1

UNIT 2
VALUATION OF SHARES

The Dividend Discount Model, also known as DDM, is in which stock price is calculated
based on the probable dividends that one will pay. They will be discounted at the expected
yearly rate. It is a way of valuing a company based on the theory that a stock is worth the
discounted sum of all of its future dividend payments. In other words, it is used to evaluate
stocks based on the net present value of future dividends.

The Dividend Discount Model (DDM) is a procedure for valuing the price of a
stock by using the predicted dividends and discounting them back to the present
value. If the value obtained from the DDM is higher than what the shares are
currently trading at, then the stock is undervalued.

The DDM is a tool used by many investors and analysts for choosing stocks. The greatest
disadvantage of the DDM is that it is inapplicable to companies which do not pay dividends.
In the DDM, a present stock value that is higher than a stock's market value indicates
that the stock is undervalued and that it is a good time to purchase shares.
A security with a greater risk must potentially pay a greater rate of return to induce investors
to buy the security. The required rate of return (aka capitalization rate) is the rate of return
required by investors to compensate them for the risk of owning the security. This
capitalization rate can be used to price a stock as the sum of its present values of its future
cash flows. The dividend discount model prices a stock by the sum of its future cash flows
discounted by the required rate of return that an investor demands for the risk of owning the
stock. Future cash flows include dividends and the sale price of the stock when it is sold. This
DDM price is the intrinsic value of the stock. If the stock pays no dividend, then the expected
future cash flow is the sale price of the stock.

Where;
D = Annual Dividend Payment
k = Capitalization Rate
P = Selling Price of Stock
n = Number of Years until Stock is Sold
In an efficient market, the market price of a stock is considered equal to the intrinsic
value of the stock, where the capitalization rate is equal to the market capitalization

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 1
2

rate, the average capitalization rate of all market participants.

Zero Growth DDM → The simplest variation of the dividend discount model assumes the
growth rate of the dividend remains constant into perpetuity, and the share price is equal to
the annualized dividend divided by the discount rate.

According to the zero-growth model, the stock price would be equal to the annual dividends
by the required rate of return as it assumes that there is no growth in dividends, i.e., the
dividend always stays the same. Intrinsic Value of Stock = Annual Dividends / Rate of
Return.

• It assumes that all dividends paid by a stock remain the same.

• Since the zero-growth model assumes that the dividend always stays the same,
the stock price would be equal to the annual dividends divided by the required
rate of return.

Intrinsic Value = Annual Dividends

---------------------------------
Required Rate of Return

Example:
If a preferred share or stock pays dividends of Rs. 100.00 per year, and the required rate of
return for the stock is 8%, then what is its intrinsic value?
Intrinsic Value = 100 / 0.08 = Rs. 1250.00

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 2
3

2. CONSTANT-GROWTH MODEL (GORDON GROWTH MODEL)

• It assumes that dividends grow by a specific percent annually.
• The constant-growth DDM (aka Gordon Growth model, because it was
popularized by Myron J. Gordon) assumes that dividends grow by a specific
percentage each year, and is usually denoted as g, and the capitalization rate is
denoted by k.

Intrinsic Value = D1
---------
k–g

Where;
D1 = Next Year’ Dividend
k = Capitalization Rate
g = Dividend Growth Rate
Example:
• If a stock pays Rs. 20.00 dividend this year, and the dividend has been growing 5%
annually, then what will be the price of the stock next year, assuming a required rate of return
of 10%?

Stock Price (Year 0) = 20 / 0.05 = Rs. 400.00

Stock Price (Year 1) = 20 (1.05) / (10% - 5%) = Rs. 420.00
• The constant-growth model is often used to value stocks of mature companies that have
increased the dividend steadily over the years. Although the annual increase is not always the
same, the constant-growth model can be used to approximate an intrinsic value of the stock
using the average of the dividend growth and projecting that average to future dividend
increases.
• Note that if both the capitalization rate and dividend growth rate remains the same every
year, then the denominator doesn't change, so the stock's intrinsic value will increase annually
by the percentage of the dividend increase.

