Alochana Chakra Journal ISSN NO:2231-3990

Evaluate Intrinsic Value of Stock Using

Decision Tree Algorithm
K. Anusha1 and A. Murugan2
1
Assistant Professor,
Department of Computer Applications,
J H A Agarsen College, Madhavaram,
(Affiliated to University of Madras),
Chennai, 600 066, India.
anushakmca@gmail.com
2
Associate Professor
PG & Research Department of Computer Science,
Dr. Ambedkar Government Arts College (Autonomous),
Chennai, Tamil Nadu, 600039 , India.
amurugan1972@gmail.com

Abstract - In the equity market, the process of stock selection for the investment decision is a humongous task as large
number of stocks are available in the market. The two toolsdeployed widely for this process are fundamental analysis and
technical analysis. This paperdiscusses the origin of fundamental analysis and also its components. Fundamental analysis
comprises of economy analysis, industry analysis and companyanalysis of the stock intended for purchase. Then the
intrinsic / real value of a stock is calculated by using financial and economic analysis, which can be compared to the
current stock prices and determined if the stock is over-valued or under-valued. Decision tree, a data mining algorithm
has been used for this purpose.

Keywords – Data Mining, Decision Tree, Fundamental Analysis, Intrinsic Value

INTRODUCTION
With disposable incomes arising and people
looking beyond conventional small saving
schemes and bank deposits to invest their
money, so many people, even with little
knowledge, are investing in equity stocks.
However, the budding stock market investor
doesn't have to just cope with the erratic nature
of the market; stock selection process in the
equity market is a tedious taskbecause of the
wide variety of stocks available for purchase
andthe numerous external factors influencing the
decision makingprocess. Fundamental analysis
and technical analysis are thetwo major tools
used to make stock marketdecisions.
A. FUNDAMENTAL ANALYSIS
Fundamental analysis is a method of
evaluating securities by
measuringthe intrinsic value of a stock.
Under fundamental analysis, analysts study
everything from the overall economy and
industry conditions to the financial condition
and management of companies. Earnings,
expenses, assets, and liabilities are all
important characteristics to fundamental
analysts.
The objective of this analysis is to establish
a value for the stock that would factor in all
of these underlying factors. As the approach
doesn't look at short term pricing and trading
swings this is considered a long term
investment approach, as it may take time for
the intrinsic value to be realized. As this
factors in forward looking expectations, this
methodology is considered to build a
valuation based on backward and forward
looking information.
B. TECHNICAL ANALYSIS

