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In The Name of ALLAH, The Most Merciful, The Most Beneficial.

SECURITY ANALYSIS

INVESTMENT & SECURITY ANALYSIS

Presented To,

Sir Ghulam Ali Bhatti

University of Sargodha

Presented By,

AAMIR RAZA MBA-08-12 (Company Analysis)

SADIA GULL MBA-08-08 (Industry Analysis)

MADEEHA ZUBAIR MBA-08-37 (Trend Analysis)

Group of Eagles

M.B.A (REGULAR) Section “A”

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Company Analysis

Fundamental Analysis: Introduction

Fundamental Analysis: What Is It?

Fundamental Analysis: The Income Statement

Fundamental Analysis: The Balance Sheet

Fundamental Analysis: The Cash Flow Statement

Fundamental Analysis: Fundamental Analysis Tools

Fundamental Analysis: Introduction to Financial Statements

Fundamental Analysis: Conclusion

Fundamental analysis

Fundamental analysis is the cornerstone of investing. In fact, some would say that you

aren't 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.

The goal of this tutorial is to provide a foundation for understanding fundamental analysis. It's

geared primarily at new investors who don't know a balance sheet from an income

statement.While you may not be a "stock-picker extraordinaire" by the end of this tutorial, you

will have a much more solid grasp of the language and concepts behind security analysis and be

able to use this to further your knowledge in other areas without feeling totally lost.

The biggest part of fundamental analysis involves delving into the financial statements. Also

known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and

all the other financial aspects of a company. Fundamental analysts look at this information to

gain insight on a company's future performance. A good part of this tutorial will be spent

learning about the balance sheet, income statement, cash flow statement and how they all fit

together.

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But there is more than just number crunching when it comes to analyzing a company. This is

where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure

aspects of a company.

Fundamental Analysis Mean

A method of evaluating a security that entails attempting to measure its intrinsic value by

examining related economic, financial and other qualitative and quantitative factors.

Fundamental analysts attempt to study everything that can affect the security's value, including

macroeconomic factors (like the overall economy and industry conditions) and company-specific

factors (like financial condition and management).

The end goal of performing fundamental analysis is to produce a value that an investor can

compare with the security's current price, with the aim of figuring out what sort of position to

take with that security (underpriced = buy, overpriced = sell or short).

Company Analysis

Fundamental analysis is about using real data to evaluate 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.

Information regarding companies can be broadly classifies into two broad groups.

Internal

External

Fundamental analysis is the process of looking at a business at the basic or fundamental financial

level. This type of analysis examines key ratios of a business to determine its financial health and

gives you an idea of the value its stock.

Many investors use fundamental analysis alone or in combination with other tools to evaluate

stocks for investment purposes. The goal is to determine the current worth and, more

importantly, how the market values the stock.

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This article focuses on the key tools of fundamental analysis and what they tell you. Even if you

don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more

closely if you understand the key ratios and terms.

Earnings

It’s all about earnings. When you come to the bottom line, that’s what investors want to know.

How much money is the company making and how much is it going to make in the future.

Earnings are profits. It may be complicated to calculate, but that’s what buying a company is

about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular

dividend.

Financial statement:

A financial statement (or financial report) is a formal record of the financial activities of a

business, person, or other entity. In British English—including United Kingdom company law—

a financial statement is often referred to as an account, although the term financial statement is

also used, particularly by accountants

Balance sheet:

For a business enterprise, all the relevant financial information, presented in a structured manner

and in a form easy to understand, are called the financial statements. They typically include four

basic financial statements:[1]

In financial accounting, a balance sheet or statement of financial

position is a summary of the financial balances of a sole proprietorship, a business partnership or

a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the

end of its financial year. A balance sheet is often described as a "snapshot of a company's

financial condition".[1]

Of the four basic financial statements, the balance sheet is the only

statement which applies to a single point in time of a business' calendar year.

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The

main categories of assets are usually listed first, and typically in order of liquidity.[2]

Assets are

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followed by the liabilities. The difference between the assets and the liabilities is known as

equity or the net assets or the net worth or capital of the company and according to the

accounting equation, net worth must equal assets minus liabilities.[3]

Another way to look at the same equation is that assets equals liabilities plus owner's equity.

Looking at the equation in this way shows how assets were financed: either by borrowing money

(liability) or by using the owner's money (owner's equity). Balance sheets are usually presented

with assets in one section and liabilities and net worth in the other section with the two sections

"balancing."

Records of the values of each account or line in the balance sheet are usually maintained using a

system of accounting known as the double-entry bookkeeping system.

A business operating entirely in cash can measure its profits by withdrawing the entire bank

balance at the end of the period, plus any cash in hand. However, many businesses are not paid

immediately; they build up inventories of goods and they acquire buildings and equipment. In

other words: businesses have assets and so they can not, even if they want to, immediately turn

these into cash at the end of each period. Often, these businesses owe money to suppliers and to

tax authorities, and the proprietors do not withdraw all their original capital and profits at the end

of each period. In other words businesses also have liabilities.

Income Statement:

Income statement, also referred as profit and loss statement (P&L), earnings statement,

operating statement or statement of operations,[1]

is a company's financial statement that

indicates how the revenue (money received from the sale of products and services before

expenses are taken out, also known as the "top line") is transformed into the net income (the

result after all revenues and expenses have been accounted for, also known as the "bottom line").

It displays the revenues recognized for a specific period, and the cost and expenses charged

against these revenues, including write-offs (e.g., depreciation and amortization of various

assets) and taxes.[1]

The purpose of the income statement is to show managers and investors

whether the company made or lost money during the period being reported.

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The important thing to remember about an income statement is that it represents a period of time.

This contrasts with the balance sheet, which represents a single moment in time.

The income statement can be prepared in one of two methods. The Single Step income statement

takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The

more complex Multi-Step income statement (as the name implies) takes several steps to find the

bottom line, starting with the gross profit. It then calculates operating expenses and, when

deducted from the gross profit, yields income from operations. Adding to income from

operations is the difference of other revenues and other expenses. When combined with income

from operations, this yields income before taxes. The final step is to deduct taxes, which finally

produces the net income for the period measured

CASH FIOW STATMENT:

In financial accounting, a cash flow statement, also known as statement of cash flows or funds

flow statement, is a financial statement that shows how changes in balance sheet accounts and

income affect cash and cash equivalents, and breaks the analysis down to operating, investing,

and financing activities. Essentially, the cash flow statement is concerned with the flow of cash

in and cash out of the business. The statement captures both the current operating results and the

accompanying changes in the balance sheet.[1]

As an analytical tool, the statement of cash flows

is useful in determining the short-term viability of a company, particularly its ability to pay bills.

International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals

with cash flow statements.

People and groups interested in cash flow statements include:

Accounting personnel, who need to know whether the organization will be able to cover payroll

and other immediate expenses

Potential lenders or creditors, who want a clear picture of a company's ability to repay

Potential investors, who need to judge whether the company is financially sound

Potential employees or contractors, who need to know whether the company will be able to

afford compensation

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Shareholders of the business

ACTIVITES OF CASH FLOW STATMENT:

The cash flow statement is partitioned into three segments, namely: cash flow resulting from

operating activities, cash flow resulting from investing activities, and cash flow resulting from

financing activities.

The money coming into the business is called cash inflow, and money going out from the

business is called cash outflow.

Operating activities

Operating activities include the production, sales and delivery of the company's product as well

as collecting payment from its customers. This could include purchasing raw materials, building

inventory, advertising, and shipping the product.

