BlogInvestment Adviser Level 18. Investing in Stocks

8. Investing in Stocks

Equity as Investment-

Equity is one of the two broad types of securities issued by companies to raise capital from investors. Unlike debt, equity securities do not involve any contractual obligation to repay the amount or make periodic payments to shareholders. Equity investors, also known as shareholders, have a residual claim on the company’s net assets and get voting rights, enabling them to participate in the management of the business. Investors who purchase equity shares look for capital appreciation and dividend income, but there is no assurance of either from the company. Equity investment involves higher risk but also has the potential for higher returns as residual benefits go to the equity investor. Choosing between equity and debt involves a trade-off between risk and return, with investors seeking higher returns likely to take on additional risk.

Diversification of risk through equity instruments – Cross-sectional versus time series

Diversification is an effective way to reduce risk in equity investments. By investing in shares of many businesses across sectors and regions, investors can mitigate risk by holding shares in different businesses. This is known as cross-sectional diversification. The concept of diversification is based on the relatively less correlated behavior of various business sectors that underlie each equity investment. Business cycles, counter-cyclical businesses, and leading and lagging behavior of investment returns, countries’ economic performance are also important factors to consider. Empirical research has demonstrated that a significant portion of risk can be reduced through diversification. In addition, investing in equities for a long period of time helps in reaping the benefits of time diversification.

Risk of Equity Investments-

Risk Type Description Diversification Mitigation Strategy
Market Risk Fluctuations in equity prices due to market dynamics Cannot be diversified Hedging
Sector Specific Risk Risks specific to a particular business sector Can be diversified Investing in shares of businesses in different sectors
Company Specific Risk Risks specific to a particular company Can be diversified Investing in shares of different companies
Transactional Risk Risk of counterparty failing to fulfill the contract terms Mitigated by transacting through a robust stock exchange  
Liquidity Risk Risk of not finding a buyer or seller for equity holdings Can be diversified Investing in liquid stocks, use of limit orders

Market Risk is inherent to equity investments due to the fluctuations in stock prices resulting from changes in the broader market. Diversification of portfolio across sectors and stocks cannot help mitigate this risk as it affects all stocks irrespective of their sector. Market risk is measured by Beta, which compares the stock’s volatility with the volatility of the broader market. It cannot be diversified away, but it can be hedged through the use of options and futures.

Sector-specific Risk is related to the factors affecting the performance of a particular business sector. These factors could include changes in regulation, competition, or technology. It can be mitigated by diversification through investing in stocks of businesses in different sectors.

Company-specific Risk is related to the factors affecting the performance of a particular company. These risks include events such as management changes, product failures, or litigation. It can be mitigated by diversifying investments across different companies.

Transactional Risk is the risk that the counterparty fails to fulfill the contract terms while buying or selling equities. This risk can be mitigated by transacting through a robust stock exchange that has adequate risk mitigation procedures in place.

Liquidity Risk is the risk that arises when an investor is unable to find a buyer or seller for their equity holdings. It can be measured by Impact Cost, which is the percentage price movement caused by an order size from the average of the best bid and offer price. This risk can be mitigated by investing in liquid stocks and using limit orders.

Overview of Equity Market

The equity market can offer investors various investment options based on their risk-return-liquidity preferences. Equity securities provide investors with the ownership claim on a company’s net assets. There are opportunities in both listed and unlisted equity spaces. The investment in listed companies is relatively more liquid than investment in unlisted companies. The listed companies are more regulated with better disclosures as they have to abide by listing norms. The market capitalization of listed companies at NSE in India was reported at Rs. 1,12,43,112 crore as of March 2020.

