, we shall look at the
three trends, identified by the theory, which exists in the market.
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i. Primary Trend
This is the major trend in the market and is thus the most important one to be identified. This trend
can be either upward or downward in nature. This trend is the long term trend which lasts generally for
more than one year. If the market is making higher highs and higher lows with each rally, then primary trend
is said to be bullish. Converse, will make the market bearish. This determines the main direction in which
market is moving.
ii. Secondary trends
This trend is also known as intermediate trend and generally lasts one to three months. It moves in
the opposite direction on primary trend and is considered to be the corrective actions being taken in the
market.
If primary trend is bullish then the secondary trend will be downwards, and conversely secondary
trend will be upwards.
iii. Minor trend
These are the short term trend generally representing day to day fluctuations in the stock prices.
These trends last from one day to three weeks.
Secondary trends comprise of these minor trends. Direction of minor trends is in the opposite
direction of the secondary trends.
2. Elliot Wave Theory
This theory was developed by Ralph Nelson Elliot in late 1930’s. It states that major moves take
place in the five successive steps resembling tidal waves.
The theory states that there is a PSYCHE OF THE CROWD inherent in all representative financial
market series. The crowd is not a physical crowd but a psychological crowd. It constantly moves from
pessimism to optimism, from fear to greed and from euphoria to panic and back in a natural psychological
sequence, creating specific patterns in price movements.
The main point emerging from the Elliott Wave concept is that markets have form (pattern).
Elliott discovered that patterns made by taking very short-term “snapshots” of stock prices, for
example every day, are similar to patterns formed by snapshots taken once a week, or once a month, or even
once a year.
Elliott isolated thirteen patterns. He cataloged them and explained that they link together, and where
they are likely to occur in the overall path of the market development.
Types of Waves
This theory has identified 2 major waves: impulse and corrective waves.
Impulse waves, also called as motive waves are the larger wave setting the direction of market.
Corrective wave on the other hand move against the larger degree wave (impulse waves).
Explanation
The main principle in the Elliott’s theory is that every impulse wave consists of five shorter waves
and every corrective wave (against the trend) is composed of three waves.
The longest cycle, according to Elliott, is called Grand Super cycle that is composed of 8 Super
cycle waves. The latter ones are each composed of 8 Cycles, etc.
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Basic 5-3 wave sequence
The chart below shows a rising 5-wave sequence. The entire wave is up as it moves from the
lower left to the upper right of the chart. Waves 1,3 and 5 are impulse waves because they move with the
trend- Waves 2 and 4 are corrective waves because they move against this bigger trend. A basic impulse
advance forms a 5-wave sequence.
A basic corrective wave forms with three waves, typically a, b and c. The chart below shows an abc
corrective sequence. Notice that waves a and c are impulse waves (green). This is because they are in the
direction of the larger degree wave. This entire move is clearly down, which represents the larger degree
wave. Waves a and c move with the larger degree wave and are therefore impulse waves. Wave b, on the
other hand, moves against the larger degree wave and is a corrective wave (red).
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Combining a basic 5 wave impulse sequence with a basic 3 wave corrective sequence yields a
complete Elliott Wave sequence, which is a total of 8 waves.
5.5 Charts - Technical analysis

