CHAPTER FOUR:

FIXED INCOME SECURITIES

Fixed-income investments have a contractually mandated payment schedule. Their investment

contracts promise specific payments at predetermined times, although the legal force behind the
promise varies and this affects their risks and required returns. At one extreme, if the issuing firm
does not make its payment at the appointed time, creditors can declare the issuing firm bankrupt.
In other cases (for example, income bonds), the issuing firm must make payments only if it earns
profits. In yet other instances (for example, preferred stock), the issuing firm does not have to
make payments unless its board of directors votes to do so.
Investors who acquire fixed-income securities (except preferred stock) are really lenders to the
issuers. Specifically, you lend some amount of money, the principal, to the borrower. In return,
the borrower promises to make periodic interest payments and to pay back the principal at the
maturity of the loan.
3.1. Bond characteristic
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. Investors have many choices when
investing in bonds, but bonds are classified into four main types: Treasury, corporate, municipal,
and foreign. Each type differs with respect to expected return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. However, Treasury bond prices
decline when interest rates rise, so they are not free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may
be unable to make the promised interest and principal payments. Different corporate bonds
have different levels of default risk, depending on the issuing company’s characteristics and
on the terms of the specific bond. Default risk is often referred to as “credit risk,” and, the
larger the default or credit risk, the higher the interest rate the issuer must pay.
Corporate bonds fall into various categories based on their contractual promises to investors.
They will be discussed in order of their seniority.
 Secured bondsare the most senior bonds in a firm’s capital structure and have the
lowest risk of distress or default. They include various secured issues that differ based
on the assets that are pledged.
 Mortgage bondsare backed by liens on specific assets, such as land and buildings. In
the case of bankruptcy, the proceeds from the sale of these assets are used to pay off the
mortgage bondholders.
 Collateral trust bondsare a form of mortgage bond except that the assets backing
the bonds are financial assets, such as stocks, notes, and other high-quality bonds.

1
  Equipment trust certificatesare mortgage bonds that are secured by specific
pieces of transportation equipment, such as locomotives and boxcars for a railroad
and airplanes for an airline.
 Debenturesare promises to pay interest and principal, but they pledge no specific assets
(referred to as collateral) in case the firm does not fulfill its promise. This means that
the bondholder depends on the success of the borrower to make the promised payment.
Debenture owners usually have first call on the firm’s earnings and any assets that are
not already pledged by the firm as backing for senior secured bonds. If the issuer does
not make an interest payment, the debenture owners can declare the firm bankrupt and
claim any unpledged assets to pay off the bonds.
 Subordinated bondsare similar to debentures, but, in the case of default, subordinated
bondholders have claim to the assets of the firm only after the firm has satisfied the
claims of all senior secured and debenture bondholders. That is, the claims of
subordinated bondholders are secondary to those of other bondholders. Within this
general category of subordinated issues, you can find senior subordinated, subordinated,
and junior subordinated bonds. Junior subordinated bonds have the weakest claim of all
bondholders.
 Income bondsstipulate interest payment schedules, but the interest is due and payable
only if the issuers earn the income to make the payment by stipulated dates. If the
company does not earn the required amount, it does not have to make the interest
payment and it cannot be declared bankrupt. Instead, the interest payment is considered
in arrears and, if subsequently earned, it must be paid off. Because the issuing firm is
not legally bound to make its interest payments except when the firm earns it, an income
bond is not considered as safe as a debenture or a mortgage bond, so income bonds offer
higher returns to compensate investors for the added risk. There are a limited number of
corporate income bonds. In contrast, income bonds are fairly popular with
municipalities because municipal revenue bonds are basically income bonds.
 Convertible bondshave the interest and principal characteristics of other bonds, with
the added feature that the bondholder has the option to turn them back to the firm in
exchange for its common stock. For example, a firm could issue a $1,000 face-value
bond and stipulate that owners of the bond could turn the bond in to the issuing
corporation and convert it into 40 shares of the firm’s common stock. These bonds
appeal to investors because they combine the features of a fixed-income security with
the option of conversion into the common stock of the firm, should the firm prosper.
Because of their desirable conversion option, convertible bonds generally pay lower
interest rates than nonconvertible debentures of comparable risk.
 Zero coupon bond promises no interest payments during the life of the bond but only
the payment of the principal at maturity. Therefore, the purchase price of the bond is the
present value of the principal payment at the required rate of return. For example, the
price of a zero coupon bond that promises to pay $10,000 in five years with a required
rate of return of 8 percent is $6,756.
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 Municipal bonds, or “munis,” are issued by state and local governments. Like corporate
bonds, munis have default risk. However, munis offer one major advantage over all other
bonds: the interest earned on most municipal bonds is exempt from federal taxes and also
from state taxes if the holder is a resident of the issuing state. Consequently, municipal bonds
carry interest rates that are considerably lower than those on corporate bonds with the same
default risk. Foreign bonds are issued by foreign governments or foreign corporations.
Foreign corporate bonds are, of course, exposed to default risk, and so are some foreign
government bonds. An additional risk exists if the bonds are denominated in a currency other
than that of the investor’s home currency. For example, if you purchase corporate bonds
denominated in Japanese yen, you will lose money even if the company does not default on
its bonds if the Japanese yen falls relative to the dollar.

3.2. Characteristics of bonds

Although all bonds have some common characteristics, they do not always have the same
contractual features. For example, most corporate bonds have provisions for early repayment
(call features), but these provisions can be quite different for different bonds. Differences in
contractual provisions, and in the underlying strength of the companies backing the bonds, lead
to major differences in bonds’ risks, prices, and expected returns. To understand bonds, it is
important that you understand the following terms.
Par Value:is the stated face value of the bond. The par value generally represents the amount
of money the firm borrows and promises to repay on the maturity date
Coupon Interest Rate:bonds require the company to pay a fixed interest each year or each
six months. When this coupon payment, as it is called, is divided by the par value, the result
is the coupon interest rate. Typically, at the time a bond is issued, its coupon payment is set
at a level that will enable the bond to be issued at or near its par
Bond quotations and prices: the price of a bond is quoted in percentage of its par value. For
example, a $5,000 par value bond quoted at 76 % would cost $3,800($5,000 x 76%).
Current Yield: is the ratio of a bond's interest payment to its current market price.
Maturity period: the number of years after which the par value is payable to the
bondholders.
Selling at a discount: is selling a bond below its par value. Because bond interest payments
are fixed amounts, a bond selling at a discount will have a current yield and YTM that are
larger than its coupon rate.
Selling at premium: is selling a bond above its par value. When a bond sells at a premium,
its current yield and YTM will be less than its coupon rate.
Bond Indenture: the written agreement between corporation and the lender detailing the
terms of the debt issue.
Zero coupon bond: a bond that pays no annual interest but is sold at a discount below par,
thus providing compensation in the form of capital appreciation.
3.3. Bond Valuation

