Chapter Five

Security Analysis
5.1 Introduction
A great deal of information is available when making an investment decision. There is market
and economic data, stock charts, industry and company characteristics, and a wealth of financial
statistical data. The amount of this information can be overwhelming and, at the same time, can
add clarity and perspective to the investment-making process.Fortunately for investors and
advisors, there are different branches of analysis which helps to organize the information. Some
analysis focuses relatively narrowly on companies themselves, while some looks more broadly,
using an international and market perspective. Our focus here is to gain a better understanding of
how analysts use the information available to value a security and make a recommendation on its
purchase or sale.
Although these fundamental and technical analysis techniques are widely used and reported in
the financial press, their use and interpretation is often misunderstood. An advisor or investor
considering an investment based on an analyst’s interpretation of these techniques, or on their
own analysis, must have a clear understanding of what the techniques measure, how they are
determined, and how they are interpreted.For example, suppose you are considering an
investment in the stock of a cyclical company and there are reports that an economic slowdown
is imminent. What does that mean for the industry, the economy and your investment? This
chapter will give you the necessary tools to answer those questions and others.

5.2 Market Theories

Three theories have been developed to explain the behavior of stock markets. The following
table describes these theories and their unique assumptions and conclusions.

Stock market theories

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Table 2.1 stock market theories

The efficient market hypothesis, the random walk theory and the rational expectations hypothesis
all suggest that stock markets are efficient. This means that at any time, a stock’s price is the best
available estimate of its true value. Many studies have been conducted to test these theories.
Some evidence supports the theories, while other theories support market inefficiencies. For
example, it seems unlikely that:
 New information is available to everyone at the same time
 All investors react immediately to all information in the same way
 All investors make accurate forecasts and correct decisions

If all investors reacted to new information in the same way and at the same time, no investor
should be able to outperform others. However, there have been times when investors have been
able to consistently outperform index averages like the S&P/TSX Composite Index. This
evidence suggests that capital markets are not entirely efficiently priced.

For example, investors do not react in the same way to the same information. One investor may
buy a security at a certain price hoping to receive income or make a capital gain. Another

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investor may sell the same security at the same price because that investor believes the security is
overvalued. Also, not everyone can make accurate forecasts and correct valuation decisions.
Finally, mass investor psychology and greed may also cause investors to act irrationally. Even
when investors do act rationally, thorough stock valuation can be a complex task.

Since stock markets are often inefficient, a better understanding of how macroeconomic factors,
industry factors, and company factors influence stock valuation should lead to better investment
results. These three factors all help to determine changes in interest rates and in the actual or
expected profitability of companies. In the following section we examine some pricing models
based on these factors.

5.3 The Methods of Investment Analysis

At the start of this material, we defined an investment as a commitment of funds for a period of
time to derive a rate of return that would compensate the investor for the time during which the
funds are invested, for the expected rate of inflation during the investment horizon, and for the
uncertainty involved. From this definition, we know that the first step in making an investment is
determining your required rate of return. Once you have determined this rate, some investment
alternatives, such as savings accounts and T-bills, are fairly easy to evaluate because they
provide stated cash flows. Most investments have expected cash flows and a stated market price
(for example, common stock), and you must estimate a value for the investment to determine if
its current market price is consistent with your required return. To do this, you must estimate the
value of the security based on its expected cash flows and your required rate of return. This is the
process of estimating the value of an asset. After you have completed estimating a security’s
intrinsic value, you compare this estimated intrinsic value to the prevailing market price to
decide whether you want to buy the security or not.
This investment decision process is similar to the process you follow when deciding on a
corporate investment or when shopping for clothes, a stereo, or a car. In each case, you examine
the item and decide how much it is worth to you (its value). If the price equals its estimated value
or is less, you would buy it. The same technique applies to securities except that the
determination of a security’s value is more formal.
This investment decision process is similar to the process you follow when deciding on a
corporate investment or when shopping for clothes, a stereo, or a car. In each case, you examine
the item and decide how much it is worth to you (its value). If the price equals its estimated value
or is less, you would buy it. The same technique applies to securities except that the
determination of a security’s value is more formal.
We start our investigation of security valuation by discussing the valuation process. There are
two general approaches to the valuation process: (1) the top-down, three-step approach; or (2)
the bottom-up, stock valuation, stock picking approach. Both of these approaches can be
implemented by either fundamentalists or technicians. The difference between the two
approaches is the perceived importance of the economy and a firm’s industry on the valuation of
a firm and its stock.