VARIABLE-GROWTH MODEL (MULTI-STAGE GROWTH MODELS)

• It typically divides growth into 3 phases: a fast initial phase, then a slower transition phase
that ultimately ends with a lower rate that is sustainable over a long period.
• Variable-growth rate models (aka multi-stage growth models) can take many forms, even
assuming the growth rate is different for every year. However, the most common form is one
that assumes 3 different rates of growth: an initial high rate of growth, a transition to slower
growth, and lastly, a sustainable, steady rate of growth. Basically, the constant-growth rate
model is extended, with each phase of growth calculated using the constant-growth method,
but using 3 different growth rates of the 3 phrases. The present values of each stage
are added together to derive the intrinsic value of the stock.

TWO STAGE GROWTH MODEL

MEANING:
DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 3
4

The two-stage dividend discount model takes into account two stages of growth. This
method of equity valuation is not a model based on two cash flows but is a two-stage
model where the first stage may have a high growth rate and the second stage is usually
assumed to have a stable growth rate.
The two-stage model can be used to value companies where the first stage has an
unstable initial growth rate and there is a stable growth in the second stage which lasts
forever. The first stage may have a positive, negative, or a volatile growth rate and will
last for a finite period while the second stage is assumed to have a stable growth rate
for the rest of the life of the company. In this model, it is assumed that the dividend paid
by a company also grows in the exact way i.e. in two such stages.

EXAMPLE
Let us take an example of a company that has paid a dividend of Rs. 4.00 this year.
Assuming a higher growth for next 3 years at 15% and a stable growth of 4% thereafter;
let us calculate the value using a two-stage dividend discount model assuming a
required rate of return of 10%.

Current Dividend = Rs. 4.00

Dividend after 1st year will be = Rs. 4.60 (4 x 1.15)
Dividend after 2nd year will be = Rs. 5.29 (4.60 x 1.15)
Dividend after 3rd year will be = Rs. 6.08 (5.29 x 1.15)
The second stage has a growth rate of 4% and hence the dividend value after 4th year
will be Rs. 6.08 x 1.04 = Rs. 6.32.
Assuming this as the constant dividend for the rest of the company’ life of the company,
we arrive at the present values as follows:
Value = Rs. 6.32 / (10% - 4%) = Rs. 105.33.
Rs. 4.60 / (1 + 10%)1 = Rs. 4.18
Rs. 5.29 / (1 + 10%)2 = Rs. 4.37
Rs. 6.08 / (1 + 10%)3 = Rs. 4.57
Rs. 105.33 / (1 + 10%)3 = Rs. 79.13
Present Value = Rs. 92.25

If the market price of the company’s share is lower than the calculated value using the
model; this means the stock price is undervalued which could mean that our estimates
of the growth of the company are higher than what market perceives. On the other
hand, if the market price is higher than the model output; it means the market expects
the company to grow faster than our estimates.

MULTI STAGE DIVIDEND DISCOUNT MODEL

MEANING:
Multi-stage dividend discount model is a technique used to calculate intrinsic value of a stock
by identifying different growth phases of a stock; projecting dividends per share for each of
the periods in the high growth phase and discounting them to valuation date, finding terminal
value at the start of the stable growth phase using the Gordon growth model, discounting it
back to the valuation date and adding it to the present value of the high-growth phase
DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 4
5

dividends. The basic concept behind the multi-stage dividend discount model is the same as
constant-growth model, i.e. it bases intrinsic value on the present value of expected future
cash flows of a stock. The difference is that instead of assuming a constant dividend growth
rate for all periods in future, the present value calculation is broken down into different
phases.

