Week 4: Basics of Valuation

basics of valuation

Week 4: Basics of Valuation

“Overview for the Week … Business Cycles and Indicators … Industry and Company Analysis … Approaches to Equity Valuation … Introducing Technical Analysis”
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  • </span>Week 4: BASICS OF VALUATION > Overview for the Week > Overview for the Week<span style=
  • Week 4: BASICS OF VALUATION > Approaches to Equity Valuation > Motivating Investment Decisions
  • Week 4: BASICS OF VALUATION > Approaches to Equity Valuation > Lecture: Approaches to Equity Valuation
  • Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Charts and Candlesticks
  • Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Moving Averages and Trends
  • Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Other Technical Indicators
  • Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Summing Up Technical Analysis

Week 4: BASICS OF VALUATION > Overview for the Week > Overview for the Week

  • My goal is for you to learn how it works and, kind of, interpret again what it means in terms of an investment decision that you are in the process of making.
  • Biblical reference for you, seven years of plenty and seven years of lean.
  • In the mid-2000s, when the internet came along and was going to change everything, we were going to have growth onward and upward forever, and there were no business cycles allowed.
  • A few years later, after the housing markets happened and crashed, the global financial crisis came along, we did have a cyclical kind of turn.
  • That said, too, the length and breadth of these cycles also sort of varies as economies change and adapt.
  • If you are, you know, as many countries were in the previous century, agriculture based subject to the vagaries of weather, you will have cyclical trends and weather patterns that kind of affect how output changes.
  • As economies in other regions of the globe move towards a more service-oriented thing, perhaps the frequency of those fluctuations is not as common anymore, and that’s just a trend in how economies are working that you need to be familiar with, affected, of course, by things like globalization, by better policy activity on the part of central bank.
  • John Maynard Keynes is well-known for his notion of animal spirits, where people get really excited about prospects and imagine, expect, start planning for much more hyper-rates of growth than otherwise possible.
  • If there is excessive supply in anticipation of all of that consumer demand, things might, sort of, tend to reverse and cycle back down again.
  • Indicators that are probably useful for you to get a broad-brush feel for economic activity, we talked about leading-lagged indicators in the context of unemployment rates a little while earlier.
  • Broadly speaking, the National Bureau of Economic Research in the US and their, sort of, parallel organizations in other regions of the World think in terms of leading, coincident, and lagged economic indicators.
  • There are in the US and in other parts of the world macro-economic forecasting shops that summarize all of these data things for you.
  • I’m, sort of, making this pitch and this presentation in terms of trying to get you to see which of those numbers that these guys put out are, sort of, relevant for you from a decision-making perspective.
  • If you look at cash allocations on-cash positions in the portfolios of mutual fund, those have tended to decline as people have been buying more and more stocks.
  • It’s-the average stock held on the NYSE is less than a year, and these are institutions, these are mutual funds by and large.
  • If you think in terms of somebody you’re saving for retirement, the mutual fund that you give it to is turning over your portfolio on a nine-month basis-that’s kind of a little excessive.
  • We talked about technology and trading, that trading costs were coming down, that it was beginning to become so easy to place a trade and so cheap to place one online through computers that people, sort of, started trading asalmost as a virtual substitute for thinking, for logic, for rationale, for reasons for investing, and that’s, kind of, what these charts are pointing to, as well.
  • Some people even call it the Fed model for interest rates, but essentially, it’s looking at a ratio of the rate, the yield you get from bonds to a, sort of, yield equivalent number that you get from stocks, and you see that this number is also, kind of, volatile and is bouncing around, but this has tended to become very quiescent in recent years,especially since interest rates globally have kind of been kept artificially low, if you will.


Week 4: BASICS OF VALUATION > Approaches to Equity Valuation > Motivating Investment Decisions