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Advocates of the top-down, three-step approach believe that both the economy/market and the
industry effect have a significant impact on the total returns for individual stocks. In contrast,
those who employ the bottom-up, stock picking approach contend that it is possible to find
stocks that are undervalued relative to their market price, and these stocks will provide superior
returns regardless of the market and industry outlook.
Both of these approaches have numerous supporters, and advocates of both approaches have
been quite successful. Most investors use both technical and fundamental analysis to make
decisions.

5.3.1 Fundamental Analysis

The fundamental analysis, also called the top-down approach or three-step approach, is a
process by which one examines a particular investment opportunity. Fundamental analysis
involves assessing the short, medium and long range prospects of different industries and
companies. It involves studying capital market conditions and the outlook for the national
economy and for the economies of countries with which it trades to shed light on securities’
prices.

First, one examines the general economy/market, then a particular industry and, finally,
individual firms within a particular industry. It assumes that both economy and the industry have
a substantial impact on individual stocks.

In fact, fundamental analysis means studying everything, other than the trading on the securities
markets, which can have an effect on a security’s value: macroeconomic factors, industry
conditions, individual company financial conditions, and qualitative factors such as management
performance. By far the most important single factor affecting the price of a corporate security is
the actual or expected profitability of the issuer.

I. Fundamental Market/Macroeconomic Analysis

Sudden unpredictable events can affect – favorably or unfavorably – the country’s economy and
the prices of its securities. Such events include international crises such as war, unexpected
election results, regulatory changes, technological innovation, debt defaults, and dramatic

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changes in the prices of important agricultural, metal and energy commodities. Many commodity
price swings can be predicted by examining supply/demand conditions. Other price changes may
not be easy to predict because they depend on price-setting agreements or on the action of cartels
such as the Organization of the Petroleum Exporting Countries (OPEC), which sets oil prices.
Many factors affect investor expectations and therefore play a part in determining the price of
securities. These factors can be grouped under the following categories: fiscal policy, monetary
policy, flow of funds and inflation.

a. The Fiscal Policy Impact

The two most important tools of fiscal policy are levels of government expenditures and
taxation. They are important to market participants because they affect overall economic
performance and influence the profitability of individual industries. They are usually disclosed in
federal and provincial budgets.

Tax Changes: By changing tax levels, governments can alter the spending power of individuals
and businesses. An increase in sales or personal income tax leaves individuals with less
disposable income, which curtails their spending; a reduction in tax levels increases net personal
income and allows them to spend more. Corporations are similarly affected by tax changes.
Higher taxes on profits, generally speaking, reduce the amount businesses can pay out in
dividends or spend on expansion. On the other hand, a reduction in corporate taxes gives
companies an incentive to expand. Conversely, tax increases lower consumer spending and
business profitability, while tax cuts boost profits and common share prices and thereby spur the
economy.

Government Spending: Governments can affect aggregate spending in the economy by

increasing or decreasing their own spending on goods, services and capital programs. On the
simplest level, an increase in government spending stimulates the economy in the short run,
while a cutback in spending has the opposite effect.
Government Debt: The main problem with a large government debt is that it restricts both fiscal
and monetary policy options. Fiscal and monetary policy choices affect the general level of
interest rates, the rate of economic growth and the rate of corporate profit growth, and all of them
affect the valuation of stocks. With high levels of government and consumer indebtedness, the
government’s ability to reduce taxes or increase government spending is impaired.

b. The Monetary Policy Impact

It is the responsibility of the central bank to maintain the external value of the country’s currency
and encourage real, sustainable economic growth by keeping inflation low, stable and
predictable.
 During a period of economic expansion, demand for credit grows and prices move
upwards too quickly, the central bank will try to lessen the pressure by restraining the rate
of growth of money and credit. This usually leads to higher short-term interest rates.

