Organization and Management

BSBA (Financial Management)

1st Semester, A.Y. 2021-2022

Lesson 2: Fundamental and Technical Analysis for Investing in

Stock
Aim

The aim of this chapter is to:

▪ Introduce fundamental analysis

▪ Explain economic analysis
▪ Explicate industry analysis

Objectives

The objectives of this chapter are to:

▪ Enlist the influence of the economy on companies

▪ Elucidate company analysis
▪ Explain technical analysis

Learning outcome

At the end of this chapter, you will be able to:

▪ Identify the tools of technical analysis

▪ Understand industry life cycle
▪ Recognize the characteristics of industry analysis

Introduction Fundamental analysis is really a logical and systematic approach to estimating the future
dividends and share price. It is based on the basic premise that share price is determined by a number of
fundamental factors relating to the economy, industry and company. In other words, fundamental analysis means
a detailed analysis of the fundamental factors affecting the performance of companies.

Each share is assumed to have an economic worth based on its present and future earning capacity.
This is called its intrinsic value or fundamental value. The purpose of fundamental analysis is to evaluate the
present and future earning capacity of a share based on the economy, industry and company fundamentals and
thereby assess the intrinsic value of the share. The investor can compare the intrinsic value of the share with
the prevailing market price to arrive at an investment decision. If the market price of the share is lower than its
intrinsic value, the investor would decide to buy the share as it is underpriced. The price of such share is expected
to move up in the future to match with its intrinsic value.

Influence of the Economy

Companies are a part of the industrial and business sector, which in turn is a part of the overall economy.
Thus, the performance of a company depends on the performance of the economy in the first place. If the
economy is in recession or stagnation, ceteris paribus, the performance of companies will be bad in general,
with some exceptions, however. On the other hand, if the economy is booming, incomes are rising and the
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

demand is good, then the industries and the companies in general may be prosperous, with some exceptions
however.

Fundamental analysis thus involves three steps:

• Economic analysis
• Industry analysis
• Company analysis

Economic Analysis

The performance of a company depends on the performance of the economy. Let us look at some of the
key economic variables that an investor must monitor as part of his fundamental analysis.

Growth rate of national income The rate of growth of the national economy is an important variable to be
considered by an investor. GNP (Gross National Product), NNP (Net National Product) and GDP (Gross
Domestic Product) are the different measures of the total income or total economic output as a whole. The
estimated growth rate of the economy would be a pointer towards the prosperity of the economy. An economy
typically passes through different stages of prosperity known as economic or business cycle.

The four stages of an economic cycle are as follows:

• Depression: This is the worst of the four stages. During a depression, demand is low and declining.
Inflation is often high and so are interest rates.
• Recovery stage: The economy begins to receive after a depression. Demand picks up leading to more
investments in the economy. Production, employment and profits are on the increase.
• Boom: The phase of the economic cycle is characterized by high demand. Investments and production
are maintained at a high-level to satisfy the high demand. Companies generally post higher profits.
• Recession: The boom phase gradually slows down. The economy slowly begins to experience a
downturn in demand, production employment, etc.; the profits of companies also start to decline. This is
the recession stage of the economy.

Inflation

Inflation leads to erosion of purchasing power in the hands of consumers, this will result in lower the
demand of products. Inflation prevailing in the economy has considerable impact on the performance of
companies. Higher rate of inflation upsets business plans.

Interest rates

Interest rates determine the cost and availability of credit for companies operating in an economy. A low
interest rate stimulates investment by making credit available easily and cheaply. On the contrary, higher interest
rates result in higher cost of production which may lead to lower profitability and lower demand.

Government Revenue, Expenditure and Deficits

Government is the largest investor and spender of money, the trend in government revenue and
expenditure and deficit have a significant impact on the performance of industries and companies’
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

expenditure by the government stimulates the economy by creating jobs and generating demand. The nature of
government spending is of greater importance in determining the fortunes of many companies.

Exchange rates

The performance and profitability of industries and companies that are major importers or exporters are
considerably affected by the exchange rates of the rupee against major currencies of the world. A depreciation
of the rupee improves the competitive position of Indian products in the foreign markets, thereby stimulating
exports. However, it would also make import more expensive. A company depending more on imports may find
that devaluation of the rupee affects its profitability adversely.

Infrastructure

The development of an economy depends very much on the infrastructure available. The availability of
infrastructure facilities, such as power, transportation, and communication systems affects the performance of
companies’ bad infrastructure lead to inefficiencies, lower productivity, wastage and delays.