Technicians rely heavily n the charts of prices and volume for the analysis of markets. Charts
organize the historical data about the market in order to make it easier for interpretations. The main
purpose of chart reading is to determine the price at various level of demand and supply, direction in which
price is moving and thus to predict its future direction of price.
In order to understand charts, following concepts shall be clear
i. Types of charts
ii. Chart patterns
1. Types of Charts
Technician use different types of
charts depending upon the nature and
duration of investment analysis.
Commonly used chart types are
explained in this section.
Figure: Types of Charts
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a. Candlestick chart
A candlestick chart is a style of bar-chart used primarily to describe price movements of a security
over time. It is a combination of a line-chart and a bar-chart, in that each bar represents the range of
price movement over a given time interval. It is most often used in technical analysis of equity and currency
price patterns.
They are composed of
 The body (black or white) - the area between the open and the close
 An upper and a lower shadow (wick): price excursions above and below the real body are called
shadows.
The wick illustrates the highest and lowest traded prices of a security during the time interval
represented. The body illustrates the opening and closing trades.
If the security closed higher than it opened, the body is white or unfilled, with the opening price at
the bottom of the body and the closing price at the top.
If the security closed lower than it opened, the body is black, with the opening price at the top and
the closing price at the bottom.
b. Line Chart
A line chart or line graph is a type of graph, which displays information as a series of data points
connected by straight line segments. It is a basic type of chart common in many fields. It is an extension of
a scatter graph, and is created by connecting a series of points that represent individual measurements with
line segments. A line chart is often used to visualize a trend in data over intervals of time, thus the line is often
drawn chronologically.
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c. Point And Figure Chart
Point and figure is a charting technique used in technical analysis, used to attempt to predict financial
market prices. Point and figure charting does not plot price against time as all other techniques do. Instead
it plots price against changes in direction by plotting a column of Xs as the price rises and a column of Os
as the price falls.
The correct way to draw a point and figure chart is to plot every price change but practicality has
rendered this difficult to do for a large quantity of stocks so many point and figure chartists use the summary
prices at the end of each day.
4. Bar Chart
The bar chart expands on the line chart by adding several more key pieces of information to
each data point. The chart is made up of a series of vertical lines that represent each data point.
The close and open are represented on the vertical line by a horizontal dash. The opening price
on a bar chart is illustrated by the dash that is located on the left side of the vertical bar conversely the close
is represented by the dash on the right.
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Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded
black, signaling up in the market
A bar that is colored red signals that the stock has gone down in value over that period. When this
is the case, the dash on the right (close) is lower than the dash on the left (open).
2. Chart Patterns
A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future
price movements. One of the three assumptions of technical analysis was that “history repeats itself’. The
chart patterns are based on this assumption only. The idea is that certain patterns are seen many times, and
that these patterns signal a certain high probability move in a stock.
While there are general ideas and components to every chart pattern, there is no chart pattern that
will tell you with 100% certainty where a security is headed.
In short, these chart patterns help technical analysts to take decisions of buy or sell shares.
Broadly, we can categorize these patterns under 3 heads. Theses heads contain the common chart patterns
formed and identified in the stock market, following chart summarizes various patterns commonly found.
Figure: Various Chart Patterns
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Note that there are various other chart patterns used in technical analysis as well. Few
commonly used are only taken above
1. Support and resistance
 Support is a level or area on the chart under the market where buying interest is sufficiently strong
to overcome selling pressure. As a result, a decline is halted and prices turn back up again. A
support level is usually identified beforehand by a previous reaction low or trough.
 Resistance is the opposite of support and represents a price level or area over the market where
selling pressure overcomes buying pressure and a price advance is turned back. A resistance
level is usually identified by a previous peak.
It is often difficult to determine whether a support level will hold or be broken. This pattern is
the weakest and most difficult to use.
2. Continuation Patterns
Continuation Patterns generally will continue the direction of the trend. For example: if a stock is in
an uptrend and then pauses or enters into a period of consolidation (i.e., trading is temporarily confined to a
well-defined pattern or range), the expectation is that the market will ultimately breakout to the upside and
continue the direction of the trend.
If the trend, on the other hand, was down prior to the consolidation, the expectation would be for the stock to
breakout to the downside and continue the direction of the downtrend.
Various types of continuation patterns are
 Symmetrical Triangles
 Ascending & Descending Triangles
 Rectangles
 Flags & Pennants
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 Symmetrical Triangles
Symmetrical Triangles are continuation patterns that generally mark a pause in the preceding
trend. It’s identified as having two converging trend lines that take the shape of a sideways triangle.
This pattern can mean the market has simply gotten ahead of itself and it needs to consolidate or it
truly is in a period of indecision and is looking for direction. Each new lower high and higher low becomes
shallower than the last.
Symmetrical Triangles in up trends are bullish, while Symmetrical Triangles in downtrends are bearish.
 Ascending & Descending Triangles

The Ascending Triangle is a variation of the Symmetrical Triangle. The difference is that the
Ascending Triangle has a flat line on top (i.e., horizontal trendline) instead of a downward slanting trendline
like in the Symmetrical Triangle. The bottom of the pattern has an upward slanting trendline. The two
lines eventually come together to form a flat-topped, right-sided triangle. This pattern is generally considered
bullish and is most reliable when found in an uptrend
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The Descending Triangle is basically the reverse of an Ascending Triangle. The flat line (horizontal
trendline) is on the bottom and a descending trendline defines the top part of the pattern. The two lines come
together to form a flat bottomed, right-sided triangle. This is a continuation pattern and is generally considered
bearish. It is most reliable when found in a downtrend.
 Rectangles
A Rectangle is a continuation pattern that forms as a trading range during a pause in the trend.
The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can
be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are
sometimes referred to as trading ranges, consolidation zones or congestion areas.
Rectangles represent a trading range that pits the bulls against the bears. As the price nears support,
buyers step in and push the price higher. As the price nears resistance, bears take over and force the price
lower.
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 Flag & Pennants
Both Flags and Pennants are categorized as continuation patterns.
The consolidation part of the pattern usually represents only a brief pause in an otherwise powerful
market. They are typically seen right after a big, quick move - either up or down. The market then usually
takes off again in the same direction. Research has shown that Flags and Pennants are some of the most
reliable chart patterns to trade.
 Flags: Bullish in Up trends