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  On the other hand, if the economy appears to be slowing down, the central bank may
pursue an easier monetary policy that increases the money supply and the availability of
credit, leading to lower short-term interest rates.
Changes in monetary policy affect interest rates and corporate profits, the two most important
factors affecting the prices of securities. Therefore, it is important to understand central bank’s
policy and how successful it is in achieving its aims.

Monetary Policy and the Bond Market:

When economic growth begins to accelerate bond yields tend to rise. If inflation begins to rise
during an expansion the central bank will most often raise short-term interest rates to slow
economic growth and contain inflationary pressures. This may lead to a more moderate
economic growth rate or even a growth recession (a temporary slowdown in economic growth
that does not lead to a full recession). If long-term rates fall while short-term rates rise, then the
bond market temporarily signals its approval of the degree of economic slowing.

Example: If the Federal Reserve raises short-term interest rates to slow economic growth and
bond yields fall simultaneously, reflecting the perceived success of this policy, then the Federal
Reserve has maintained the balance between economic growth and the needs of the bond market.

c. The Flow of Funds Impact

The flow of funds is important to stock valuation. When the relative valuation of stocks and
bonds or stocks and T-bills changes; capital flows from one asset class to the other. These flows
are determined largely by shifts in the demand for stocks and bonds on the part of the country’s
retail and institutional investors and of foreign investors. These shifts are caused largely by
changes in interest rate levels. However, understanding why these shifts occur can be important
to determining if a rise or fall in stock market levels is sustainable.

d. The Inflation Impact

Inflation creates widespread uncertainty and lack of confidence in the future. These factors tend
to result in higher interest rates, lower corporate profits, and lower price-earnings multiples.
There is an inverse relationship between the rate of inflation and price-earnings multiples.
Inflation also means higher inventory and labour costs for manufacturers. These increases must
be passed on to consumers in higher prices if manufacturers are to maintain their profitability.
But higher costs cannot be passed on indefinitely; buyer resistance eventually develops. The
resulting squeeze on corporate profits is reflected in lower common share prices.

II. Fundamental Industry Analysis

It has often been suggested that industry and company profitability has more to do with industry
structure than with the product that an industry sells. Industry structure results from the strategies
that companies pursue relative to their competition. Companies pursue strategies that they feel
will give them a sustainable competitive advantage and lead to long-term growth. Pricing
strategies and company cost structures affect not just long-term growth, but the volatility of sales

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and earnings.Therefore, industry structure affects a company’s stock valuation. It is a framework
that can easily be applied to virtually every industry. Many investors and investment advisors
(IAs) rely on research departments and other sources of information on industry structure.

Classifying Industries by Stage of Growth

a. Emerging Growth Industries
New products or services are being developed at all times to meet society’s needs and demands.
Today, rapid innovation is particularly evident in software and hardware development in the
computer industry.Emerging growth industries may not always be directly accessible to equity
investors if privately owned companies dominate the industry, or if the new product or service is
only one activity of a diversified corporation. Emerging industries usually demonstrate certain
financial characteristics. For example, a new company or industry may be unprofitable at first,
although future prospects may appear promising. Large start-up investments may even lead to
negative cash flows. It may not be possible to predict which companies will ultimately survive in
the new industry.

b. Growth Industries
A growth industry is one in which sales and earnings are consistently expanding at a faster rate
than most other industries. Companies in these industries are referred to as growth companies
and their common shares as growth stocks. A growth company should have an above-average
rate of earnings on invested capital over a period of several years. It should also be possible for
the company to continue to achieve similar or better earnings on additional invested capital. The
company should show increasing sales in terms of both dollars and units, coupled with a firm
control of costs.