Monsoon

The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of
the Indian economy. The performance of agriculture to a very extent depends on the monsoon; the adequacy of
the monsoon determines the success or failure of the agricultural activities in India.

Economic and political stability

A stable political environment is necessary for steady and balanced growth. Stable long-term economic
policies are what are needed for industrial growth. Such stable policies emanate only from stable political
systems as economic and political factors are interlinked.

INDUSTRY ANALYSIS

An industry ultimately invests money in the securities of one or more specific companies, each company
can be characterized as belonging to an industry. The performance of companies would therefore, be
influenced by the fortunes of the industry to which it belongs. An industry “as a group of firms producing
reasonably similar products which serve the same needs of common set of buyers.

INDUSTRY LIFE CYCLE

The industry life cycle theory is generally attributed to Julius Grodinsky. According to the industry life
cycle theory, the life of an industry can be segregated into to the pioneering stage the expansion stage, the
stagnation stage, and the decay stage. This kind of segregation is extremely useful to an investor, because the
profitability of an industry depends upon its stage of growth.

Pioneering stage

This is the first stage in the industrial life cycle of a new industry, where the technology as well as the
products are relatively new and have not reached a state of perfection. Pioneering stage is characterized by
rapid growth in demand for the output of industry. As a result, there is a greater opportunity for profit. Many firms
compete with each other vigorously. Weak firms are eliminated and a lesser number of firms survive the
pioneering stage. Example: Leasing industry.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Expansion stage

Once an industry has established itself, it enters the second stage of expansion or growth. These
companies continue to become stronger. Each company finds a market for itself and develops its own strategies
to sell and maintain its position in the market. The competition among the surviving companies brings about
improved products at lower prices. Companies in the expansion stage of an industry are quite attractive for
investment purposes.

Stagnation stage

In this stage, the growth of the industry stabilizes. The ability of the industry to grow appears to have
been lost. Sales may be increasing, but at a slower rate than that experienced by competitive industries or by
the overall economy. The transition of an industry from the expansion stages to stagnation stages is very slow.
Important reason for this transition is change in social habits and development of improved technology. Example:
The black and white television industry in India provides is a good example of an industry which passed from the
expansion stages to stagnation stage.

Decay stage

Decay stage occurs when the products of the industry are no longer in demand. New products and new
technologies have come to the market. Customers have changed their habits, style and liking. As a result, the
industry become obsolete and gradually ceases to decay of an industry.

INDUSTRY CHARACTERISTICS

In an industry analysis, there are a number of key characteristics that should be considered by the
analyst.

Demand supply gap The demand for the product usually tends to change at a steady rate, whereas the
capacity to produce the product tends to change at irregular intervals, depending upon the installation of
additional production capacity. As a result, an industry is likely to experience under-supply and over-supply of
capacity at different times. Excess supply reduces the profitability of the industry through a decline in the unit
price realization. On the contrary, insufficient supply tends to improve the profitability through higher unit price
realization.

Competitive conditions in the industry The level of competition among various companies in an industry
is determined by certain competitive forces. These competitive forces are:

• Barriers to entry
• The threat of substitution
• Bargaining power of the suppliers
• The rivalry among competitors

Permanence

Permanence is the phenomenon related to the products and the technology used by the industry. If an
analyst feels that the need for a particular industry will vanish in a short period, or that the rapid technological
changes would render the products obsolete within short period of time, it would be foolish to invest in such
industry.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Labor conditions

In our country, the labor unions are very powerful. If the labor in a particular industry is rebellious and is
inclined to resort to strikes frequently, the prospects of that industry cannot become bright.

Attitude of government

The government may encourage certain industries and can assist such industries through favorable
legislation. On the contrary, the government may look with disfavor on certain other industries. In India this has
been the experience of alcoholic drinks and cigarette industries. A prospective investor should consider the role
that the government is likely to play in the industry.

Supply of raw materials

This is also one of the important factors that determines the profitability of an industry. Some industry
may have no difficulty in obtaining the major raw materials as they may be indigenously available in plenty. Other
industries may have to depend on a few manufactures within the country or on imports from outside the country
for their raw material supply.

Cost structure

The cost structure, that is the fixed and variable cost, affect the cost of production and profitability of the
firm. The higher the fixed cost component, higher is the sales volume necessary to achieve breakeven point.
Conversely, the lower the proportion of fixed cost relative to variable cost, lower would be the breakeven point.
It provides higher margin of safety. So, an analyst would consider favorably an industry that has a lower
breakeven point.

