CHAPTER 6 - SECURITY ANALYSIS

The aim of the analysis is to determine what stock to buy and at what price, there are
two basic analysis methods; i.e. fundamental analysis and technical analysis.
Fundamental analysis is the cornerstone of investing. In fact, some would say that you
are not really investing if you aren't performing fundamental analysis. Because the
subject is so broad, however, it's tough to know where to start. There are an endless
number of investment strategies that are very different from each other, yet almost all
use the fundamentals. Fundamental analysis maintains that markets may misprice a
security in the short run but that the "correct" price will eventually be reached. Profits
can be made by trading the mispriced security and then waiting for the market to
recognize its "mistake" and re-price the security.
Technical analysis maintains that all information is reflected already in the stock price.
It considers the trends that are your friend' and sentiment changes predate and predict
trend changes. Investors' emotional responses to price movements lead to recognizable
price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their
price predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods
for stock picking. For example many fundamental investors use technical for deciding
entry and exit points. Many technical investors use fundamentals to limit their universe
of possible stock to 'good' companies. The choice of stock analysis is determined by the
investor's belief in the different paradigms for "how the stock market works".
6.1 Types of Security Analysis
Security analysis can be broadly classified into two types: Fundamental analysis and
Technical analysis.
I. Approaches to Fundamental Analysis

There are two basic approaches followed in fundamental analysis. The first approach is the
‘Top down Approach' also known as the 'Economy-Industry-Company Approach' (E-I-C
approach). The second is the 'Bottom up Approach' or the 'Company - Industry - Economy
Approach (C-I-E approach)'. In the E-I-C approach, we start with the economy to identify
the trends and make an estimate of the economic parameters. Based on this, we identify the
industries which are promising and then zero in on the companies for investing. In the C-I-
E approach, we start with a shortlist of companies which are promising and then analyze
these with reference to the trends in the respective industry and economy. This approach
requires a good understanding of the market in order to start with a short list of companies
that are promising.

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Fundamental analysis is one of the important approaches to security analysis. When an
investor wants to make an investment decision he makes detailed analysis of the securities
issued by the companies in the market. In doing this he either rely on fundamentals of the
company or on the past price movements. Sometimes an investor considers both price
trends and fundamental of the company. Fundamental analysis is the examination of
underlying forces that affect the well being of the economy, industry and companies. It is
the method of evaluating the securities by attempting to measure intrinsic value of a
particular stock. At company level, it involves examination of financial data, management,
business concept and competition. At industry level, there is examination of demand and
supply forces of products offered. For national economy, fundamental analysis focuses on
economic data to assess present and future growth of economy and its effect on stock
market.
Fundamental analysis includes three kinds of analysis:
(a) Economy analysis
(b) Industry analysis
(c) Company analysis
This can be presented diagrammatically as follows:

Fundamental analysis focuses on valuation and the estimation of intrinsic value of a

Figure 2.1. Fundamental Analysis

security. The objective is to estimate what ought to be price based on the intrinsic value of
the security. This is used to identify the under-priced and over-priced securities in the
market. The intrinsic value of a security is defined as the present value of all future cash
payments to be paid on the security to the investor. The cash payment to the investor may
be in the form of dividends, interest, liquidation proceeds or repayment of the principal
amount. The intrinsic value is that value which is justified by the facts, e.g. assets, earnings,

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dividend, definite prospects including the factor of management. The intrinsic value of a
stock is estimated by discounting the company's prospective earnings stream or the
shareholder's prospective dividend stream. These depend on the economic and industrial
environment, relative importance of the company within its industry, the company's
financial strength, its policies, quality of assets and management. Investors using this
approach hold a large number of undervalued stocks in their portfolio with the hope that,
on average, these portfolios will do better than the market.

The basic approach followed in fundamental analysis is to estimate the intrinsic value of the
security. In order to estimate the intrinsic value of security, we need to forecast the earnings
and dividends on the security. A firm is a part of an industry which is a component of the
economy. Thus, the status and trends in the economy have a bearing on the performance of
the firm. The fundamental analysts seek to establish relationships between economic,
industrial and company indicators with a view to forecast the earnings and dividends of the
company.

A. Economy Analysis

Companies are a part of industrial and business sector which in turn is a part of overall
economy. Thus, performance of a company depends on performance of economy as a
whole. If the economy is in recession or stagnation, ceteris paribus, the performance of
company will be bad in general. On the other hand, if economy is booming, companies may
be prosperous. From this, we can understand the importance of studying the forces
operating in the overall economy, as well as influences peculiar to industries while
estimating stock price changes. The objective of economic analysis is to study the impact of
important macroeconomic factors on the stock market as well as to study the trends of these
factors. The important macroeconomic indicators that influence stock market are as follows:

 GDP growth
Gross domestic product (GDP) is a measure of the total production of final goods and
services in the economy during a specified period of time. It is the important indicator of the
performance of economy of the country. It represents the average of the growth rates of
three important sectors of the economy i.e. service sector, industrial sector and agricultural
sector. The higher the growth rate of GDP, the more it is favorable for the stock market.