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Technical analysis differs from fundamental
analysis in that it uses only a particular
stock's past prices and volumesfor
determining the future price of the stock.
The underlying notion of technical analysis
is that the collective actions – buying and
selling – of all the participants in the market
accurately reflect all relevant information
pertaining to a security, and therefore,
continually assign a fair market value to
the security.Technical analysts assume that
all known fundamentals are factored into
price and hence don’t attempt to measure a
security's intrinsic value; instead, they use
stock charts to identify patterns and trends
that suggest how a stock will perform in the
future.
The goal of this analysis is to capitalize on
pricing opportunities and trends that can be
identified in the market activity around each
share. As the technical analysis is purely
based on historical market activity, this is
considered to be a backward looking
methodology.
C. FUNDAMENTAL ANALYSIS VS TECHNICAL
ANALYSIS
Both fundamental analysis and technical
analysis are used for researching and
forecasting future trends in stock prices; but,
fundamental analysis is considered to be the
opposite of technical analysis. While
fundamental analysis is based on
unstructured data like news, articles, etc.,
technical analysis makes use of structured
data like past stock movements.
When it comes to comparing and choosing a
methodology between the two there are two
key considerations to factor in.
First, the time horizon of your approach is
important to consider. Fundamental analysis
is a long term investment strategy whereas
technical analysis is considered far more of
a short term methodology. By pricing on
intrinsic values fundamental analysis is
working towards the long-term value of a
company, whereas by trading on market
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trends technical analysis is short-term
focused.
Second, you need to consider what your
investment approach is. Are you an investor
or a trader? Fundamental analysis is
investing in companies and relying on their
underlying value to drive your returns.
Technical analysis is really a trading
strategy where you are aiming to drive
returns out of identified trends and
opportunities.
Trading can take far more active time and
management on the part of the investor,
though major funds invest millions in
sophisticated technical analysis trading
software. The average individual will likely
be far better served focusing on a
fundamental analysis investment strategy.
This paper has discussed about the main
components involved in fundamental analysis
and also about using data mining tools for
carrying out fundamental analysis.
II. RELATED WORK
The external factors influencing the stock
selectionhave been studied by various
researchers and some literature ismentioned
below.
In 1934, Graham and Dodd published the book
Security Analysis at the Columbia University.
This book emphasized that by acomplete
analysis of the company, good returns could
beearned and the worth of the stock could be
found.
Authors of [1], [2] and [3]showed that the in
India, macroeconomic variables and thestock
market index were co-integrated and they had a
long equilibrium relationship.
Author of [4] also showed a causalrelation
between the macroeconomic variables and the
Indianstock market index. Hence the economy
analysis did play animportant role in
determining the share price.
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Author of [5] studied the factors influencing the
stock selectiondecision of small investors of
Assam and found that the mostinfluential
decision variables were financial statements of
companies, referral, public information and
profitabilityvariables. The least influencing
decision variables includedgovernment policies,
calculation of risk, economic variablesand
discounted cash flow tools.
Author of [6] studied the factors influencing the
investment decisions of investors in theNigerian
capital market. The most influencing factors
werefound to be past performance of the
company’s stock, expectedstock split, dividend
policy, expected corporate earnings andget-rich-
quick.
Authors of [7]identified the factors
whichaffected the purchase decision of
individual investors of equityshares in Mumbai.
Out of the 36 variables surveyed it wasfound
that market capitalization of the company
followed bypast performance of the company
were the most influencing.And the least
influencing variable was found to befluctuations
in the indices of major markets.
III.PROPOSED WORK
Fundamental analysis of stocks requires
analyzing different financial, micro-economic
and macro-economic factors to determine the
intrinsic value of a stock. Thus, the fundamental
analysis comprised of the economy analysis,
industry analysis and company analysis. By
evaluating the overall economy conditions, the
industry scenario and the fundamentals of the
company based on the information which was
publicly available and accessible, the stock price
was determined.
For economy analysis, the economic indicators
employed include inflation, interest rates,
purchasing power, growth rate, GDP, etc. The
main assumption behind studying the economy
before purchasing a company’s stock was that if
the economy was growing and robust then the
company would also do well and eventually the
share prices would increase.
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The next focus of analysis was the industry
analysis as even if the economy prospered
certain industries alone would get extra benefits
owing to government policies. Hence it becomes
important to analyze the industry as well before
stock investing. Industry analysis would analyze
factors like competition level, foreign entrants,
government attitude, threat of potential entrants,
cost structure, etc.
The last step was the company analysis wherein
factors like company financials, future prospects
of the company, the quality of top management,
competitive advantage, labor relations, market
share, etc. The financials of the company were
generally available in the balance sheets and
income statements. Also several financial ratios
of the company should be looked at to estimate
the net worth of the company investing in. Some
of the important ratios calculated during
company analysis have been explained below:
 EARNINGS PER SHARE (EPS):This is calculated
as, (Net Income - Dividends on preferred
stock) / Number of outstanding shares. This
ratio shows how much of a company’s profit
is assigned to each share.
 DIVIDEND PAYOUT RATIO: This compares
dividends paid out to the stockholders to the