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The value of any financial asset, a stock, a bond, a lease, or even a physical asset such as an
apartment building or a piece of machinery is simply the present value of the cash flows the asset
is expected to produce.
The cash flows from a specific bond depend on its contractual features as described above. For a
standard coupon-bearing bond, the cash flows consist of interest payments plus the amount
borrowed when the bond matures. In the case of a floating rate bond, the interest payments vary
over time. In the case of a zero coupon bond, there are no interest payments, only the face
amount when the bond matures. For a “regular” bond with a fixed coupon rate, here is the
situation:
i) General valuation method
n
INT Parvalue
∑ ( 1+r ) + (1+ r )t
t
Value of Bond (Bo) = t =1
Or
ii) Time value formula
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
Where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per period
1
1−
(1+k d )n
for n periods = kd
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods =
1
( 1+k d )n
Illustration: H-Corporation sold a $1,000,000 bond issue at the beginning of 1990 in order to obtain
funds for expansion. The bonds were issued at face values of $1,000 with an original maturity of 10
years and a coupon rate of 10%. If an investor requires a 12% rate of return on these securities, what
would be the value of these bonds to the investor in 1994? Assume the bond is to be purchased at the
end of 1994 and that the first interest payment would be received at the end of 1995.
Given: Date of issue = End of 1994
Par value =$ 1, 000
Coupon rate = 10%
Maturity Periods = 10 years
Effective interest rate = 12%

Solution

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According to the above given, H-corporation will pay $100 per year for the next ten Years. Also H-
corporation will pay the face value ( $1000) at the end of the tenth year. Thus, we estimate the market
value of the bond by calculating the present value of these cash flows separately and adding the result
together.
i)Using the general valuation method.
n
INT Parvalue
∑ ( 1+r )t t
Bo = t =1 + (1+ r )
100 100 100 100 1000
1 2 3 10 10
Bo = (1 .12 ) + (1 .12 ) + (1 .12 ) +………. + (1 .12 ) + (1 .12 )
Bo = 886.99
ii) Using the time value formula
First, we calculate the present value of the annuity stream, which is $100 per year for ten years

[ ]
1
1−
(1. 12)10
Bo = 100 0 . 12 = 565.02
Second, the present value of the face value (i.e. $1000) which is going to be received at the end of the
tenth year
1000
10
Bo = (1 .12 ) = 321 .97
Then, we add the values for the two parts together to get the bond’s value.
Total bond value = 565.02 + 321.97 = 886.99
Impact of Required rate of return (RRR) on bond values- when the RRR on a bond differs from its
coupon rate, the value of a bond would differ from its par/face value. When the RRR is more than the
coupon rate, the bond value would be less than its par value that is the bond would sell at discount.
Conversely, in case the RRR is less than coupon rate, the bond value would be more than the par value
that is the bond would sell at a premium.
Consider the following example,
Given:Par value = $1,000
Coupon rate = 10%
Maturity period = 10 years
Required - compute the value of the bond assuming the following RRR:
a) 10% b)8% c)12%
Solution

[ ]
1
1−
(1.10)10 1000
a) Po = 100
0.10 10
+ (1 .10 ) = $1,000

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 [ ]
1
1−
(1.08)10 1000
b) Po = 100
0.08 10
+ (1 .08 ) = $1,134

[ ]
1
1−
(1.12)10 1000
c) Po = 100
0.12 10
+ (1 .12 ) = $886.99
Thus, as you can see from the above example, an increase in interest rate will cause the prices of
outstanding bond to fall, whereas a decrease in rates will cause bond prices to rise.
3.4. Bond yield
If you examine the bond market table of The Wall Street Journal or a price sheet put out by a
bond dealer, you will typically see information regarding each bond’s maturity date, price, and
coupon interest rate. You will also see the bond’s reported yield. Unlike the coupon interest rate,
which is fixed, the bond’s yield varies from day to day depending on current market conditions.
Moreover, the yield can be calculated in three different ways, and three “answers” can be
obtained. These different yields are described in the following sections.
Yield to Maturity (YTM)
YTM is defined as the rate required in the market on a bond and is used as a basis for reaching
bond investment decisions. If the bond's price is not too far from its par value, a good first guess
as the bonds YTM is obtained by using the coupon rate as the discount rate. The intrinsic value
computed making use of the coupon rate, as a discount rate, would be the par value of the
bond.YTM is the rate of return investors earn if they buy a bond at a specific price and hold it
until maturity.
The YTM for a bond that sells at par consists entirely of an interest yield, but if the bond sells at
a price other than its par value, the YTM will consist of the interest yield plus a positive or
negative capital gains yield. Note also that a bond’s yield to maturity changes whenever interest
rates in the economy change, and this is almost daily. One who purchases a bond and holds it
until it matures will receive the YTM that existed on the purchase date, but the bond’s calculated
YTM will change frequently between the purchase date and the maturity date.
The approximate YTM can be found using the following approximation formula:
M −Bo
I+
n
M + Bo
Approximate YTM = 2
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 years to
maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM =?

