3 Lecture 7

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2018.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem and Nosheen Khan
Lecture 7
Technical Analysis of Securities
The focus of technical analysts is not on finding undervalued or overvalued shares, nor is the
focus on expected ROR, rather it is focused on estimating the timing of change in the direction of
share price trend. In a sense this method attempt to estimate direction of future price
movement. Here it should be emphasized that expected ROR is also based on future expected
price,P1 , therefore attempts to estimate future expected price of the stock next year is also
required by fundamental analysts, but the difference lies in the methodology used by technical
analysts and fundamental analysts.
Technical analysts insist on using only that data that is generated in the stock market due to
trading in a share, i.e. price of share and volume of its trading, and time. They mostly use daily
price data and graph it on a graph paper over time at x-axis; sometime they also place daily
volume of trading in that share also on the same graph. Similar exercise is also done with the
index of stock prices, or sector or industry indices such as index of banking share prices, or index
of automobile share prices. The idea is to say something about the overall share prices, that is
share market; or share prices of companies in a certain industry such as banking. There is no
fixed rule that a graph should be prepared using data of how many past days: 30, 60, 120, 360
days or what ? This approach ignores fundamental financial data of the company such as sales,
total assets, net income, EPS, DPS, growth rate, beta of share, etc. This approach also ignores
fundamental economic data such as growth rate of GNP, inflation rate, interest rate, exchange
rate, etc.
Technical analysts try to read past pattern of a share price over time; and claim to discover from
these past price patterns future direction of price movement. Specifically, they claim to know
when an upward trend in price would change into a down ward trend and vice a versa. The
important word here is WHEN, which implies this type of security analysis is focused on
discovering the timing of change in the direction of a share price or the change in direction
prices of all the shares traded on stock exchange, that is change in the direction of the whole
stock market index. Technical analysts are not interested in quantum of price change , and
therefore they are not interested in estimating a future price and nor in estimating expected
ROR. This approach has an underlying assumption that past is a good predictor of future, and
past price trends are likely to repeat themselves in future. Technical analysts believe that the
past behavior of prices is a good indicator of their future behavior. For example, if in the past
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when ever price was lower than the 200- days moving average price , and then on a certain day
the price of share pierced the 200-day moving average price line from below then it is an
indication that now a long term upward trend in the price of that share has set in; and in future
days price would continue to move upward. It is considered a buy signal for the share has been
generated on that day when this piercing of 200-day moving average line from below was
experienced by the share price line.
But, there is no technical rule that tells us for haw many days the expected upward trend would
continue in the share price, nor is there a rule that can guide us about the amount of increase in
price. Nor is there a logic why price would now continue in future days to show upward trend?
Technical analysts spend a lot of time and energy in discovering the patterns of share price
during the past periods; and then those patterns are taken as a guide for future price patterns.
Practitioner of technical analysis claim to have the ability to time the exit (sell) and entry (buy) in
the market correctly; that is, they claim to know when price has hit the bottom (psychological
floor) and therefore would increase; and they can buy at such low price before increase in price
occurs. And they claim also to know when price is at its peak (psychological ceiling), and would
fall in future days; and thus they conclude this is the time to sell before price falls. This is correct
that if an investor can always buy share before increase in price and sell share before decline in
price, then she stands to make a very high ROR.
It is interesting to note that mostly financial press reports about the performance of stock market
using the jargon (lingo) of technical analysis. The following paragraphs do not give exhaustive
treatment to technical analysis; but the idea is to give you a taste of this method of security
analysis:
1. Dow Theory : This theory identifies 3 types of trend in share prices. A) Primary Trend: It lasts
for a long period such as a few years, and index of share prices keeps a long term upward or
down ward trend. B) Intermediate Trend: Within primary trend of prices, interruptions in
the opposite direction that may last for a few weeks or months are observed in the price. C )
Daily Trend: Random movement of prices up or down around primary and secondary trend.
2. Bulls Market: When successive price ups (Peaks) are above the previous price peaks, and
successive price low (troughs) are at higher price than the previous price low, then it is called