COMPANY ANALYSIS

Company analysis is the final stage of fundamental analysis. The economy analysis provides the investor
a broad outline of the prospects of growth in the economy, the industry analysis helps the investor to select the
industry in which investment would be rewarding. Now, he has to decide the company in which he should invest
his money. Company analysis provides answer to this question. In company analysis, the analyst tries to forecast
the future earnings of the company, because there is a strong evidence that the earnings have a direct and
powerful effect upon share prices. The level, trend and stability of earnings of a company, however depend upon
a number of factors concerning the operations of the company.

Financial statements

The financial statements of a company help to assess the profitability and financial health of the company.
The two basic financial statements provided by a company are the balance sheet and the profit and loss account.
The balance sheet indicates the financial position of the company on a particular date, namely the last day of
the accounting year. The profit and loss account, also called income statement, reveals the revenue earned, the
cost incurred and the resulting profit and loss of the company for one accounting year.

Analysis of financial statements

Financial ratios are most extensively used to evaluate the financial performance of the company, it also
helps to assess the whether the financial performance and financial strengths are improving or deteriorating,
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

ratios can be used for comparative analysis either with other firms in the industry through a cross sectional
analysis or a time series analysis.

TECHNICAL ANALYSIS

Technical analysis is explained in the paragraphs given below. Importance of timing in investment. While
fundamental analysis and security evaluation explain why share prices fluctuate, how they are determined and
what to buy or sell, the technical analysis will help the decision, when to buy and traditional theory of capital
market efficiency postulates, that entry into the market at any time leads to the same average return as that of
the market. However, in the real world of imperfections, are investors who have burnt their fingers by entering
the market at the wrong time. Investment timing is, therefore, crucial as the market is continuously jolted by
waves of buying and selling and prices are moving in trends and cycles and are never stable. The stock market
is different from other markets, as there is a continuous buying and selling and bid and offer rates as under a
system of auctions. The resultant prices, led by the sheer force of the market, may fluctuate either way and may
exhibit waves or trends. Entry and exit in the market will, therefore, make all the difference to the spread between
buying and selling prices and the profits or losses. Timing of investment is, therefore, of vital importance for
trading in the stock market.

Basic tenets of technical analysis Technical analysis of the market is based on some basic tenets,
namely, that all fundamental factors are discounted by the market and are reflected in prices. Secondly, these
prices move in trends or waves which can be both, upward or downward depending on the sentiment,
psychology and emotions of operators or traders. Thirdly, the present trends are influenced by the past trends,
and the projection of future trends is possible by an analysis of past price trends. Analysis of historical trends
confirmed the above principles and the Random Walk Theory explaining the randomness of price changes have
been found to be not applicable by the technical analysts in practice.

Basics of Technical Analysis

A technical analysis believes that the share price is determined by the demand and supply forces
operating in the market. A technical analysis concentrates on the movement of share prices. By examining past
share price movements, future share price can be accurately predicted. The basic premise of technical analysis
is that prices move in trends or waves which may be upward or downward. A rational behind the technical
analysis is that share price behaviour repeats itself over time and analysts attempt to drive methods to predict
this repetition.

Basic Principles of Technical Analysis

The market value of a security is related to the demand and supply factors operating in the market. There
are both rational and irrational factors which surround the supply and demand factors of a security. Security
prices behave in a manner that their movement is continuous in a particular direction for some length of time.
Trends in stock prices have been seen to change, when there is a shift in the demand and supply factors. The
shift in demand and supply can be detected through charts prepared specially to show the market action.
Patterns which are projected by charts record price movements and these recorded patterns are used price
movements and these recorded patterns are used by analysts to make forecasts about the movement of prices
in future.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

TOOLS OF TECHNICAL ANALYSIS

Dow Theory This theory is formulated by Charles H. Dow.

Dow who is the editor of the Wall Street Journal in the U.S.A formulated a hypothesis that the stock
market does not move on random basis, but is influenced by three distinct cyclical trends that guide its direction.
According to Dow Theory, the market has three movements and these movements are simultaneous in nature.
These movements are the primary movements, secondary reactions and minor movements.

The primary movement is the long-range cycle that carries the entire market up or down. This is the long-
term trend in the market. The secondary reactions act as a restraining force on the primary movement. These
are in the opposite direction to the primary movement and last only for a short while and are known as corrections.
These are secondary reactions. The third movement in the market is the minor movements which are the day-
to-day fluctuations in the market. The minor movements are not significant and have no analytical value as they
are of very short duration. The three movements of the market have been compared to the tides, the waves and
the ripples in the ocean.