In addition to equity shares, companies may also issue preference shares. Preference shares rank above equity shares with respect to the payment of dividends and distribution of company’s net assets in case of liquidation. However, preference shares do not generally have voting rights like equity shares, unless stated otherwise. Preference shares share some characteristics with debt securities like fixed dividend payment. Similar to equity share, preference shares can be perpetual. Dividends on preference shares can be cumulative, non-cumulative, participating, non-participating or some combination thereof (i.e., cumulative participating, cumulative non-participating, non-cumulative participating, non-cumulative non-participating). In case preference stock is cumulative, the unpaid dividends would accumulate to be paid in full at a later time, whereas in non-cumulative stocks the unpaid or omitted dividend does not get paid. A non-participating preference share is one in which a dividend is paid, usually at a fixed rate, and not determined by a company’s earnings. Participating preference share gives the holder the right to receive specified dividends plus an additional dividend based on some prespecified conditions. Participating preference shares can also have liquidation preferences upon a liquidation event.

Equity research and stock selection

Fundamental Analysis-

Fundamental analysis is the process of evaluating a company’s financial and economic fundamentals to determine its intrinsic value. This analysis is based on the company’s financial statements, economic data, and other qualitative factors such as management quality, industry trends, and macroeconomic conditions.

a. Top-Down Approach versus Bottom-Up Approach:

There are two approaches to conducting fundamental analysis: the top-down approach and the bottom-up approach.

  • Top-Down Approach: This approach starts with the analysis of the broader economic factors that affect the industry and then narrows down to the individual company level. The top-down approach considers macroeconomic factors such as interest rates, inflation, and government policies that can impact the overall economy and the industry in which the company operates. Investors using the top-down approach then analyze the industry’s growth potential and select individual companies within that industry that are expected to benefit from the macroeconomic trends.
  • Bottom-Up Approach: This approach starts with the analysis of individual companies and then narrows down to the industry level. The bottom-up approach focuses on analyzing the company’s financial statements, management quality, and competitive position to determine its potential for growth and profitability. Investors using the bottom-up approach then evaluate the industry trends and assess whether the company is well-positioned to benefit from those trends.

b. Buy Side Research versus Sell Side Research:

There are two types of fundamental research: buy side research and sell side research.

  • Buy Side Research: Buy side research is conducted by investors, such as mutual funds, hedge funds, and pension funds, who buy and hold securities for their clients. The primary focus of buy side research is to identify undervalued or overvalued securities that can provide superior returns.
  • Sell Side Research: Sell side research is conducted by brokerage firms, investment banks, and other financial institutions that provide research reports and recommendations to their clients. The primary focus of sell side research is to generate trading commissions and investment banking fees by providing research and analysis to their clients.

c. Sector Classification:

Sector classification is the process of grouping companies based on their industry or sector. There are several sector classification systems, including the Global Industry Classification Standard (GICS) and the Standard Industrial Classification (SIC) system.

Sector classification is useful for investors because it allows them to compare companies within the same industry and assess their competitive position. Investors can also use sector classification to identify industry trends and select individual companies that are well-positioned to benefit from those trends.

  1. Stock Analysis Process

a. Economic Analysis: Economic analysis involves assessing the broader economic environment in which the company operates. This analysis includes evaluating factors such as GDP growth, inflation, interest rates, and government policies. A favorable economic environment can positively impact the company’s growth prospects and profitability.

b. Industry Analysis: Industry analysis involves evaluating the company’s position within its industry. This analysis includes assessing factors such as the size of the industry, the company’s market share, competitive landscape, and barriers to entry. An attractive industry with high growth prospects and limited competition can positively impact the company’s long-term prospects.

c. Company Analysis: Company analysis involves evaluating the company’s financial performance, management, strategy, and competitive position. This analysis includes assessing factors such as revenue growth, profitability, return on investment, debt levels, and cash flow. An attractive company with a strong competitive position, solid financials, and competent management can be a good investment opportunity.

Fundamentals Driven model – Estimation of intrinsic value

Intrinsic value refers to the true or inherent value of an asset or security based on its fundamental characteristics such as cash flow, earnings, assets, liabilities, and growth prospects. Fundamental analysis is the cornerstone of the valuation process, which involves analyzing a company’s financial statements, competitive positioning, industry dynamics, and macroeconomic factors to estimate its intrinsic value. One of the widely used methods for estimating intrinsic value is a fundamentals-driven model.