 Trends in public investment and savings

The investment level in the economy is addition of domestic savings and inflow of foreign
capital minus investments made abroad. The higher the level of savings and investment,

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and the greater the allocation of same to equities, the more it is favorable for the stock
market.
 Interest rates
Interest rates affect the present value of future cash flows – high interest rates reduce the
attractiveness of investment opportunities, and low interest rates increase the appeal of
investment opportunities. A low interest rate environment is aimed at promoting business
investment expenditures and, subsequently, higher growth rates. Mortgage payments and
high-priced consumer durable goods such as automobiles are also sensitive to interest-rate
movements. When interest rates are high, consumers spend less.
 Inflation
The effect of inflation on the corporate sector tends to be uneven. While certain industries
may benefit, others may suffer. Inflation also affects the real value of the equity shares.
Therefore, the real growth of GNP without inflation is always favorable and desirable.
 Employment
The unemployment rate is the percentage of the labor force that is actively looking for work.
The unemployment rate measures the level to which an economy is operating at full
capacity. A rising unemployment figure can point to a slowdown in the economy.

 Budget deficit
The budget deficit of a government is the difference between government expenditure and
government revenues. Shortfalls in the budget must be offset by government borrowing. If
government borrowing is excessive, interest rates may be forced to go up and total demand
for credit in the economy will increase. Higher interest rates are negative for business
investment and, consequently, company growths.
 Current account deficit
The current account is the difference between imports and exports, including merchandise,
services, and transfers such as foreign aid. If the current account shows a deficit, this means
that the country imports more than it exports; a surplus indicates that the country exports
more than it imports. Current account deficits have to be funded somehow. Sometimes,
foreign direct investment into a country will offset a current account deficit, or high interest
rates may attract capital flow into a country. The level of the current account is affected by
changes in the exchange rate. If a currency depreciates exports may increase, as it becomes
less costly for foreigners to purchase domestically produced goods.
 Exchange rates
The exchange rate is the rate at which domestic currency can be converted into foreign
currency. Movements in exchange rates can affect the international competitiveness of
domestically produced products. Sharp currency devaluation can lead to a rise in exports.
Exchange rates can also have an effect on inflation rates. Depreciation of a currency

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increases the cost of imported goods, which results in an increase in local prices and
consequently, the inflation rate.
 Government policy
The government uses the tools of fiscal policy and monetary policy to promote GDP
growth, regulate employment levels, and stabilize prices. These policies are described
below.
a) Fiscal policy
Fiscal policy refers to the taxation and spending policies of the government designed to
calibrate the economy. Government can stimulate growth in real GDP by creating tax
incentives for investment. Likewise, increases in general tax rates immediately divert
income from consumers and result in decreases in consumption. Decreases in government
spending reduce the demand for goods and services. Fiscal policy is a direct way to
stimulate or slow down an economy. One way to examine the net impact of a fiscal policy is
to look at the government’s budget deficit. If a large deficit is present, this means the
government is spending more than it is taking in by the way of taxes. The net effect will be
an increase in the demand for goods (through spending) by more than it reduces the
demand for goods (through taxes). As a result, the economy will experience a push towards
growth. Budget deficits are, however, associated with increased interest rates.
b) Monetary policy
Monetary policy refers to actions taken by a central bank to control interest rates and the
money supply (the supply of money in the economy). Increases in the money supply lower
short-term interest rates, subsequently encouraging investment and consumption demand.
Over a longer period of time, however, many economists believe that a higher money
supply will lead only to higher prices and inflation, and will not have a permanent effect on
economic growth levels. Tools that the central bank has at its disposal include: buying and
selling bonds for its own account to increase or decrease the money supply in the system;
the interest rate charged to banks on short-term loans; and reserve requirements dealing
with the amount of deposits that banks must hold as cash on hand or as deposits with the
central bank. The ability of a central bank to maintain stable prices and interest rates whilst
stimulating growth and maintaining a high level of employment is essential for providing
an environment conducive to running profitable businesses.

 Infrastructural facilities and arrangements

The infrastructural bottlenecks have always been a hurdle for the industries in Ethiopia.
The facilities such as electricity and water supply, transportation facilities,
telecommunication systems, assured supply of basic raw-material to the industry affects
the performance of industries and thereby affect stock market as well.

