MBA & MBA – Banking and Finance (Term-IV) Course : Security Analysis and Portfolio Management Unit I: Introduction to Security Analysis Lesson No. 1.3– Measurement of Return Unit II: Valuation of Securities Lesson 2.1Approaches to Security Analysis

SECURITY RETURNS  Investors want to maximize expected returns subject to their tolerance for risk.  Return could be categorized into:- 1. Realized return (ex-post or historical return) 2. Expected return (ex-ante or future return) Realized return is after the fact return- that is the return that was earned (or could have been earned). It is historical return. Expected return is the return from an asset that investors anticipate they will earn over some future period. It is a predicted return. It may occur or may not occur.

ELEMENTS IN RETURN  Return consists of the following two components:- 1. Periodic cash receipts (or income) on the investment, either in the form of interest or dividend 2. Change in the price of the asset that is capital gain or loss

RETURN MEASUREMENT Total return :  The total return for a given holding period relates all the cash flows received by an investor during the period to the amount of money invested in the asset. It is defined as  Total Return = Cash payments received + Price change over the period Purchase price of the asset

EXPECTED RETURN  The expected return of any stock is the weighted average rate of return. The probabilities of the rate of return are used as weights. N E(R) = ∑ R i P i i=1 where E(R) = expected return, R i = return, P i = probability.

APPROACHES TO VALUATION  There are essentially three main schools of thought on the matter of security price valuation. Advocates of these schools are classified as:- 1. Fundamentalist (Fundamental Analysis) 2. Technicians (Technical Analysis) 3. Efficient Market Advocates (Efficient Market Hypothesis)

FUNDAMENTAL ANALYSIS  The Fundamental Analyst focuses on the “intrinsic” value of a stock.  Intrinsic Value depends on the earning potentials of the security.  The earning potential of the security depends in turn on such fundamental factors as Quality of management, Outlook for the industry and the economy and so on.  Buy a security if Market price < Intrinsic Value  Sell a security if Market price > Intrinsic Value  Intrinsic Value is the Discounted value of the stream of future receipts from the security.

TECHNICAL ANALYSIS  Technical Analysis involves a study of market generated data like prices and volumes to determine the future direction of price movement.  The basic assumption of all the chartists or technical theories is that history tends to repeat itself; i.e. past patterns of price behavior in individual securities will tend to recur in the future.  Technicians thus predict stock prices on the basis of historical data.

EFFICIENT MARKET HYPOTHESIS  EMH means that the stock market is always efficient.  In an efficient market, stock prices reflect its true worth. Thus, there is no difference between Market price and Intrinsic Value of a security.  Stock market efficiency means that all the information relating to a security / company is passed on to all the investors simultaneously, freely and conveniently.  As such no investor is in a position to beat others.

FORMS OF MARKET EFFICIENCY  Weak-form: Prices reflect all information found in the record of past prices and volumes.  Semi-Strong form: Prices reflect not only all information found in the record of past prices and volumes but also all other publicly available information.  Strong-form: Prices reflect all available information, public as well as private.

FUNDAMENTAL ANALYSIS ECONOMIC-INDUSTRY-COMPANY FRAMEWORK (E-I-C framework)  Economic Analysis – Key variables commonly used to describe the state of the economy are: Growth rate of gross domestic product Industrial growth rate State of agriculture Savings and investments Government budget and deficit Price level and inflation Interest rates Balance of payment, forex reserves, and exchange rate Infrastructural facilities and arrangement

INDUSTRY ANALYSIS  Key characteristics in an industry analysis are: Past sales and earnings performance Permanence The attitude of Government toward the Industry Labour Conditions Competitive Conditions Industry share prices relative to industry earnings

COMPANY ANALYSIS It is based upon the following two broad categories of information:- 1. Internal information – It consists of data and events made public by firms concerning their operations. For example- Financial Statements. 2. External information – Generated independently.

FINANCIAL STATEMENTS Accounts and statements are devices created to summarize certain types of information about real corporate goods and processes. Tests of financial statements- 1. Correctness 2. Completeness 3. Consistency 4. Comparability