There are several fundamentals-driven models for estimating the intrinsic value of a stock, including the discounted cash flow (DCF) model and the asset-based valuation (ABV) model.

a. Discounted Cash Flow Model (DCF):
The DCF model estimates the present value of a company’s future cash flows, discounted at a required rate of return or cost of capital. The model assumes that the value of a company is equal to the sum of its discounted future cash flows, which include cash inflows from operations, investments, and financing activities, net of cash outflows such as capital expenditures, debt repayments, and dividends. The DCF model requires assumptions about the company’s growth rate, discount rate, and terminal value, which can be based on historical trends, management guidance, market data, and analyst estimates. The DCF model is widely used by both buy-side and sell-side analysts to estimate the intrinsic value of a company and to compare it to the current market price.

b. Asset-Based Valuation (ABV):
The ABV model estimates the value of a company’s assets, net of liabilities, as a proxy for its intrinsic value. The model assumes that the value of a company is equal to the sum of its tangible and intangible assets, net of its liabilities and off-balance-sheet obligations. Tangible assets include physical assets such as property, plant, and equipment, while intangible assets include intellectual property, brands, and goodwill. Liabilities include debts, leases, and other obligations that the company owes to its creditors. The ABV model is often used for companies with stable and predictable cash flows, and where the value of assets is a key driver of the business.

Both the DCF and ABV models have their advantages and limitations. The DCF model is widely used by analysts due to its ability to capture the value of a company’s future cash flows, growth potential, and other qualitative factors that affect the company’s value. However, the DCF model requires numerous assumptions and forecasts, which can be subject to errors, uncertainties, and biases. The ABV model, on the other hand, provides a more conservative estimate of the intrinsic value, based on the value of the company’s tangible and intangible assets, which are more readily observable and less prone to estimation errors. However, the ABV model may overlook the growth potential, competitive positioning, and other qualitative factors that affect the company’s value.

Relative Valuation

Ratio Description Formula Ideal Ratio
P/E Ratio Measures the price investors are willing to pay for each dollar of earnings. Market price per share / Earnings per share (EPS) Varies by industry and company, but lower is generally better
Price to Book Ratio Measures the price investors are willing to pay for each dollar of the company’s assets. Market price per share / Book value per share Varies by industry and company, but lower is generally better
P/S Ratio Measures the price investors are willing to pay for each dollar of the company’s sales. Market price per share / Sales per share Varies by industry and company, but lower is generally better
PEG Ratio Compares the P/E ratio to the company’s expected earnings growth rate. P/E ratio / Expected earnings growth rate Less than 1 is generally seen as favorable
EVA and MVA Measures the economic value added and market value added by the company. EVA = Net Operating Profit after Taxes – (Capital * Cost of Capital) / MVA = Market Value – Capital Invested Positive values are generally seen as favorable
EBIT/EV & EV/EBITDA Ratio Measures the return a company generates on its invested capital. EBIT / Enterprise value (EV) & EV / EBITDA Varies by industry and company, but higher is generally better
EV/S Ratio Compares the enterprise value (market value of equity plus net debt) to the company’s sales. Enterprise value / Sales Varies by industry and company, but lower is generally better
Dividend Yield Measures the amount of dividends paid by the company relative to its stock price. Annual dividend per share / Market price per share Varies by industry and company, but higher is generally better
Earning Yield Measures the earnings generated by the company relative to its stock price. Earnings per share (EPS) / Market price per share Varies by industry and company, but higher is generally better
Specific Valuation Metrics Various metrics used to evaluate companies in specific industries, such as price per subscriber for telecom companies or price per barrel of oil equivalent for energy companies. Varies by industry and company Varies by industry and company

Combining relative valuation and discounted cash flow models

Both relative valuation and discounted cash flow (DCF) models have their strengths and weaknesses. The former is more straightforward and less time-consuming, while the latter is more comprehensive but involves more assumptions and projections. Hence, many analysts and investors use a combination of both models to arrive at a more informed investment decision.