a bulls market. This behavior shows long term upward trend in the price of that share, or if
you are considering the index then upward trend in whole stock market
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3. Bears Market: When successive increases in price fails to cross the previous peak, and
successive falls in price are lower than the previous trough (fall) in the price, then it is called
bears market. This depicts a long term down ward trend in price.
4. Reversal: When in an upward (bullish) trend, the next peak in price is lower than the
previous peak, and the next fall in prices is below the previous trough, then it is called
reversal of the long term upward trend to the long term downward trend. If in the
subsequent next upward price move, the peak is again below the previous peak, and trough
is lower than the previous trough then it is taken as confirmation of reversal or confirmation
of change in long term trend from upward to downward in the price of that share or that
market index.
5. Confirmation: To confirm that upward market trend has changed to the downward trend in
KSE-100 Index, the confirmation is found by looking at the similar price movement in
another index, for example KSE-30 index, or SBP all share index. And if these indices also
show similar price behavior then you say the reversal in KSE-100 index has been confirmed.
6. Correction and Consolidation: If an increase in price is partially off-set by subsequent
decline in price, then such a decline is called correction. A period of no significant price
change after the correction is called consolidation.
7. psychological price ceiling or Resistance Level: A price level above which price hesitates to
go after repeatedly touching that level from below is called ceiling or resistance at that price.
It is assumed that at such a high price supply of share from investors in the form of sell
orders is so big that price fails to go above that level. And the same applies to the market
index.
8. psychological price floor or Support Level: A price level low enough that below which
price is hesitating to fall after repeatedly falling to that level. It is assumed that at such a low
price the demand of shares becomes so high among investors that the price does not fall
below that level. To see that at certain level there is support present one should see that not
once, but many times, price falls very close to that level but does not go below that level.
And the same applies to the market index.
9. over-bought market: Refers to unjustified high prices, so it is time to sell
10. oversold market: Refers to unjustified low prices, so it is time to buy
11. profit taking On a day when investors are selling their already held shares, a general decline
in prices on that particular day is observed; and this decline is attributed to profit taking,
causing a temporary decline in prices in an otherwise upward moving price trend.
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12. short covering On a day when an increase in prices is observed as short sellers are buying
those shares that they had short sold in the past, and therefore on that specific day prices
went up temporarily in an otherwise declining market.
13. market sentiments being bullish A period when generally share prices are increasing day
after day; vice-a-versa is called bearish sentiments .
14. advances to decline : A-D. It is a number calculated by subtracting the number of
companies whose share has declined in price from the number of companies whose share
has experienced an increase in price on a day. For example, on a day shares of 180
companies saw increase in price and 160 companies experienced decline in price, then A – D
= 180 -160 = 20. Daily this number is placed on the graph paper and the trend of the line is
studied in comparison with the line of KSE-100 index. If both A-D line and index line are
showing upward trend then technical analysts conclude that the market is technically
strong, and if both lines have negative slope then market is technically weak.
If index line is falling but A – D line is rising then this divergence in trend is taken as a signal
of change in index (the market) trend from down to upward. If index line is upward but A-D
line is falling then it indicates Weakening of the market implying that in future index would
fall. A-D line is also an indicator of the breadth of the market, bigger the A – D number,
more is the breadth of market
15. Breadth of the market: higher A-D indicates higher breadth of market. Fifty weeks high and
low price also indicates breadth of the market. I if large number of shares hit their 52 weeks
high on a day then it is concluded that market was bullish on that day. If in a period when
index is upward sloping, and a large number of shares hit their 52 week low price on a day
then it is taken as a Sign of Trouble for the market index in future; and market is described
as in troubled waters.
16. Volume of Trading: If volume of trading is high, it is considered that market is bullish; and if
with high trading volume the prices are also increasing then market is considered very
bullish on that day. For the technical analysts, it is a golden rule to assume that high volume
accompanies rising price, and low volume of trading accompanies falling price.
17. Short interest ratio: number of shares shorted on a day/average daily trading volume per
