Monday, April 02, 2007

VOLUME SPEAKS VOLUMES


In valuating firms for the purpose of stock buy/sell or for the purpose of acquisitions, the focus is more on statistical/stochastic analysis based on historical data OR a DCF, based on a more futuristic estimate built upon free cash flows (other valuations like market multiples are less reliable). But the analysts and past academic research undermines the implication and effect on trade volumes per day. The implications of volumes to a trader, risk manager, acquisition consultant, and analyst are different

The Trader

The market still believes that the trade volume in terms of number of shares traded in a given time is a fair estimated of liquidity risk for the stock in question, but I believe that for comparing various stocks at same level, number of shares traded per unit market capitalization would be a more accurate measure. Still in most of the analytics in bloomberg, reuters etc the analysis tables are based on the volume, which doesn't accurately measure the intensity of the trend. For example: (http://www.bloomberg.com/apps/cbuilder?ticker1=GOOG:US).

Two ratio's which accurately capture the essence of the trade-volume characteristics would be:
(1)Trade-Volume per unit Market Capitalization
This would present a fair comparative against various stocks in the portfolio or market, and hence determine the intensity of the trend in case of a high value
(2)Trade-Volume per unit market trade-volume
To get a fair idea about a comparison with market in terms of significance of the trend

Risk Manager
The risk manager should be concerned about the trade volume-volatility during the day. A medium trade-volume with high trade volume-volatility enhances the liquidity risk, and thus affecting the VaR. The VaR value can be(and should be) modified to adjust for the effect of changed in trade-volume volatility in the Future.Thus,
VARactual=f(VARbased on historical returns) + f(VARvolume)
The VARvolume may be calculated as the least dollar amount you can lose if the returns on share remains constant, in case of liquidation of the position.
A more practical way of doing this is to get quotes for the stock from block traders of the total investment in the stock.

Acquisition Consultant/Analyst
A valuation should be based on a short term growth rates and the terminal value should be calculated after a shorter number of years, when the trade volumes are very high. High trade volumes indicate that the shareholders are expecting a short term, higher rate of return of the stock and hence the analyst should base his valuation in coherence with the market sentiments.Inverse applies when trade volumes are low.

A low trade-volume does not always indicate a weak market position, but a possibility of future potential growth.

Useful Extract:
"Increasing volume on increasing price indicates increasing buying pressure and a possible price advance.
Increasing volume on decreasing price indicates increasing selling pressure and a possible price decrease.
Decreasing volume on increasing price indicates easing buying pressure and a possible price plateau or reversal.
Decreasing volume on decreasing price indicates a slowing of selling pressure and a possible price plateau or reversal.
Higher-than-normal volume (spikes) at price highs indicates selling into strength and a price ceiling.
Higher than normal volume (spikes) at price lows indicates buying on weakness and price support. "1


Pic from http://www.cityequities.com/images/menu/coin2.jpg
*From discussions with Sumeet Sablok
**All the views are from understanding of the issues by the author and suggestions to improve methodologies in finance, and may not reflect the standard theories in practice.

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