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 B. Industry Analysis
The performance of any company depends 50% on the factors of economy and remaining
50% on the factors of industry in which company operates. At any point of time, there may
be industries which are on upswing of the cycle called as sunshine industries and those
which are on the decline called sunset industries. Industry analysis takes into account three
important aspects:
1) Industry life cycle analysis
Every industry goes through a life cycle with four distant phases, though the duration of
each of the stages may be different for different industries. The development of any
industry may be analyzed in terms of its life cycle phases. These phases are:
a) Pioneering stage is a period of slow sales growth as the product is introduced in
the market. Profits are non-existent in this stage because of the heavy expenses
incurred with product introduction.
b) Expansion (growth) stage is a period of rapid market acceptance and substantial
profit improvement.
c) Stagnation (mature) stage is a period of slowdown in sales growth because the
product has achieved acceptance by most potential buyers. Profits stabilize or
decline because of increased competition.
d) Decline stage is the period when sales show a downward drift and profits erode.

For an investor, it is prudent to invest in an industry that is in the growth stage. While an
industry in the pioneering stage could be promising, an investor should exercise caution
because many of the companies may not survive this stage. When an industry enters the
maturity stage, it is advisable to moderate one's investment and disinvest from industries
which are entering the decline stage.

2) Analysis of the structure and characteristics of industry

Every industry is one of its kind having distinct characteristics and features. Detailed
analysis of these helps in correct decision making and proper security analysis. These
include following factors:

a) Product line - The position of the industry in its various life cycle stages should be
noted. It is also necessary to know the industries with high growth potential like
computers, electronics, chemicals, etc. and whether industry is in priority. Product
may be new one or an import substitution product which has a good fortune.
b) Raw (material and other inputs) - Under this head, we have to look for the
industries depending on import of scarce raw-materials, import and export
restrictions, scarcity of other inputs, etc. Industries which has limited supply of raw -

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 material domestically and where imports are restricted have dim growth prospects.
Labor and other input problems also serve as an obstacle in growth.
c) Nature of demand - Whether the industry is cyclical, fluctuating or stable has to be
looked into. If the demand for the product is seasonal then it leads to problems in
growth. The demand for the product should be expanding and its price should not
be controlled by government. Thus, nature of demand for the product and industry
is an important factor that determines the scope of operations and profitability.
d) Permanence – Permanence, which is a phenomenon related to the products
and technology of the industry and relative permanence is an important factor to
be considered. If the need for the particular industry is likely to vanish in an extremely
short period of time, it would not be wise investing in this industry. In this age of
rapid technological advance, the degree of permanence of an industry is an
important aspect in industry analysis.
e) Labor conditions - The labor conditions in an industry can play an important part
in industry analysis. Healthy labor conditions in an industry can lead to higher
productivity levels and better utilization of assets. If the labor is highly unionized
and the industrial relations climate is not healthy, it can have a negative impact on
the industry.
f) Past sales and earnings performance - The two important factors that
determine the success of any firm are sales and earnings. Therefore, in order to get
a perspective about the future, the starting point is the historical performance of
sales and earnings. If the industry has a short history, it indicates that the
industry has not proved its ability to weather a variety of economic growth
prospects. Investment in such an industry would demand an element of caution.
The historical record of industry is useful for calculating the average levels and
growth rates for sales and earnings. Though
the past performance may not repeat in the future, it is useful, in order to make
estimates of the future trends. An important factor that determines the earnings
performance of an industry is the cost structure. We need to know whether the
industry is investment intensive, raw material intensive or labor intensive. If it is
investment intensive, the fixed costs are likely to be higher and the breakeven levels
of sales will also be higher.
g) Attitude of government towards industry - Policies of the government and the
attitude of the Government towards an industry can have considerable
influence on the industry. If the government feels that the domestic industry needs
protection it can impose restrictive import quotas or tariffs that would assist the
domestic industry. On the other hand if the government feels that the domestic

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 industry is well developed and does not need protection, it can remove barriers and
thus encourage foreign competition. Besides, government can assist selected
industries through favorable tax legislation.

3) Analysis of competitive conditions and the influence on industry attractiveness:

Porter’s Model

Competitive conditions in an industry dictate the price levels and profitability levels in an
industry. The analysis of competitive conditions and the influence on industry attractiveness
can be done with the help of Porter's model. Michael Porter identified five forces that
determine the intrinsic long-run profit attractiveness of a market or market segment i.e.
industry competitors, potential entrants, substitutes, bargaining power of buyers and
suppliers. Porter’s five forces of competition framework can be depicted as shown in the
following figure

Figure: 2.2. Porter’s five.

The detailed description of these forces is as under:

(a) Industry competitors - A segment is unattractive if it contains numerous, strong or

aggressive competitors. It is even more unattractive if the segment is stable or
declining, if plant capacity additions are done in large increments, if fixed costs are
high, if exit barriers are high, or if competitors have high stakes in staying in the
segment. These conditions will lead to frequent price wars, advertising battles, and
new product introductions and will make it expensive to compete.