month ratio. If the ratio is increasing, it is sign for the bearish sentiments about that share.
Short interest ratio is compared every day with the historical range of this ratio, which is
between 3 to 6 in New York. If on a given day, the ratio is above 6 then it is considered high
and indicated pessimistic sentiments prevailing about that share on that day. The same logic
applies to the whole market as well.
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18. Contrary Opinion: When liquidity of mutual funds is low then it means they are fully
invested in the market; and it happens close the peak of market prices of shares. Such view
implies that now it is likely that prices have attained their peak and only direction they can
take in future is downwards, therefore it is time to get out of the market, that is, time to sell.
19. Moving Average Line: Average price of a last few days, such as last 7 days, or last 30 days, or
last 200 days is placed daily on the graph paper, the resulting line is moving average line.
BUY SIGNAL: On a day when price of a share crosses the moving average line from below on
high trading volume, then it is a buy signal for that share. SELL SIGNAL: on a day when share
price falls below its moving average price on high trading volume, then it is a sell signal for
that share. OTHER SELL SIGNALS: on a day when price of a share is below its moving average
price line, and during the day price rises to come close to its moving average price but does
not succeed to go higher than the moving average and turns downward , then it is taken as
sell signal generated on that day about that share. If moving average line has been rising
and then flattens and then declines, and the share price line crosses it from above then it is
sell signal on that day for that share. If moving average price line is falling and the share
price line crosses it from below then it is a sell signal for that share.
20. Abortive recovery: In an upward trend, if price falls and then increases but fails to surpass
the previous peak price; and the next fall goes below the previous trough in price, then it
indicates change in the primary price trend from upward to downward. If the subsequent
price rally (peak) again fail to reach the previous peak and subsequent price fall again
penetrates below the previous trough (low) then change of primary price trend from upward
to downward is confirmed, and bear market has set in for that share.
21. momentum is said to be present in a share or in the market because after a rise in one
period, in the next period again a rise is experienced in its price. But it is not clear what is the
period length that should be compared, that is, month to month, week to week, or what.
22. depth of market is present in a market by virtue of no single investor being able to nudge
the price in one or the other direction because of the huge size of any asset and huge
quantum of funds needed to nudge the price of any asset in the desired direction. Generally
if trading volume of a share is high it is difficult for a single investor to nudge its price one
way or other, and there is depth in the market.
23. market being directionless On a day because of no visible trend in prices
24. relative strength A share shows relative strength because of faster increase in price of a
share compared to index. Three types of relative strengths can be calculated:
P MCB / KSE-100 index ratio: daily this ratio is calculated and placed on the graph, if the graph
makes an upward sloping line then you conclude that MCB share has relative strength
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compared to the whole market. P MCB / Index of banking sector. Daily this ratio is calculated
and placed on the graph. If the graph is upward then MCB is showing relative strength in the
banking industry, meaning MCB share price is increasing faster than the index of the prices
of banks’ shares. Index of banking industry / KSE-100 index: this ratio is calculated daily and
placed on the graph, if the line is showing upward slope then banking industry stocks as a
whole have relative strength compared to the overall stock market, meaning the prices of
the shares of banks are rising faster than prices of all the shares in the market. Similarly if
line of relative strength ratio is down ward sloping then it indicates relative weakness in the
price of that share or in the shares of that industry.
As a rule of thumb, if a share’s relative strength has been increasing for the last 4 month,
then it is taken as a buy signal for that stock. Relative strength is also used to identify
promising sectors of economy for the investment. For example if relative strength of textile
is increasing (the graph is upward sloping) and of cement is deteriorating (graph is
downward sloping) then investors should divest from cement and invest in textile shares. Be
careful about interpreting the relative strength because it is possible that relative strength of
a share is increasing over time simply because its share price is falling slower than fall in
market index.
There is a lack of unanimity among those who use technical analysis about even their very basic
calculations. For example moving average of prices of how many days should be used: 7-days
moving average, 30-days moving average, or 200-days moving average while making the moving
average graph. Therefore, usually business school professors do not teach this method of
analysis.
A Final Word About Security Analyses