Flag patterns in uptrends are bullish. They are typically referred to as simply ‘Bull Flags’’ Bull Flags
are characterized first by a sharp upward price move. The consolidation that follows is identified by a short
series of lower tops and lower bottoms that slant against the trend. The trendlines that can be drawn on the
top of the pattern and the bottom of the pattern run parallel to one another (like a downward sloping
rectangle).
 Flags: Bearish in Downtrends
Flags in downtrends are bearish. Bear Flags look like the inverse of Bull Flags. They are
characterized by a sharp downward price move, followed by a short series of higher lows and higher highs.
The trendlines that can be drawn also run parallel to one another. But this time, it looks like an upward
sloping rectangle.
 Pennants: Bullish in Uptrends
Pennants in uptrends are bullish. Pennants look very much like small symmetrical triangles. But
the characteristic, near straight-up, ‘pole-like’ move that precedes the pennant part, makes its identification
unmistakable. The pause after the sharp move higher is defined by two converging trendlines that form a
small right sided triangle.
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• Pennants: Bearish in Downtrends
Pennants in downtrends are bearish. Bear Pennants look like upside down Bull Pennants. In the
Bear Pennant, there’s a big move to the downside, followed by a short consolidation pattern that looks like a
small triangle.
3. Reversal Patterns
Reversal Patterns have a tendency of reversing the trend. These consolidation patterns can signal a
reversal in both uptrends as well as downtrends. Some of the reversal patterns are:
 Double top
 Double bottom
 Wedges
 Head and shoulder
 Double top
Double Tops appear on a chart in the shape of the letter “M” and are quite common price formation
at the end of a bull market. It appears as two consecutive peaks of approximately the same price
The two peaks are separated by a minimum in price, a valley. The price level of this minimum is called the
neck line of the formation. The formation is completed and confirmed when the price falls below the neck
line, indicating that further price decline is imminent or highly likely.
 Double bottom
A double bottom is the opposite of a double top and appears as a letter “W” on a chart. It is the end
formation in a declining market. It is identical to the double top, except for the inverse relationship in price.
The pattern is formed by two price minima separated by local peak defining the neck line.
• Wedges
The wedge pattern is a commonly found pattern in the price charts of financially traded assets. The
pattern is characterized by a contracting range in prices …………………………………. prices (known
as a rising wedge) or a downward trend in prices (known as a falling wedge).
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A wedge pattern is considered to be a temporary halt of primary trend. It is a type of formation in
which trading activities are confined within converging straight lines which form a pattern.
It should take about 3 to 4 weeks to complete the wedge.
• Head and Shoulders formation
The Head and Shoulders formation is one of the most well known reversal patterns.
There are two major kinds of formations under this pattern:
 Head and Shoulders Top
 Head and Shoulders Bottom
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• Head and Shoulders Top
 Head and Shoulders formation consists of a left shoulder, a head, and a right shoulder and a line
drawn as the neckline.
 The left shoulder is formed at the end of an extensive move during which volume is noticeably high.
After the peak of the left shoulder is formed, there is a subsequent reaction and prices slide down up
to a certain extent which generally occurs on low volume.
 The right shoulder is formed when prices move up again but remain below the central peak called
the Head and fall down nearly equal to the first valley between the left shoulder and the head or at
least below the peak of the left shoulder.
 A neckline is drawn across the bottoms of the left shoulder, the head and the right shoulder. When
prices break through this neckline and keep on falling after forming the right shoulder, it is the
ultimate confirmation of the completion of the Head and Shoulders Top formation.
• Head and shoulders bottom
 This formation is simply the inverse of a Head and Shoulders Top and often indicates h change in
the trend and the sentiment.
 The formation is upside down in which volume pattern is different than a Head and Shoulder Top.
 Prices move up from first low with increase volume up to a level to complete the left shoulder
formation and then falls down to a new low.
 It is followed by a recovery move that is marked by somewhat more volume than seen before to
complete the head formation.
 A corrective reaction on low volume occurs to start formation of the right shoulder and then a sharp
move up that must be on quite heavy volume breaks though the neckline.
5.6 Technical Indicators
There are numerous trading rules and indicators used in technical analysis. These indicators are
interpreted in order to make the buy or sell decision. Different analysts use different techniques to interpret
the ongoing market signals.
Technical indicators can be categorized under Three heads.
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1. Contrary-Opinion Rules
Most technical analysts rely on the trading rules that assume that the majority of investors are wrong
as market approaches peaks and troughs. These analysts try to determine when the majority of investors is
either bullish or bearish and then take decision in the opposite direction. Some of these prominent rules are:-
a. Mutual Fund Cash Positions: Mutual funds can holds some part of their portfolio in cash for
several reasons. Technical analysts assume that mutual fund managers are poor judges of market
turning point. Mutual funds ratio of cash as a percentage of the total asset in their portfolio are used
to make buy or sell decision in this rule
Interpretation: Analysts buy when Mutual funds have high percentage of cash (Bullish
indicator) and sell when Mutual funds have low percentage of cash (Bearish indicator).
b. Credit Balance in Brokerage Account: Credit balances result when investors sell stock and
leave their proceeds with their brokers, expecting to reinvest them shortly.
Interpretation: Technical analyst view these credit balances as potential purchasing power. Thus,
decline in these credit balances (when people are buying) is considered bearish. Conversely,
increase in these credit balances (when people are selling) is considered bullish.
c. Investment advisory Opinion: Technicians believe that most of investment advisory firms are
trend followers and thus opposite direction shall be taken when majority of these firms are in same
direction.
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Interpretation: Analysts buy when majority of investment advisory firms are bearish (bullish
indicator) and alternately sell when majority of investment advisory firms are bullish (bearish
indicator).
d. Odd Lot Trading: “Odd Lot” is a stock order comprised of less than 100 shares of stock. So any
stock order from 1 share to 99 shares is considered to be an odd lot. Technical analysts believe that
odd letters do not wait for market to be in peak or bottom.
Interpretation: Analysts get a buy signal (bullish) when high number of odd lot sales are done
in the market and sell (bearish) when high number of odd lot purchases are done.
e. Short Selling: Short selling refers to the sale of a security that is not owned by the seller, in a belief
that the security’s price will decline, enabling it to be bought back at a lower price to make a profit.
Interpretation: As there is increasing levels of short selling in the market, it indicates that
market will become bearish and hence giving a buy signal. As there is decreasing levels of short
selling in the market, it indicates that market will become bullish and hence giving a sell signal.
2. Follow the Smart money: Some Technical analysts have created a set of indicators and corresponding
rules that they believe indicate the behavior of smart and sophisticated investors. Analysts move in the same
direction as these smart money investors moves. Some of these indicators are:
a. Confidence Index: It is the ration of a group of lower grade bonds to a group of higher
grade bonds.
Interpretation: When ratio is high, investor’s confidence is high and thus is a bullish indicator.
Conversely when the ratio is low or declining, it indicates bearish market.
b. Insider Transaction: the hypothesis that insider activity may be indicative of future prices has received
some support in academy literature. Some indicators may have the best picture of as to hoe the
future price of stock move
Interpretation: If insiders are selling heavily, it is a bearish indicator and one must start selling
as well, and vice versa.
c. Debit Balance In Broker Account: Debit balance in brokerage accounts represents the borrowings
by knowledgeable investors from brokers.
Interpretation: Hence, high debit balances indicate buying by these sophisticate investors and
thus giving a bullish sign, while low debit balance indicate selling and would be a bearish indicator.
3. Price and volume techniques:
a. Advance decline Line: All the stocks rising in prices are referred to advances and falling stocks
are referred as declines.
The Advance/Decline line is a plot of the cumulative sum of the daily difference between the
number of issues advancing and the number of issues declining in a particular stock market index.
Thus it moves up when the index contains more advancing than declining issues, and moves down
when there are more declining than advancing issues.
Interpretation: When A/D Line moves up it signals bullish market and when line moves down
it signals bearish market,
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b. Moving Average: A moving average is the average price of a security over a set amount of time.
By plotting a security’s average price, the price movement is smoothed out. Once the day-to-day