EXAMPLE:
Current Stock Price = Rs. 40
Expected Dividend Growth Rate = 25%, 20%, 15%, 10%, 5% for 5 Initial Years
respectively and 5% stable growth rate from
6th year onwards
Recent Dividend = Rs. 1.5 per share
Cost of Equity = 10%

PV of Stable Growth Phase = 1 / (1.10)5 * 3.14 / (10%-5%) = Rs. 39.00

Intrinsic value of the stock
= PV of dividends in high-growth phase + PV of terminal value

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 5
6

= Rs. 9.33 + Rs. 39.00

= Rs. 48.3

Relative valuation, also referred to as comparable valuation, is a very useful and effective
tool in valuing an asset. Relative valuation involves the use of similar, comparable assets in
valuing another asset.

The book value is the value of assets minus the value of the liabilities. The market value of
acompany is the market price of one of its shares multiplied by the number of shares
outstanding. The book-to-market ratio is a useful indicator for investors who need to assess
the value of a company.

P/E Ratio
Value investors have long considered the Price Earnings ratio (also known as the P/E
ratio) a useful metric for evaluating the relative attractiveness of a company's stock price.
Made popular by the late Benjamin Graham, who was also known as the "Father of Value
Investing" as well as Warren Buffett's mentor?
P/E ratio is one of the widely used and common stock valuation tool. It is a ratio of a
company’s current market share price compared to its annual earnings per share.

EXAMPLE:
Company ABC may have reported earnings of Rs. 10 per share, while company XYZ has
reported earnings of Rs. 20 per share. Each is selling on the stock market for Rs. 50.
What does this mean?

Company ABC has a price-to-earnings ratio of 5, while Company XYZ has a P/E ratio of
2.5. This means company XYZ is much cheaper on a relative basis. For every share
purchased, the investor is getting Rs. 20 of earnings as opposed to Rs. 10 in earnings
from ABC. All else being equal, an intelligent investor should opt to purchase shares of
XYZ

The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per
share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative
value of a company's stock. It's handy for comparing a company's valuation against its
historical performance, against other firms within its industry, or the overall market.

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 6
7

Relative valuation models are used to value companies by comparing them to other
businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. The
logic is that if similar companies are worth 10x earnings, then the company that’s being
valued should also be worth 10x its earnings. This guide will provide detailed examples of
how to perform relative valuation analysis.

Market Value Method:

This method is used only in case of listed companies, since they have a market value.
Market value of a company = No. of shares outstanding × market price per share

TECHNICAL ANALYSIS
Meaning: It is the process of identifying trend reversal at the earliest to formulate the
buying and selling strategy
Technical analysis is a method of evaluating securities by analyzing the statistics
generated by marketing activities: such as fast price and volume.
Technical analysis does not attempt to measure a securities in intrinsic values but
instead use charts and other tools to identify pattern that can suggest future Activity.
Technical analysis takes a completely different approach; it doesn't care one bit about
the "value" of a company or a commodity. Technicians (sometimes called chartists)
are only interested in the price movements in the market.
Technical analysis attempts to understand the emotions in the market by studying the
market itself, as opposed to its components.
Technical analysis really just studies supply and demand in a market in an attempt to
determine what direction, or trend, will continue in the future.
Technical analysis is a method of evaluating securities by analyzing the statistics
generated by market activity, such as past prices and volume.
Technical analysts do not attempt to measure a security's intrinsic value, but instead
use charts and other tools to identify patterns that can suggest future activity.
ASSUMPTION
The market value of the scrip is determined by the interaction of supply and
demand.
The market discounts everything.
The market always moves in trend.
Any layman knows the fact that history repeats itself.

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 7
8

TECHNICAL TOOLS:

It is a process of identifying trend reversal at earlier stages to formulate the buying and
selling strategy. With the help of various indicators they analyse the relationship between
price& volume, supply & demand, etc. An investor who does this analysis is called
technician.

ASSUMPTIONS:
1.The market value is determined by the interaction of supply and demand.