The purpose of both types of security analyses is to identify those stocks that are promising to
increase investors’ wealth. That is identifying undervalued shares so that long position can be
taken in those shares; and identifying overvalued shares so that short position can be taken in
those shares.
Regardless of your preference for the use of fundament analysis or technical analysis as the
guiding methodology for identifying good buys, your focus on expected ROR is only half the
story. The remaining half of the story is Risk which must also be considered. Regrettably
technical analysts use no measures of risk while fundamental analysts do try to incorporate
relevant risk of share in the form of beta of that share while doing their analysis. Risk is
uncertainty about expected ROR. Therefore decision to buy a specific share must be guided
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both by the consideration of its expected returns as well as its risk. In this course you shall learn
in detail about the relationship of risk and return of securities, and how these are quantified and
then used in decision making about investing in shares.
Question Two: What Combination to Buy

Common sense answer is not to buy a single security. You know that risking everything on one
endeavor is too risky; similarly putting all your money in one stock is too risky. If you put all your
eggs in one basket and then basket of eggs is damaged due to an unexpected shock, then you
stand to lose all your eggs; similarly if you invest in shares of one company only and that Co
faces bad times then you stand to lose big. Therefore it is advisable to buy a combination of
securities, such combination of different shares or securities is called portfolio of securities.
More importantly just any combination of securities won’t do. Modern Portfolio Theory (MPT)
,proposed by Harry Markowitz in 1950s, has proven that you should preferably buy an efficient
combination of securities, or in other words you should try to build an efficient portfolio, not
just any portfolio.
The following questions are relevant in this regard. What is meant by an efficient portfolio?
How to build an efficient portfolio of securities? Which securities are included in it, and which are
not? And those included, what proportion of your own money (OE) is invested in each of those
securities, it is called weight of a security in your portfolio and is denoted with symbol ‘x’ . In an
efficient portfolio which securities have positive weight ( that is you have long position in those
securities, i.e. you buy those), and which securities have negative weight (you take short position
)? What is Expected ROR of a portfolio and what is its total risk ? Can total risk of portfolio be
divided into components such as diversifiable risk and non diversifiable risk? For an investor,
which risk is relevant while making investment decision?
It is hoped that this course would help you answer these questions in detail and with
mathematical precision. Such precision is the result of theoretical developments in the Modern
Portfolio Theory (MTP) during 1950s and 1960s due to contribution of Markowitz, Sharpe,
Lintner, and Mossin. The application of MPT in real life took off during 1970s due to the
availability of computing power to the investors. A new set of industries based on the
application of MPT emerged such as mutual funds industry, pension funds industry, hedge funds
industry. In short the whole area of professional money management really became an industry
after the wide spread availability of computers made it possible even for small investors to do
the risk and return calculations required by MPT.
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Question Three: When to Buy or Sell