company's total net income. It accounts for
retained earnings, income that is not paid
out, but rather retained for potential growth.
 PRICE / EARNINGS RATIO (P/E): This was given
by the formula, (Market price per share) /
EPS. This ratio showed how closely the
price of the stock followed the earnings per
share. If the P/E ratio was high it implied
that the market participants were expecting
the stock price to continue to increase. When
the P/E ratio began to decline it implied that
the stock prices would soon fall.
 RETURN ON ASSETS (ROA): This was given by
the formula, (Net income + Interest expense)
/ Total assets. This ratio showed how well
the company was using its tangible assets.
Higher ROA showed that the assets were
efficiently used and the company was
robust. A declining ROA showed that the
company was not earning to its capacity and
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that the stock prices would eventually
decline.
 RETURN ON EQUITY (ROE):This was given by
the formula, (Post-tax earnings) /
Shareholder equity. This ratio showed how
well the shareholders’ money was utilized
and how profitably that money was invested.
A low ROE indicated that the shareholders’
money was not properly utilized.
 DEBT/EQUITY RATIO: This was given by the
formula, (Total liabilities) / Shareholders’
equity. This was a leverage measure in terms
of the available capital versus the capital
employed. A low level of this ratio indicated
that the credit available was not fully
utilized.
 MARKET CAPITALIZATION:This was given by the
formula, (Number of shares) x (Price per
share). This was a measure of the amount of
shares traded in the market. Based on the
market capitalization, stocks were classified
into small-cap, medium-cap and large-cap.
 PRICE/SALES RATIO: This was given by the
formula, (Share price) / (Revenue over a 12
month time frame). This measure showed if
the share price of the stock represented the
value of the stock.
 PRICE/BOOK RATIO: This was given by the
formula, (Stock price) / (Total assets –
Intangible assets and liabilities). This
measure compared the share price with the
stock’s intrinsic value. This measure
indicated the overvaluation or
undervaluation of the stock.
Fundamental analysis assumed that the current
share price and the future share price depended
on the intrinsic value of the share and the
expected return. As and when new information
about the company was released, the analysis
got updated as the expected return changed.
Hence the changes in the share prices were
predicted even before the change actually
happened. The economy and industry analysis in
the background also helped to forecast the
growth opportunities for the shares.
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A. INTRINSIC VALUE
Intrinsic value of a stock, often called as the
true worth of a stock is the total amount that
you might earn from it in the future.This is
calculated on the basis of the monetary
benefit you expect to receive from it in the
future. Let us put it this way – it is the
maximum value at which you can buy the
stock, without making a loss in the future
when you sell it.
The Discounted Cash Flow (DCF) analysis is
a commonly used valuation method to
determine a company's intrinsic value. The
DCF model forecasts the future cash flow of
a stock and discount it to the present value
by using the firm’s weighted average cost of
capital (WACC). WACC is the expected
rate of return that investors want to earn
that's above the company's cost of capital.
To use the intrinsic value for our buying
decision we have to compare it to the stock’s
price. When the intrinsic value is above the
stock price that means the stock is
undervalued by the market and has upside
potential. Hence, the investor will look at it
as an opportunity and buy the stock at its
current market value in expectation of gain.
If the intrinsic value of a stock is less than
market value, the stock is considered
overpriced and the investors relying on
fundamental analysis will exit from it. When
the intrinsic value is near or equal to the
price that means that the stock is valued fair
by the stock market.
B. DECISION TREE ALGORITHM
A decision tree is a decision support tool that
uses a tree-like graph or model of decisions
and their possible consequences, including
chance event outcomes, resource costs, and
utility. It is efficient for processing large
amount of data, so is often used in data
mining application.
A decision tree is a structure that includes a
root node, branches, and leaf nodes. Each
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internal node denotes a test on an attribute,
each branch denotes the outcome of a test,
and each leaf node holds a class label. The
topmost node in the tree is the root node.In
compare the values of the root attribute with
record’s attribute. On the basis of
comparison, we follow the branch
corresponding to that value and jump to the
next node. We continue comparing our
record’s attribute values with other internal
nodes of the tree until we reach a leaf
node with predicted class value.
Once a decision tree is built it can be applied
to new data to classify it. The general
motive of using Decision Tree is to create a
training model which can be used to predict
class or value of target variables by learning
decision rules inferred from prior data
(training data).
Tree based learning algorithms are
considered to be one of the best and mostly
used supervised learning methods. Tree
based methods empower predictive models
with high accuracy, stability and ease of
interpretation. Unlike linear models, they
map non-linear relationships quite well.
They are adaptable at solving any kind of
problem at hand (classification or
regression).
decision trees, for predicting a class label for
a record we start from the root of the tree.
We
Orange is a platform built for data mining
and analysis on a GUI based workflow. This
signifies that users do not have to know how
to code to be able to work using Orange.
Users can perform tasks ranging from basic
visuals to data manipulations,
transformations, and data mining. It
consolidates all the functions of the entire
process into a single workflow.
In Orange, data mining is done via visual
programming or even python scripting. The
tool has components for machine learning,
add-ons for bio-informatics and text mining
and is packed with features for data
analytics.
IV. RESULTS AND DISCUSSION
Financial data of 8 automobile companies were
collected from their websites, relevant data were
collated and intrinsic values calculated.Gap
between intrinsic values & market prices
calculated and depending on the gap value, risk
profile assigned as low or high for each
company