During the growth period, the companies that survive lower their prices as their cost of
production declines and competition intensifies. This leads to growth in profits. Cash flow may
or may not remain negative. Growth stocks typically maintain above-average growth over
several years and growth is expected to continue. Growth companies often finance much of their
expansion using retained earnings. This means that they do not pay out large amounts in
dividends. However, investors are willing to pay more for securities that promise growth of
capital. In other words, growth securities are characterized by relatively high price-earnings
ratios and low dividend yields. Growth companies also have an above average risk of a sharp
price decline if the marketplace comes to believe that future growth will not meet expectations.

c. Mature Industries
Industry maturity is characterized by a dramatic slowing of growth to a rate that more closely
matches the overall rate of economic growth. Both earnings and cash flow tend to be positive,
but within the same industry, it is more difficult to identify differences in products between
companies. Therefore, price competition increases, profit margins usually fall, and companies
may expand into new businesses with better prospects for growth. Where consumer goods are
concerned, product brand names, patents and copyrights become more important in reducing

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price competition. Mature industries usually experience slower, more stable growth rates in sales
and earnings. The reference to more stable growth does not suggest that they are immune from
the effects of a recession. However, during recessions, stable growth companies usually
demonstrate a decline in earnings that is less than that of the average company. Companies in the
mature stage usually have sufficient financial resources to weather difficult economic conditions.

d. Declining Industries
As industries move from the mature/stable to the declining stage, they tend to stop growing and
begin to decline. Declining industries produce products for which demand has declined because
of changes in technology, an inability to compete on price, or changes in consumer tastes. Cash
flow may be large, because there is no need to invest in new plant and equipment. At the same
time, profits may be low.

III. Fundamental Company Analysis

The analysis of a company requires looking closely at the company’s financial history and recent
events, with a goal of assessing the future prospects of the company. The types of information
that an analyst must gather include:
 Financial statement data and related disclosures;
 Major news items in recent years;
 Position and market share in industry;
 International investment;
 Where the company is in its life cycle (i.e. high growth/developmental, maturing,
declining);
 Contributions of major product, divisions, or subsidiaries to the company’s performance;
 Research and development efforts;
 Sensitivity of company to commodity prices (e.g., oil); and
 Major litigation.

One of the key ingredients in a company analysis is the analysis of the financial disclosures.
Financial statements in the most countries are based on Generally Accepted Accounting
Principles (GAAP). GAAP are a set of principles that promulgated from a number of sources,
including the Financial Accounting Standards Board (FASB), the Accounting Principles Board
(APB), and the American Institute of Certified Public Accountants Research Bulletins (among
others).

Many firms make accounting choices that represent their financial statements in the best possible
light. The different choices that firms can make give rise to the comparability problems.
Financial statement analysis gives us a good amount of ammunition for evaluating a company’s
performance and future prospects. But comparing financial results of different companies is not
so simple. There is more than one acceptable to represent various items of revenue and expense
according to GAAP. This means two firms may have exactly the same economic income/

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earnings yet very different accounting income/earnings.Economic earnings are the real and
sustainable cash flow that a firm could pay out to stockholders without impairing the productive
capacity of a firm. In contrast, accounting earnings are earnings of a firm as reported in its
income statement and affected by several factors regarding valuation of assets.

Furthermore, interpreting a single firm’s performance overtime is complicated when inflation

distorts the dollar/birr measuring rod. Comparability problems are especially acute in this case
because the impact of inflation on reported results often depends on the particular method the
firm adopts to account for inventories and depreciation. The security analyst must adjust the
earnings and the financial ratio figures to a uniform standard before attempting to compare
financial results across firms and over time.

As a result, earnings statements for different companies may be more or less rosy presentations
of “true economic earnings. Analysts commonly evaluate the quality of earnings reported by a
firm. This concept refers to the realism and sustainability of reported earnings, in other words,
the extent to which we might expect the reported level of earnings to be sustained.