6
 Br . 1 ,000−Br . 1 ,090
Br .100+
15
=9 %
Br . 1 , 000+Br . 1, 090
Approximate YTM = 2
If an investor buys Zebra’s bond at Br. 1,090 and holds it for 15 years, the approximate yield or
rate of return per year is 9%.
Yield to Call
If you purchased a bond that was callable and the company called it, you would not have the
option of holding the bond until it matured. Therefore, the yield to maturity would not be
earned. This would be beneficial to the company, but not to its bondholders.
Yield to call (YTC)is the rate of return earned by an investor if he buys a bond at a specified
price, Bo, and the bond is called before its maturity date. YTC, therefore, is computed only for
callable bonds. A callable bond is a bond which is called and retired prior to its maturity date at
the option of the issuer. A bond is called by an issuer when the market interest rate falls below
the coupon interest rate. The YTC can be found by solving the following equation.
Call price−Bo
I+
n
Call price+ Bo
Approximate YTC = 2
Example: X Company is intending to purchase Y Company’s outstanding bond which was
issued on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual coupon, and a 30
year original maturity. There is a 5-year call protection, after which time the bond can be called
at 108. X company is to acquire the bond on January 1, 1999 when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y company bond.
Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br. 1,000 x
108%);
n = 3 (call protection – 2 years elapsed since the bond was issued); YTC =?
Br . 1 ,080−Br . 1 ,175
Br .100+
3
=6 . 06 %
Br . 1 , 080+Br . 1, 175
Approximate YTC = 2
If X Company buys Y Company bond and holds the bond until the bonds are called by Y
Company, the approximate annual rate of return would be 6.06%.
Current Yield
If you examine brokerage house reports on bonds, you will often see reference to a bond’s
current yield. The current yield is the annual interest payment divided by the bond’s current
price. For example, if 1000 par bond with a 10 percent coupon were currently selling for $985,
the bond’s current yield would be 10.15 percent ($100/$985).

7
Unlike the yield to maturity, the current yield does not represent the return that investors should
expect to receive from holding the bond. The current yield provides information regarding the
amount of cash income that a bond will generate in a given year, but since it does not take
account of capital gains or losses that will be realized if the bond is held until maturity (or call),
it does not provide an accurate measure of the bond’s total expected return. The fact that the
current yield does not provide an accurate measure of a bond’s total return can be illustrated with
a zero coupon bond. Since zeros pay no annual income, they always have a current yield of zero.
This indicates that the bond will not provide any cash interest income, but since the bond will
appreciate in value over time, its total rate of return clearly exceeds zero.

3.5. Risks in bond

Interest rate risk: the risk of a decline in bond’s price due to an increase in interest rate. Interest
rate risk is higher on bonds with long term maturity than on those maturing in the near future.
Generally the longer the maturity of the bond, the more its price changes in response to a given
change in interest rate. That is, the shorter the time period until a bond’s maturity, the less
responsive is its market value to a given change in interest.
Reinvestment rate: the risk that a decline in interest rate will lead to decline in income from a
bond portfolio.
An increase in interest rates will hurt bondholders because it will lead to a decline in the value of
a bond portfolio. But can a decrease in interest rates also hurt bondholders? The answer is yes,
because if interest rates fall, a bondholder will probably suffer a reduction in his or her income.
For example, consider a retiree who has a portfolio of bonds and lives off the income they
produce. The bonds, on average, have a coupon rate of 10 percent. Now suppose interest rates
decline to 5 percent. Many of the bonds will be called, and as calls occur, the bondholder will
have to replace 10 percent bonds with 5 percent bonds. Even bonds that are not callable will
mature, and
When they do, they will have to be replaced with lower-yielding bonds. Thus, our retiree will
suffer a reduction of income.
The risk of an income decline due to a drop in interest rates is called reinvestment rate risk, and
its importance has been demonstrated to all bondholders in recent years as a result of the sharp
drop in rates
Note that interest rate risk relates to the value of the bonds in a portfolio, while reinvestment rate
risk relates to the income the portfolio produces. If you hold long-term bonds, you will face
interest rate risk, that is, the value of your bonds will decline if interest rates rise, but you will not
face much reinvestment rate risk, so your income will be stable. On the other hand, if you hold
short-term bonds, you will not be exposed to much interest rate risk, so the value of your
portfolio will be stable, but you will be exposed to reinvestment rate risk, and your income will
fluctuate with changes in interest rates.
Default risk: another important risk associated with bond is default risk, if the issuer defaults,
investors receive less than the promised return on the bond. Therefore, investors need to asses a

8
bond’s default rids before making a purchase. NB - the greater the default risk, the higher the
bond’s yield to maturity.
3.6. Rating of bonds
Bond ratings are based on both qualitative and quantitative factors, some of which are listed
below:
1. Various ratios, including the debt ratio and the times-interest-earned ratio. The better the
ratios, the higher the rating.
2. Mortgage provisions: Is the bond secured by a mortgage? If it is, and if the property has a
high value in relation to the amount of bonded debt, the bond’s rating is enhanced.
3. Subordination provisions: Is the bond subordinated to other debt? If so, it will be rated at
least one notch below the rating it would have if it were not subordinated. Conversely, a bond
with other debt subordinated to it will have a somewhat higher rating.
4. Guarantee provisions: Some bonds are guaranteed by other firms. If a weak company’s debt
is guaranteed by a strong company (usually the weak company’s parent), the bond will be
given the strong company’s rating.
5. Sinking fund: Does the bond have a sinking fund to ensure systematic repayment? This
feature is a plus factor to the rating agencies.
6. Maturity: Other things the same, a bond with a shorter maturity will be judged less risky than
a longer-term bond, and this will be reflected in the ratings.
7. Stability: Are the issuer’s sales and earnings stable?
8. Regulation: Is the issuer regulated, and could an adverse regulatory climate ause the
company’s economic position to decline? Regulation is especially important for utilities and
telephone companies.
9. Antitrust: Are any antitrust actions pending against the firm that could erode its position?
10. Overseas operations: What percentage of the firm’s sales, assets, and profits are from
overseas operations, and what is the political climate in the host countries?
11. Environmental factors: Is the firm likely to face heavy expenditures for pollution control
equipment?
12. Product liability: Are the firm’s products safe? The tobacco companies today are under
pressure, and so are their bond ratings.
13. Pension liabilities: Does the firm have unfunded pension liabilities that could pose a future
problem?
14. Labor unrest: Are there potential labor problems on the horizon that could weaken the firm’s
position? As this is written, a number of airlines face this problem, and it has caused their
ratings to be lowered.
15. Accounting policies: If a firm uses relatively conservative accounting policies, its reported
earnings will be of “higher quality” than if it uses less conservative procedures. Thus,
conservative accounting policies are a plus factor in bond ratings.
Representatives of the rating agencies have consistently stated that no precise formula is used to
set a firm’s rating; all the factors listed, plus others, are taken into account, but not in a