This is a question about correctly timing your “entry in” and the “exit from” the market.
Common sense answer is: buy a stock when its price is low and sell it when its price is high. But
in real life how can one know that today’s price is the lowest, and it won’t go down further
tomorrow, and therefore today is the best time to buy. Or today’s price is the highest and
therefore today is the correct time to sell; and tomorrow or in future price won’t go up further.
Is it not possible that price may go down further tomorrow? And if that happens then you would
regret that you should have waited one more day so you could have bought even cheaper that
particular stock?
This dilemma leads to an interesting question: can anyone correctly time her market exit and
entry? This question can be posed also as: If anyone has the ability to beat the market
consistently? Beating the market means being able to always buy a stock before its price goes
up; and always selling it before its price falls; thus resulting ROR would be higher than ROR on
overall market portfolio comprising of all the stocks. Numerous research studies have shown
that no portfolio manager has shown such ability consistently. Showing this ability once or twice
is not the issue; ability to always buy at the lowest price and sell at the highest price in any given
time period is the issue. It means correctly timing your entry and exit from the market. No
investor has shown such ability: be they individual investors, or professional money managers
(portfolio managers) working for financial institutions that have huge research and
computational resources at their disposal.
Those who do Technical Analysis claim to be able to correctly judge if price is now too high and
therefore it is time to sell (Over Bought Market); or price is now too low and therefore it is time
to buy (Over Sold Market). But empirical testing of their proposed trading strategies (called
technical trading systems) have shown conclusively that no system of trading based on technical
rules was found capable of generating correct buy and sell signals for their users on a consistent
basis. Though some research studies have found support for the “momentum based trading
strategies” where a winner stock in past period seems to be a winner in the next period, and a
looser in past period was found to be a likely looser in the next period as well. But even in this
case a universal agreement about acceptable length of period for such comparison is non-
existent because one analyst can use a one week period and the other analyst can use a one
month or one year period, or a one day period to classify winners and losers.
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Generally, the issue of timing is more relevant for the short term traders who frequently buy and
sell almost on daily basis. Presently, due to ease in order execution as a result of information
technology revolution, even frequent intra-day trading is becoming easier and popular.
There is strong support in research literature for the “Buy and Hold” strategy over a reasonably
long period. Such long term investors are more likely to be better-off in terms of increase in their
wealth than the short term traders. It must be clearly understood that the nature of corporate
shares is such that these are securities with no maturity, that is, theoretically their maturity is
infinitely long period of time. Therefore holding period envisioned by investors should be a very
long period. But, unfortunately even the professional money managers working for mutual
funds, pension funds, treasury departments of banks, etc, are evaluated on quarterly basis. This
short term performance evaluation culture results in a bias in favor of showing good results
every quarter; and therefore leads to excessive attention to market timing. All this results in
more frequent trading than is warranted by common sense. Probably the only beneficiary are
brokerage-houses, because by virtue of frequent trading activity by investors, brokerage houses
stand to earn commission fee for executing the order of the investor on the exchange floor.
Please understand that an investor pays commission to the broker both ways, i.e., when a share
is bought as well as when a share is sold. Therefore brokers as a community has an inherent
interest in seeing that investors do frequent trading, and do not opt for the “Buy and Hold
Strategy”.
It should be clear to you now that if time horizon for investing in shares is very long then the
question “when to buy” has a common sense answer: today. Because it does not matter much
that you wait a few more days in the hope of buying at lower price if your investment horizon
(expected holding period) is next 20 years. Similarly, after holding a share for 15 years, if a long
term investor has decided to liquidate her holding due to certain personal circumstances, then it
is not a matter of great importance to wait for a few more days before selling her shares in the
hope of getting higher selling price: “today” also is the right answer for her.
Just looking at the value of major stock indices such as KSE-100 index (Pakistan) or Dow Jones 30
index (USA) or S&P 500 index (USA) over the last 50 years gives very strong evidence in favor of
“buy and hold” strategy while doing investment in corporate shares. Compound annual growth
rate of all these indices has been in double digits for more than the last half a century; and no
other security or investment instrument has give such high rate of return over such a long period
of time. Therefore commonly held belief that investing in corporate shares can make you very
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wealthy is correct; but for that to happen investor should have the patience of holding her
investment for a long period: you should buy shares not for yourself but for your grand children.
Now this approach to investing in shares is not stated in such stark terms by text book authors,
nor is it promoted by professional investment advisers, probably for good reasons of self interest
as their bread and butter is linked with investors indulging in frequent buying and selling of
shares. As an example of the efficacy of long term buy and hold strategy , please note that in
1993 KSE-100 index was in the range of 900 and these days (end of 2018) it is in the range of
44,000. Using Fc-100, in CMPD mode you enter: -900 PV exe, 44,000 FV exe, 0 Pmt exe, 25 n
exe , and solve i , you get 16.83% compound annual growth rate; so annual ROR was more than
16 % per year for the last 25 years. Which, it should be noted, is a very high growth rate of the
wealth of investors, but for that to happen to your wealth you have to show patience by holding
shares of KSE-100 index for 25 years.
Remember as soon as you get into a mindset of becoming rich overnight; and chose shares as the
vehicle to attain that goal you are in the arena of gambling and out of arena of professional
investing. Then the only relevant question you should ask yourself is why select share market to
satisfy your urge to gamble? There are available better, easier, and cheaper modes of doing
gamble or playing games of chance than the share market.
What This Course Aims to Teach