fluctuations are removed, traders are better able to identify the true trend and increase the probability
that it will work in their favor.
There are a number of different types of moving averages that vary in the way they are calculated,
but how each average is interpreted remains the same.
Interpretations: Moving average line can be used in different ways to interpret buy or sell signal
by the technical indicators. These are:
i. When a moving average is heading upward and the price is above it, the security is in an
uptrend. Conversely, a downward sloping moving average with the price below can be used to
signal a downtrend.
ii. When a short-term average is above a longer-term average, the trend is up. On the other hand,
a long-term average above a shorter-term average signals a downward movement in the trend.
iii. When the price of a security that was in an uptrend falls below a moving average, it is a sign
that the uptrend may be reversing, and vice versa.
There are several other indicators (Relative strength index, oscillators, breadth of market, etc)
commonly used by technical analyst to interpret the market timing and buy and sell signal.
5.7 Evaluation of technical analysis
Studies have been made to determine the validity of technical theories and technical indicators, but
studies give no definite answer as to whether these are effective predictors of future stock price.
A. Strengths of technical analysis
1. Focus on Price
By focusing on price action, technicians are automatically focusing on the future. The market is
thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the
market, it makes sense to look directly at the price movements.
2. Supply, Demand, and Price Action
Many technicians use the open, high, low and close when analyzing the price action of a security.
Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect
forces of supply and demand.
3. Support/Resistance
Simple chart analysis can help identify support and resistance levels. When prices move out of the
trading range, it signals that either supply or demand has started to get the upper hand. If prices move above
the upper band of the trading range, then demand is winning. If prices move below the lower band, then
supply is winning.
4. Pictorial Price History
The price chart is an easy to read historical account of a security’s price movement over a period of
time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are
displayed at the bottom. With this historical picture, it is easy to identify the following:
 Reactions prior to and after important events.
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 Past and present volatility.
 Historical volume or trading levels.
 Relative strength of a stock versus the overall market.
5. Assist with Entry Point
Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis
to decide what to buy and technical analysis to decide when to buy. Simply waiting for a breakout above
resistance or buying near support levels can improve returns.
B. Weaknesses of Technical Analysis
There are some limitations attached to the technical analysis. These are:
1. Analyst Bias
Just as with fundamental analysis, technical analysis is subjective and our personal biases can be
reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is
a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a
disgruntled eternal bear, then the analysis will probably have a bearish tilt.
2. Open to Interpretation
Even though there are standards, many times two technicians will look at the same chart and paint
two different scenarios or see different patterns. Both will be able to come up with logical support and
resistance levels as well as key breaks to justify their position. It is in the eye of the beholder.
3. Too Late
Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial
portion of the move has already taken place. After such a large move, the reward to risk ratio is not great.
4. Always Another Level
Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even
if they are bullish, there is always some indicator or some level that will qualify their opinion.
5. Trader’s Remorse
Not all technical signals and patterns work. When you begin to study technical analysis, you will
come across an array of patterns and indicators with rules to match. Even though many principles of technical
analysis are universal, each security will have its own idiosyncrasies.
1. What is technical Analysis?
2. Explain the Elliot Wave theory of technical Analysis.
3. Discuss the strength and weaknesses of technical Analysis.
5.9 Summary
As an approach to investment analysis, technical analysis isradically different from fundamental
analysis. Technical analysis doesn’t evaluate a large number of factors relating to the company, the industry
and the economy. Instead, they analyzed market generated data like prices and volumes to determine the
direction of price movement.Technical analysts use a variety of tools to predict the market.Among them,
important are Dow Theory, charts, moving average, short selling, odd lot theory, Relative strength analysis,
volume of trade, the breadth of the market etc. technical analysis appears to be a highly controversial approach
to security analysis having severe critics. In a rational, well-ordered and efficient market, technical analysis
is a worthless exercise.
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However, given the imperfections, inefficiencies and irrationalities that characterize the real world
market, technical analysis can be helpful to earn abnormal return in the market.
5.10 Glossary
Technical analysis: Technical analysisinvolves a study of market-generated data like prices and
volumes to determine the future direction of price movement of securities.
Bull market: Bull marketis the market exhibiting the increasing trend.
Relative Strength analysis: Relative Strength analysisis based on the assumption that prices of
some securities rise rapidly during the bull phase, but fall slowly during the bear phase in relation to the market
as a whole.
Short selling: Short sellingrefers to the selling of shares that you don’t have.
Short sellers: Short sellersare those who will sell now in the hope of purchasing at a lower price in
the future to make a profit.
1. Technical analysts believe that one can use past price changes to predict future price changes.
How do they justify this belief?
2. Discuss the Dow theory and its three components. Which component is most important?
3. Write short notes on
i. Short Selling
ii. Relative Strength Analysis
iii. Odd Lot Theory.
1. Benjamin Graham and David L. Dodd. (2008). Security Analysis.McGraw-Hill Education; 6th
edition.
2. S. Kevin (2006). Security Analysis and Portfolio Management.Prentice Hall India Learning
Private Limited.
3. Rohini Singh (2009). Security Analysis and Portfolio Management.Excel Book A-45 Naraina,
phase 1, New Delhi.
4. Shashi K. Gupta & Rosy Joshi (2014).Security Analysis and Portfolio Management Kalyani
Publishers.
5. V.A. Avadhani, Security Analysis and Portfolio Management.Himalyana Publication.
*****
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LESSON-6
PORTFOLIO MANAGEMENT
Structure
6.1 Introduction
6.2 Portfolio Management
6.3 Portfolio Management Process
6.4 Portfolio – Objectives and Constraints
6.5 Types of Portfolio
6.6 Portfolio Management Strategies
6.7 Assets Allocation Strategies
6.8 Monitoring and Revision of Portfolio
6.9 Measuring Portfolio Performance
6.11 Summary
6.12 Glossary
1. Describe the meaning of portfolio management
2. Discuss the approaches of portfolio construction
3. Understand reasons and process of portfolio construction of financial instruments.
6.1 Introduction
“Portfolio means combined holding of many kinds of financial securities i.e. shares, debentures,
government bonds, units and other financial assets.” The term investment portfolio refers to the various
assets of an investor which are to be considered as a unit. It is not merely a collection of unrelated assets but
a carefully blended asset combination within a unified framework. It is necessary for investors to lake all
decisions as regards us their wealth position in a context of portfolio. Making a portfolio means putting
ones eggs in different baskets with varying element of risk and return.
The objective of portfolio is to reduce risk by diversification and maximize gains. Thus, portfolio
is a combination of various instruments of investment. It is also a combination of securities with different
risk-return characteristics. A portfolio is built up out of the wealth or income of the investor over a
period of time with a view to manage the risk- return preferences.
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6.2 Portfolio Management
Portfolio management in common parlance refers to the selection of securities and their continuous
shifting in the portfolio to optimize the returns to suit the objectives of the investor.
Portfolio management includes portfolio planning, selection and construction, review and
evaluation of securities. The skill in portfolio management lies in achieving a sound balance between the
objectives of safety, liquidity and profitability. Timing is an important aspect of portfolio revision. Ideally,
investors should sell at market tops and buy at market bottoms. Investors may switch from bonds to share in
a bullish market and vice-versa in a bearish market.
Portfolio management is an art and science of making decisions about investment mix and
policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing
risk against performance.
This however requires financial expertise in selecting the right mix of securities in changing
market conditions to get the best out of the stock market.
Portfolio management service is one of the merchant banking activities recognized by Securities
and Exchange Board of India (SEBI). The portfolio management service can be rendered either by the
SEBI recognized categories I and II merchant bankers or portfolio managers or discretionary portfolio manager
as defined in clause (e) and (f) of rule 2 SEBI (portfolio managers) Rules 1993.
According to the definitions as contained in the above clauses, a portfolio manager means any