9
mathematically precise manner. Statistical studies have borne out this contention, for researchers
who have tried to predict bond ratings on the basis of quantitative data have had only limited
success, indicating that the agencies use subjective judgment when establishing a firm’s rating
Importance of bond rating
Bond ratings are important both to firms and to investors. First, because a bond’s rating is an
indicator of its default risk, the rating has a direct, measurable influence on the bond’s interest
rate and the firm’s cost of debt. Second, most bonds are purchased by institutional investors
rather than individuals, and many institutions are restricted to investment-grade securities. Thus,
if a firm’s bonds fall below BBB, it will have a difficult time selling new bonds because many
potential purchasers will not be allowed to buy them. As a result of their higher risk and more
restricted market, lower-grade bonds have higher required rates of return, kd, than high-grade
bonds.

10
 CHAPTER 5
STOCK AND EQUITY VALUATION
In finance, valuation is the process of estimating what something is worth. Items that are usually
valued are a financial asset or liability. Valuations can be done on assets (for example,
investments in marketable securities such as stocks, options, business enterprises, or intangible
assets such as patents and trademarks) or on liabilities.
Investors who are considering multiple investments or outlining an investment strategy may
request equity valuations of a company, to make the most informed investment decision.
Valuation methods based on the equity of a company typically include a thorough analysis of
cash accounts, as well as a forecast or projection of future dividends, future earnings (revenue)
and the distribution of dividends.
The total equity of a company is the sum of both tangible assets and intangible qualities.
Tangible assets include working capital, cash, inventory, and shareholder equity. Intangible
qualities, or intangible "assets," may include brand potential, trademarks and stock valuations.
There are different methods/techniques of equity valuation. The majors are:
1. Balance Sheet Valuation
2. Dividend discount model
3. Earning Multiplier Approach
5.1. Balance Sheet Valuation
In balance sheet valuation approach, there are four measures derived from it. These are; book
value, liquidation, replacement cost, and Tobin’s Q ratio.
Book Value Method:it is Net worth (Equity share capital plus reserve and surplus) of a
company divided by total number of outstanding equity shares. Thus this form of valuation is
based on the books of a business, where owners' equity, is determined by a simple equation of
total assets minus total liabilities and this is used to set a price. The company whose stocks sell
for less than book value are generally considered to be undervalued, or having less risk than
companies selling for greater than book value. Because most companies sell for much more than
book value, a company selling for less than book value may well have considerable upside
potential. But the basic limitation of this value is that the book value doesn’t reflect the true
current economic value of the share. It also doesn’t consider the future earnings potential of the
company.
Liquidation Value Method: This approach is similar to the book valuation method, except that
the liquidation values of assets are used instead of the book value of the assets. Using this
approach, the liabilities of the business are deducted from the liquidation value of the assets to
determine the liquidation value of the business.
In simple words, the liquidation value of a company is equal to what remains after all assets have
been sold and all liabilities have been paid. Liquidation value of an equity share is calculated by
dividing liquidation value of the business by total no. of outstanding equity shares.

11
Replacement Cost Method: is one of the interesting in valuing a firm is the replacement cost of
its assets less its liabilities. Some analysts believe the market value of the firm cannot get too far
above its replacement cost because, if it did, competitors would try to replicate the firm. The
competitive pressure of other similar firms entering the same industry would drive down the
market value of all firms until they came into equality with replacement cost.
Tobin’s Q: This idea is popular among economists, and the ratio of market price to replacement
cost is known as Tobin’s Q, after the Nobel Prize winning economist James Tobin. Tobin's Q
Ratio is the market value of a company's assets divided by their replacement value. Replacement
value is being the current cost of replacing the firm’s assets. In other words, the ratio of all the
combined stock market valuations to the combined replacement costs should be around one. The
formula is the following:
For an individual company, the Q ratio is equal to the market price of the firm divided by its
replacement cost.
Tobin's Q Ratio = Market Capitalization / Average Total Assets
or
Q Ratio = Market Price of Firm
Replacement Cost
If individuals or companies want to enter a business, certainly it would be an important
consideration whether they could buy a business for less than what it would take to replicate the
company by starting from scratch, especially since bought out established company has revenue
generation since day one.
If the Q ratio is significantly less than 1, then it would be cheaper for potential competitors to
buy the firm rather than start a new business, so this would tend to increase its market price. If it
is sold for significantly more than the Q ratio of 1, then competitors would enter the market, and
drive down the price of the firm until it is approximately equal to 1.
As the replacement cost of a company would be difficult to ascertain quickly, the Q ratio cannot
be a driving force in determining daily stock prices for companies. However, it could be an
indicator for long-term trends and as a potential takeover target if the company’s Q ratio is less
than 1.
5.2 Dividend discount model
The most theoretically sound stock valuation method, called income valuation or the discounted
cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows)
the stock will bring to the stockholder in the foreseeable future, and a final value on disposal.
Dividend valuation model is conceptually a very sound approach. According to this approach the
value of an equity share is equal to the present value of dividends expected from its ownership
plus the present value of the sale price expected when the equity share is sold.
Financial theory states that the value of a stock is the worth all of the future cash flows expected
to be generated by the firm discounted by an appropriate risk-adjusted rate. We can use