2.The market discounts everything. The information regarding the issuing of bonus shares
and right issues may support the prices. These are some of the factors which cause shift in
demand & supply and change in direction of trends.

3.The market always moves in trend, except for certain minor deviations. The trend may
either be increasing or decreasing. It may continue in same manner or reverse.

4.In the rising market, many purchase shares in greater volume. When the market moves
down, people are interested in selling it. The market technicians assume that past prices
predict the future.

Price indicator :
The Dow Theory
The Dow Theory has always been a very integral part of technical analysis. The Dow Theory
was used extensively even before the western world discovered candlesticks. In fact, even
today, Dow Theory concepts are being used. In fact, traders blend the best practices from
Candlesticks and Dow Theory.

The Dow Theory was introduced to the world by Charles H. Dow, who also founded the
Dow-Jones financial news service (Wall Street Journal). During his time, he wrote a series of
articles starting from the 1900s which in the later years was referred to as ‘The Dow Theory’.
Much credit goes to William P Hamilton, who compiled these articles with relevant examples
over a period of 27 years. Much has changed since the time of Charles Dow, and hence there
are supporters and critics of the Dow Theory.

The Dow Theory Principles

The Dow Theory is built on a few beliefs. These are called the Dow Theory tenets. Charles H
Dow developed these tenets over the years of his observation on the markets. 9 tenets are
considered as the guiding force behind the Dow Theory. They are as follows:

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 8
 9

Sl
Tenet What does it mean?
No

The stock market indices discount everything which is known & unknown in
01 Indices discounts everything the public domain. If a sudden and unexpected event occurs, the stock market
indices quickly recalibrate itself to reflect the accurate value

Overall there are 3 broad market

02 Primary Trend, Secondary Trend, and Minor Trends
trends.

This is the major trend of the market that lasts from a year to several years. It
indicates the broader multiyear direction of the market. While the long term
03 The Primary Trend
investor is interested in the primary trend, an active trader is interested in all
trends. The primary trend could be a primary uptrend or a primary downtrend

These are corrections to the primary trend. Think of this as a minor counter-
reaction to the larger movement in the market. Example – corrections in the
04 The Secondary Trend
bull market, rallies & recoveries in the bear market. The counter-trend can
last anywhere between a few weeks to several months

These are daily fluctuations in the market; some traders prefer to call them
05 Minor Trends/Daily fluctuations
market noise

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 9
 10

We cannot confirm a trend based on just one index. For example, the market
All Indices must confirm with is bullish only if CNX Nifty, CNX Nifty Midcap, CNX Nifty Smallcap etc.
06
each other. all move in the same upward direction. It would not be possible to classify
markets as bullish, just by the action of CNX Nifty alone

The volumes must confirm along with the price. The trend should be
supported by volume. The volume must increase as the price rises and should
07 Volumes must confirm reduce as the price falls in an uptrend. In a downtrend, the volume must
increase when the price falls and decrease when the price rises. You could
refer chapter 12 for more details on volume

Markets may remain sideways (trading between a range) for an extended

Sideway markets can substitute period. Example:- Reliance Industries between 2010 and 2013 was trading
08
secondary markets. between 860 and 990. The sideways markets can be a substitute for a
secondary trend

The closing price is the most Between the open, high, low and close prices, the close is the most important
09
sacred. price level as it represents the final evaluation of the stock during the day.

The different phases of Market

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 10
11

Dow Theory suggests the markets are made up of three distinct phases, which are self-
repeating. These are called the Accumulation phase, the Markup phase, and the Distribution
phase.

The Accumulation phase usually occurs right after a steep sell-off in the market. The steep
sell-off in the markets would have frustrated many market participants, losing hope of any
uptrend in prices. The stock prices would have plummeted to rock bottom valuations, but the
buyers would still be hesitant to buy fearing another sell-off. Hence the stock price languishes
at low levels. This is when the ‘Smart Money’ enters the market.