Bullish Trend

During the bull market (upward moving market), in the first phase, the price would advance with the
revival of confidence in the future of business. During the second phase, price would advance due to
improvements in corporate earnings, in the third phase, prices advance due to inflation and speculation.
According to Dow Theory, the formulation of higher bottoms and higher tops indicates a bullish trend.

Bearish Trend

The bear market is also characterized by three phases, in the first phase, price begin to fall due to
abandonment of hopes. In the second phase, companies start to reporting lower profits and lower dividends, in
the final phase, price falls still further due to distress selling. A bearish market would be indicated by the
formulation of lower tops and lower bottoms. The theory also makes certain assumptions, which have been
referred to as the hypothesis of the theory.

• The first hypothesis states that the primary trend cannot be manipulated. It means that no single individual
or institution or group of individuals and institutions or group of individuals and institutions can exert
influence on the major trends of the market.
• The second hypothesis states that the averages discount everything. Which means is that the daily prices
reflect the aggregate judgement and emotions of all stock market participants. In arriving at the price of
a stock, the market discounts everything known and predictable about the stock that is likely to affect the
demand and supply position of the stock.
• The third hypothesis states that the theory is not infallible. The theory is concerned with the trend of the
market and has no forecasting value as regards the duration.

Chartist Method

As referred to earlier, technical analysis is a study of the market data in terms of factors affecting supply
and demand schedules, namely, prices, volume of trading, etc. A study of the historical trends of market behavior
shows the cycle and trends in prices, which may repeat as the present is a reflection of the past and the future
of the present. This is the basis for forecasting the future trends, which are used for deciding on the basis of the
buy or sell signals. For forecasting, analysts use charts and diagrams to depict the past trends and project the
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

future. However, these methods are rough and ready methods and there are no foolproof methods of forecasting
the stock prices. The technical analysis only helps to improve the knowledge of the probabilities of price behavior
(upswing or downswing) and help the investment process.

Charts and Trade Lines

The technical analysis uses charts for analysis of prices. Fitting a trend line for price changes on a daily-
basis is the first step in the analysis of charts. These changes may be pointing upwards or downwards or stable
over a horizontal one. The movements are such that there are both peaks and troughs in these price changes,
peaks showing an upward trend troughs or reactions to the uptrend, viz., line joining the lowest points or troughs
pointing up. If this line is pointing downwards, then it is a bearish phase. If the movements are downwards
generally, then there will be rallies moving up the prices. These upper peaks, if they are joined, give the trend
line as much as the lowest troughs.

Criticism of Dow

The Dow Theory is subject to various limitations in actual practice. Dow has developed this theory to
depict the general trend of the market, but not with the intention of projecting the future trends or to diagnose the
buy and sell signals in the market. These applications of the Dow Theory have come in the light of analytical
studies of financial analysts. This theory is criticized on the ground that it is too subjective and based on historical
interpretation; it is not infallible as it depends on the interpretative ability of the analyst. The results of this theory
do not also give meaningful and conclusive evidence of any action to be taken in terms of buy and sell operations.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Lesson 2: Assessment
In a clean sheet of yellow pad paper or a short coupon bond, write your answer. Make sure indicate the
following (name, year and block, subject and the name of your lecturer). Lastly, submit to your module
coordinators on time.

Questions
1. What are the three steps involving in fundamental analysis?
2. What is technical analysis?
3. What are the three phases bear market?
4. Why does company analysis important?
5. Site the importance of financial statements.

Task
Write a summarization about the types of tools technical analysis.

Case Study 2
CALCULATING THE RISKS IN MAKING INVESTMENT DECISIONS

Introduction

Investment decisions involve weighing up the risks and the likely rewards of various options. It is often
the riskiest alternatives that yield the highest possible gains, while the least risky options may yield smaller
rewards. Business decision-makers therefore have to weigh up risk so as to provide the most suitable rewards
for stakeholders including shareholders and customers. The starting point is a company’s overall aim, which then
filters down into a strategy, creating a balanced portfolio made up of numerous investments.

This case study examines the processes involved in weighing up risks in order to create a balanced
portfolio at BG Group, one of the leading energy businesses in the UK. The case study illustrates typical stages
involved in deciding whether to bid for the right to explore for and develop new gas fields and, importantly, how
much to bid. Before weighing up the risks, ethics is an integral part of BG Group’s considerations, i.e., making
morally correct decisions, whether these be concerned with environmental issues, health and safety or any other
decision involving the difference between ‘right and wrong’ behaviour. In other words, the ‘best’ investment
decision will balance economic, social and environmental considerations.