Under IAS 7, operating cash flows include:[11]

Receipts from the sale of goods or services

Receipts for the sale of loans, debt or equity instruments in a trading portfolio

Interest received on loans

Dividends received on equity securities

Payments to suppliers for goods and services

Payments to employees or on behalf of employees

Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US

GAAP)

Items which are added back to [or subtracted from, as appropriate] the net income figure (which

is found on the Income Statement) to arrive at cash flows from operations generally include:

Depreciation (loss of tangible asset value over time)

Deferred tax

Amortization (loss of intangible asset value over time)

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Any gains or losses associated with the sale of a non-current asset, because associated cash flows

do not belong in the operating section.(unrealized gains/losses are also added back from the

income statement)

Investing activities

Examples of investing activities are

Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)

Loans made to suppliers or received from customers

Payments related to mergers and acquisitions

Financing activities

Financing activities include the inflow of cash from investors such as banks and shareholders, as

well as the outflow of cash to shareholders as dividends as the company generates income. Other

activities which impact the long-term liabilities and equity of the company are also listed in the

financing activities section of the cash flow statement.

Under IAS 7,

Proceeds from issuing short-term or long-term debt

Payments of dividends

Payments for repurchase of company shares

Repayment of debt principal, including capital leases

For non-profit organizations, receipts of donor-restricted cash that is limited to long-term

purposes.

Items under the financing activities section include:

Dividends paid

Sale or repurchase of the company's stock

Net borrowings

Payment of dividend tax

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Fundamental Analysis Tools

These are the most popular tools of fundamental analysis. They focus on earnings, growth, and

value in the market. For convenience, I have broken them into separate articles. Each article

discusses related ratios. There are links in each article to the other articles and back to this

article.

The articles are:

i. Earnings per Share – EPS

ii. Price to Earnings Ratio – P/E

iii. Projected Earning Growth – PEG

iv. Price to Sales – P/S

v. Price to Book – P/B

vi. Dividend Payout Ratio

vii. Dividend Yield

viii. Book Value

ix. Return on Equity

1. Earnings per Share – EPS

Using our example above, Company A had earnings of $100 and 10 shares outstanding, which

equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares

outstanding, which equals an EPS of 2 ($100 / 50 = 2).

EPS = Net Earnings / Outstanding Shares

So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of

its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same

industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it.

For that information, we need to look at some ratios.

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2. Price-Earnings Ratio - P/E Ratio

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is

the most popular metric of stock analysis, although it is far from the only one you should

consider.

You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

3. PEG = P/E/ (projected growth in earnings)

The P/E is the most popular way to compare the relative value of stocks based on earnings

because you calculate it by taking the current price of the stock and divide it by the Earnings Per

Share (EPS). This tells you whether a stock’s price is high or low relative to its earnings.

Some investors may consider a company with a high P/E overpriced and they may be correct. A

high P/E may be a signal that traders have pushed a stock’s price beyond the point where any

reasonable near term growth is probable.

However, a high P/E may also be a strong vote of confidence that the company still has strong

growth prospects in the future, which should mean an even higher stock price.

You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

PEG = P/E / (projected growth in earnings)

4. Price to Sales – P/S

We still have the problem of needing some measure of young companies with no earnings, yet

worthy of consideration. After all, Microsoft had no earnings at one point in its corporate life.

One ratio you can use is Price to Sales or P/S ratio. This metric looks at the current stock price

relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock

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by the total revenues of the company. You can also calculate the P/S by dividing the current

stock price by the sales per share.

P/S = Market Cap / Revenues

P/S = Stock Price / Sales Price Per Share

5. P/B = Share Price/Book Value Per Share

Investors looking for hot stocks aren’t the only ones trolling the markets. A quiet group of folks

called value investors go about their business looking for companies that the market has passed

by.

Some of these investors become quite wealthy finding sleepers, holding on to them for the long

term as the companies go about their business without much attention from the market, until one

day they pop up on the screen, and some analyst ―discovers‖ them and bids up the stock.

Meanwhile, the value investor pockets a hefty profit. Value investors look for some other

indicators besides earnings growth and so on. One of the metrics they look for is the Price to

Book ratio or P/B. This measurement looks at the value the market places on the book value of

the company.

You calculate the P/B by taking the current price per share and dividing by the book value per

share.

P/B = Share Price / Book Value Per Share

6. Dividend Payout Ratio

The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like a measurement

invented because it looked like it was important, but nobody can really agree on why.

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The DPR (it usually doesn’t even warrant a capitalized abbreviation) measures what a

company’s pays out to investors in the form of dividends.

You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.

DPR = Dividends Per Share / EPS

7. Dividend Yield

This measurement tells you what percentage return a company pays out to shareholders in the

form of dividends. Older, well-established companies tend to payout a higher percentage then do

younger companies and their dividend history can be more consistent.

You calculate the Dividend Yield by taking the annual dividend per share and divide by the

stock’s price.

Dividend Yield = annual dividend per share / stock's price per share

8. Book Value

There are several ways to define a company’s worth or value. One of the ways you define value

is market cap or how much money would you need to buy every single share of stock at the

current price. Another way to determine a company’s value is to go to the balance statement and

look at the Book Value. The Book Value is simply the company’s assets minus its liabilities.

Book Value = Assets – Liabilities

9. Return on equity

1 Return on Equity (ROE) is one measure of how efficient ly a company uses its

assets to produce earnings. You calculate ROE by dividing Net Income by Book

Value. A healthy company may produce an ROE in the 13% to 15% range. Like

all metr ics, compare companies in the same industry to get a bet ter picture.

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Net Profit ÷ Average Shareholder Equity for Period = Return on Equity a

ROE=ROA*leverage.

2 Financial Statement Analysis

Financial statement analys is is defined as the process of ident ifying

financial st rengths and weaknesses o f the firm by proper ly establishing

relat ionship between the items o f the ba lance sheet and the profit and loss

account .

There are various methods or techniques that are used in analyzing financial statements, such as

comparative statements, schedule of changes in working capital, common size percentages, funds

analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision

making purposes. They play a dominant role in setting the framework of managerial decisions.

But the information provided in the financial statements is not an end in itself as no meaningful

conclusions can be drawn from these statements alone. However, the information provided in the

financial statements is of immense use in making decisions through analysis and interpretation of

financial statements.

2.1 Tools and Techniques of Financial Statement Analysis :

1. Horizontal and Vertical Analysis

2. Ratios Analysis

1. Horizontal and Vertical Analysis:

2.1.1 Horizontal Analysis or Trend Analysis :

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Comparison of two or more year's financial data is known as horizontal analysis, or trend

analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and

percentage form.

Trend Percentage:

Horizontal analysis of financial statements can also be carried out by computing trend

percentages. Trend percentage states several years' financial data in terms of a base year. The

base year equals 100%, with all other years stated in some percentage of this base.

Vertical Analysis:

It is the procedure of preparing and presenting common size statements. Common size

statement is one that shows the items appearing on it in percentage form as well as in dollar

form. Each item is stated as a percentage of some total of which that item is a part. Key financial

changes and trends can be highlighted by the use of common size statements.

Ratios Analysis:

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means

one number expressed in terms of another. A ratio is a statistical yardstick by means of which

relationship between two or various figures can be compared or measured. Ratios can be found

out by dividing one number by another number. Ratios show how one number is related to

another.

Profitability Ratios:

Profitability ratios measure the results of business operations or overall performance and

effectiveness of the firm. Some of the most popular profitability ratios are as under:

Gross profit ratio

Net profit ratio

Operating ratio

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Expense ratio

Return on shareholders investment or net worth

Return on equity capital

Return on capital employed (ROCE) Ratio

Dividend yield ratio

Dividend payout ratio

Earnings Per Share Ratio

Price earning ratio

Liquidity Ratios:

Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are

calculated to comment upon the short term paying capacity of a concern or the firm's ability to

meet its current obligations. Following are the most important liquidity ratios.