This course is aimed at learning the answers to the first two questions: 1) What to buy, and 2)
what combination to buy; because these are answerable questions. The third question ( when to
buy?), is a question about the market timing and that is not answerable; therefore this course
won’t pretend to teach the answer to the third question.
RATE OF RETURNS
In this course the word rate of return (ROR), or simply return and the word risk would be used
frequently. It is important to be very clear about various types of percentage rate of returns on
shares
Actual ROR , Historic ROR, Realized ROR, Ex-post facto ROR
Above terms are all various ways to express the past ROR that has actually been earned , usually
during the last one year. On shares of companies, actual percentage rate of return (ROR) for one
period (usually one year) investment is:
Actual ROR = Realized capital gains yield + Realized dividend yield
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realized capital gains yield is: (selling price - buying price ) / buying price; and realized
dividend yield is: cash dividend per share received / buying price.
This actual ROR needs no theory, it is a historical fact, and it is actually available for past periods
for all the shares, so there is no argument about it, and no disagreement among analysts.
Example: Realized ROR
For example if you bought on January 1 a share of MCB at 200 and received during the year DPS
of Rs 5, and sold the share after one year on December 31 for Rs 250. Then your actual, or
realized, historic, or ex-post facto ROR is:
Realized Capital Gains Yield = (250 - 200) / 200 = 25%
Realized Dividend Yield = 5 / 200 = 2.5%
Realized ROR = 25% + 2.5% = 27.5% per year.
Since all of this has actually HAPPENED, it is a historic fact, there is no ambiguity about it, there is
no disagreement about it, and this information is available to all investors, therefore actual or
realized RORs are not the issue. And, more importantly, these RORs are no guarantee, or even a
good reliable guide, for future ROR from the same share for the next period or next year.
Having said that, it must be acknowledged that the tendency to project the past into future and
making expectation about future ROR of a stock based upon its past RORs is wide spread.
Probably it is a reflection of human inclination, as depicted in many other spheres of life, to
believe that the patterns of past would continue to repeat themselves in future. It is likely that
abhorrence to change or a fear of unknown is the basis of such thought patterns. In any case,
there is no reason to believe that a share which has given 60% ROR last year would give close to
60% ROR next year as well; rather it is possible that a company whose share gave very high ROR
in one year, went bankrupt the next year, and its share became worthless.
Expected ROR , Future ROR, Ex-ante ROR

Investors making investment decision today are interested in expected ROR, or ex-ante ROR,
which they hope to earn after completion of a holding period, usually one year. There are
theories about expected ROR, and since it is a future oriented number, therefore it has to be
estimated by investors before making the investment decision. And there can be a disagreement
among the analysts about the expected ROR from a share. Usually such estimation is done for
one period, which is usually next one year.
The skill of a security analyst lies in correctly estimating expected ROR for the next year, and this
skill of a security analyst is judged by the accuracy of her estimated expected ROR when it is
compared after one year with the actually realized ROR from that particular stock. Formula for
expected ROR is very similar to formula for actual ROR: symbol Kc would be used for ROR.
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Expected ROR = Expected dividend yield + expected capital gains yield