person who pursuant to contract or arrangement with a client, advises or directs of undertakes on
behalf of the client (whether as a discretionary portfolio manager or otherwise) the management or
administration of a portfolio of securities or the funds of the client, as the case may be. A merchant
banker acting as a portfolio Manager shall also be bound by the rules and regulations as applicable to the
portfolio manager.
6.3 Portfolio Management Process
Portfolio management is on-going process involving the following basic tasks
1.
2.
3.
4.
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6.4 Portfolio - Objective and Constraints
Constraints
The management of customer portfolios is an involved process. Besides assessing a customer’s risk
profile, a portfolio manager must also take into account other considerations, such as the tax status of the
investor and of the type of investment vehicle, as well as the client’s resources, liquidity needs and time
horizon of investment.
Resources One obvious constraint facing an investor is the amount of resources available for investing.
Many investments and investment strategies will have minimum requirements. For example, setting up a
margin account in the USA may require a minimum of a few thousand dollars when it is established. Likewise,
investing in a hedge fund may only be possible for individuals who are worth more than one million dollars,
with minimum investments of several hundred thousand dollars.
Tax status In order to achieve proper financial planning and investment, taxation issues must be
considered by both investors and investment managers. In some cases, the funds are not taxed at all. Investors
will need to assess any trade-offs between investing in tax- free funds and fully taxable funds. Investors in a
higher tax category will seek investment strategies with favorable tax treatments. Tax-exempt investors will
concentrate more on pretax returns.
Liquidity needs At times, an investor may wish to invest in an investment product that will allow for
easy access to cash if needed. Liquidity considerations must be factored into the decision that determines
what types of investment products may be suitable for a particular client. Highly liquid stocks or fixed-
interest instruments can guarantee that a part of the investment portfolio will provide quick access to
cash without a significant concession to price should this be required.
Time horizons an investor with a longer time horizon for investing can invest in funds with longer-
term time horizons and can most likely stand to take higher risks, as poor returns in one year will most
probably be cancelled by high returns in future years before the fund expires. A fund with a very short-term
horizon may not be able to take this type of risk, and hence the returns may be lower.
Special situations besides the constraints already mentioned, investors may have special
circumstances or requirements that influence their investment universe. For example, the number of dependants
and their needs will vary from investor to investor. An investor may need to plan ahead for school or university
fees for one or several children. Certain investment products will be more suited for these investors. Other
investors may want only to invest in socially responsible funds, and still other investors, such as corporate
insiders or political officeholders, may be legally restricted regarding their investment choices.
Objectives
Apart from the major objective of, minimizing the risk ate given level of return and maximizing
the return at a given level of risk, following are the objectives to be considered by the portfolio manager
while constructing the portfolios:
Security/Safety of Principal: Security not only involves keeping the principal sum intact but also
keeping intact its purchasing power intact. Safety means protection for investment against loss under reasonably
variations. In order to provide safety, a careful review of economic and industry trends is necessary.
Stability of Income: So as to facilitate planning more accurately and systematically the reinvestment
consumption of income is important.
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Capital Growth: This can be attained by reinvesting in growth securities or through purchase of
growth securities. Capital appreciation has become an important investment principle. Investors seek growth
stocks which provides a very large capital appreciation by way of rights, bonus and appreciation in the market
price of a share.
Marketability: It is the case with which a security can be bought or sold. This is essential for
providing flexibility to investment portfolio.
Liquidity i.e. nearness to money: It is desirable to investor so as to take advantage of attractive
opportunities upcoming in the market
Diversification: The basic objective of building a portfolio is to reduce risk of loss of capital and / or
income by investing in various types of securities and over a wide range of industries.
Favorable Tax status (Tax Incentives): The effective yield an investor gets form his investment
depends on tax to which it is subject. By minimizing the tax burden, yield can be effectively improved.
Investors try to minimize their tax liabilities from the investments. The portfolio manager has to keep a list of
such investment avenues along with the return risk, profile, tax implications, yields and other returns. Investment
programmers without considering tax implications may be costly to the investor.
Types of Portfolio
When it comes to investing there are many options available to individuals. A person can invest in
stocks, bonds, mutual funds, etc. Once a person invests in multiple products their performance needs to
be tracked and strategies made to ensure the investor reaps the most profit possible. This is where the
investment portfolio comes into play.
Maintaining a diverse portfolio helps to mitigate loss because the investor has not placed all of their
eggs in one basket. There are different types of investment portfolios. Perhaps the most common type’s
individuals are exposed to be:
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Figure: Types of portfolios
1. Aggressive Investment Portfolio In general, aggressive investment strategies are those that
a. Shoot for the highest possible return
b. Are most appropriate for investors who, for the sake of this potential high return, have a high risk
tolerance and a longer time horizon.
Aggressive portfolios generally have a higher investment in equities. Aggressive investment
portfolios are for investors not afraid of high risk. This type of portfolio may incorporate mutual
funds that aim for high capital gain, equities, stocks, bonds, cash and maybe some commodities.
An aggressive portfolio contains high growth investments that will hopefully appreciate in value.
This strategy attempts to achieve high long-term growth by investing in often risky but profitable,
short-term stocks.
Under normal market conditions, the Aggressive Growth Portfolio will invest approximately
100% of its total assets in equity securities. The Aggressive Growth Portfolio can invest up to
100% of its total assets in equity securities and up to 25% of its total assets in fixed income
securities.
2. Balanced or Moderate Investment Portfolio a moderately aggressive portfolio is meant for
individuals with a longer time horizon and an average risk tolerance.
Investors who find these types of portfolios attractive are seeking to balance the amount of risk and
return contained within the fund.
The portfolio would consist of approximately 50-55% equities, 35-40% bonds, 5- 10% cash
and equivalents. The Moderate Portfolio’s primary investment objective is to seek long-term
capital appreciation and also the Moderate Portfolio seeks current income.
3. Conservative Investment Portfolio The conservative investment strategies, which put safety
at a high priority, are most appropriate for investors who are risk averse and have a shorter
time horizon.
Conservative portfolios will generally consist mainly of cash and cash equivalents, or high-
quality fixed-income instruments. The main goal of a conservative portfolio strategy is to maintain the
real value of the portfolio, or to protect the value of the portfolio against inflation.
The conservative investment portfolio is geared towards preserving capital. A minimal risk investment
strategy is used. This type of portfolio is ideal for retirees who are focused more on having assets
available than a stream of income from interest.
Under normal market conditions, the Conservative Portfolio will invest approximately 65% of its
total assets in fixed income securities and cash and approximately 35% of its total assets in equity
securities. The Conservative Portfolio can invest up to 100% of its total assets in fixed income securities and
or some time up to 20% of its total assets in equity securities. Investors can further break down the above
asset classes into subclasses, which also have different risks and potential returns.
6.6 Portfolio Management Strategies
Two types of investment portfolio management:
 Passive Portfolio Management
 Active Portfolio Management
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Passive Portfolio Management:
 Holding securities in the portfolio for the relatively long periods with small and infrequent changes;
 Investors act as if the security markets are relatively efficient. The portfolios they hold may be
surrogates for the market portfolio (index funds).
 Passive investors do not try outperforming their designated benchmark.
The reasons when the investors with passive portfolio management make changes in their portfolios:
 The investor’s preferences change;
 The risk free rate changes;
 The consensus forecast about the risk and return of the benchmark portfolio changes.
Active Portfolio Management:
 Active investors believe that from time to time there are mispriced securities or groups of securities
in the market;
 The active try to outperform the markets and earn higher returns
 The active investors use deviant predictions - their forecast of risk and return differ from consensus
opinions.
Table: Active vs Passive Strategies