Current ratio

Liquid / Acid test / Quick ratio

Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm have

been employed. These ratios are also called turnover ratios because they indicate the speed with

which assets are being turned over into sales. Following are the most important activity ratios:

Inventory / Stock turnover ratio

Debtors / Receivables turnover ratio

Average collection period

Creditors / Payable turnover ratio

Working capital turnover ratio

Fixed assets turnover ratio

Over and under trading

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Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and

payment schedules of its long term obligations. Following are some of the most important long

term solvency or leverage ratios.

Debt-to-equity ratio

Proprietary or Equity ratio

Ratio of fixed assets to shareholders funds

Ratio of current assets to shareholders funds

Interest coverage ratio

Capital gearing ratio

Over and under capitalization

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two

limitations involve the comparability of financial data between companies and the need to look

beyond ratios.

Advantages of Financial Statement Analysis:

1. The investors get enough idea to decide about the investments of their funds in the specific

company.

2. Regulatory authorities like International Accounting Standards Board can ensure whether the

company is following accounting standards or not.

3.It can help the government agencies to analyze the taxation due to the company. Moreover,

company can analyze its own performance over the period of time through financial statements

analysis

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Major Statements

1. Income statement

It is basically the first financial statement you will come across in an annual report or quarterly

Securities And Exchange Co It also contains the numbers most often discussed when a company

announces its results - numbers such as revenue, earnings and earnings per share. Basically, the

income statement shows how much money the company generated (revenue), how much it spent

(expenses) and the difference between the two (profit) over a certain time period.

When it comes to analyzing fundamentals, the income statement lets investors know how well

the company’s business is performing - or, basically, whether or not the company is making

money. Generally speaking, companies ought to be able to bring in more money than they spend

or they don’t stay in business for long. Those companies with low expenses relative to revenue -

or high profits relative to revenue - signal strong fundamentals to investors.

Revenue

Revenue, also commonly known as sales, is generally the most straightforward part of the

income statement. Often, there is just a single number that represents all the money a company

brought in during a specific time period, although big companies sometimes break down revenue

by business segment or geography.

The best way for a company to improve profitability is by increasing sales revenue. For instance,

Starbucks Coffee has aggressive long-term sales growth goals that include a distribution system

of 20,000 stores worldwide. Consistent sales growth has been a strong driver of Starbucks’

profitability.

The best revenue are those that continue year in and year out. Temporary increases, such as those

that might result from a short-term promotion, are less valuable and should garner a lower price-

to-earnings multiple for a company.

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Expenses

There are many kinds of expenses, but the two most common are the cost of sold goods (COGS)

and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense

most directly involved in creating revenue. It represents the costs of producing or purchasing the

goods or services sold by the company. For example, if Wal-Mart pays a supplier $4 for a box of

soap, which it sells to customers for $5. When it is sold, Wal-Mart’s cost of good sold for the

box of soap would be $4.

Next, costs involved in operating the business are SG&A. This category includes marketing,

salaries, utility bills, technology expenses and other general costs associated with running a

business. SG&A also includes depreciation and amortization. Companies must include the cost

of replacing worn out assets. Remember, some corporate expenses, such as research and

development (R&D) at technology companies, are crucial to future growth and should not be cut,

even though doing so may make for a better-looking earnings report. Finally, there are financial

costs, notably taxes and interest payments, which need to be considered.

Profits = Revenue - Expenses

Profit, most simply put, is equal to total revenue minus total expenses. However, there are

several commonly used profit subcategories that tell investors how the company is performing.

Gross profit is calculated as revenue minus cost of sales. Returning to Wal-Mart again, the gross

profit from the sale of the soap would have been $1 ($5 sales price less $4 cost of goods sold =

$1 gross profit).

Companies with high gross margins will have a lot of money left over to spend on other business

operations, such as R&D or marketing. So be on the lookout for downward trends in the gross

margin rate over time. This is a telltale sign of future problems facing the bottom line. When cost

of goods sold rises rapidly, they are likely to lower gross profit margins - unless, of course, the

company can pass these costs onto customers in the form of higher prices.

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Operating profit is equal to revenues minus the cost of sales and SG&A. This number

represents the profit a company made from its actual operations, and excludes certain expenses

and revenues that may not be related to its central operations. High operating margins can mean

the company has effective control of costs, or that sales are increasing faster than operating costs.

Operating profit also gives investors an opportunity to do profit-margin comparisons between

companies that do not issue a separate disclosure of their cost of goods sold figures (which are

needed to do gross margin analysis). Operating profit measures how much cash the business

throws off, and some consider it a more reliable measure of profitability since it is harder to

manipulate with accounting tricks than net earnings.

Net income generally represents the company's profit after all expenses, including financial

expenses, have been paid. This number is often called the "bottom line" and is generally the

figure people refer to when they use the word "profit" or "earnings".

When a company has a high profit margin, it usually means that it also has one or more

advantages over its competition. Companies with high net profit margins have a bigger cushion

to protect themselves during the hard times. Companies with low profit margins can get wiped

out in a downturn. And companies with profit margins reflecting a competitive advantage are

able to improve their market share during the hard times - leaving them even better positioned

when things improve again.

BALANCE SHEET

The components of Balance Sheet

Assets, liability and equity are the three main components of the balance sheet. Carefully

analyzed, they can tell investors a lot about a company's fundamentals.

Assets

There are two main types of assets:

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Current Assets

Current assets are likely to be used up or converted into cash within one business cycle - usually

treated as twelve months. Three very important current asset items found on the balance sheet

are: cash, inventories and accounts receivables.

Non-current assets

They are defined as anything not classified as a current asset. This includes items that are fixed

assets, such as property, plant and equipment (PP&E). Unless the company is in financial

distress and is liquidating assets, investors need not pay too much attention to fixed assets. Since

companies are often unable to sell their fixed assets within any reasonable amount of time they

are carried on the balance sheet at cost regardless of their actual value. As a result, it's is possible

for companies to grossly inflate this number, leaving investors with questionable and hard-to-

compare asset figures.

Liabilities

current liabilities

Current liabilities are obligations the firm must pay within a year, such as payments owing to

suppliers.

Non-current liabilities

They represent what the company owes in a year or more time. Typically, non-current liabilities

represent bank and bondholder debt.

Quick Ratio

Subtract inventory from current assets and then divide by current liabilities. If the ratio is 1 or

higher, it says that the company has enough cash and liquid assets to cover its short-term debt

obligations.

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Quick Ratio =

Current Assets - Inventories

Current Liabilities

Equity

Equity represents what shareholders own, so it is often called shareholder's equity. As described

above, equity is equal to total assets minus total liabilities.

Equity = Total Assets – Total Liabilities

3.cash flow statement

shows how much cash comes in and goes out of the company over the quarter or the year. At first

glance, that sounds a lot like the income statement in that it records financial performance over a

specified period.

What distinguishes the two is accrual accounting, which is found on the income statement.

Accrual accounting requires companies to record revenues and expenses when transactions

occur, not when cash is exchanged. At the same time, the income statement, on the other hand,

often includes non-cash revenues or expenses, which the statement of cash flows does not

include.

Just because the income statement shows net income of $10 does not means that cash on the

balance sheet will increase by $10. Whereas when the bottom of the cash flow statement reads

$10 net cash inflow, that's exactly what it means. The company has $10 more in cash than at the

end of the last financial period. You may want to think of net cash from operations as the

company's "true" cash profit.

