Fundamental & Technical Analysis: Valuation of Shares & Market Efficiency

Posted on Aug 18, 2024 in Other subjects

ITEM 6: EVALUATION OF SHARES

FUNDAMENTAL ANALYSIS AND VALUATION OF ASSETS

Fundamental Analysis

Objective: Determine the intrinsic value of a financial asset.

Intrinsic Value: Present value of future cash flows generated by the asset, discounted at an appropriate risk-adjusted rate.

Aspects to Study in Fundamental Analysis

External Analysis:

Variables affecting the general environment, the economy, and the industry.

  • General Environment:
    • Economic scenario: Inflation, interest rates, GDP…
    • Social environment: Labor market, labor disputes, union relations…
    • Political environment: Political stability, taxation, international relations…
    • Technological advancements: Development of new technologies, R&D…
  • Industry Analysis:
    • Position of the sector in the economy
    • Degree of rivalry among existing firms
    • Existence of potential competitors
    • Threat of substitutes
    • Bargaining power with customers and suppliers
Internal Analysis:

The study of areas in which the company has direct control: finance, marketing, human resources, investment.

FUNDAMENTAL ANALYSIS AND VALUATION OF ASSETS

Objective: To take advantage of stock market inefficiencies for above-normal profits.

Two Procedures:

  1. Calculation of Intrinsic Value (VI): After determining the appropriate discount rate, future cash flows are discounted to calculate VI.
    If VI > Market Price (P) ? BUY
  2. Calculation of the Expected Rate of Return (IRR):
    • Define the required rate of return (K): Minimum return required on the investment (e.g., using CAPM)
    • Calculate the expected rate of return (IRR). Knowing the market price of the asset, calculate the IRR of the investment.
      If IRR > K ? INVEST

EFFICIENT MARKET

Definition: The price of an asset matches its intrinsic value.

If the market is efficient: VI = P and IRR = K. Therefore, the market is in equilibrium.

CONCEPT OF EFFICIENT MARKET

Definition: A market is efficient if stock prices fully reflect all available information.

Characteristics of an Efficient Market:

  • An efficient market is more than a perfect market.
  • Financial asset prices fluctuate randomly around their intrinsic value.
  • All information received by the market is immediately incorporated into prices, resulting in a random walk (price variations cannot be predicted).
  • Investors can only expect to earn a normal rate of return. A priori, NPV = 0. A posteriori, NPV = Positive or negative depending on chance.

DIFFERENT LEVELS OF EFFICIENCY

Different Scenarios for Efficiency:

Based on the available data, we can define the following levels of efficiency: weak, semi-strong, and strong.

  • Weak Efficiency: Prices fully incorporate information from past prices of stocks.
    • Unable to use historical prices for extraordinary profit.
    • If historical information could be used to make extra profits, everyone would act on it, and the extraordinary profit would disappear. From this perspective, technical analysis is not valid.
  • Semi-Strong Efficiency: Prices incorporate all publicly available information, including past prices and other available data.
  • Strong Efficiency: Anything that relates to the value of stocks and is known to at least one investor is completely incorporated into the share price.

Empirical Evidence:

  • Weak Form: Based on analysis of autocorrelation in the profitability of a stock. Generally accepted as having low efficiency.
  • Semi-Strong Form: Event studies generally support the semi-strong form.
  • Strong Form: Analysis of insider information does not support this form of efficiency.

Opposing Views:

  • Market Anomalies
  • Speculative Bubbles

IMPLICATIONS FOR FINANCIAL MANAGEMENT

  • Accounting and Efficient Markets: Accounting manipulations do not mislead the market. The accounting method used should not affect the price if there is no real effect on cash flows.
  • Technical Analysis: In weakly efficient markets, technical analysis is not useful.
  • Fundamental Analysis: In semi-strong efficient markets, fundamental analysis is not useful for achieving extraordinary results.
  • Insider Information: In strongly efficient markets, insider information does not lead to extraordinary results.

VALUATION OF SHARES

Dividend Discount Model

The value of a share equals the present value of expected future dividends.

P0 = Intrinsic Value of the share

Di = Dividend for the period i

k = Required rate of return

Valuation with Different Growth Patterns

a) No Growth:

P0 = Intrinsic Value of the share

Di = Dividend for the period i

EPS = Earnings per share

k = Required rate of return

b) Constant Growth Model (Gordon-Shapiro):

g = Growth rate of dividends

c) Variable Growth:

RF = BN = Net Income

V = Sales

A = Assets

RFi = Margin x Turnover x Leverage = Equity

Hypothesis: g = RF (Return on retained profit)

Retention rate constant over time

Constant dividend growth

Cost of Capital (k)

  • Required rate k = Risk-free rate + Risk premium
  • CAPM Model

TECHNICAL ANALYSIS

Concept: Study the movements of financial asset prices over time to identify patterns of future behavior. Primarily based on graphical analysis (charting). More recently, includes mathematical and statistical treatment.

Origin: Late 1880s by Charles H. Dow.

BASIC PRINCIPLES:

  • Prices move in trends.
  • The market has a memory. Studying the past can help predict the future.

