Q.
4
Discuss the following: (20)
1. Technical Analysis
2. Fundamental Analysis
3. Horizontal Analysis
4. Vertical Analysis
Ans part 1
Technical Analysis
Technical analysis is a trading discipline employed to
evaluate investments and identify trading opportunities
by analyzing statistical trends gathered from trading activity, such as
price movement and volume. Unlike fundamental analysts, who attempt to
evaluate a security's intrinsic value, technical analysts focus
on patterns of price movements, trading signals and various other analytical
charting tools to evaluate a security's strength or weakness.
Technical analysis can be used on any security with historical
trading data. This includes stocks, futures, commodities,
fixed-income, currencies, and other securities. In this tutorial, we’ll usually
analyze stocks in our examples, but keep in mind that these concepts can be
applied to any type of security. In fact, technical analysis is far more
prevalent in commodities and forex markets where traders focus
on short-term price movements.
Technical analysts believe past trading activity
and price changes of a security can be valuable indicators of the
security's future price movements. They may use technical analysis independent
of other research efforts or in combination with some concepts of intrinsic
value considerations but most often their convictions are based solely on the
statistical charts of a security. The Market Technicians Association (MTA) is
one of the most popular groups supporting technical analysts in their
investments with the Chartered Market Technicians (CMT) designation a popular
certification for many advanced technical analysts.
There are two primary methods used to analyze securities and make
investment decisions: fundamental analysis and technical
analysis. Fundamental analysis involves analyzing a company’s financial
statements to determine the fair value of the business, while technical
analysis assumes that a security’s price already reflects all
publicly-available information and instead focuses on the statistical analysis
of price movements. Technical analysis attempts to understand the market
sentiment behind price trends by looking for patterns and trends rather than
analyzing a security’s fundamental attributes.
Charles Dow released a series of editorials discussing technical
analysis theory. His writings included two basic assumptions that have
continued to form the framework for technical analysis trading.
- Markets are efficient with values representing factors that influence a security’s price, but
- Market price movements are not purely random but move in identifiable patterns and trends that tend to repeat over time
Ans part 2
Fundamental analysis
Fundamental analysis is a method of evaluating
a security in an attempt to assess its intrinsic value, by examining related
economic, financial, and other qualitative and quantitative factors.
Fundamental analysts study anything that can affect the security's value,
including macroeconomic factors (e.g. economy and industry conditions) and
microeconomic factors (e.g. financial conditions and company management). The
end goal of fundamental analysis is to produce a quantitative value that an
investor can compare with a security's current price, thus indicating whether
the security is undervalued or overvalued.
Fundamental analysis determines the health and
performance of an underlying company by looking at
key numbers and economic indicators. The purpose is to identify fundamentally
strong companies or industries and fundamentally weak companies or industries.
Investors go long (purchasing with the expectation that the stock will rise in value)
on the companies that are strong, and short (selling shares that you believe
will drop in value with the expectation of repurchasing when at a lower price)
the companies that are weak. This method of security analysis is considered to
be the opposite of technical
analysis, which forecasts
the direction of prices through the analysis of historical market data, such as
price and volume.
Fundamental analysis uses real, public data in the evaluation a
security's value. Although most analysts use fundamental analysis to value stocks,
this method of valuation can
be used for just about any type of security. For example, an investor can
perform fundamental analysis on a bond's value by looking at economic factors,
such as interest rates and the overall state of the economy. He can also look
at information about the bond issuer, such as potential changes in credit ratings.
For stocks and equity instruments, fundamental analysis uses
revenues, earnings, future growth, return on equity,
profit margins, and other data to determine a company's underlying value and
potential for future growth. In terms of stocks, fundamental analysis focuses
on the financial statements of the company being evaluated. One of the most
famous and successful fundamental analysts is the so-called "Oracle of
Omaha," Warren Buffett, who is well known for successfully
employing fundamental analysis to pick securities.