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Three Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash flow statement is divided

into three sections: cash flows from operations, financing and investing. Basically, the sections

on operations and financing show how the company gets its cash, while the investing section

shows how the company spends its cash.

Cash Flows from Operating Activities

This section shows how much cash comes from sales of the company's goods and services, less

the amount of cash needed to make and sell those goods and services. Investors tend to prefer

companies that produce a net positive cash flow from operating activities. High growth

companies, such as technology firms, tend to show negative cash flow from operations in their

formative years. At the same time, changes in cash flow from operations typically offer a

preview of changes in net future income. Normally it's a good sign when it goes up. Watch out

for a widening gap between a company's reported earnings and its cash flow from operating

activities. If net income is much higher than cash flow, the company may be speeding or slowing

its booking of income or costs.

Cash Flows from Investing Activities

This section largely reflects the amount of cash the company has spent on capital expenditures,

such as new equipment or anything else that needed to keep the business going. It also includes

acquisitions of other businesses and monetary investments such as money market funds.

You want to see a company re-invest capital in its business by at least the rate of depreciation

expenses each year. If it doesn't re-invest, it might show artificially high cash inflows in the

current year which may not be sustainable.

Cash Flow From Financing Activities

This section describes the goings-on of cash associated with outside financing activities. Typical

sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings.

Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend

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payments and common stock repurchases.

Cash Flow Statement Considerations:

Savvy investors are attracted to companies that produce plenty of free cash flow (FCF). Free

cash flow signals a company's ability to pay debt, pay dividends, buy back stock and facilitate

the growth of business. Free cash flow, which is essentially the excess cash produced by the

company, can be returned to shareholders or invested in new growth opportunities without

hurting the existing operations. The most common method of calculating free cash flow is:

Problems with EPS

If you're looking to analyze the fundamental performance of a company's business, one of the

key pieces of data you'll consider are the company's earnings, or rather, the amount of profits a

company generates during a specific period of time.

The problem with all this arises when you consider all the different ways that companies have of

presenting their earnings. As Investopedia Advisor Ben McClure noted:

The issue for us came up several months ago when we first presented the following chart, which

shows the one-year trailing Price-Earnings Ratio (P/E Ratio) for the S&P 500 since January

1871:

One of our very knowledgeable readers recognized that we computed the P/E ratio using the

S&P 500's reported earnings per share and argued that using the index' o earnings per share

perating would provide a better measure, noting in an e-mail that operating earnings per share

are what nearly all market analysts and managers use in their decision making process.

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As it happens, the primary reason we use reported earnings per share data for our S&P 500

database and performance calculating tool is because we only have this data for the entire

historical series we maintain going back to January 1871. We don't have operating earnings data

going back anywhere near this far, so we're more or less locked into using the S&P 500's

reported EPS figures.

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Industry Analysis

It refers to the production of an economic good (either material or a service) within an

economy. There are four key industrial economic sectors: the primary sector, largely raw

material extraction industries such as mining and farming; the secondary sector, involving

refining, construction, and manufacturing; the tertiary sector, which deals with services (such as

law and medicine) and distribution of manufactured goods; and the quaternary sector, a relatively

new type of knowledge industry focusing on technological research, design and development

such as computer programming, and biochemistry. A fifth, quinary, sector has been proposed

encompassing nonprofit activities. The economy is also broadly separated into public sector and

private sector, with industry generally categorized as private. Industries are also any business or

manufacturing.

Industry analysis is a tool that facilitates a company's understanding of its position

relative to other companies that produce similar products or services. Understanding the forces at

work in the overall industry is an important component of effective strategic planning. Industry

analysis enables small business owners to identify the threats and opportunities facing their

businesses, and to focus their resources on developing unique capabilities that could lead to a

competitive advantage.

"Many small business owners and executives consider themselves at worst victims, and at best

observers of what goes on in their industry. They sometimes fail to perceive that understanding

your industry directly impacts your ability to succeed. Understanding your industry and

anticipating its future trends and directions gives you the knowledge you need to react and

control your portion of that industry," Kenneth J. Cook wrote in his book The AMA Complete

Guide to Strategic Planning for Small Business. "However, your analysis of this is significant

only in a relative sense. Since both you and your competitors are in the same industry, the key is

in finding the differing abilities between you and the competition in dealing with the industry

forces that impact you. If you can identify abilities you have that are superior to competitors, you

can use that ability to establish a competitive advantage."

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Classification systems

The North American Industry Classification System or NAICS

It is used by business and government to classify business establishments according to

type of economic activity (process of production) in Canada, Mexico and the United States. It

has largely replaced the older Standard Industrial Classification (SIC) system; however, certain

government departments and agencies, such as the U.S. Securities and Exchange Commission

(SEC), still use the SIC codes.

The Industry Classification Benchmark (ICB)

It is a company classification system developed by Dow Jones and FTSE. It is used to

segregate markets into sectors within the macroeconomy. The ICB uses a system of 10

industries, partitioned into 19 supersectors, which are further divided into 41 sectors, which then

contain 114 subsectors.[1][2]

The Global Industry Classification Standard (GICS)

It is an industry taxonomy developed by Morgan Stanley Capital International (MSCI),

and Standard & Poor's (S&P) for use by the global financial community. The GICS structure

consists of 10 sectors, 24 industry groups, 68 industries and 154 sub-industries into which S&P

has categorized all major public companies. The system is similar to ICB (Industry Classification

Benchmark), a classification structure maintained by Dow Jones Indexes and FTSE Group.

STAGES OF THE INDUSTIRY LIFE CYCLE

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INTRODUCTION

In the introduction stage of the life cycle, an industry is in its infancy. Perhaps a new,

unique product offering has been developed and patented, thus beginning a new industry. Some

analysts even add an embryonic stage before introduction. At the introduction stage, the firm

may be alone in the industry. It may be a small entrepreneurial company or a proven company

which used research and development funds and expertise to develop something new. Marketing

refers to new product offerings in a new industry as "question marks" because the success of the

product and the life of the industry is unproven and unknown.

A firm will use a focus strategy at this stage to stress the uniqueness of the new product or

service to a small group of customers. These customers are typically referred to in the marketing

literature as the "innovators" and "early adopters." Marketing tactics during this stage are

intended to explain the product and its uses to consumers and thus create awareness for the

product and the industry. According to research by Hitt, Ireland, and Hoskisson, firms establish a

niche for dominance within an industry during this phase. For example, they often attempt to

establish early perceptions of product quality, technological superiority, or advantageous

relationships with vendors within the supply chain to develop a competitive advantage.

Because it costs money to create a new product offering, develop and test prototypes, and market

the product from its embryonic stage to introduction, the firm's and the industry's profits are

usually negative at this stage. Any profits are typically reinvested into the company to further

prepare it for the next life cycle stage. Introduction requires a significant cash outlay to continue

to promote and differentiate the offering and expand the production flow from a job shop to

possibly a batch flow. Market demand will grow from the introduction, and as the life cycle

curve experiences growth at an increasing rate, the industry is said to be entering the growth

stage. Firms may also cluster together in close proximity during the early stages of the industry

life cycle to have access to key materials or technological expertise, as in the case of the U.S.

Silicon Valley computer chip manufacturers.

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GROWTH Like the introduction stage, the growth stage also requires a significant amount of capital

for the firm. The goal of marketing efforts at this stage is to differentiate a firm's offerings from

other competitors within the industry. Thus the growth stage requires funds to launch a newly

focused marketing campaign as well as funds for continued investment in property, plant, and

equipment to facilitate the growth required by the market demands. However, the industry is

experiencing more product standardization at this stage, which may encourage economies of

scale and facilitate development of a line-flow layout for production efficiency.