  • The text book also says that there are certain behavioral traits that individuals and even professional managers, to some degree, might exhibit that makes them not particularly successful investors over time.
  • Of course, most people who drive frequently on their commutes to and from work and elsewhere will tell you that they are above average and that we know statistically is not possible.
  • If you go out and talk to the mutual fund managers and ask them are they an above average or an average mutual fund manager.
  • Overconfidence causes people to, sort of, to do these sorts of things and to over trade.
  • Let’s say you had a thousand dollars to invest in a particular stock.
  • You put your money in there, sometime passed, the stock doubled in value.
  • ‘ The thinking behind this, the metal accounting behind this is essentially to say, “Look I put a thousand in there, I will take my first thousand back, the rest of it was house money, easy come, easy go. If it goes I don’t really care.” And as I talk to people casually informally in my classroom offline, all students will say there is nothing wrong with thinking about things this way.
  • Money really at, that time, seemed that it was growing on trees.
  • Is it too late to get in? Is it not too late to get in? But, anyway, that was the time when I had enough money and started my career to, sort of, put money into these markets.
  • I had already stocked most of them were technology, they were doing fairly well.
  • Some of them I had bought at IPO time or thereabouts.
  • My wife moves, she’s like, ‘well, sell your stocks; we need to put money down in the house.
  • Of course, I don’t want to sell all these stocks.
  • Just not because it was a good investment decision at that time, but because we needed to buy property as we were relocating.
  • Only because of the need for liquidity, not because I thought that it was a considered investment decision that it was time to get out.
  • Anyway as it turned out with time, in the early late 1990’s early 2000’s, switching out of NASDAQ’s stocks into California real estate was not a bad trade to have done.
  • I was fairly proud of myself for having done something like this, even though I cannot professionally take credit for it.
  • Part of the reason that I couldn’t do anything about it then was that the property was embroiled in litigation, and those of you familiar with India know that real estate related litigation goes on forever and never finishes.
  • Thanks to that litigation and its eventual resolution couple of years ago, that investment, again, purely because of circumstantial reasons turned out to be in a profitable outcome for me.
  • These kind of things happen and that’s part of the investing space as well.
  • More seriously, I want to talk in terms of my investing approaches where I’ve actually used the stuff that I’ve learnt and I’m trying to teach you.
  • It is not something I manage personally, it is something that is given to a hedge fund manager, whose been doing fairly well for us over time.
  • I might change the allocation of assets a little bit, too much in one stock, bring it out and put it in bonds that kind of thing.
  • Again, with college funds around the planet, and particularly in the U.S. which is where most of my, sort of, background comes from, there are multiple tax differed plans and formats that you can choose to put money away for college.
  • I just bought shares in one particular stock, and added to it periodically over time.
  • The idea there again is something that we will get a little more of a glimpse of in a couple of sessions down the road. This is a stocks and some not selling it.
  • Which, since I teach in investments class most of the time, I tend to talk about current events, about markets, it’s, sort of, not difficult for me to implement what I’m learning.
  • If I’m talking about earnings announcements in a particular quarter for a particular company, I might just actually go take positions in it and tell my classes when I lose and when I make money.
  • Since they see me doing it in real time, and sharing my winning stories as well as my losing ones.
  • There are some years when I do well and in those years we take a nicer vacation.
  • That’s another bucket, and that’s what works for me.
  • One in particular that I want to mention in passing, he has figured out a way to really piggy back on stocks that the big institutions trail, and he just kind of goes along for the ride.
  • He’s successful enough to have given up his job as a software guy at a big software company in Silicon Valley, and he stays at home and trades full time.
  • Pick a level, pick a strategy, pick a plan that you are comfortable with, that’s consistent with your risk level and take it from there.
  • The lessons that we will learn as this course progresses, will hopefully give you some tools, and tricks, and methods that lets you figure out what sort of investor, trader you want to be.

Week 4: BASICS OF VALUATION > Approaches to Equity Valuation > Lecture: Approaches to Equity Valuation

  • Are most of you who’ve seen any kind of financial television even if in a fleeting moment in an airport or anywhere else, has seen something like a ticker tape where prices are fluctuating constantly? Every day in the media you read stories about markets went up so much, down so much because of something.
  • Or a situation where a portfolio management team would meet to look at the state of their existing portfolio, listen to some of their in-house analysts make recommendations, and then argue about, and finally arrive at a course of action for that portfolio over the short or medium term.
  • Then you have the day traders, whose sole job it is to jump in and out every time prices move and try and capture fractions of a point here a couple of points there.
  • So you’ve got all of these reasons that are behind why prices fluctuate up and down.
  • What price should you pay, which one of these bouncing prices should you pay? What’s a fair price? On these questions you should ask yourselves that’s the point of evaluation, eventually, right? That you got something at a reasonable price.
  • Think back to the IPO discussion we had a little while back, and there too for companies that were going public for the first time, in businesses that people barely understood, we were trying to come up with a fair price at which we would offer the stock to the public.
  • At least, in the secondary market, presuming that the stock has already been trading for a while, it is some sense of evaluation, some sense of reasonable price that has already been established.

Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Charts and Candlesticks

  • The black bars tend to coincide with prices falling -are more frequent when prices are falling.
  • The white bars are more frequent when prices are rising.
  • There is a pink line above which prices seem to have a little trouble crossing.
  • They reach up to the pink line and then they, kind of, stop and then markets fell off.
  • This pink line is acting as a barrier that these guys cannot, that prices cannot really traverse.
  • It’s a price level that markets are resisting breaking away from.
  • Now what’s happening? As the prices have gone up, that same pink line which was originally resistance now starts to become something like support.
  • All kinds of things can happen with prices, and what technical analysis in this elementary simple, kind of, presentation that I’m giving you is to give you some clues in terms of entry and exit points.
  • You notice on this slide I said, “Can we see any trends?” Trends are what technical analysts live for.
  • Up trends, if you want to think about them like that, are trends that as prices move up and down, you see higher highs being made periodically over time.
  • Down trends has exactly the opposite consequence: lower highs and even lower lows.
  • Identifying those kinds of trends lets you have the confidence that as long as the trend is not violated, maybe you should stay on it and ride it.
  • Trends in this sense are kind of like expectations of where the stocks’ price movement is going to go towards.
  • Notice we’ve done all of this just by looking at prices and price movements.
  • Why not plot price changes instead of prices? You know, prices might change.
  • Why not plot price changes? There are arithmetic price plotting software that’s out there.
  • If prices are moving, but if the stock has a million shares outstanding and only ten thousand of them are trading in a day, is that move mean anything? A move coming with significant volume, whatever that is, is obviously a lot more credible than a move coming on very low volumes.
  • They tell you how the money comes in, and, of course, the inference is, “Is that a bullish or a bearish signal?” is kind of the question people are always asking themselves in terms of a trend, and given what I just said about how important trends were.

Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Other Technical Indicators

  • Other than prices and volumes-you start asking then once you get into the idea that, you know, by looking at charts like these you can get a sense of supply and demand for some asset or class of assets.
  • Are there more indicators? People think one of the most common ones in recent months, in recent years is a momentum indicator, which is basically looking at a change in closing price from one day in the past to another day in the future.
  • A 10-day momentum would be the difference in price between-difference between a price ten days ago and a price today.
  • You don’t even have to do it in terms of prices.
  • If there are 3,000 stocks trading on an exchange, if 2,500 of them are moving up and 500 of them are moving down that breadth indicator is a broader indicator of the general direction of price movement across an exchange for those stocks.
  • Why stop there? And, again I’m just moving along here just to give you an idea of how this is an empirical undertaking and you can come up with and tweak, and come up with clever ways of doing this like the Japanese did 200 years ago and still are doing.
  • There is this thing called the MACD oscillator which, notice how it’s defined on the slide for you, is difference between the 12-day moving average minus a 26-day moving average of advances and decliners.
  • I mentioned traders’ remorse briefly as when a stock is trying to break a resistance line actually breaks it, sucks traders into it saying, “Okay. The resistance plan is broken. We are a new trend now.” And once enough people are sucked in, it kind of falls back down below that support line.
  • I was telling you about moving average convergence and divergence.
  • What the hell is convergence and divergence? When an oscillator moves with the price, it’s converging.
  • Over bought; too much buying too quickly, over sold; too much rapid selling too quickly is kind of the idea there, right? Prices are too high or too low and subject to a decliner ink lease.
  • That’s kind of the fence that over bought and over sold indicators give you.
  • Who are convinced that somewhere between these kind of cycles, these kind of oscillators and cycles-there’s actually some if we are even to rigorously apply the tools of quantitative science, we might come up with a better measure than that exists out there.
  • What a Bollinger band is, is plotting the price in the middle, and it’s plotting two standard deviations away from the mean on both sides of that price.
  • Those bar charts are prices moving, and notice what is happening here that when markets are in an uptrend here, the price tends to hug the upper Bollinger band.
  • When prices are in down-trend mode, when markets are in downtrend mode, prices are hugging the lower band.
  • Suddenly something happens here which is switch from a down trending market to an up trending market, a reversal, and prices move quickly and rapidly through the middle, through the upper band and then begin to hug in again.
  • There are tools that people use broadly at the market level to kind of get a sense of where stocks are going and where they are likely to go.

Week 4: BASICS OF VALUATION > Introducing Technical Analysis > Lecture: Summing Up Technical Analysis

  • I have a dear friend in California, who’s a pure technician, who is only now saying, ‘Maybe, I should start thinking about reading accounting books to understand what else is out there,’ but he and other technical analysts like him look at hundreds of charts every day; that’s their homework.
  • They will flip; they will look at a chart for barely a few seconds or flip a cursor on a computer because most of these are now computer generated, and that’s all some of these charts have, nothing, nothing, nothing, maybe that’s worth to look.
  • The more educated you get about technical analysis, the more patterns will come out.
  • ‘ You find the right set of rhymes, technical analysis has value to you.
  • The reason, remember in the beginning I started talking to you about TA and said something about my colleagues will, kind of, criticize me for even putting this kind of thing online, and I try to justify, defend myself by saying, “It was for historical context.” But be that as it may, most academic studies tend to say that technical analysis does not consistently make money for its adherence.
  • You are better off just buying and holding the market rather than frequently trading it, and there have been, for generations, all kinds of technical trading rules that have been put to rigorous empirical, statistical, academic examination, and the net result seems to be the same.
  • You may decide at the end of, you know, a foray into technical analysis that, “Nah! I’m happy over the accounting numbers,” and go from there.
  • What do I do? Just to share that with you, as I’m sharing everything else about these things, I tend to look at technical analysis to tell me when to make an investment.
  • How I decide to do that tends to be from a very rigorous examination of the company, its characteristics, its markets, its financial statements-I’m a finance guy after all-and a thorough analysis of research reports, what in this business is called fundamental analysis, which is our topic next.
  • Fundamental analysis is what I tend to do more than technical, but having done the fundamental analysis and having decided which stock is worthy of my small, little part of money, I will then frequently go look at the charts to tell me when I should put that money to work.
  • I do tend to use both TA and fundamental analysis in my work.
  • There again, I mean, if I’m making-if there again, there are variations, if I am making a huge investment, then the fundamental analysis really trumps all and I really do it carefully.
  • If I’m just playing, if I’m throwing a smaller amount of money, I might get a little careless with fundamental analysis, too and might tend to go towards more on the TA side, but without fundamental analysis, even little bit of it, I am not about to commit money to these markets.

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