Analyzing a Company’s profitability

Profitability can generally be described as how well a company can get a return on the
investments they make. If a company is bringing in more revenue than it costs to create those
revenues, then a company can be called profitable.

Profitability can be labeled as a measurement of business success. If you are the owner,
employee, stockholder, or a person who at least has some stake in the success of the company,
then you need to be thinking profitability. A company can do many things wrong, but if it is still
profitable, then many other missteps along the way are often forgiven.

If you have a stake in the company's success, then you certainly want to measure profitability.
The best thing about measuring is that once something can be measured, it can be improved

Working through a ratio analysis can often be broken down into pieces to make the whole
analysis more manageable. There are others: liquidity, debt management, solvency, and many
more. Let's leave those other areas alone for now and focus on profitability. The profitability of a
company can be measured by the profitability ratios. This can be a foggy and opinionated area,
with many sources giving varying interpretations of which ratios should go where. These ratios
can be calculated by relating the profits either to sales, or to investment, or to the equity shares.
Thus, we have three groups of profitability ratios. These are listed below.

1. Profitability related to sales

Gross Profit (Sales−Cost of goods sold)

a) Gross profit margin =
Sales

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 EBIT
b) Operating margin =
Sales

Earningsafter tax (EAT )

c) Net profit margin =
Sales

2. Profitability Related to Investment

Earningsafter tax
a) Return on assets =
Total assets

EBIT
b) Return on capital employed =
Total capital employed

Earningsafter tax (EAT )

c) Return on equity=
shareholder s ' eaquity

3. Profitability related to equity shares (EPS)

¿
a) Earnings per share = Net profit available¿ equity shareholders number of equity shares

EPS
b) Earnings yield=
Market price pershare

Dividend per share(DPS )

c) Dividend yield =
Market price per share

DPS
d) Dividend payout ratio=
EPS

Market price per share

e) Price earnings ratio(P/E ratio)=
EPS

4. Overall profitability (or earning power)

EAT Sales EAT

a) Return on investment = x or
Sales Total assets Total assets

The overall profitability is measured by the return on investment, which is the product of net
profit ratio and investment turn over. It is a central measure of the earning power of or operating
efficiency of a company.

5.3.2 Technical Analysis

Many investors analyze stocks based on their fundamentals – such as their revenue, valuation or
industry trends – but fundamental factors are not always reflected in the market price. Technical

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analysis is a tool, or method, used to predict the probable future price movement of a security –
such as a stock or currency pair – based on market data.

Technical analysis seeks to predict price movements by examining historical data, mainly price
and volume.It helps traders and investors navigate the gap between intrinsic value and market
price by leveraging techniques like statistical analysis and behavioral economics. Technical
analysis helps guide traders to what is most likely to happen given past information.

The theory behind the validity of technical analysis is the notion that the collective actions –
buying and selling – of all the participants in the market accurately reflect all relevant
information pertaining to a traded security, and therefore, continually assign a fair market value
to the security.

Technical analysts view the range of data studied by fundamental analysts as too massive and
unmanageable to pinpoint price movements with any real precision. Instead, they focus on the
market itself, whether it is the commodity, equity, interest rate or foreign exchange market.

They study, and plot on charts, the past and present movements of prices, the volume of trading,
statistical indicators and, for example in the case of equity markets, the number of stocks
advancing and declining. They try to identify recurrent and predictable patterns that can be used
to predict future price moves.