Research and development funds will be needed to make changes to the product or services to

better reflect customer's needs and suggestions. In this stage, if the firm is successful in the

market, growing demand will create sales growth. Earnings and accompanying assets will also

grow and profits will be positive for the firms. Marketing often refers to products at the growth

stage as "stars." These products have high growth and market share. The key issue in this stage is

market rivalry. Because there is industry-wide acceptance of the product, more new entrants join

the industry and more intense competition results.

The duration of the growth stage, as all the other stages, depends on the particular industry under

study. Some items—like fad clothing, for example—may experience a very short growth stage

and move almost immediately into the next stages of maturity and decline. A hot toy this holiday

season may be nonexistent or relegated to the back shelves of a deep-discounter the following

year. Because many new product introductions fail, the growth stage may be short for some

products. However, for other products the growth stage may be longer due to frequent product

upgrades and enhancements that forestall movement into maturity. The computer industry today

is an example of an industry with a long growth stage due to upgrades in hardware, services, and

add-on products and features.

During the growth stage, the life cycle curve is very steep, indicating fast growth. Firms tend to

spread out geographically during this stage of the life cycle and continue to disperse during the

maturity and decline stages. As an example, the automobile industry in the United States was

initially concentrated in the Detroit area and surrounding cities. Today, as the industry has

matured, automobile manufacturers are spread throughout the country and internationally.

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MATURITY As the industry approaches maturity, the industry life cycle curve becomes noticeably

flatter, indicating slowing growth. Some experts have labeled an additional stage, called

expansion, between growth and maturity. While sales are expanding and earnings are growing

from these "cash cow" products, the rate has slowed from the growth stage. In fact, the rate of

sales expansion is typically equal to the growth rate of the economy.

Some competition from late entrants will be apparent, and these new entrants will try to steal

market share from existing products. Thus, the marketing effort must remain strong and must

stress the unique features of the product or the firm to continue to differentiate a firm's offerings

from industry competitors. Firms may compete on quality to separate their product from other

lower-cost offerings, or conversely the firm may try a low-cost/low-price strategy to increase the

volume of sales and make profits from inventory turnover. A firm at this stage may have excess

cash to pay dividends to shareholders. But in mature industries, there are usually fewer firms,

and those that survive will be larger and more dominant. While innovations continue they are not

as radical as before and may be only a change in color or formulation to stress "new" or

"improved" to consumers. Laundry detergents are examples of mature products.

DECLINE

Declines are almost inevitable in an industry. If product innovation has not kept pace

with other competitors, or if new innovations or technological changes have caused the industry

to become obsolete, sales suffer and the life cycle experiences a decline. In this phase, sales are

decreasing at an accelerating rate, causing the plotted curve to trend downward. Profits may

continue to rise, however. There is usually another, larger shake-out in the industry as

competitors who did not leave during the maturity stage now exit the industry. Yet some firms

will remain to compete in the smaller market. Mergers and consolidations will also be the norm

as firms try other strategies to continue to be competitive or grow through acquisition and/or

diversification.

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INDUSTRY FORCES

The first step in performing an industry analysis is to assess the impact

of Porter's five forces. "The collective strength of these forces determines the ultimate profit

potential in the industry, where profit potential is measured in terms of long term return on

invested capital," Porter stated. "The goal of competitive strategy for a business unit in an

industry is to find a position in the industry where the company can best defend itself against

these competitive forces or can influence them in its favor." Understanding the underlying forces

determining the structure of the industry can highlight the strengths and weaknesses of a small

business, show where strategic changes can make the greatest difference, and illuminate areas

where industry trends may turn into opportunities or threats.

EASE OF ENTRY

Ease of entry refers to how easy or difficult it is for a new firm to begin competing in the

industry. The ease of entry into an industry is important because it determines the likelihood that

a company will face new competitors. In industries that are easy to enter, sources of competitive

advantage tend to wane quickly. On the other hand, in industries that are difficult to enter,

sources of competitive advantage last longer, and firms also tend to benefit from having a

constant set of competitors.

The ease of entry into an industry depends upon two factors: the reaction of existing competitors

to new entrants; and the barriers to market entry that prevail in the industry. Existing competitors

are most likely to react strongly against new entrants when there is a history of such behavior,

when the competitors have invested substantial resources in the industry, and when the industry

is characterized by slow growth. Some of the major barriers to market entry include economies

of scale, high capital requirements, switching costs for the customer, limited access to the

channels of distribution, a high degree of product differentiation, and restrictive government

policies.

POWER OF SUPPLIERS

Suppliers can gain bargaining power within an industry through a number of different

situations. For example, suppliers gain power when an industry relies on just a few suppliers,

when there are no substitutes available for the suppliers' product, when there are switching costs

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associated with changing suppliers, when each purchaser accounts for just a small portion of the

suppliers' business, and when suppliers have the resources to move forward in the chain of

distribution and take on the role of their customers. Supplier power can affect the relationship

between a small business and its customers by influencing the quality and price of the final

product. "All of these factors combined will affect your ability to compete," Cook noted. "They

will impact your ability to use your supplier relationship to establish competitive advantages

with your customers."

POWER OF BUYERS

The reverse situation occurs when bargaining power rests in the hands of buyers.

Powerful buyers can exert pressure on small businesses by demanding lower prices, higher

quality, or additional services, or by playing competitors off one another. The power of buyers

tends to increase when single customers account for large volumes of the business's product,

when a substitutes are available for the product, when the costs associated with switching

suppliers are low, and when buyers possess the resources to move backward in the chain of

distribution.

AVAILABILITY OF SUBSTITUTES

"All firms in an industry are competing, in a broad sense, with industries producing

substitute products. Substitutes limit the potential returns of an industry by placing a ceiling on

the prices firms in the industry can profitably charge," Porter explained. Product substitution

occurs when a small business's customer comes to believe that a similar product can perform the

same function at a better price. Substitution can be subtle—for example, insurance agents have

gradually moved into the investment field formerly controlled by financial planners—or

sudden—for example, compact disc technology has taken the place of vinyl record albums. The

main defense available against substitution is product differentiation. By forming a deep

understanding of the customer, some companies are able to create demand specifically for their

products.

COMPETITORS

"The battle you wage against competitors is one of the strongest industry forces with

which you contend," according to Cook. Competitive battles can take the form of price wars,

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advertising campaigns, new product introductions, or expanded service offerings—all of which

can reduce the profitability of firms within an industry. The intensity of competition tends to

increase when an industry is characterized by a number of well-balanced competitors, a slow rate

of industry growth, high fixed costs, or a lack of differentiation between products. Another factor

increasing the intensity of competition is high exit barriers—including specialized assets,

emotional ties, government or social restrictions, strategic inter-relationships with other business

units, labor agreements, or other fixed costs—which make competitors stay and fight even when

they find the industry unprofitable.

Qualitative analysis

Following factors are included in qualitative aspect of industrial analysis

Customers

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. For example, think of

a military supplier who has 100% of its sales with the U.S. government. One change in

government policy could potentially wipe out all of its sales. For this reason, companies will

always disclose in their 10-K if any one customer accounts for a majority of revenues.

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.

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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.

Competition

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. 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.

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

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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. As a result, the U.S. Food and

Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before

they can be sold and distributed to the general public. However, the consequence of all this

testing is that it usually takes several years and millions of dollars before a drug is approved.

Keep in mind that all these costs are above and beyond the millions that the drug company has

spent on research and development.