Smart money is usually the institutional investors who invest in a long term perspective. They
invariably seek value investments which are available after a steep sell-off. Institutional
investors start to acquire shares regularly, in large quantities over an extended period of time.
This is what makes up an accumulation phase. This also means that the sellers trying to sell
during the accumulation phase will easily find buyers, and therefore the prices do not decline
further. Hence invariably, the accumulation phase marks the bottom of the markets. More
often than not, this is how the support levels are created. Accumulation phase can last up to
several months.

Once the institutional investors (smart money) absorb all the available stocks, short term
traders since the support. This usually coincides with the improved business sentiment. These
factors tend to take the stock price higher. This is called the markup phase. During the
Markup phase, the stock price rallies quickly and sharply. The most important feature of the
markup phase is speed. Because the rally is quick, the public at large is left out of the rally.
New investors are mesmerized by the return, and everyone from the analysts to the public
sees higher levels ahead.

Finally, when the stock price reaches new highs (52 weeks high, all-time high), everyone
around would be talking about the stock market. The news reports turn optimistic, business
environment suddenly appears vibrant, and everyone (public) wants to invest in the markets.
By and large, the public wants to get involved in the markets as there is a positive sentiment.
This is when the distribution phase occurs.

The judicious investors (smart investors) who got in early (during the accumulation phase)
will start offloading their shares slowly. The public will absorb all the volumes offloaded by
the institutional investors (smart money) there by giving them the well-needed price support.
The distribution phase has similar price properties as that of the accumulation phase.
Whenever the prices attempt to go higher in the distribution phase, the smart money offloads
their holdings. Over a period of time, this action repeats several times, and thus the resistance
level is created.

Finally, when the institutional investors (smart money) completely sell off their holdings,
there would no further support for prices. Hence, what follows after the distribution phase is a
complete sell-off in the markets, also known as the mark down of prices. The selloff in the
market leaves the public in an utter state of frustration.

Completing the circle, what follows the selloff phase is a fresh round of accumulation phase,
and the whole cycle repeats. It is believed that that entire cycle from the accumulation phase
to the selloff spans over a few years.

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 11
 12

It is important to note that no two market cycles are the same. For example, in the Indian
context, the bull market of 2006 – 07 is way different from the bull market of 2013-14.
Sometimes the market moves from the accumulation to the distribution phase over a
prolonged multi-year period. On the other hand, the same move from the accumulation to the
distribution can happen over a few months. The market participant needs to tune himself to
evaluating markets in the context of different phases, as this sets a stage for developing a
view on the market.

The Dow Patterns

Like in candlesticks, there are few important patterns in Dow Theory as well. The trader can
use these patterns to identify trading opportunities. Some of the patterns that we will study
are:

1. The Double bottom & Double top formation

2. The Triple Bottom & Triple Top
3. Range formation, and
4. Flag formation
The support and resistance is also a core concept for the Dow Theory, but we have discussed
it much earlier a chapter dedicated to it because of its importance (in terms of placing targets
and stop-loss).

The Double bottom and top formation

A double top & double bottom is considered a reversal pattern. A double bottom occurs when
a stock’s price hits a shallow price level and rebounds back with a quick recovery. Following
the price recovery, the stock trades at a higher level (relative to the low price) for at least 2
weeks (well spaced in time). After which the stock attempts to hit back to the low price
previously made. If the stock holds up once again and rebounds, then a double bottom is
formed.

A double bottom formation is considered bullish, and hence one should look at buying
opportunities. Here is a chart that shows a double bottom formation in Cipla Limited:

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 12
13

Notice the time interval between the two bottom formations. The price level was well spaced
in time.