Area of comparisons Active investment management Passive investment
management
Aim To achieve better results than management To achieve the
average in the market average market results
Strategies used and decision Short term positions, the quick Long term positions, slow
making and more risky decisions; decisions
keeping the "hot" strategy
Investor/manager tense laid-back
Taxes and turnover of investment High taxes, relatively high Low taxes, small turnover of
portfolio turnover of portfolio portfolio
Performance results before costs In average equal to the In average equal to the actively
and taxes passively managed portfolios managed portfolios
Performance results after costs In average lower than market In average higher than the
and taxes index after taxes results of actively managed
portfolio returns after taxes
Supporters All brokerage firms, investment Passively managed pension
funds, hedging fund, specialized funds, index funds
investment companies Quantitative: risk management,
Analytical methods Qualitative: avoiding risk, long term statistical analysis,
forecasts, emotions, intuition, precise fundamental analysis
success, speculation, gambling
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There are arguments for both active and passive investing though it is probably a case that a larger
percentage of institutional investors invest passively than do individual investors. Of course, the active versus
passive investment management decision does not have to be a strictly either/ or choice. One common
investment strategy is to invest passively in the markets investor considers to be efficient and actively in the
markets investor considers inefficient. Investors also combine the two by investing part of the portfolio
passively and another part actively.
6.7 Asset Allocation Strategies
An asset allocation focuses on determining the mixture of asset classes that is most likely to
provide a combination of risk and expected return that is optimal for the investor. Asset allocation is a
bit different from diversification. It focus is on investment in various asset classes. Diversification, in contrast,
tends to focus more on security selection — selecting the specific securities to be held within an asset class.
Asset classes here is understood as groups of securities with similar characteristics and properties.
Asset allocation proceeds other approaches to investment portfolio management, such as market
timing (buy low, sell high) or selecting the individual securities which are expected will be the “winners”.
These activities may be integrated in the asset allocation process. But the main focus of asset allocation is to
find such a combination of the different asset classes in the investment portfolio which the best matches with
the investor’s goals - expected return on investment and investment risk.
Two major asset allocation strategies are:
Strategic asset allocation identifies asset classes and the proportions for those asset classes that
would comprise the normal asset allocation. Strategic asset allocation is used to derive long-term asset
allocation weights. The fixed-weightings approach in strategic asset allocation is used.
Investor using this approach allocates a fixed percentage of the portfolio to each of the asset classes,
of which typically are three to five. Generally, these weights are not changed over time.
When market values, change, the investor may have to adjust the portfolio annually or after
major market moves to maintain the desired fixed-percentage allocation.
Tactical asset allocation produces temporary asset allocation weights that occur in response to
temporary changes in capital market conditions.
86
The investor’s goals and risk- return preferences are assumed to remain unchanged as the
asset weights are occasionally revised to help attain the investor’s constant goals. For example, if the investor
believes some sector of the market is over- or under valuated. The passive asset allocation will not have any
changes in weights of asset classes in the investor’s portfolio — the weights identified by strategic asset
allocation are used.
6.8 Monitoring and Revision of the Portfolio
Portfolio revision is the process of selling certain issues in portfolio and purchasing new ones
to replace them.
The main reasons for the necessity of the investment portfolio revision:
 As the economy evolves, certain industries and companies become either less or more attractive as
investments;
 The investor over the time may change his/her investment objectives and in this way his/ her portfolio
isn’t longer optimal;
 The constant need for diversification of the portfolio. Individual securities in the portfolio often change
in risk-return characteristics and their diversification effect may be lessened.
Three areas to monitor when implementing investor’s portfolio monitoring:
 Changes in market conditions;
 Changes in investor’s circumstances;
 Asset mix in the portfolio.
6.9 Measuring Portfolio Performance
Portfolio performance evaluation involves determining periodically how the portfolio performed
in terms of not only the return earned, but also the risk experienced by the investor.
For portfolio evaluation appropriate measures of return and risk as well as relevant standards (or
“benchmarks”) are needed. In general, the market value of a portfolio at a point of time is determined by
adding the markets value of all the securities held at that particular time.
The market value of the portfolio at the end of the period is calculated in the same way, only using
end-of-period prices of the securities held in the portfolio.
The return on the portfolio (rp):
rp = (Ve - Vb) / Vb,
Where:
Ve - beginning value of the portfolio
Vb - ending value of the portfolio.
The essential idea behind performance evaluation is to compare the returns which were obtained on
portfolio with the results that could be obtained if more appropriate alternative portfolios had been chosen for
the investment.
Such comparison portfolios are often referred to as benchmark portfolios. In selecting them investor
should be certain that they are relevant, feasible and known in advance. The benchmark should reflect the
objectives of the investor.
87
Portfolio Beta can be used as an indication of the amount of market risk that the portfolio had during
the time interval. It can be compared directly with the betas of other portfolios. You cannot compare the ex
post or the expected and the expected return of two portfolios without adjusting for risk.
To adjust the return for risk before comparison of performance risk adjusted measures of performance can
be used:
 Sharpe’s ratio;
 Treynor’s ratio;
 Jensen’s Alpha.
Sharpe’s ratio shows an excess a return over risk free rate, or risk premium, by unit of total
risk, measured by standard deviation:
Sharpe’s ratio = (ř p- ř f) / p,
Where:
ř p - the average return for portfolio p during some period of time;
ř f - the average risk-free rate of return during the period;
p - standard deviation of returns for portfolio p during the period.
Treynor’s ratio shows an excess actual return over risk free rate, or risk premium, by unit of
systematic risk, measured by Beta:
Treynor’s ratio = (ř p — ř f) / βp,
Where:
βp - Beta, measure of systematic risk for the portfolio p.
Jensen‘s Alpha shows excess actual return over required return and excess of actual risk
premium over required risk premium. This measure of the portfolio manager’s performance is based on
the CAPM
Jensen’s Alpha = (ř p- ř f) — βp ( ř m - ř f),
Where:
ř m - the average return on the market in period t;
( ř m - řf) - the market risk premium during period t.
It is important to note, that if a portfolio is completely diversified, all of these measures (Sharpe,
Treynor’s ratios and Jensen’s alfa) will agree on the ranking of the portfolios.
The reason for this is that with the complete diversification total variance is equal to systematic
variance. When portfolios are not completely diversified, the Treynor’s and Jensen’s measures can rank
relatively undiversified portfolios much higher than the Sharpe measure does.
Since the Sharpe ratio uses total risk, both systematic and unsystematic components are included.
1. What is portfolio management?
2. Discuss the strategies of portfolio management.
3. How would you formulate the asset mix according to the given objectives?
88
6.11 Summary
Portfolio is a combination of various securities. It can be constructed according to the traditional
approach or modern approach. In the traditional approach the constraints, the investor’s need for current
income and income in constant rupees are analysed. Liquidity, safety, time horizon of the investment, tax
consideration and temperament of the individual investor’s are the other constraints to frame the objectives.
The general objectives of the portfolio are current income, constant income, capital appreciation and preservation
of capital. According to the objectives the portfolio, whether it is a bond portfolio or a stock portfolio or a
combination of both of bond and stock is decided. After that, the equity component of the portfolio is chosen.
The traditional approach takes the entire financial plan of the individual investor. In the modern approach,
Markowitz model is used. More importance is given to the risk and return analysis.
6.12 Glossary
Portfolio construction: Portfolio construction is the process of blending together the broad asset
classes to obtain an optimum return with minimum risk.
Traditional approach: Traditional approach of portfolio construction is based on the financial needs
of the individual investors.
Modern approach: Modern approach his based on the risk and return analysis.
Portfolio returns: Portfolio returns are the weighted returns of all securities constituting the portfolio.
Portfolio risk: Portfolio risk is simply weighted average risk of all securities in the portfolio and is
measured by the standard deviation together with the covariance between securities.
1. Select suitable portfolios for an investor who falls in the risk bracket of 40 per cent.
Portfolio P1 P2 P3 P4 P5
Standard deviation 15% 16% 18% 12% 19%
Return 16% 18% 22% 19% 23%
2. Compute the beta for the following security:

