Pairs trading – Identifying undervalued or overvalued assets through fundamental analysis

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If you trade over long intervals, one technical analysis is not enough to identify undervalued or overvalued asset, because the difference in their value could be caused by fundamental factors.

So fundamental analysis is used to estimate the relative values of the assets in the long term based on a comparison of financial multiples. The analysis can be performed on almost any financial indicators of the performance of a company.

As you know, there are many models of the fundamental measurement of fair value of shares, one of which is based on discounted future net income, the other on the carrying value of the company.

The first model assumes that the net profit of the company will increase its own capital, and since these profits will be available only in the future, it is discounted based on the current risk-free interest rate.

However, to accurately predict future flows of net income is impossible, so most of its current value is extrapolated to future periods. Given that we are talking about the valuation of the shares, then as the net profit ratio is used EPS ( born Earnings Per Share), reflects the net profit attributable to its common share :

\ mathrm {EPS} = \ frac {\ mathrm {I_N-D_P}} {\ mathrm {S_A}}

where:
IN – Retained profit for the period ;
DP – preferred dividends accrued during the period;
SA – the weighted average number of ordinary shares outstanding during the period.

Data on the company’s profits come from the profit and loss account. Knowing the EPS can roughly predict the future value of the book value (BV) of the shares used in the second model estimates the fair value of the shares.

The current value of BV is based on balance sheet data by dividing shareholders’ equity by the number of common shares:

\ mathrm {BV} = \ frac {\ mathrm {Equity}} {\ mathrm {Stocks}}

EPS and BV values are used to calculate the two most popular market value, which measures the attractiveness of common stock of a company. First, this ratio P / E, which is calculated by the following formula:

\ mathrm {P / E} = \ frac {\ mathrm {P}} {\ mathrm {EPS}}

where : P – the stock price , EPS – earnings per share.

In other words, the P / E ratio expresses the market value of the units of the company’s profits. A lower value of the coefficient indicates that the profit of the company estimated the market for less than the profit of the company from which the value is greater.

In addition, the P / E ratio shows how many periods must pass in order to fully cover the current stock price.

The second popular financial ratio P / BV, is calculated as the ratio of the current market price per share to its book value :

\ mathrm {P / BV} = \ frac {\ mathrm {P}} {\ mathrm {BV}}

This factor determines how much the stock is overvalued relative to its book value. In its crudest form, it means – what proportion of the spent funds for the purchase of shares, the investor will be able to reclaim in the event of bankruptcy of the company.

The coefficient of less than one indicates that the stock is trading below its carrying value and is undervalued, and vice versa, the value of the coefficient which is greater than one indicates that the company’s shares are overvalued.

Comparing the shares of the two companies, shows the advantage of a stock with a lower ratio of P / BV.

It should, however, be noted that the P / BV is important for industrial companies and financial institutions, and generally shows negligible importance for software companies and those in the service sector.

In addition, a comparison of various issuers of shares by means of coefficients is appropriate only in one industry, comparing the same companies from different sectors of the economy. It is necessary to know the average value of the coefficients for the industry as a whole.

Another formula, often used to compare the market value of the company, involves the P / S ratio, which reflects the ratio of market capitalization to the volume of its sales.

\ mathrm {P / S} = \ frac {\ mathrm {MCap}} {\ mathrm {Sales}}

This figure is considered in view of the fact that using the intricacies of accounting can significantly improve the P / E index, and the rate of P / S is very difficult to correct.

Pairs trading, as in the case with the strategies of Buy & Hold, you can significantly reduce your overall portfolio risk by simultaneously opening positions for a lot of couples. In such a case, even if some couples do not justify the expectations of a return on their relations to the mean.

Pairs transactions can be used by almost any investor, but at the same time keeping an eye on the huge number of possible pairs is very difficult.

This problem is addressed by modern software systems that enable real-time calculation of all necessary parameters for an unlimited number of couples, as well as automatically paired transactions on a predetermined algorithm, which makes the strategy of pairs trading more profitable.

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