More Than Just Finance

Ethical decisions are integral in making investment decisions. BG Group’s Statement of Business
Principles sets out the fundamental values and ethical principles within which the Company operates. BG Group
will only enter countries, where the Company can operate in accordance with its Business Principles. The
following example gives an outline of the important statistical and financial procedures involved in making an
investment decision. However, it is important to emphasize the weight given to non-financial factors involved in
decision-making.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Gas is the cleanest fossil fuel, but any form of energy production involves some form of environmental
cost, e.g., the sight of wind farms located in fields, or harmful release of greenhouse gases, when burning fossil
fuels. BG Group will only bid to explore, if it can operate within its ethical guidelines. The company always seeks
to apply its business principles. This can sometimes be difficult, since natural gas resources are found in
countries at different stages of economic, environmental, political and social development.

BG Group

The gas industry is today in the private and public sector and there are a number of companies competing
in the industry. Some of these companies are government-owned. Others are owned by private shareholders
who appoint directors to represent their interest. The directors appoint professional managers to run the
business. Like electricity and telecommunications, gas is a ‘network industry’. In the case of gas, consumers are
linked to a central network of gas pipelines. Group is an integrated business in that it has activities across the
whole range of gas operations, from the reservoir to the customer.

BG Group’s Exploration and Production (E&P) business finds and develops gas reserves. Natural gas is
delivered to customers either by BG Group’s Transmission and Distribution (T&D) business using pipelines or
by the Liquefied Natural Gas(LNG) business via LNG ships. BG Group’s power businessfocuses on the creation
of electricity by natural gas-fired power generation plants. The illustration shows the gas chain indicating the
various links in an integrated business involved in bringing gas to final consumers. Demand for gas is projected
to grow at an increasing rate over the next decade, outstripping the growth in demand for other major sources
of energy. As an energy source, gas is a relatively clean fossil fuel, abundant and is increasingly becoming the
fuel of choice for consumers, on both environmental and economic grounds.

Field Development

The gas business has a number of characteristics that are particularly important in relation to investment
decision-making:

▪ It is very capital-intensive, so that decisions may typically involve spending several hundred million
pounds.
▪ There are long lead times between the start of a project and the receipt of earnings from that project,
typically over five years from first investment to first revenue.
▪ The taxation and contract structure is unique to the energy industry and is complex. Gas is a finite
resource for a nation. Its exploitation is of strategic importance to the host government for some time.

Government owns the rights to minerals found on land (onshore) and under water (offshore) in their
countries. Governments divide the ground into exploration ‘blocks’ and invite energy companies to bid for the
right to explore for oil and gas in those blocks. To earn the right to explore a block, the energy company commits
to a work programme, which describes the steps it will take in order to find oil/gas. The energy company’s
investment and expertise helps governments access the mineral wealth beneath the ground. BG Group makes
important decisions as to whether or not to apply for the right to explore for new gas fields and how much to bid.

Key Risks

Shown below are some of the key risks in a typical gas project and the experts responsible for addressing
those risks:

▪ Geologists and geophysicists evaluate the risks around volume and the chance of finding those volumes.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

▪ Engineers examine facility and well design, costs, production rates.

▪ HSSE managers assess health, safety, security and environmental risks.
▪ Economists analyze market demand and price, government and partner commercial terms.

Investment appraisal

Discounted cash flow is an important technique for investment appraisal. The discounted cash flow
approach is a way of valuing the future returns on investment by assessing the values of these returns in terms
of their value today. It places emphasis on the cost of funds tied up in a project by considering the timing of cash
flows. For example, we all instinctively know that £1 in the hand today is worth more than a promise of £1 in the
future.

This is because:

▪ Inflation may lower the real value of money.

▪ The money cannot be put to constructive use in the meantime (i.e., earning interest in the bank or applied
to another project).
▪ There is always the risk that unforeseen circumstances will prevent you receiving the amount you have
been promised.

Appraising investments using the discounted cash flow method allows the Company to undertake a capital
allocation process, which involves ranking projects and selecting those that add the most value to the Company.
It therefore incurs the opportunity cost of those projects that add value, but cannot be financed as sufficient funds
are not available to undertake them. Ultimately, the value of any investment is the present value of the future
free cash flows, Net Present Value (NPV) that the investment is expected to generate.