Security price 410 415 418 422 420 419
Market price 3282 3285 3286 3290 3294 3298
3. Explain the constraints in the formation of objectives.

4. What are the differences between the traditional approach and modern approach?
5. State the modern approach in the construction of the portfolio.
89
1. Farrell, J.I., Jr. Guide to Portfolio Management. New York: McGraw-Hill, 1983.
2. Harrington, D.R. Modern Portfolio Theory. 2d ed. Englewood Cliffs, N.J.: Prentice Hall, 1987.
3. Markowitz, H.M. Portfolio Selection: Diversification f Investments. New York: John Wiley,
1959.
4. Markowitz, H.M. “Individual versus Institutional Investing.” Financial Services Review 1 (1991).
5. Sharpe, W.F. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.”
Journal of Finance (September 1964).
6. Sharpe, W.F. Portfolio Theory and Capital Markets. New York: McGraw-Hill, 1970.
*****
90
ASSINMENTS
Attempt 75% Assignments
1. Discuss the operational mechanism of stock exchange in India.

2. Technical analysts believe that one can use past price changes to predict future price changes.
How do they justify this belief?
3. What is Company Analysis? What is its objective? Bring out the relevance of such analysis in
investment decisions.
4. How would you assess the present value of a bond? Explain the various bond value theorems with
examples.
5. Explain the nature of New Issues Market (NIM). How does NIM differ from secondary market?
6. Discuss the strategies of portfolio management.
*****
91