In the course of their studies, technicians attempt to probe the psychology of investors
collectively or, in other words, the “mood” of the market.Technical analysis is the process of
analyzing historical market action in an effort to determine probable future price trends. As
mentioned, technical analysis can be applied to just about any market, although the focus of this
section is on equity markets. Market action includes three primary sources of information –
price, volume and time.Technical analysis is based on three assumptions:
 All influences on market action are automatically accounted for or discounted in price
activity. Technical analysts believe that all known market influences are fully reflected in
market prices. They believe that there is little advantage to be gained by doing fundamental
analysis. All that is required is to study the price action itself. By studying price action, the
technician attempts to measure market sentiment and expectations.
 Prices move in trends and those trends tend to continue for relatively long periods of time.
Given this assumption, the primary task of a technical analyst is to identify a trend in its early
stages and carry positions in that direction until the trend reverses itself. This is not as easy as
it may sound.
 The future repeats the past. Technical analysis is the process of analyzing an asset’s historical
prices in an effort to determine probable future prices. Technicians believe that markets
essentially reflect investor psychology and that the behaviour of investors tends to repeat
itself. Investors tend to fluctuate between pessimism, fear and panic on the one side, and
optimism, greed and euphoria on the other side. By comparing current investor behaviour as

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 reflected through market action with comparable historical market behaviour, the technical
analyst attempts to make predictions. Even if history does not repeat itself exactly, technical
analysts believe that they can learn a lot from the past.

Commonly Used Tools in Technical Analysis

The four main methods used by a technical analyst to identify trends and possible trend turning
points are chart analysis, quantitative analysis, analysis of sentiment indicators and cycle
analysis. They are often used in conjunction with one another.

A. Chart analysis
It is the use of graphic representations of relevant data. Charts offer a visual sense of where the
market has been, which helps analysts project where it might be going. The most common type
of chart is one that graphs either the hourly, daily, weekly, monthly, or even yearly high, low and
close (or last trade) of a particular asset (stock, market average, commodity, etc.)bar chart.

Technical analysts use price charts to identify support and resistance levels and regular price
patterns. Support and resistance levels are probably the most noticeable and recurring patterns on
a price chart. The most common types are those that are the lows and highs of trading ranges.
o A support level, the low of the trading range, is the price at which the majority of investors
start sensing value, and therefore are willing to buy (demand is strong), and the majority of
existing holders (or potential short sellers) are not willing to sell (supply is low). As demand
begins to exceed supply, prices tend to rise above support levels.
o A resistance levels, the high of the trading range, is the opposite. At this point, supply
exceeds demand and prices tend to fall.
Chart formations reflect market participant behavioural patterns that tend to repeat themselves.
They can indicate either a trend reversal (reversal pattern), or a pause in an existing trend
(continuation pattern).

B. Quantitative analysis
It is a form of technical analysis that has been greatly enhanced by the growing sophistication of
computers. There are two general categories of statistical tools: moving averages and oscillators.
They are used to supplement chart analysis, either by identifying (or confirming) trends, or by
giving an early warning signal that a particular trend is starting to lose momentum. A moving
average is simply a device for smoothing out fluctuating values (week-to-week or day-to-day) in
an individual stock or in the aggregate market as a whole. It shows long-term trends. By
comparing current prices with the moving average line, the technician can see whether a change
is signaled. A moving average is calculated by adding the closing prices for a stock (or market
index) over predetermined period of time and dividing the total by the time period selected.

Table: 2.2. Calculation of five-week moving average for a particular stock closing price

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An amount of $18.37 would be plotted on a chart at the end of Week Five. At the end of Week
Six, a new five-week total would be calculated for Weeks Two to six, dropping Week One. If
Week Six’s closing price was $19.50, the total would be $93.85 and the average would be
$18.77, which would be plotted on the chart next to the previous week’s $18.37.

Although we have shown a five-week average in the example for simplicity, a 40-week (or 200-
day) moving average is a common longer-term moving average used by technical analysts.

If the overall trend has been down, the moving average line will generally be above the current
individual prices, as shown in the following figure.

The following is figure showing buy signal

If the price breaks through the moving average line from below on heavy volume (line a–b) and
the moving average line itself starts to move higher, a technician might speculate the declining
trend has been reversed. In other words, it is a buy signal.

If the overall trend has been up, the moving average line will generally be below the current
individual prices, as shown in the following figure.

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The following is figure showing sell signal

If the price breaks through the moving average line from above on heavy volume (line c–d) and
the moving average line itself starts to fall, the upward trend is reversed. This is a sell signal.

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