12
dividends as a measure of the cash flows returned to the shareholder. There are several dividend
discount models (DDMs) from all the stable model and the two-stage model are the major one.
5.2.1 Inputs into the DDM
Several inputs are required to estimate the value of an equity using the DDM.
 D1 = Dividends expected to be received in one year.
 g = Growth rate in dividends
 K = the required rate of return for the investment. The required rate of return can be
estimated using the following formula:
K= Risk-free rate + (Market risk premium x Beta).
The rate on treasury bills can be used to determine the risk-free rate. The market risk premium is
the expected return of the market in excess of the risk-free rate. Beta can be thought of as the
sensitivity of the stock compared with the market.
5.2.2 Stable Model /Constant growth DDM
The stable model is best suited for firms experiencing long-term stable growth. Generally, stable
firms are assumed to grow at the rate equal to the long-term nominal growth rate of the economy
(inflation plus real growth in GDP). In other words, the model assumes it is impossible to grow
at 30% forever; otherwise, the company would be larger than the economy.
Value of stock = D1 / K-g
If the growth rate of the firm exceeded the required rate of return, you could not calculate the
value of the stock. This is because if g > K, the result would be negative, and stocks do not have
a negative value. Another caution is that models are often very sensitive to the assumptions made
regarding growth rates, time frame, or the required rate of return.
Finally, the dividend discount model generally understates the intrinsic value of the firm.
Important considerations such as the value of patents, brand name, and other intangible assets
should be used in conjunction with the DDM to assess the value of a firm's equity. These
intangibles should be added to the result of a DDM calculation to arrive at a more appropriate
valuation.
To make the DDM practical, we need to introduce some simplifying assumptions. A useful and
common first pass at the problem is to assume that dividends are trending upward at a stable
growth rate that we will call g. Then if g = 0.05, and the most recently paid dividend was D 0 =
3.81, expected future dividends are:
D1 = D0(1+g) = 3.81 x1.05 = 4.00
D2 = D0(1+g)2 = 3.81 x (1.05)2 = 4.20
D3 = D0(1+g)3 = 3.81 x (1.05)3 = 4.41 etc
Using these dividend forecasts in Equation, we solve for intrinsic value as:
D 0(1+ g) D 0 ( 1+ g ) 2 D 0(1+ g)3
Vo= + + +…
1+ K (1+ K)2 (1+ K )3
This equation can be simplified to:

13
 D 0(1+ g) D 1
Vo= =
k −g k −g
Note: we divide D1 (but not D0) by k - g to calculate intrinsic value. If the market capitalization
rate for Steady State is 12%, we can use the above equation to show that the intrinsic value of a
share of Steady State stock is:
$ 4.00
V0 = =$ 57.14
0.12−0.05
The above equation is called the constant growth DDM or the Gordon model, after Myron J.
Gordon, who popularized the model. It should remind you of the formula for the present value of
perpetuity. If dividends were expected not to grow, then the dividend stream would be a simple
perpetuity, and the valuation formula for such a non-growth stock would be V 0 = D1/k. As g
increases, the stock price also rises.
The constant growth DDM is valid only when g is less than k. If dividends were expected to
grow forever at a rate faster than k, the value of the stock would be infinite. If an analyst derives
an estimate of g that is greater than k, that growth rate must be unsustainable in the long run. The
appropriate valuation model to use in this case is a multistage DDM. The constant growth DDM
is so widely used by stock market analysts that it is worth exploring some of its implications and
limitations. The constant growth rate DDM implies that a stock’s value will be greater:
(i) The larger its expected dividend per share.
(ii) The lower the market capitalization rate, k.
(iii) The higher the expected growth rate of dividends.
Another implication of the constant growth model is that the stock price is expected to grow at
the same rate as dividends. To see this, suppose Steady State stock is selling at its intrinsic value
of $57.14, so that V0 = P0. Then:
D1
Po=
k −g
Note that price is proportional to dividends. Therefore, next year, when the dividends paid to
Steady State stockholders are expected to be higher by g = 5%, price also should increase by 5%.
To confirm this, note
D2 = $4(1.05) = $4.20
P1 = D2/(k - g) = $4.20/(0.12 - 0.05) = $60.00
Note, $60.00 is 5% higher than the current price of $57.14.
To generalize:
D2 D 1 (1+ g ) D 1
P 1= = = ( 1+ g )
k−g k −g k −g
P1 = P0(1 + g)
Therefore, the DDM implies that, in the case of constant expected growth of dividends, the
expected rate of price appreciation in any year will equal that constant growth rate, g. Note that
for a stock whose market price equals its intrinsic value (V 0 = P0) the expected holding period
return will be

14
E(r) = Dividend yield + Capital gains yield
D1 P 1−P 0 D 1
¿ + = +g
P0 P0 P0
This formula offers a means to infer the market capitalization rate of a stock, for if the stock is
selling at its intrinsic value, then E(r) = k, implying that k = D1/P0 + g. By observing the
dividend yield, D1/P0, and estimating the growth rate of dividends, we can compute k. This
equation is known also as the discounted cash flow (DCF) formula. This is an approach often
used in rate hearings for regulated public utilities. The regulatory agency responsible for
approving utility pricing decisions is mandated to allow the firms to charge just enough to cover
costs plus a “fair” profit, that is, one that allows a competitive return on the investment the firm
has made in its productive capacity. In turn, that return is taken to be the expected return
investors require on the stock of the firm. The D 1/P0 + g formula provides a means to infer that
required return.
5.2.3 The Two-Stage Model
The two-stage model attempts to cross the chasm from theory to reality. The two-stage model
assumes that the company will experience a period of high-growth followed by a decline to a
stable growth period.
The first issue to deal with when using the two-stage model is to estimate how long the high
growth period should last. Should it be 5 years, 10 years, or maybe longer?
The next requirement is that the model makes an unexpected transition from high growth to slow
growth. In other words, the model assumes that the firm may be growing at 9% for five years
only to then grow at 6% (stable growth) until eternity. Is this realistic? Probably not. Most firms
experience a gradual decline in growth rates as their business matures (hence, using a three-stage
dividend discount model may be more appropriate).
Finally, just like the stable growth model, the two-stage dividend discount model is very
sensitive to the inputs used to determine the value of the equity.
Example:
Assume that the first growth rate is 9% and pertains to the next five year and the second growth
rate is 6% for all years following with the current dividend of $1.30 and K=12.39%.
D0 = $1.30
K = 12.39%
g1= 9%
g2 =6%
D 0(1+ g 1) D 0 ( 1+ g 1 ) 2 D 0(1+ g 1)3 D 0(1+ g 1) 4 D 0(1+ g 1)5
P for the first five year = + + + +
1+ K (1+ K )2 (1+ K )3 (1+ K )4 (1+ K)5
D1 = $1.30 * 1.09 = $1.42
D2 = $1.42 * 1.09 = $1.54
D3 = $1.54 * 1.09 = $1.68
D4 = $1.68 * 1.09 = $1.84
D5 = $1.84 * 1.09 = $2.00
Now, we must discount the dividends by the appropriate rate to determine their present value.