Example of Fundamental Analysis
Even the market as a whole can be evaluated using fundamental
analysis. For example, analysts looked at fundamental indicators of the S&P
500 from July 4 to July 8, 2016. During this time, the S&P rose to 2129.90
after the release of a positive jobs' report in the United States. In fact, the market
just missed a new record high, coming in just under the May 2015 high of
2132.80. The economic surprise of an additional 287,000 jobs for the month of
June specifically increased the value of the stock market on July 8, 2016.
However, there are
differing views on the market's true value. Some analysts believe the economy
is heading for a bear market, while other analysts believe it will continue
as a bull market.
Ans part 3
Horizontal Analysis
Horizontal analysis is
used in financial
statement analysis to compare
historical data, such as ratios, or line items, over a number of accounting
periods. Horizontal analysis can either use absolute comparisons or percentage
comparisons, where the numbers in each succeeding period are expressed as a
percentage of the amount in the baseline year, with the baseline amount being
listed as 100%. This is also known as base-year
analysis.
Horizontal analysis allows investors and analysts to see what has
been driving a company's financial performance over a number of years, as well
as spotting trends and growth patterns such as seasonality.
It enables analysts to assess relative changes in different line items over
time, and project them. By looking at the income statement, balance sheet and
cash flow statement at the same time, one can create a complete picture of
operational results, and see what has been driving a company’s performance and
whether it is operating efficiently and profitably.
The analysis of critical measures of business performance, such as
profit margins, inventory turnover and
return on equity, can detect emerging problems and strengths. For example, earnings per share (EPS) may
have been rising because the cost of goods sold has been falling, or because
sales have been growing strongly. And coverage ratios, like the cash
flow-to-debt ratio and the interest coverage ratio can reveal whether a company
can service its debt and has enough liquidity.
Horizontal analysis also makes it easier to compare growth rates and
profitability among different companies.
Horizontal Analysis Example
Horizontal analysis typically shows the changes from the base
period in dollar and percentage. For example, when someone says that revenues
have increased by 10% this past quarter, that person is using horizontal
analysis. The percentage change is calculated by first dividing the dollar
change between the comparison year and the base year by the item value in the
base year, then multiplying the quotient by 100%.
For example, assume an investor wishes to invest in company XYZ.
The investor may wish to determine how the company grew over the past year.
Assume that in company XYZ's base year, it reported net income of $10 million
and retained earnings of $50 million. In the current year, company XYZ reported
net income of $20 million and retained earnings of $52 million. Consequently,
it has an increase of $10 million in its net income and $2 million in its
retained earnings year over year. Therefore, company ABC's net income grew by
100% YOY, while its retained earnings only grew by 4%.
Ans part 4
Vertical
analysis
Vertical analysis is a
method of financial
statement analysis in which each line item is listed as a
percentage of a base figure within the statement. Thus, line items on an income
statement can be stated as a percentage of gross sales, while line items on a balance sheet can be
stated as a percentage of total assets or liabilities, and vertical analysis of
a cash flow statement shows each cash inflow or outflow as a
percentage of the total cash inflows.
Vertical analysis makes it much easier to compare the financial
statements of one company with another, and across industries because one can
see the relative proportions of account balances. It also makes it easier to
compare previous periods for time series analysis,
in which quarterly and annual figures are compared over a number of years in
order to gain a picture of whether performance metrics are improving or
deteriorating.
For example, by showing the various expense line items in the
income statement as a percentage of sales, one can see how these are
contributing to profit margins and whether profitability is improving over
time. It also makes it easier to compare the profitability of a company with
its peers.
Financial statements that include vertical analysis clearly show
line item percentages in a separate column. These types of financial
statements, including detailed vertical analysis, are also known as common-size
financial statements and are used by many companies to provide
greater detail on a company’s financial position. Common-size financial
statements often incorporate comparative financial statements that include
columns comparing each line item to a previously reported period.
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