Expected dividend yield = Expected dividend per share next year / current price
Expected dividend yield = DPS 1 / P0
Expected capital gains yield = (expected price next year – current price )/ current price
Expected capital gains yield = (P1 - P0) / P0
Note that estimating the ROR for next year requires estimating 2 items:
a) P 1 , that is price of the share after one year.
b) DPS1, that is expected cash dividend per share that stock is likely to give to the stockholders
during next year.
Since both these items are estimated for the next year therefore expected ROR is as good as
these estimates are.
Expected ROR or expected Kc = ( DPS 1 / Po ) + (P 1 - Po)/ Po
In this expression Po refers to current price of share which is available and needs no estimation.
Please note that estimating DPS for next year requires estimating EPS for the next year, which in
turn requires estimating NI for the next year, which ultimately requires estimating income
statement for the next year. As Income statement for the next year cannot be estimated
without an estimate of an asset base, therefore it inevitably requires estimation of balance sheet
for the next year as well. These forecasting exercises you have done in your previous courses
such as Corporate Finance.
Estimating P1 (expected price after one year) is more tricky. If you decide to apply a growth rate
on current price then it gives P1 = Po (1 + g); in this formulation the dispute is about the right
methodology for estimating growth rate of share price. Mostly analysts do not seem to agree on
growth rate for a company, and their individual growth rate forecasts tend to vary greatly.
Remember under assumption of 5 major policies remaining unchanged next year, this growth
rate can be estimated as: g = ROE (1 - d). But this condition of no-change in 5 policies is rather
restrictive and therefore unrealistic in most cases because keeping the management
performance un-changed in 5 major areas of performance is a tall order. To be specific, for ROE
(1 - d) to be the growth rate in share price, performance in the following 5 areas should be same
as last year’s performance , i.e., no change in
1) net profit margin ,NI/S, meaning ability to extract profit from sales revenues is constant; if last
year it was 3% of sale , next year it should also be 3% of sales.
2) total assets turnover, S/TA, meaning productivity of assets in generating sales should be
constant, if last year 1 rupee of asset was helping generate 2 rupees of sales then next year it
should remain the same.
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3) financial leverage, TA/OE, it means capital structure, and therefore financial risk, remains
unchanged; if last year it was 5, then next year it should be 5 as well.
4) dividend payout ratio (d) , DPS / EPS, percentage of NI given out as cash dividend is constant; if
last year a co gave 30% of its NI as cash dividend then next year also it should give 30% of NI as
cash dividend.
5) number of shares outstanding remains unchanged. It means, the co offers no new share as
bonus shares or stock dividends; issues no new share as right offering to existing shareholders to
raise equity funds for the co; issues no new share as a seasoned offering to general public to
raise equity funds. It also means co repurchases no share next year so that number of shares
outstanding remains the same next year as they were last year.
Please note keeping these 5 policies constant also means ROE next year would be same as last
year because ROE = NI/S * S/TA * TA / OE. As these 3 ratios are assumed constant than by
implication ROE is assumed constant year after year.
For example, last year the 3 component ratios of ROE were:
NI/S = 3%; S/TA = 2 times; TA/OE = 5 times. Then last year’s ROE was:
ROE = 3% * 2 * 5 = 30%
Since 3 component of ROE would be same next year under policy constancy assumption
therefore ROE next year would also be 30% as it was last year. But you must be clear about the
fact that EPS won’t be same next year as it was last year because
EPS = NI/S * S/TA * TA / OE * OE / # shares
as S , TA , and OE cancel out, and you are left with: NI /# shares, and this is EPS.
Since OE/# shares is BV per share, therefore you can write:
EPS = ROE * OE/# shares
EPS = ROE * BV per share
and since BV of OE in balance sheet would increase next year due to profits or OE would
decrease due to losses, therefore BV per share would be different next year as compared to the
previous year. Also DPS next year won’t be the same as DPS last year because DPS = EPS * d.
Though ‘d’, dividend payout ratio, is constant, but as EPS next year would be different than last
year’s EPS , therefore DPS next year would come out different than the DPS of the previous year.
With these 5 policies constancy restrictions in place, you can estimate:
g = ROE (1 - d)
P1 = Po (1 + g)
DPS 1 = DPS o (1 + g)
Example: Expected ROR
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For example current price of a company’s shares is Rs 50, Its ROE last year was 10% and its
dividend payout ratio (d ) was 50%, and it had paid Rs 2 DPS last year. Then you would conclude
that:
growth rate of its OE is= ROE (1 - d) = 10% (1 - 0.5) = 5%.
It has paid Rs 2 DPS in the most recent year, i.e. DPS o , therefore you would estimate its next
year DPs as : DPS1 = DPSo (1 + g) = 2(1 + 0.05) = 2.1 Rs. And estimate for its next year’s share
price is:P1 = Po (1 + g) = 50 (1 + 0.05) = 52. 5 Rs
And based on these estimates you would estimate expected ROR for the next year :
Kc = (DPS 1 / Po ) + (P1 – Po ) / Po
Kc = ( 2.1 / 50) + (52.5 - 50) / 50
Kc = 0.042 + 0.05
Kc = 0.092 or 9.2% per year
This is your estimate for the expected ROR from this share for the next year if you bought it at
today’s price of Rs 50. Please note very carefully that this expected ROR may or may not be
realized actually by the end of one year and therefore it has risk.
One approach used to estimate P1 requires next year’s EPS and multiplying it with current PE
ratio of the Company. Another approach of estimating P 1 is to estimate next year’s BV per share
(OE / number of shares) and multiplying it with current MV to BV ratio of the Company.
If you do not want to make restrictive assumption of the constancy of 5 policies, and want to use
such growth rate to estimate P1 , one approach to estimating growth rate is to use GNP growth
rate as proxy for the growth rate of share price, such GNP growth rate estimates are easily
available for any country. It is important to note that there is no single correct answer or a
single approach available to estimate the requisite inputs for estimating expected ROR of a share
for the next year. Therefore different analysts estimate different expected ROR for a share; and
mostly this difference in opinion is due to estimating different growth rate for that company
based on their own analysis of the prospects of that company.
Actual (and also expected) ROR per year for multi-period holding period
For example, you bought on January 1 , 2005 a share of MCB at 100, and in 2005 it gave you cash
dividends of Rs 4, in 2006 cash dividends of Rs 6, in 2007 cash dividends of RS 3, in 2008 cash
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dividends of Rs 8, in 2009 cash dividends of Rs 7. At the end of 2009 you sold the share on
December 31 for Rs 250. What was your realized annual ROR from this investment?
First put the Cash flows on time line:
Time 0 - 100
Time 1 4
Time 2 6
Time 3 3
Time 4 8
Time 5 7 + 250 = 257, assuming dividends are given by the co at the end of each year.
Use CASH mode of FC -100 and enter in data editor all these cash flows , and solve IRR. You get
23.93% per year. Note: underlying assumption in this solution, like all IRR calculations, is that
interim cash flows were reinvested at IRR; it means DPS of 4, 3, 6, and 8 were reinvested to earn
23.93% per year; and it must be stated that such assumptions, at best, are unrealistic in real life.
One can apply this methodology for a future holding period of next 5 years as well if DPS for each
of the next 5 years is estimated and an estimate of P 5 (price after 5 years) is also made. But
making such precise forecasts for extended periods in future is not realistic and practically not
useable in real life. In practice the whole exercise boils down to an attempt to estimate DPS 1
and P1 and based on these numbers estimating an expected Kc for the next year.
Generic ROR on Various Investments