TYPES OF CHARTS:

  1. Line Chart: Constructed with closing prices.
  2. Bar Chart: A vertical line represents the minimum and maximum price of the session. A short horizontal line on the left marks the opening price, and one on the right marks the closing price.
  3. Daily Charts: Represent movements of each session. Used for short or medium-term positions.
  4. Weekly and Monthly Charts: Similar to bar charts but for a week or month. Used for long-term positions.

TRENDS

Definition: The direction in which asset prices are moving. Caused by an imbalance between supply and demand.

TYPES:

I) According to Motion:

  • Upward Trend: Maximum and minimum levels, formed in a zigzag movement, are successively higher. Draw a straight line connecting two minimums.
  • Downward Trend: Maximum and minimum levels, formed in a zigzag movement, are successively lower. Draw a straight line connecting two peaks, with the first being higher than the second.
  • Horizontal Trend: All peaks are at the same level, and the same is true for minimums.

II) According to Length:

  • Long-term: Lasts more than a year.
  • Medium-term: Lasts longer than a month but less than a year.
  • Short-term: Lasts between one week and one month.

SUPPORT AND RESISTANCE

Concepts:

  • Trends move in a zigzag pattern: They have maximums and minimums.
  • Maximum points are called resistance. Occurs when, at a certain price level, there is enough supply to stop the uptrend.
  • Minimum points are called support. Occurs when, at a certain price level, there is enough demand to stop the downtrend.

Features:

  • Support and resistance levels are indicators of possible changes in trends.
  • Support and resistance levels switch roles when they are broken.
  • Round numbers often act as support and resistance.

Drawing Support and Resistance Lines:

  • A support line is obtained by connecting at least two support points. The same applies to a resistance line.
  • These lines should be adjusted every time a support or resistance point is broken. Sometimes, a broken resistance line becomes a support line, and vice versa.
  • When drawing support and resistance lines, consider the timeframe of the investment under consideration.

CHANNELS

Channels: Formations that occur in a clear graphical trend. Support and resistance lines are parallel, either rising, falling, or horizontal. When a channel is drawn, the price tends to move within it.

VOLUME

Volume:

  • The number of contracts traded in a session.
  • Represents the reaction of investors to different market situations.
  • Represented as vertical bars on the horizontal axis below the price chart.
  • Helps to understand the strength of trends.
  • An uptrend is strong when volume increases as the price rises.
  • A downtrend is strong when volume increases as the price drops.

KEY REVERSAL FIGURES

Head and Shoulders Formation:

Characterized by three peaks and two support points. The first peak is followed by a second, higher peak, and a third peak lower than the second and approximately equal to the first. Draw the neckline by connecting the two support points of the left shoulder and the head. This figure provides a useful piece of information: the target price. Calculated by taking the distance from the neckline to the highest point of the figure (the head) and projecting it downwards to obtain the target price.

Inverse Head and Shoulders Formation:

The reverse of the previous figure. It usually occurs at bottoms instead of tops. Therefore, the consequences of these formations are bullish rather than bearish.

Double Top Formation:

Characterized by two resistance points and a support point. The two resistance points are approximately at the same level. Its visual appearance is similar to an M. The double top indicates a minimum target price. It is found by measuring the distance from the two peaks to the lowest point that acts as support. Then, that distance is projected downwards from the breakout line.

Double Bottom Formation:

The reverse of the double top formation. It has two support points and a resistance point. Resembles a W.

KEY CONTINUATION FIGURES

Symmetrical Triangle Formation:

No clear indication of where the price will continue, but usually involves a breakout. Requires a minimum of two resistance points and two support points. Connecting the two resistance points should result in a line with a downward slope (the second is below the level of the first). Connecting the two support points should result in an upward sloping line. These two lines tend to converge. Two ways of calculating the target price:

  1. Draw a vertical line from the starting point of the triangle up to the resistance line. If the asset breaks the support or resistance line, the calculated distance is projected in the direction of the breakout.
  2. Draw a line parallel to the support line from the first resistance point. If the support line is broken, draw a line parallel to the resistance line from the first support point.

Ascending Right Triangle Formation:

Usually occurs in upward trends and represents a pause in the trend. Indicates an upward breakout. Characterized by a flat resistance line, which the asset exceeds when it breaks out, indicating upward movement. The minimum target price is determined by the base, similar to the symmetrical triangle.

Descending Right Triangle Formation:

Occurs in downtrends. The flat line is the support line. Indicates a downward breakout.

Wedge Formation:

Similar to triangles. They consist of a support line and a resistance line (each with at least two points) that converge. It takes between one and three months to form, and the characteristic volume is decreasing. Wedges are often formed against the prevailing trend. Two types: ascending, which often occur in downtrends, and its minimum target is located at the first support point; and descending, which occur in upward trends, and its target is located at the first resistance point at the beginning of the wedge.

STATISTICS IN TECHNICAL ANALYSIS

Moving Average:

A trend-following indicator aimed at identifying or signaling the beginning or end of a trend or the next change. Its calculation allows for smoothing of the price series, absorbing the behavior of the observed series. Allows for dampening the volatility of stock prices and hence their constant fluctuations.

  • Moving averages are considered lines of support and resistance, thus generating alerts for a change in trend.
  • The greater the number of observations (k), the greater the importance of the signal generated.
  • Choice of size depends on the type of trend analysis (short, medium, long).
  • Weighted moving averages allow for assigning more importance to information contained in the most recent observations.