C. ORANGE DATA MINING TOOL

TABLE 1
COMPARATIVE RESULTS

Company Profit Net Profit Dividend Return on Market Intrinsic Intrinsic Risk
Capital Price Value Value Vs
Market
Price
1 10% 9% 87 39% 2,555 2,467 -3% Low
2 4% 3% 4 22% 474 429 -9% High
3 15% 13% 60 29% 2,925 2,723 -7% High
4 21% 18% 125 44% 20,538 18,516 -10% High
5 9% 9% 9 18% 672 615 -8% High
6 7% 2% 3 30% 91 88 -3% Low
7 9% 7% 80 23% 6,672 6,105 -8% High
8 3% -13% 0 11% 174 154 -11% High

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A new file is opened in orange tool and the above data table is given as input.

Fig. 1 Feeding Input Data in Orange Tool

The data table is fed into the tree viewer and the risk is classified based on the gap.

Fig. 2Training the Data for Classifying the Risk

A new file is opened and a new data table is loaded without classification of high risk and low risk. The
name field is left empty. The already predicted and trained tree viewer is connected to the below
mentioned data table.

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Fig. 3Risk Prediction
Therefore, the predictions are made for the name field based on the previously trained gap value of the
data table.
Fig. 4Results of Prediction
Going forward, data sets of any number of
companies can be fed into this model and their
risk profile can be predicted.
V.CONCLUSION
This study has discussed about the fundamental
analysis approach for valuing the stock prices
and arriving at the investment decision. Decision
tree, a data mining technique has been used for
this purpose. This will be helpful for the
investors to choose the stock for investments in
order to earn better returns.
REFERENCES
1. Venkatesh, C. K. (2012). Fundamental analysis as a
method of share valuation in comparison with technical
analysis. International Journal of Applied Financial
Management Perspectives, 1(1), 79-81.
2. Naik, P. K., &Padhi, P. (2012). The impact of
macroeconomic fundamentals on stock prices revisited:
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Evidence from Indian data.Eurasian Journal of
Business and Economics, 5(10), 25-44.
3. Naik, P. K. (2013). Does stock market respond to
economic fundamentals? Time-series analysis from
Indian data. Journal of Applied Economics and
Business Research, 3(1), 34-50.
4. Bhattacharya, B, Mukherjee, J. (2002). “The Nature of
The Casual Relationship between Stock Market and
Macroeconomic Aggregates in India: An Empirical
Analysis”, Paper presented in the 4 th Annual
Conference on Money and Finance, Mumbai, India.
5. Das, S. K. (2012). Small investor’s behavior on stock
selection decision: A case of Guwahati stock
exchange.International Journal of Advanced Research
in Management and Social Sciences, 1(2), 59-78.
6. Obamuyi, T. M. (2013). Factors influencing investment
decisions in capital market: A study of individual
investors in Nigeria.Organizations and Markets in
Emerging Economies, 4(1), 141-161.
7. Kaur, P., &Rajam, R. (2012). Investors' behavior of
equity investment: Empirical study of individual
investors of North Central Mumbai. DYPDBM
International Business Management Research
Journal,(12), 52-67
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