For one year investment, ROR on any instrument has 2 component, namely, an income yield and
a capital gains yield. Income yield is due to cash paid by that instrument (security or asset) to the
investor. For shares this cash payment is called cash dividends, for bonds it is called interest
payment, on commercial or residential rental property it is called rent income; but for
investment in paintings, or plots of land, or jewelry there is no cash income. The second
component of ROR , namely, capital gains yield is due to the increase in price of that investment
since you bought it, it may be a capital loss also if price has declined since you bought that
investment. In case of investment in plots of land, jewelry, antique furniture, and paintings all
the ROR is from capital gains yield as there is no income yield from these assets. But in case of
investments in share, bonds, and residential or commercial rental property cash income in the
form of dividends, interest, or rent gives rise to an income yield. In case of investment in foreign
currencies, if you kept it in a bank deposit account you may earn interest as well (your interest
yield) along with increase in value of foreign currency against local currency ( your capital gains
yield in local currency).
The following are examples of Realized ROR on different assets.
For example realized ROR on one year’s investment in shares is:
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[(selling price – purchase price) / purchase price] + [ cash dividends received / purchase price].
ROR on one year’s investment in bonds is:

[(Selling price – purchase price) / purchase price] +[ interest received / purchase price]
ROR on one year’s investment in residential or commercial rental property is:
[(Selling price – purchase price) / purchase price] + [ rental income / purchase price]
ROR on one year’s investment in a plot of land is:
(Selling price - purchase price) / purchase price
ROR on one year’s investment in Paintings:
ROR on one year’s investment in jewelry is:
Note: Selling price does not mean you have to actually sell the asset, it means if you had sold it at
the end of the year then at this price you would have sold it because it was the prevailing price
at the end of the year. But ROR is still there and can be calculated even though you decided not
to sell your investment. Expected ROR on the above stated assets is also calculated in the
same manner by changing selling price with expected next year’s price P 1); and dividends
received or interest received, or rental income received is changed with the expected
dividends, expected interest income, and expected rental income. Purchase price is changed
with current price P0
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2018.

A Final Word About Security Analyses

Question Two: What Combination to Buy

Question Three: When to Buy or Sell

What This Course Aims to Teach

Expected ROR , Future ROR, Ex-ante ROR

Expected ROR = Expected dividend yield + expected capital gains yield

Generic ROR on Various Investments

ROR on one year’s investment in bonds is:

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