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M.B.

A IV Semester Course 406 FM-02

SECURITY ANALYSIS AND

INTERNATIONAL CENTRE FOR DISTANCE EDUCATION

LESSON-2 NEW ISSUE MARKET 15

LESSON-3 VALUATION OF SECURITIES 26

LESSON-4 FUNDAMENTAL ANALYSIS 37

LESSON-5 TECHNICAL ANALYSIS 58

LESSON-6 PORTFOLIO MANAGEMENT 80

Figure: Structure of Stock exchange

Public Right Private Book Bonus

Expected Cash Flows Required Rate of return

Figure: Approaches to Equity Valuation

PHASE NATURE PURPOSE INDICATORS

FIRST Economic To access the general economic Economic indicators

THIRD Company To analyse the Financial and Analysis of Financial Aspects:

Figure: Factors Affecting Economic Analysis

Surveys Indicators Diffussion

Figure : Economic Forecasting Techniques

Business Cycle and Industry sector

Figure: Forces Driving Industry’s competitiveness

Figure: Indicators for Company Analysis

Figure: Tools for financial analysis

Figure: Categories of Financial Ratios

 Downward Trends (Bearish market)

5.5 Charts - Technical analysis

Figure: Types of Charts

Figure: Various Chart Patterns

 Ascending & Descending Triangles

 Flags: Bullish in Up trends

2. Compute the beta for the following security:

3. Explain the constraints in the formation of objectives.

1. Discuss the operational mechanism of stock exchange in India.

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