15
 P1 = $1.42 / (1.1239) = $1.26
P2 = $1.54 / (1.1239)2 = $1.22
P3 = $1.68 / (1.1239)3 = $1.19
P4 = $1.84 / (1.1239)4 = $1.15
P5 = $2.00 / (1.1239)5 = $1.12
P for the first five year =¿$5.94.
Next, we value the stable growth period:
D1 = $2.00 (1.06) = $2.12
K = 12.8%
g2 = 6%
P0= $2.12 / (0.128 - 0.06) = $31.18
5.2.4 Problems with dividend discounting model
Problems with dividend discount models include the difficult of forecasting dividends and
potential benefits of owning a share other than dividends.
Forecasting: One problem with dividend discount models is that long term forecasting is
difficult, and the valuation is very sensitive to the inputs used: the discount rate and any growth
rates in particular. This much is true for any DCF, but a dividend discount model adds an extra
layer of difficulty to the forecasts by requiring forecasts of dividends, which means anticipating
the dividend policy a company will adopt. As with other DCF models, the discount rate is most
likely to be calculated using CAPM. It can be argued that changes to the dividend policy do not
matter, as the money belongs to shareholders however it is used. However, in this case, one
might as well use a free cash flow discount valuation.
Omissions: Dividend discounts also omit cash flows other than discounts, for example:
(i) the potential benefits from a takeover bid which gives shareholders a one-off cash flow
which usually comfortably exceeds the value of the dividend stream that would be
expected without the takeover, and,
(ii) Other benefits that may be gained through having a say in the running of a company.
This is well illustrated by the price differences between shares of different classes entitled to the
same dividends but with different voting rights.
5.3 Earning multiplier approach
As noted, many investors prefer to estimate the value of common stock using an earnings
multiplier model. The reasoning for this approach recalls the basic concept that the value of any
investment is the present value of future returns. In the case of common stocks, the returns that
investors are entitled to receive are the net earnings of the firm. Therefore, one way investors can
estimate value is by determining how many dollars they are willing to pay for a dollar of
expected earnings (typically represented by the estimated earnings during the following12-month
period). For example, if investors are willing to pay 10 times expected earnings, they would
value a stock they expect to earn $2 a share during the following year at $20. You can compute
the prevailing earnings multiplier, also referred to as the price/earnings (P/E) ratio, as follows:
Earning multiplier = price / earning
= Current market price

16
 Expected 12-Month earnings
The infinite period dividend discount model can be used to indicate the variables that should
determine the value of the P/E ratio as follows:
D1
p=
k −g
If we divide both sides of the equation by E(expected earnings during the next 12 months), the
P D 1 / E1
result is =
E1 K−g

Thus, the P/E ratio is determined by

1. The expected dividend payout ratio (divided by earnings)
2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)
As an example, if we assume a stock has an expected dividend payout of 50 percent, a required
rate of return of 12 percent, and an expected growth rate for dividends of 8 percent, this would
imply the following:
D/ E = 0.50; k = 0.12; g = 0.08
0.50
P/E =
0.12−0.08
= 12.5
The spread between k and g is the main determinant of the size of the P/E ratio.

Chapter 6:
Security analysis
17
The aim of the analysis is to determine what stock to buy and at what price, there are two basic
analysis methods; i.e. fundamental analysis and technical analysis. Fundamental analysis is the
cornerstone of investing. In fact, some would say that you are not really investing if you aren't
performing fundamental analysis. Because the subject is so broad, however, it's tough to know
where to start. There are an endless number of investment strategies that are very different from
each other, yet almost all use the fundamentals. Fundamental analysis maintains that markets
may misprice a security in the short run but that the "correct" price will eventually be reached.
Profits can be made by trading the mispriced security and then waiting for the market to
recognize its "mistake" and re-price the security.
Technical analysis maintains that all information is reflected already in the stock price. It
considers the trends that are your friend' and sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to recognizable price chart
patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions
are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for stock
picking. For example many fundamental investors use technical’s for deciding entry and exit
points. Many technical investors use fundamentals to limit their universe of possible stock to
'good' companies. The choice of stock analysis is determined by the investor's belief in the
different paradigms for "how the stock market works".
6.1 Fundamental analysis
Fundamental analysis of a business/investment involves analyzing its financial statements, its
management, competitive advantages, and its competitors and markets. When applied to futures
and foreign exchange, it focuses on the overall state of the economy, interest rates, production,
earnings, and management.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives of fundamental analysis. These are:
i) To conduct a company stock valuation and predict its probable price evolution,
ii) To make a projection on its business performance,
iii) To evaluate its management and make internal business decisions,
iv) To calculate its credit risk.
Components of Fundamental Analysis:
Economic analysis;
Industry analysis and
Company analysis
6.1.1 Economic analysis
The economy is study to determine if overall conditions are good for the stock market. Is
inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade
balance favorable? Is the money supply expanding or contracting? These are just some of the
questions that the fundamental analyst would ask to determine if economic conditions are right
for the stock market.