Likewise, in a double top formation, the stock attempts to hit the same high price twice but
eventually sells off. Of course, the time gap between the two attempts of crossing the high
should at least be 2 weeks. In the chart below (Cairn India Ltd), we can notice the double top
at 336 levels. On close observation, you will notice the first top was around Rs.336, and the
second top was around Rs.332. With some amount of flexibility, a small difference such as
this should be considered alright.

From my own trading experience, I find both double tops and double bottoms handy while
trading. I always look for opportunities where the double formation coincides with a
recognizable candlesticks formation.

For instance, imagine a situation wherein the double top formation, the 2nd top forms a
bearish pattern such as a shooting star. This means, both from the Dow Theory and
candlestick perspective there is consensus to sell; hence the conviction to take the trade is
higher.

The triple top and bottom

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 13
14

As you may have guessed, a triple formation is similar to a double formation, except that the
price level is tested thrice as opposed twice in a double bottom. The interpretation of the
triple formation is similar to the double formation.

As a rule of thumb, the more number of times the price tests, and reacts to a certain price
level, the more sacred the price level is considered. Therefore by this, the triple formation is
considered more powerful than the double formation.

The following chart shows a triple top formation for DLF Limited. Notice the sharp sell-off
after testing the price level for the 3rd time, thus completing the triple top.

Key takeaways from this chapter

TECHNICAL ANALYSIS VS FUNDAMENTAL ANALYSIS

Fundamental analysis is a method of evaluating securities by attempting to measure

the intrinsic value of a stock. Fundamental analysts study everything from the overall
economy and industry conditions to the financial condition and management of companies.
Earnings, expenses, assets and liabilities are all important characteristics to fundamental
analysts.

Technical analysis differs from fundamental analysis in that the stock's price and
volume are the only inputs. The core assumption is that all known fundamentals are factored
into price; thus, there is no need to pay close attention to them. Technical analysts do not
attempt to measure a security's intrinsic value, but instead use stock charts to identify patterns
and trends that suggest what a stock will do in the future.

The most popular forms of technical analysis are simple moving averages, support
and resistance, trend lines and momentum-based indicators.

Simple moving averages are indicators that help assess the stock's trend by averaging
the daily price over a fixed time period. Buy and sell signals are generated when a shorter
duration moving average crosses a longer duration one.
DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 14
15

Support and resistance utilize price history. Support is defined as areas where buyers
have stepped in before, while resistance consists of the areas where sellers have impeded
price advance. Practitioners look to buy at support and sell at resistance.

Trend lines are similar to support and resistance, as they give defined entry and exit
points. However, they differ in that they are projections based on how the stock has traded in
the past. They are often utilized for stocks moving to new highs or new lows where there is
no price history.

Advances and Declines

Advances and declines refers generally to the number of stocks (or other assets in a particular
market) that closed at a higher and those that closed at a lower price than the previous day,
respectively. Technical analysts look at advances and declines to analyze stock market
behavior, discern volatility, and predict whether a price trend is likely to continue or reverse.

Typically, a market will be more bullish if more stocks advance than decline and vice versa
Advances and declines form the basis of many different technical indicators, including the
advance-decline ratio, the advance-decline index, and the absolute breadth index. For

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 15
16

example, a low advance-decline ratio can indicate an oversold market, while a high advance-
decline ratio can signal an overbought market.1

Either of these conditions could mean that a market trend has become unsustainable and is
about to reverse.

Often times, traders combine the advances and declines indicators with other forms of
technical analysis. A great example would be looking at momentum indicators, like the
relative strength index (RSI) or moving average convergence-divergence (MACD) for a
divergence, and then looking at advances and declines as a confirmation that a trend change
is beginning to occur.

Advances and Declines Indicators

There are many different technical indicators that are calculated using advances and declines:

Advance-decline ratio: The advance-decline ratio, or ADR, compares the number of stocks
that closed higher against the number of that closed lower during a particular period (and can
be used across many timeframes).
Advance-decline index: The advance-decline Index, or ADI, is a market breadth indicator
that represents the total difference between advancing and declining securities within an
index. Sometimes, the current index level is represented as a horizontal line on a price chart
known as the advance-decline line.