One approach is to use the relative valuation ratios (e.g., P/E, P/B, P/S) to estimate the terminal value of a company and then discount it back to the present using a suitable discount rate. The terminal value represents the expected value of the company beyond the projection period (usually 5-10 years) based on the assumption that it will continue to grow at a stable rate.

Another approach is to use the DCF model to derive the intrinsic value of a company and then compare it to its market value (i.e., stock price) to determine whether it is overvalued, undervalued, or fairly valued. The DCF model requires estimating the future cash flows of the company, the appropriate discount rate, and the terminal value.

It is important to note that both approaches are subject to various assumptions and uncertainties, such as the accuracy of the financial projections, the appropriate discount rate, the reliability of the comparable companies or transactions, and the sustainability of the competitive advantages of the company. Therefore, investors should use multiple methods and sensitivity analysis to validate their assumptions and reduce the risk of errors or biases.

Technical Analysis

Technical analysis is a method used by investors and traders to analyze past market data, primarily price and volume data, to identify patterns and forecast future price movements. Unlike fundamental analysis, which focuses on a company’s financial and economic factors, technical analysis is solely based on the analysis of market data.

Some commonly used technical analysis tools include:

  1. Chart Patterns: Technical analysts study different chart patterns such as head and shoulders, triangles, double tops and bottoms, and others to identify price trends and reversal points.
  2. Moving Averages: A moving average is a line that plots the average price of a security over a specified period of time. By analyzing the position of the moving average line, traders can identify trends in the market.
  3. Relative Strength Index (RSI): The RSI is a momentum oscillator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
  4. Bollinger Bands: Bollinger Bands consist of a moving average and two standard deviations plotted above and below the moving average. They are used to identify price volatility and overbought and oversold conditions.
  5. Fibonacci Retracement: Fibonacci retracement is a method of technical analysis that uses horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before the price moves in the original direction.

Technical analysts believe that the market is efficient, meaning that all the available information is already priced into the market. Therefore, they use technical analysis to identify patterns and signals that can help them make informed investment decisions. However, it is important to note that technical analysis is not always accurate, and traders should use other methods of analysis, such as fundamental analysis, to make well-informed investment decisions.

Mock Test:-

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Investment Advisor Level 1


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1. What does the P/E ratio compare?

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2. What is the expected return for equity investors compared to debt investors?

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3. What is the main focus of technical analysis?

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4. How does technical analysis differ from fundamental analysis?

5 / 82

5. What does a dividend yield of 5% indicate?

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6. What is the primary characteristic of equity shares?

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7. What does SWOT analysis involve in company analysis?

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8. What characteristic distinguishes preference shares from equity shares?

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9. How does diversification help reduce risk in equity investments?

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10. Which investment avenue is historically viewed as a good inflation hedge?

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11. Which valuation method is suitable for non-cyclical sectors like FMCG and Pharma?

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12. How can company-specific risk be mitigated in equity investments?

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13. What does it indicate if a company's stock price is lower than its book value?

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14. How is the intrinsic value of a stock calculated using the P/E ratio?

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15. Which indicator is commonly used in technical analysis to reduce the impact of day-to-day price fluctuations?

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16. How is impact cost measured in assessing liquidity risk?

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17. Which of the following is NOT an investment avenue available to investors?

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18. What two variables affect the P/E ratio?

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19. How are cyclical and noncyclical sectors classified based on their relationship with the business cycle?

20 / 82

20. What is the purpose of industry analysis in top-down stock analysis?

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21. Which type of shares ranks above equity shares in terms of dividend payment and distribution of net assets?

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22. In relative valuation, what are multiples used for?

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23. How is Free Cash Flows to the Firm (FCFF) calculated?

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24. Which elements are essential in understanding price behavior according to technical analysis?