All in all, investors should always be on the lookout for regulations that could potentially have a

material impact upon a business' bottom line. Investors should keep these regulatory costs in

mind as they assess the potential risks and rewards of investing.

The Importance of Industry Analysis

A comprehensive industry analysis requires a small business owner to take an objective

view of the underlying forces, attractiveness, and success factors that determine the structure of

the industry. Understanding the company's operating environment in this way can help the small

business owner to formulate an effective strategy, position the company for success, and make

the most efficient use of the limited resources of the small business. "Once the forces affecting

competition in an industry and their underlying causes have been diagnosed, the firm is in a

position to identify its strengths and weaknesses relative to the industry," Porter wrote. "An

effective competitive strategy takes offensive or defensive action in order to create a defendable

position against the five competitive forces." Some of the possible strategies include positioning

the firm to use its unique capabilities as defense, influencing the balance of outside forces in the

firm's favor, or anticipating shifts in the underlying industry factors and adapting before

competitors do in order to gain a competitive advantage.

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Technical Analysis

What Is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing the statistics generated

by market activity, such as past prices and volume. Technical analysts do not attempt to measure a

security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future

activity

Just as there are many investment styles on the fundamental side, there are also many

different types of technical traders. Some rely on chart patterns, others use

technical indicators and oscillators, and most use some combination of the two. In any case, technical

analysts' exclusive use of historical price and volume data is what separates them from their fundamental

counterparts. Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued -

the only thing that matters is a security's past trading data and what information this data can provide

about where the security might move in the future.

The field of technical analysis is based on three assumptions:

1. The market discounts everything

2. Price moves in trends

3. History tends to repeat itself

1. The Market Discounts Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the

fundamental factors of the company. However, technical analysis assumes that, at any given time, a

stock's price reflects everything that has or could affect the company - including fundamental factors.

Technical analysts believe that the company's fundamentals, along with broader economic factors

and market psychology, are all priced into the stock, removing the need to actually consider these factors

separately. This only leaves the analysis of price movement, which technical theory views as a product of

the supply and demand for a particular stock in the market.

2. Price Moves in Trends

In technical analysis, price movements are believed to follow trends. This means that after a trend

has been established, the future price movement is more likely to be in the same direction as the trend

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than to be against it. Most technical trading strategies are based on this assumption.

3. History Tends

To Repeat Itself is another important idea in technical analysis is that history tends to repeat itself, mainly

in terms of price movement. The repetitive nature of price movements is attributed to market psychology;

in other words, market participants tend to provide a consistent reaction to similar market stimuli over

time. Technical analysis uses chart patterns to analyze market movements and understand trends.

Although many of these charts have been used for more than 100 years, they are still believed to be

relevant because they illustrate patterns in price movements that often repeat themselves.

Not Just for Stocks

Technical analysis can be used on any security with historical trading data. This includes

stocks, futures and commodities, fixed-income securities, forex, etc. 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 more frequently associated with commodities and forex, where the participants

are predominantly traders.

Stock Price and Volume Techniques

Dow Theory on stock price movements is a form of technical analysis that includes some

aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written

by Charles H. Dow (1851–1902),journalist, founder and first editor of the Wall Street Journal and co-

founder of Dow Jones and Company. Following Dow's death, William Peter Hamilton, Robert

Rhea and E. George Schaefer organized and collectively represented "Dow Theory," based on Dow's

editorials. Dow himself never used the term "Dow Theory," nor presented it as a trading system.

Six Basic Tenets of Dow Theory

The market has three movements

(1) The "main movement", primary movement or major trend may last from less than a year to several

years. It can be bullish or bearish. (2) The "medium swing", secondary reaction or intermediate reaction

may last from ten days to three months and generally retraces from 33% to 66% of the primary price

change since the previous medium swing or start of the main movement. (3) The "short swing" or minor

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movement varies with opinion from hours to a month or more. The three movements may be

simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary

movement.

Market trends have three phases

Dow Theory asserts that major market trends are composed of three phases: an accumulation

phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period

when investors "in the know" are actively buying (selling) stock against the general opinion of the

market. During this phase, the stock price does not change much because these investors are in the

minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the

market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when

trend followers and other technically oriented investors participate. This phase continues until rampant

speculation occurs. At this point, the astute investors begin to distribute their holdings to the market

(phase 3).

The stock market discounts all news

Stock prices quickly incorporate new information as soon as it becomes available. Once news

is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees

with one of the premises of the efficient market hypothesis.

Stock market averages must confirm each other

In Dow's time, the US was a growing industrial power. The US had population centers but factories were

scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first

stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull

market in industrials could not occur unless the railway average rallied as well, usually first. According to

this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce

more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health

in manufacturers, he or she should look at the performance of the companies that ship the output of them

to market, the railroads. The two averages should be moving in the same direction. When the performance

of the averages diverge, it is a warning that change is in the air.

Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones

Transportation Index in chart form. The index contains major railroads, shipping companies, and air

freight carriers in the US.

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Trends are confirmed by volume

Dow believed that volume confirmed price trends. When prices move on low volume, there

could be many different explanations why. An overly aggressive seller could be present for example. But

when price movements are accompanied by high volume, Dow believed this represented the "true"

market view. If many participants are active in a particular security, and the price moves significantly in

one direction, Dow maintained that this was the direction in which the market anticipated continued

movement. To him, it was a signal that a trend is developing.

Trends exist until definitive signals prove that they have ended

Dow believed that trends existed despite "market noise". Markets might temporarily move in

the direction opposite to the trend, but they will soon resume the prior move. The trend should be given

the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend

or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this

determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by

different investors.

Assumptions

Before one can begin to accept the Dow theory, there are a number of assumptions

that must be accepted. Rhea stated that for the successful application of the Dow theory, these

assumptions must be accepted without reservation.

Manipulation

The first assumption is: The manipulation of the primary trend is not possible. When

large amounts of money are at stake, the temptation to manipulate is bound to be present.

Hamilton did not argue against the possibility that speculators, specialists or anyone else

involved in the markets could manipulate the prices. He qualified his assumption by asserting

that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even

secondary movements could be prone to manipulation. These short movements, from a few

hours to a few weeks, could be subject to manipulation by large institutions, speculators,

breaking news or rumors. Today, Hamilton would likely add message boards and day-traders to

this list.

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Hamilton went on to say that individual shares could be manipulated. Examples of manipulation

usually end the same way: the security runs up and then falls back and continues the primary

trend. Examples include:

Pair Gain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the

hoax was revealed, the stock immediately fell back and returned to its primary trend.

Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock

settled around 10 and drifted lower from there.

In 1979/80, there was an attempt to manipulate the price of silver by the Hunt brothers. Silver

skyrocketed to over 50$ per ounce, only to come back down to earth and resume its long bear market after

the plot to corner the market was unveiled.

While these shares were manipulated over the short term, the long-term trends prevailed after

about a month. Hamilton also pointed out that even if individual shares were being manipulated,

it would be virtually impossible to manipulate the market as a whole. The market was simply too

big for this to occur.

2.2 Market Movements

Dow and Hamilton identified three types of price movements for the Dow

Jones Industrial and Rail averages: primary movements, secondary movements and daily

fluctuations. Primary moves last from a few months to many years and represent the broad

underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a

few months and move counter to the primary trend. Daily fluctuations can move with or against

the primary trend and last from a few hours to a few days, but usually not more than a week.