Absolute breadth index: The absolute breadth Index, or ABI, is a technical indicator that's
based on the differences between advances and declines on an index. Unlike the prior two
readings, the ABI ignores the direction that prices are going and instead focuses purely on the
differences to measure volatility.

New highs and lows- circuit filters.

Lower circuits are calculated based on the closing price of the previous day and it may vary
from stock to stock. The maximum price a stock can reach on a given trading day is called
the “upper circuit” and a minimum price that a stock can hit on a particular trading day is
known as the “lower circuit”.

A high-low index is an index that tracks the new 52-week highs and new 52-week lows
between stocks in a prevailing index. It is used in technical analysis, analysis of charts, and
past stock data as an indicator to determine the direction of the market or index – whether the
market will go up or down.

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 16
17

As per this regulatory mechanism, benchmark indices can move only within a prescribed
range. They cannot go above or below the stipulated upper and lower limits respectively.
These limits are known as circuit-breakers, circuit filters, or simply, circuits.

In the Indian stock market, an upper circuit and a lower circuit are mechanisms that are used
to regulate extreme price movements of stocks or securities. These circuit filters, also known
as price bands, are put in place to prevent stocks from being overbought or oversold, which
could result in volatile market conditions.

An upper circuit is the maximum percentage increase in the price of a stock in a single
trading session. When a stock hits its upper circuit, trading in that particular stock is
temporarily suspended. This is to prevent investors from continuously buying the stock at
inflated prices, which could cause a market bubble.

On the other hand, a lower circuit is the maximum percentage decrease in the price of a stock
in a single trading session. When a stock hits its lower circuit, trading in that particular stock
is also temporarily suspended. This is to prevent investors from continuously selling the stock
at deflated prices, which could cause a market crash.

It is important to note that upper and lower circuits are calculated based on the previous
closing price of the stock. The percentage increase or decrease is predetermined by the stock
exchange and varies from stock to stock. The circuit filters are put in place by the Securities
and Exchange Board of India (SEBI) to promote stability in the stock market.

Investors need to be aware of the circuit filters when making investment decisions. For
example, if a stock is trading close to its upper circuit, it may not be a good time to buy that
stock, as the chances of a price correction are higher. Similarly, if a stock is trading close to
its lower circuit, it may not be a good time to sell that stock, as the chances of a price rebound
are higher.

Upper and lower circuits for stocks

Stock exchanges set up a price band for each stock based on its last traded price. This is done
to protect investors from sudden and extreme price fluctuations in a single trading session.
These price bands are commonly referred to as upper and lower circuits.

The purpose of setting up these price bands is to protect investors from the drastic volatility
of the stock market. Stock prices are affected by a range of factors such as news, events, and
market sentiment. Without these circuit filters in place, investors may panic and make hasty
decisions, leading to market bubbles or crashes.

By putting these circuit filters in place, investors are assured of some stability in the stock
market. They can make informed decisions based on prevailing market conditions without
having to worry about sudden and extreme price movements.

Upper and lower circuits for indices

DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 17
18

In addition to individual stocks, upper and lower circuits are also applied to stock indices in
the Indian stock market. A stock index is a benchmark that represents the overall
performance of a group of stocks in a particular market. Some examples of stock indices in
the Indian market include the BSE Sensex and the NSE Nifty 50.

In India, a circuit breaker is triggered when the index experiences a 10%, 15%, or 20% rise or
fall. If the index moves by 10% after 2:30 pm, trading will continue, as end-of-day trading is
typically more volatile. However, if the movement occurs between 1 pm and 2:30 pm, trading
will be halted for 15 minutes. If it happens before 1 pm, trading will be suspended for 45
minutes.