18
 The macro-economy is the overall economy environment in which all firms operate. The key
variables/factors commonly used to describe the state of the macro-economy are:
 Growth rate of gross domestic product
 Industrial growth rate
 Agriculture and monsoons
 Savings and investments
 Government budget and deficit
 Price level and inflation
 Interest rate
 Balance of payment, foreign exchange reserves, and exchange rate
 Infrastructure facilities and arrangements sentiments
6.1.2 Industry analysis
Industry analysis is a market assessment tool designed to provide a business with an idea of the
complexity of a particular industry. Industry analysis involves reviewing the economic, political
and market factors that influence the way the industry develops. Major factors can include the
power wielded by suppliers and buyers, the condition of competitors, and the likelihood of new
market entrants.
Industry analysis is a market strategy tool used by businesses to determine if they want to enter a
product or service market. Company management must carefully analyze several aspects of the
industry to determine if they can make a profit selling goods and services in the market.
Analyzing economic factors, supply and demand, competitors, future conditions and
government regulations will help management decide whether to enter an industry or invest
money elsewhere.
a) Economic Factors: Economic factors of industry analysis include raw materials, expected profit
margins and the interference of substitute goods. The cost of raw materials is an important factor
in industry analysis because over-priced goods will not sell in an established market. Profit
margins are closely linked to materials costs because offering discounts or sales prices will
shrink company profits and lessen cash inflows for future production activity. Substitute goods
allow consumers to purchase a cheaper good that performs relatively like the original item.
b) Supply and Demand: A supply and demand analysis helps management understand if enough
consumers are willing to purchase more goods in an industry. If demand is high and supply is
low, a company may be willing to enter the market and offer goods near the market price to gain
a competitive advantage in the industry. A trend of declining demand indicates an industry that is
oversold, and any new competitors will likely lose money because consumers are not interested
in current goods or services.
c) Competitors: The number of competitors is an important factor for proper industry analysis. If
few competitors exist in a market, they may be charging consumers higher prices because of
limited availability of products or services. As new competitors enter the market, existing
companies can lower prices to maintain their current market share; newer competitors may not
be able to match these price cuts if their products costs are too high. As industries contract,
inefficient producers are forced out.
19
d) Future Conditions: While no company managers can predict the future of an industry, they can
try to determine where the industry is in the business cycle. If the industry is in an emerging
market stage, companies can enter an industry and expect to earn a profit from rising consumer
demand. If the industry is in a plateau stage, then only the most efficient producers with the
lowest costs can continue to earn profits. At the end of a business cycle, demand is declining and
producers leave the industry for more profitable markets.
e) Government Regulations: Some industries have heavier regulations or taxes than others, which
must be considered by companies looking to enter new markets. Taxes and other government
fees add to the cost of doing business, which eats into profits earned by companies. Properly
understanding the amount of government regulation in an industry helps management to
determine if expected profit margins will earn a high enough return to cover these costs.
Techniques for evaluating relevant Industry Factors
Each industry has differences in terms of its customer base, market share among firms,
industry-wide growth, competition, regulation and business cycles. Learning about how the
industry works will give an investor a deeper understanding of a company's financial soundness.
i) Customers Base: Some companies serve only a handful of customers, while others serve
millions. In general, it's a red flag (a negative) if a business relies on a small number of
customers for a large portion of its sales because the loss of each customer could
dramatically affect revenues.
ii) Market Share: Understanding a company's present market share can tell volumes about the
company's business. The fact that a company possesses an 85% market share tells you that it
is the largest player in its market by far. Furthermore, this could also suggest that the
company possesses some sort of "economic moat," in other words, a competitive barrier
serving to protect its current and future earnings, along with its market share. Market share is
important because of economies of scale. When the firm is bigger than the rest of its rivals, it
is in a better position to absorb the high fixed costs of a capital-intensive industry.
iii) Industry Growth: One way of examining a company's growth potential is to first examine
whether the amount of customers in the overall market will grow. This is crucial because
without new customers, a company has to steal market share in order to grow. In some
markets, there is zero or negative growth, a factor demanding careful consideration. For
example, a manufacturing company dedicated solely to creating audio compact cassettes
might have been very successful in the '70s, '80s and early '90s. However, that same
company would probably have a rough time now due to the advent of newer technologies,
such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of
what it was during the peak of its popularity.
iv) Competitions: Simply looking at the number of competitors goes a long way in
understanding the competitive landscape for a company. Industries that have limited barriers
to entry and a large number of competing firms create a difficult operating environment for
firms. One of the biggest risks within a highly competitive industry is pricing power. This
refers to the ability of a supplier to increase prices and pass those costs on to customers.

20
 Companies operating in industries with few alternatives have the ability to pass on costs to
their customers. A great example of this is Wal-Mart. They are so dominant in the retailing
business, that Wal-Mart practically sets the price for any of the suppliers wanting to do
business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.
v) Regulation: Certain industries are heavily regulated due to the importance or severity of the
industry's products and/or services. As important as some of these regulations are to the
public, they can drastically affect the attractiveness of a company for investment purposes.
In industries where one or two companies represent the entire industry for a region (such as
utility companies), governments usually specify how much profit each company can make. In
these instances, while there is the potential for sizable profits, they are limited due to regulation.
In other industries, regulation can play a less direct role in affecting industry pricing. For
example, the drug industry is one of most regulated industries. And for good reason no one wants
an ineffective drug that causes deaths to reach the market.
6.1.3 Company analysis
At the final stage of fundamental analysis, the investor analyzes the company. The Company is
one's perception of the state of a company - it cannot necessarily be supported by hard facts and
figures. A company may have made losses consecutively for two years or more and one may not
wish to touch its shares - yet it may be a good company and worth purchasing into. There are
several factors one should look at this analysis:
Which company has performed well in comparison with other similar companies?
Which company is performing well in comparison to earlier years?
Which company is better by its management, policies, location and labor relations?
Which company is the market leader by its productions and segment?
6.1.3.1 Objectives of Company analysis
Company analysis focuses on finding attractive firms by:
a) Analyzing individual firms.
b) Understanding each firm's strengths and risks.
c) Identifying attractive firms with superior management and strong performance
(measured by sales and earnings growth).
Stock selection focuses on finding attractive stocks by:
a) Computing each stock’s intrinsic value.
b) Comparing the intrinsic value to the stock’s market price.
c) Identifying attractive stocks, which are substantially undervalued.

6.1.3.2 Significant Factors to be Considered for Company Analysis

It is imperative that one completes the politico economic analysis and the industry analysis
before a company is analyzed because the company's performance at a period of time is to an
extent a reflection of the economy, the political situation and the industry. The different issues
regarding a company that should be examined are:

21
1. The Management: The single most important factor one should consider when investing in
a company and one often never considered is its management. It is upon the quality,
competence and vision of the management that the future of company rests.A good,
competent management can make a company grow while a weak, inefficient management
can destroy a successful company.
2. The Annual Report: The primary and most important source of information about a
company is its Annual Report. By law, this is prepared every year and distributed to the
shareholders.The Annual Report is broken down into the following specific parts:
a) The Director's Report: The Director’s Report is a report submitted by the directors of a
company to its shareholders, advising them of the performance of the company under
their stewardship
b) The Auditor's Report: The auditor represents the shareholders and it is his duty to report
to the shareholders and the general public on the stewardship of the company by its
directors. Auditors are required to report whether the financial statements presented do, in
fact, present a true and fair view of the state of the company.
c) The Financial Statements: The published financial statements of a company in an
Annual Report consist of its Balance Sheet and other statements.
3. Ratios: No person should invest in a company until he has analyzed its financial statements
and compared its performance in the previous years, and with that of other companies.This
can be difficult at times because:
(a) The size of the companies may be different.
(b) The composition of a company's balance sheet may have changed significantly.
Ratios can be broken down into four broad categories:
a) Profit and Loss Ratios: These show the relationship between two items or groups of items in
a profit and loss account or income statement. The more common of these ratios are:
1. Sales to cost of goods sold.
2. Selling expenses to sales.
3. Net profit to sales and
4. Gross profit to sales.
b) Balance Sheet Ratios:these deals with the relationship in the balance sheet such as:
(i) Shareholders’ equity to borrowed funds.
(ii) Current assets to current liabilities.
(iii) Liabilities to net worth.
(iv)Debt to assets and
(v) Liabilities to assets
c) Balance Sheet and Profit and Loss Account Ratios: These relate an item on the balance
sheet to another in the profit and loss account such as:
1. Earnings to shareholder's funds.

22
 2. Net income to assets employed.
3. Sales to stock.
4. Sales to debtors and
5. Cost of goods sold to creditors.
d) Financial Statements and Market Ratios:These are normally known as market ratios and
are arrived at by relation financial figures to market prices:
1. Market value to earnings and
2. Book value to market value.
These ratios have been grouped into eight categories that will enable an investor to easily
determine the strengths or weaknesses of a company. Market value, Earnings, Profitability,
Liquidity, Leverage, Debt Service Capacity, Asset-Management/Efficiency, and Margin
It must be ensured that the ratios being measured are consistent and valid. The length of the
periods being compared should be similar. Large non-recurring income or expenditure should be
omitted when calculating ratios calculated for earnings or profitability, otherwise the conclusions
will be incorrect.
Ratios do not provide answers. They suggest possibilities. Investors must examine these
possibilities along with general factors that would affect the company such as its management,
management policy, government policy, the state of the economy and the industry to arrive at a
logical conclusion and he must act on such conclusions.
4. Cash flow Analysis: In cash flow analysis, investors must always checks; how much is the
company's cash earnings? How is the company being financed and using it?The answers to
these questions can be determined by preparing a statement of sources and uses of funds. A
statement of sources and uses begins with the profit for the year to which are added the
increases in liability accounts (sources) and from which are reduced the increases in asset
accounts (uses). The net result shows whether there has been an excess or deficit of funds
and how this was financed.
6.2 Technical analysis
While fundamental analysis helps you decide what companies you may want to invest in; i.e.
based on the company's management, products and services, financial records, and other
information. And it won't always help you figure out when to buy, sell or hold. There will be
times when the stock of a solid company falters and times when a riskier company performs
well. As a result, although fundamental analysis is important, it's not always sufficient to make
investment decisions. Technical analysis, the study of price movements and trends, can help you
figure out when to enter and exit the market.
Technical analysts base trading decisions on examinations of prior price and volume data to
determine past market trends from which they predict future behavior for the market as a whole
and for individual securities. Several assumptions lead to this view of price movements. In
technical analysis, charts are similar to the charts that you see in any business setting. I.e. The

23
foundation of technical analysis is the chart. A chart is simply a graphical representation of a
series of prices over a set time frame.
Technical analysis is one of the oldest techniques used to make market decisions. Based on the
ideas of Charles Dow, technical analysts use a variety of technical indicators, or series of data
points plotted on a price chart that has been formed using price or price & volume statistics for a
particular security over a particular time period. The goal is to spot market trends and manage
risks associated with price movements.
While some indicators use complex formulas and others are simpler, all of them seek to establish
visual patterns that make sometimes confusing price data easier to understand and interpret.
Indicators can be applied to stock, indexes, futures contracts and any other tradable instruments
whose prices move in response to supply and demand.
While each indicator depicts patterns made by the price movements of securities, studying just
one may not give you a complete picture of the direction the price is likely to head. For example,
an indicator may make false signals, called whipsaws, where prices move in one direction and
quickly revert to an original trajectory. Examining more than one study makes it easier to spot
true signals.

6.2.2 Assumptions of Technical analysts

Technical analysts base trading decisions on examinations of prior price and volume data to
determine past market trends from which they predict future behavior for the market as a whole
and for individual securities. Several assumptions lead to this view of price movements:
i) The market value of any good or service is determined solely by the interaction of supply
and demand.
ii) Supply and demand are governed by numerous rational and irrational factors. Included in
these factors are those economic variables relied on by the fundamental analyst as well as
opinions, moods, and guesses. The market weighs all these factors continually and
automatically.
iii) Disregarding minor fluctuations, the prices for individual securities and the overall value
of the market tend to move in trends, which persist for appreciable lengths of time.
iv) Prevailing trends change in reaction to shifts in supply and demand relationships. These
shifts, no matter why they occur, can be detected sooner or later in the action of the
market itself.
6.2.3 The Top Five Strengths of Technical Analysis
Technical analysis involves the use of charts and technical indicators to predict the price
movement of a currency. Many people (called technicians) swear by this approach to price
forecasting while others (called fundamentalists) won’t touch it. Most traders know that technical
analysis has its advantages and strong points, but that it also has limitations. Many foreign
exchange (Forex) traders use charting methods alone while others use a combination of
approaches. Let’s examine the benefits of technical analysis.

24
 i) Technical analysis focuses on price movement. .
ii) Trends are easily found.
iii) Patterns are easily identified.
iv) Charting is quick and inexpensive.
v) Charts provide a plenty of information

6.2.4 Limitations of Technical Analysis

 The same tools for everyone:-With the democratization of information, most market players
use technical analysis software that relies on the same mathematical models.
 Lack of hindsight and reflection: -Monitoring the trend is an imperative, it follows a
succession of phases of increase or decrease manic, totally disconnected with the
underlying reality.
 The classical figures do not work: - The sense of the individual manager is an afterthought
because "the market is always right" one is always wrong all cons.
 The volatility has taken over:-The volatility, the most senior-and-down of each session, has
exploded since January. It induces changes daily to a breadth of 5 to 8 times higher than the
average.

25