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25. Which cash flow measure considers the cash flows available to all capital contributors, including both equity and debt?

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26. What is liquidity risk in relation to equity holdings?

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27. How is the Enterprise Value-to-Sales (EV/sales) ratio calculated?

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28. How is the Economic Value Added (EV calculated?

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29. According to Michael Porter's model, what is the first factor that determines the intensity of competition in an industry?

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30. What does a lower P/S ratio indicate?

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31. Which investment avenue offers exposure to assets that are otherwise difficult to obtain?

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32. How is the price-to-sales (P/S) ratio calculated?

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33. What are the assumptions of technical analysis?

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34. How is the historical or trailing P/E ratio calculated?

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35. Which valuation approach is most appropriate when the stream of future cash flows, timings of these cash flows, and expected rate of return are known?

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36. How are trading volumes important in confirming a trend in technical analysis?

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37. What is the primary measure of market risk for equity shares?

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38. Which investment avenue is NOT considered a structured product?

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39. How do technical analysts use charts in their analysis?

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40. Which type of preference share gives the holder the right to receive additional dividends based on prespecified conditions?

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41. Which investment category has low correlation with financial investments like equities and bonds?

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42. What is the primary reason why equity investors get voting rights?

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43. What does a positive Market Value Added (MV indicate?

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44. How is the Price to Book Value (P/BV) ratio calculated?

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45. How is Free Cash Flows to Equity (FCFE) calculated?

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46. Which industries outperform others during a recession phase?

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47. How is the Weighted Average Cost of Capital (WAC calculated?

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48. Can technical analysis be applied to fixed income securities?

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49. What are the two major strategies suggested by Michael Porter for companies?

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50. Which type of investment offers benefits of risk diversification when held in a portfolio along with stocks and bonds?

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51. What does an earnings yield of 10% indicate?

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52. Who typically generates investment recommendations for internal consumption within their organization?

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53. How is the dividend yield calculated?

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54. How can the growth rate used in valuation be calculated?

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55. What is the regulatory body that licenses professionals as Registered Investment Advisers (RIAs)?

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56. What is the term used to describe securities of companies that are in financial distress or near bankruptcy?

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57. In the Discounted Cash Flow (DCF) model, what is the purpose of discounting cash flows?

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58. What is the main characteristic of equity securities?

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59. Which type of risk affects the performance of businesses in a particular sector?

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60. How is the earnings yield calculated?

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61. What is the purpose of calculating the terminal value in the Discounted Cash Flow (DCF) model?

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62. What is the term used to describe preference shares that can be converted into a specified number of equity shares?

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63. Which industries benefit from inflation by increasing prices and experiencing higher profit margins?

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64. What is one advantage of technical analysis mentioned in the given text?

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65. What does the PEG ratio measure?

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66. What is the purpose of fundamental analysis in stock selection?

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67. What is the primary characteristic of equity securities?

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68. What does a P/E ratio of 10 suggest?

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69. What is the purpose of estimating intrinsic value in the top-down approach to stock analysis?

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70. How is the cost of equity calculated using the Capital Asset Pricing Model (CAPM)?

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71. Which valuation method is suitable for businesses that are capital intensive, such as cement and steel?

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72. What does "Don't put all your eggs in one basket" signify in relation to equity investments?

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73. What conclusions can be drawn from past price movements in technical analysis?

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74. What does a PEG ratio of 1 indicate?

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75. What does the term "competitive structure" refer to in industry analysis?

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76. What is the purpose of company analysis in the top-down approach to stock analysis?

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77. Which investment category is known for its unregulated market and relatively more illiquid nature?

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78. What is the most common stock valuation measure used by analysts?

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79. What does it mean if a preference share is cumulative?

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80. What is the top-down approach in fundamental analysis?

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81. Which investment vehicle allows investors to avail professional expertise at lower costs?

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82. How can relative valuation metrics help in understanding the gaps in calculated intrinsic values?

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