If the index moves by 15%, trading will be halted for the remainder of the trading day if it
occurs after 2:30 pm. If the movement happens between 1 pm and 2:30 pm, trading will be
suspended for 45 minutes. If it occurs before 1 pm, trading will be suspended for 1 hour and
45 minutes.

If the index experiences a 20% rise or falls at any time during the trading day, trading will be
suspended for the day. This circuit breaker system helps prevent extreme market volatility,
protects investors from significant losses, and provides them with time to reassess their
positions.

Drives the upper/lower circuit

The forces of demand and supply are the most fundamental drivers that lead a company to
reach the point of upper or lower circuit in the Indian stock market. However, several other
factors can also impact the demand and supply of a particular stock or index, leading to its
maximum high or low price points.

Below are the details about the same:

Change in the structure of the organization due to mergers and acquisitions

When two companies merge, investors may anticipate an improvement in the financial
performance of the newly formed company, leading to an increase in demand for its stock.
Similarly, when a company acquires another company, it may lead to a decrease in demand
for its stock due to the additional debt burden it may take on.

Political disturbances

This can also impact the demand and supply of stocks. Unrest, instability, or conflict in a
country can lead to a decrease in investor confidence, causing a fall in stock prices. On the
other hand, political stability and favorable policies can lead to an increase in investor
confidence and a rise in stock prices.

Changes in trade agreements

This is another factor that impacts the demand and supply of stocks. A favorable trade
agreement can lead to an increase in demand for stocks of companies that stand to benefit
DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 18
19

from the agreement. Conversely, an unfavorable trade agreement can lead to a decrease in
demand for such stocks.

Changes in interest rates

An increase in interest rates can lead to a decrease in borrowing and investment, leading to a
fall in stock prices. Conversely, a decrease in interest rates can lead to an increase in
borrowing and investment, leading to a rise in stock prices.

Financial performance of a company

This is another critical factor that impacts the demand and supply of its stock. A company
with strong financial performance is likely to attract more investors, leading to an increase in
demand for its stock. On the other hand, a company with weak financial performance is likely
to discourage investors, leading to a decrease in demand for its stock.

Expansions, insolvencies, and consolidations

When a company announces an expansion, investors may anticipate an increase in its future
revenue, leading to an increase in demand for its stock. Conversely, when a company faces
insolvency or consolidation, investors may anticipate a decrease in its future revenue, leading
to a decrease in demand for its stock.

Investor confidence

Positive news about a company or index can lead to an increase in investor confidence and a
rise in stock prices. Conversely, negative news about a company or index can lead to a
decrease in investor confidence and a fall in stock prices.

Five essential facts related to the upper and lower circuit

ESSENTIAL FACTS RELATED TO THE UPPER AND LOWER CIRCUIT:

1. Circuit filters are implemented on the previous day's closing price. This means that the
upper and lower circuits are calculated based on the previous day's closing price of the stock.

2. You can find the circuit filters on the stock exchange's website. The upper and lower
circuit levels are publicly available information and can be easily found on the website of the
stock exchange.

3. Stocks generally start with a 20% circuit. This means that the circuit limit is set at 20%
of the previous day's closing price of the stock.

4. When a stock hits its upper circuit, it means that the stock's price has increased by the
maximum limit allowed for the day. In such a scenario, there are only buyers and no sellers
for that stock. Similarly, when a stock hits its lower circuit, it means that the stock's price has
decreased by the maximum limit allowed for the day. In this scenario, there are only sellers
and no buyers for that stock.
DR. MEENAKSHI BINDAL
BBA 5
UNIT 2 , IAPM
Page 19
20

5. Intraday trades are converted to delivery when the upper or lower circuit is hit. When a
stock hits its upper or lower circuit, intraday trades are automatically converted to delivery
trades. This is because trading in that PARTICULAR stock is halted for the rest of the day,
and the only way to trade in that stock is through delivery.

DR. MEENAKSHI BINDAL

BBA 5
UNIT 2 , IAPM
Page 20