Therefore, it is necessary to forecast the economic cash flows and discount them appropriately to allow for the
fact that they will not be received, until sometime in the future. BG Group uses a discount rate that reflects the
return its investors (shareholders and banks) expect for investing in a non-risk free activity (compared to
depositing money in a bank account). The NPV calculation always assumes the project is a success. However,
there is a chance that no oil or gasis present (geological risk), this risk must therefore be reflected in the valuation.

This is achieved by assigning probabilities to the values of successful and unsuccessful outcomes. The
sum of these risked values is the Expected Monetary Value (EMV). calculation can be illustrated by a decision
tree. Decision trees are a simple way of choosing from alternative courses of action when faced with uncertainty.
The basic procedure for constructing a decision tree is to set out a series of alternative branches of the tree and
then to calculate the probability of the event occurring and the likely money value of the return. In a decision tree,
it is possible to distinguish between points of decision and points where chance and probability (uncertainty) may
come into play. For example, this process can be used to illustrate possible returns from drilling a well and then
exploiting a gas field.

The inputs from geologists, engineers and others underpin the economic analysis and ultimately the
calculation of value. These inputs relate to both internal and external data:

▪ Internal-technical data relating to the costs involved in developing the block, e.g., the costs of building
and developing the gas platforms, likely volume and quality of hydrocarbons.
▪ External-commercial data about the future demand for, and price of, gas as well as likely tax changes,
and information about local markets and other data.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Economists can then develop models projecting the likely costs and revenues of developing new fields.
Essential components of these models are as follows:

▪ Revenues (price x volume)

▪ Costs
▪ Government take (e.g., taxes because the blocks that companies bid for are government property).
Revenues less costs, less government take = the net cash flows which are discounted to give the NPV.

BG Group then uses all of this information to calculate the EMV of decisions. The EMV is equal to: EMV =
(NPV of success x chance of success) plus (NPV of failure x chance of failure) The following example uses
estimated returns expected from BG Group committing itself to drilling one exploration well. The net present cost
will be £16m.

There is a 16% chance that the three-year project will be a success, yielding a return at NPV of £114m.

▪ First of all, we work forward across the diagram from the decision fork, where the choice is: ‘drill
exploration well’ or ‘don’t drill exploration well’.
▪ Next, we set out the probabilities of gas being discovered and the NPV of success or failure (these are
based on the geologists’ and economists’ calculations).
▪ If the well is not drilled, there will be a return of £0. If the exploration well is drilled and no gas is found
there will be a loss of £16m. There is an 84% chance of this being the case.
▪ If the exploration well is drilled and gas is found there will be a gain of £114m. There is a 16% chance of
this happening.

We can now work out the EMV, if the decision is made to go ahead with exploiting the field. Therefore,
on a risked basis drilling the well is attractive on economic grounds in that it generates a positive EMV. The
opportunity would be presented to management to compete for funds in the capital allocation process.

Portfolio Considerations

At this phase of the investment decision, a number of factors must be considered. The overriding goal of
the company is to create shareholder value. In order to achieve the optimal growth for an acceptable level of
risk, the company invests on a portfolio basis. This means that it will invest in a number of different wells and at
times share the costs and working interest with partners in order to improve the risk/reward balance and stay
within a budget. As the returns of these individual wells are likely to be uncorrelated or weakly correlated (e.g.,
failure in one exploration well is unlikely to affect the chance of success of another), the risk of the overall portfolio
is lower than that of an individual well.

This is especially important at the exploration stage due to the high risk of failure. In addition to this idea
of investing in projects which help to reduce the overall risk profile of the Company, decision makers must
consider the strategic fit to the current business and where the company’s skills and expertise lie. Only after
considering all of these factors can a decision be made on whether or not to invest in a particular project. The
gas market is an exciting one to be involved in. The world’s demand for energy is growing rapidly and it is
imperative that it is supplied with clean energy reserves by principled companies. BG Group is a major world
player in this market and it constantly needs to make the right sorts of investment decisions, which balance the
needs of global consumers, its shareholders, the communities in which it operates governments and other
stakeholders.
Organization and Management
BSBA (Financial Management)
1st Semester, A.Y. 2021-2022

Questions

1. What do investment decisions involve?

2. What does this case study examine?
3. What are the key risks in a typical gas project and who are the experts responsible for addressing those
risks?

Prepared by:
Jessalyn Marie E. Maaba
Lecturer