2.2.1 Primary Movement

Primary movements represent the broad underlying trend of the market and can last from a few

months to many years. These movements are typically referred to as bull and bear markets. Once

the primary trend has been identified, it will remain in effect until proved otherwise. (We will

address the methods for identifying the primary trend later in this article.) Hamilton believed that

the length and the duration of the trend were largely indeterminable. Hamilton did study the

averages and came up with some general guidelines for length and duration, but warned against

attempting to apply these as rules for forecasting.

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2.2.2 Secondary Movements

Secondary movements run counter to the primary trend and are reactionary in nature. In a bull

market a secondary move is considered a correction. In a bear market, secondary moves are

sometimes called reaction rallies. Earlier in this article, a chart of Coca-Cola was used to

illustrate reaction rallies (or secondary movements) within the confines of a primary bear trend.

Below is a chart illustrating a correction within the confines of a primary bull trend.

In Sept-96, the DJIA ($INDU) recorded a new high, thereby establishing the primary trend as

bullish. From trough to peak, the primary advance rose 1988 points. During the advance from

Sept-96 to Mar-97, the DJIA never declined for more than two consecutive weeks. By the end of

March, after three consecutive weeks of decline, it became apparent that this move was not in the

category of daily fluctuations and could be considered a secondary move. Hamilton noted some

characteristics that were common to many secondary moves in both bull and bear markets. These

characteristics should not be construed as rules, but rather as loose guidelines to be used in

conjunction with other analysis techniques. Based on historical observation, Hamilton estimated

that secondary movements retrace 1/3 to 2/3 of the primary move, with 50% being the typical

amount. In actuality, the secondary move in early 1997 retraced about 42% of the primary move.

(7158 - 5170 = 1988; 7158 - 6316 = 842, 842/1988 = 42.35%).

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1. Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move.

Just with a visual comparison, we can see that the secondary move was sharper that the preceding primary

advance. The primary move advanced 38% (1988/5170 = 38%) and lasted from Jul-96 to Mar-97, about 8

months. The secondary move witnessed a correction of 11.7% (842/7158 = 11.7%) and lasted a mere five

weeks.

2. At the end of the secondary move, there is usually a dull period just before the turnaround. Little price

movement, a decline in volume, or a combination of the two can mark this dullness. Below is a daily chart

focusing on the Apr-97 low for the secondary move outlined above.

April 7 through 10 marked the dull point (red line on volume). There was little price movement and

volume was the lowest since the decline began. The DJIA ($INDU) then gapped down on an increase

in volume. After the down gap, there was a reversal day and then the DJIA proceeded with a gap up and

breakout to a reaction high on increasing volume (green line on volume). The new reaction high

combined with the increase in volume indicated that the secondary move was over and the primary trend

had resumed.

3. Lows are sometimes accompanied by a high-volume washout day. The September/October lows in 1998

were accompanied by record volume levels. At the time, the low on Sept-1 witnessed the highest volume

ever recorded and the Oct-8 low recorded the second highest volume ever. Although these high-volume

lows were not a signal in and of themselves, they helped form a pattern that preceded a historical advance.

The Three Stages of Primary Bull Markets and Primary Bear Markets

Hamilton identified three stages to both primary bull markets and primary bear

markets. These stages relate as much to the psychological state of the market as to the movement

of prices. A primary bull market is defined as a long sustained advance marked by improving

business conditions that elicit increased speculation and demand for stocks. A primary bear

market is defined as a long sustained decline marked by deteriorating business conditions and

subsequent decrease in demand for stocks. In both primary bull markets and primary bear

markets, there will be secondary movements that run counter to the major trend.

2.2.3 Primary Bull Market - Stage 1 - Accumulation

Hamilton noted that the first stage of a bull market was largely indistinguishable from

the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear

market, still reigns at the beginning of a bull market. It is a period when the public is out of

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stocks, the news from corporate America is bad and valuations are usually at historical lows.

However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is

the stage of the market when those with patience see value in owning stocks for the long haul.

Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffet stated

in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else

thought he was crazy.

In the first stage of a bull market, stocks begin to find a bottom and quietly firm up.

When the market starts to rise, there is widespread disbelief that a bull market has begun. After

the first leg peaks and starts to head back down, the bears come out proclaiming that the bear

market is not over. It is at this stage that careful analysis is warranted to determine if the decline

is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low

forms above the previous low, a quiet period will ensue as the market firms and then an advance

will begin. When the previous peak is surpassed, the beginning of the second leg and a primary

bull will be confirmed.

2.2.4 Primary Bull Market - Stage 2 - Big Move

The second stage of a primary bull market is usually the longest, and sees the largest

advance in prices. It is a period marked by improving business conditions and increased

valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is

considered the easiest stage to make money as participation is broad and the trend followers

begin to participate.

2.2.5 Primary Bull Market - Stage 3 - Excess

The third stage of a primary bull market is marked by excessive speculation and the

appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this

scenario is certainly familiar.) During the third and final stage, the public is fully involved in the

market, valuations are excessive and confidence is extraordinarily high. This is the mirror image

to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to

offer tips, the top cannot be far off.

2.2.6 Primary Bear Market - Stage 1 - Distribution

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Just as accumulation is the hallmark of the first stage of a primary bull market,

distribution marks the beginning of a bear market. As the "smart money" begins to realize that

business conditions are not quite as good as once thought, they start to sell stocks. The public is

still involved in the market at this stage and become willing buyers. There is little in the

headlines to indicate a bear market is at hand and general business conditions remain good.

However, stocks begin to lose a bit of their luster and the decline begins to take hold.

While the market declines, there is little belief that a bear market has started and most

forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move)

that retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets

were quite swift and sharp. As with his analysis of secondary moves in general, Hamilton noted

that a large percentage of the losses would be recouped in a matter of days or perhaps weeks.

This quick and sudden movement would invigorate the bulls to proclaim the bull market alive

and well. However, the reaction high of the secondary move would form and be lower than the

previous high. After making a lower high, a break below the previous low would confirm that

this was the second stage of a bear market.

2.2.7 Primary Bear Market - Stage 2 - Big Move

As with the primary bull market, stage two of a primary bear market provides the largest move.

This is when the trend has been identified as down and business conditions begin to deteriorate.

Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As

business conditions worsen, the sell-off continues.

2.2.8 Primary Bear Market - Stage 3 - Despair

At the top of a primary bull market, hope springs eternal and excess is the order of the day. By

the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low,

but the selling continues as participants seek to sell no matter what. The news from corporate

America is bad, the economic outlook bleak and not a buyer is to be found. The market will

continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the

worst possible outcome, the cycle begins again.

2.3 Signals

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Through the writings of Dow and Hamilton, Rhea identified 4 separate theorems that addressed

trend identification, buy and sell signals, volume, and trading ranges. The first two were deemed

the most important and serve to identify the primary trend as bullish or bearish. The second two

theorems, dealing with volume and trading ranges, were not considered instrumental in primary

trend identification by Hamilton. Volume was looked upon as a confirming statistic and trading

ranges were thought to identify periods of accumulation and distribution.

2.4 Performance of the Dow Theory

Mark Hulbert, writing in the New York Times - 6-Sept-98, notes a study that was published in

the Journal of Finance byStephen Brown of New York University and William

Goetzmann and Alok Kumar of Yale. They developed a neural network that incorporated the

rules for identifying the primary trend. The Dow theory system was tested against buy-and-hold

for the period from 1929 to Sept-98. When the system identified the primary trend as bullish, a

long position was initiated in a hypothetical index fund. When the system signaled a bearish

primary trend, stocks were sold and the money was placed in fixed income instruments. By

taking money out of stocks after bear signals, the risk (volatility) of the portfolio is significantly

reduced. This is a very important aspect of the Dow theory system and portfolio management. In

the past few years, the concept of risk in stocks has diminished, but it is still a fact that stocks

carry more risk than bonds.

Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about

2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted

returns, the margin of out-performance would increase. Over the past 18 years, the Dow theory

system has under-performed the market by about 2.6% per year. However, when adjusted for

risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind

that 18 years is not a long time in the history of the market. The Dow theory system was found to

under-perform during bull markets and outperform during bear markets.

2.5 Criticisms of Dow Theory

The first criticism of the Dow theory is that it is really not a theory. Neither Dow nor Hamilton

wrote proper academic papers outlining the theory and testing the theorems. The ideas of Dow

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and Hamilton were put forth through their editorials in the Wall Street Journal. Robert Rhea

stitched the theory together by poring over these writings.

Secondly, the Dow theory is criticized for being too late. The trend does not change from bearish

to bullish until the previous reaction high has been surpassed. Many traders feel that this is

simply too late and misses much of the move. Dow and Hamilton sought to catch the meat of the

move and enter during the second leg. Even though this is where the bulk of the move will take

place, it is also after the first leg and part way into the second leg. And, if one has to wait for

confirmation from the other average, it could even be later in the move.

Thirdly, because it uses the DJIA and DJTA, the Dow theory is criticized as being outdated and

no longer an accurate reflection of the economy. This may be a valid point, but as outlined

earlier, the DJTA is one of the most economically sensitive indices. The stock market has always

been seen as a great predictor of economic growth. To at least keep the industrials up to speed,

Home Depot, Intel, Microsoft and SBC Corp have been added to the average to replace Chevron,

Goodyear, Sears and Union Carbide, as of 1-Nov-99.

2.6 Conclusions

The goal of Dow and Hamilton was to identify the primary trend and catch the big

moves. They understood that the market was influenced by emotion and prone to over-reaction

both up and down. With this in mind, they concentrated on identification and following: identify

the trend and then follow the trend. The trend is in place until proved otherwise. That is when the

trend will end, when it is proved otherwise.

Dow theory helps investors identify facts, not make assumptions or forecast. It can be

dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not

impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow

theory may be able to form the foundation for analysis, it is meant as a starting point for

investors and traders to develop analysis guidelines that they are comfortable with and

understand.

Reading the markets is an empirical science. As such there will be exceptions to the

theorems put forth by Hamilton and Dow. They believed that success in the markets required

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serious study and analysis that would be fraught with successes and failures. Success is a great

thing, but don't get too smug about it. Failures, while painful, should be looked upon as learning

experiences. Technical analysis is an art form and the eye grows keener with practice. Study both

successes and failures with an eye to the future.

Types of Trend

There are three types of trend:

Uptrend’s

Downtrends

Sideways/Horizontal Trends

As the names imply, when each successive peak and trough is higher, it's referred to as an upward trend.

If the peaks and troughs are getting lower, it's a downtrend. When there is little movement up or down in

the peaks and troughs, it's a sideways or horizontal trend. If you want to get really technical, you might

even say that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in

either direction. In any case, the market can really only trend in these three ways: up, down or nowhere.

The Importance of Trend

It is important to be able to understand and identify trends so that you can trade with rather than against

them. Two important sayings in technical analysis are "the trend is your friend" and "don't buck the

trend," illustrating how important trend analysis is for technical traders.

Technical indicators and Oscillators

Indicators are calculations based on the price and the volume of a security that measure such things as

money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual

price movements and add additional information to the analysis of securities. Indicators are used in two

main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals.

There are two main types of indicators: leading and lagging. A leading indicator precedes price

movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it

follows price movement. A leading indicator is thought to be the strongest during periods of sideways or

non-trending trading ranges, while the lagging indicators are still useful during trending periods.

Indicators that are used in technical analysis provide an extremely useful source of additional information.

These indicators help identify momentum, trends, volatility and various other aspects in a security to aid

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in the technical analysis of trends. It is important to note that while some traders use a single indicator

solely for buy and sell signals, they are best used in conjunction with price movement, chart patterns and

other indicators.

Technical Analysis: Conclusion

Here's a brief summary of what we've covered:

Technical analysis is a method of evaluating securities by analyzing the statistics generated by market

activity. It is based on three assumptions: 1) the market discounts everything, 2) price moves in trends and

3) history tends to repeat itself.

Technicians believe that all the information they need about a stock can be found in its charts.

Technical traders take a short-term approach to analyzing the market.

Criticism of technical analysis stems from the efficient market hypothesis, which states that the market

price is always the correct one, making any historical analysis useless.

One of the most important concepts in technical analysis is that of a trend, which is the general direction

that a security is headed. There are three types of trends: uptrend, downtrends and sideways/horizontal

trends.

A trend line is a simple charting technique that adds a line to a chart to represent the trend in the market or

a stock.

A channel, or channel lines, is the adsdition of two parallel trend lines that act as strong areas of support

and resistance.

Support is the price level through which a stock or market seldom falls. Resistance is the price level that a

stock or market seldom surpasses.

Volume is the number of shares or contracts that trade over a given period of time, usually a day. The

higher the volume, the more active the security.

A chart is a graphical representation of a series of prices over a set time frame.

The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to

seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and

annually.

The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to

past data points. It can be either linear or logarithmic.

There are four main types of charts used by investors and traders: line charts, bar charts, charts and point

and figure charts.

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A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future

price movements. There are two types: reversal and continuation.

A head and shoulders pattern is reversal pattern that signals a security is likely to move against its

previous trend.

A cup and handle pattern is a bullish continuation pattern in which the upward trend has paused but will

continue in an upward direction once the pattern is confirmed.

Double tops and double bottoms are formed after a sustained trend and signal to chartists that the trend is

about to reverse. The pattern is created when a price movement tests support or resistance levels twice

and is unable to break through.

A triangle is a technical analysis pattern created by drawing trend lines along a price range that gets

narrower over time because of lower tops and higher bottoms. Variations of a triangle

include ascending and descending triangles.

Flags and pennants are short-term continuation patterns that are formed when there is a sharp price

movement followed by a sideways price movement.

The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical

triangle except that the wedge pattern slants in an upward or downward direction.

A gap in a chart is an empty space between a trading period and the following trading period. This occurs

when there is a large difference in prices between two sequential trading periods.

Triple tops and triple bottoms are reversal patterns that are formed when the price movement tests a level

of support or resistance three times and is unable to break through, signaling a trend reversal.

A rounding bottom (or saucer bottom) is a long-term reversal pattern that signals a shift from a downward

trend to an upward trend.

A moving average is the average price of a security over a set amount of time. There are three

types: simple, linear and exponential.

Moving averages help technical traders smooth out some of the noise that is found in day-to-day price

movements, giving traders a clearer view of the price trend.

Indicators are calculations based on the price and the volume of a security that measure such things as

money flow, trends, volatility and momentum. There are two types: leading and lagging.

The accumulation/distribution line is a volume indicator that attempts to measure the ratio of buying to

selling of a security.

The average directional index (ADX) is a trend indicator that is used to measure the strength of a current

trend.

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The Aroon indicator is a trending indicator used to measure whether a security is in an uptrend or

downtrend and the magnitude of that trend.

The Aroon oscillator plots the difference between the Aroon up and down lines by subtracting the two

lines.

The moving average convergence divergence (MACD) is comprised of two exponential moving averages,

which help to measure a security's momentum.

The relative strength index (RSI) helps to signal overbought and oversold conditions in a security.

The on-balance volume (OBV) indicator is one of the most well-known technical indicators that reflects

movements in volume.

The stochastic oscillator compares a security's closing price to its price range over a given time period.