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 (b) Potential entrants - A segment's attractiveness varies with the height of its
entry and exit barriers. The most attractive segment is one in which entry barriers
are high and exit barriers are low. Few new firms can enter the industry, and poor-
performing firms can easily exit. When both entry and exit barriers are high, profit
potential is high, but firms face more risk because poorer-performing firms stay in
and fight it out. When entry and exit barriers are both low, firms easily enter and
leave the industry, and the returns are stable and low. The worst case is when entry
barriers are low, and exit barriers are high. Here, firms enter during good times but
find it hard to leave during bad times. The result is chronic over capacity and
depressed earnings.

(c) Substitutes - A segment is unattractive when there are actual or potential

substitutes for the product. Substitutes place a limit on prices and on the profits that
a segment can earn. If technology advances or competition increases in these
substitute industries, prices and profits in the segment are likely to fall.

(d) Bargaining power of the buyers - A segment is unattractive if the buyers

possess strong or growing bargaining power. Buyers will try to force prices down,
demand more quality or services and set competitors against each other, all at the
expense of seller profitability. Buyers' bargaining power grows when they become
more concentrated or organized, when the product represents a significant fraction
of the buyer's costs, when the product is undifferentiated, when the buyers'
switching costs are low, when buyers are price sensitive because of low profits, or
when buyers can integrate upstream.
(e) Bargaining power of the suppliers - A segment is unattractive if the company's
suppliers are able to raise prices or reduce quantity supplied. Suppliers tend to be
powerful when they are concentrated or organized, when there are few substitutes,
when the supplied product is an important input, when the cost of switching
suppliers are high, and when the suppliers can integrate downstream.

C. Company Analysis
Having completed the economic analysis and industry analysis, the next step is to carry
out an analysis of the companies in the identified industry. The specific market and
economic environment may enhance the performance of the company for a period of
time but ultimately it is the firm's own capabilities that will judge its performance in the
long run. For this reason, the firms in the same industry are to be compared with one
another to find out the best performer. The following factors are significant to company
analysis:

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(1) Marketing policies
This is most important variable; it influences future earnings in terms of both quality
and quantity. This in turn is determined by the share of the company in the industry,
growth of its sales. Strong competitive position will provide greater earnings with more
certainty then a company with poor competitive position.
(2) Accounting policies
There is a risk of faulty interpretation of the corporate earnings and consequently
wrong decision making. The accounting variations in the reporting costs, expenses and
extraordinary items could change earnings to a greater extent, the accounting policies
related to inventory pricing methods, depreciation methods, non-operating income, tax
carry over affect company to greater extent and should be critically examined.
(3) Profitability
When we put a security we are buying the right to future earnings. We are interested in
income stability and growth of these earnings. To study relationship between expense
and sales, one need to study trends of profitability ratios namely gross profit margin,
net profit margin, earning per share, etc.
(4) Dividend policy
It is observed that management tries to maintain stable dividend policy with increased
dividends. This is possible only when a company expects increased rate of earnings in
future.
(5) Capital structure
Capital structure of the company is to be studied before making an investment in that
company. Return on equity holder's investment can be magnified by using debt
financing along with equity instead of equity financing only. The mixing of fixed cost of
funds such as debt and preference capital maximizes earnings available to shareholders
and hence should be carefully examined.
(6) Management
The company capability depends on the efficiency of its management. The functions of
management are to plan, organize, control and co -ordinate activities of the company to
achieve desired results. Therefore, it is necessary to judge the ability of management.
The ability of management is judged by:
 Ability to maintain competitiveness of the firm.
 Ability to work with employees and union.
 Ability to finance company when required and maintain efficient production.
 Ability to maintain profits margins and cut down costs.
 Ability to expand firm's activities.
(7) Financial statement analysis

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It is the process of analyzing financial strengths and weaknesses of the company
through various techniques. Financial statement analysis may be done: as ratio analysis
and trend analysis. The former type includes internal and external analysis and the later
type includes horizontal and vertical analysis. There are various tools of financial
statement analysis which are as follows:
(a) Ratio Analysis
Financial ratio analysis is one of the important tools used for analyzing financial
statements. It helps in analysis of the financial statements with the help of ratios. Based
on the specific characteristics being highlighted, ratios are categorized into:
 Liquidity Ratio - Liquidity ratio tell us about the ability of a firm to meet its
short term financial obligations. It includes Current ratio, Acid-test ratio or
Quick ratio and Cash ratio.
 Leverage Ratios - A firm uses a combination of equity and debt for financing its
assets. Leverage ratios help us in assessing the risk arising from the use of debt
capital. Leverage ratios include Debt equity ratio, Interest coverage ratio and debt
service coverage ratio.
 Turnover Ratios - Turnover Ratios help us to measure the efficiency of utilization of
the assets of a firm. These are also called activity ratios or asset management ratios.
It includes Inventory turnover ratio, Debtors turnover ratio, fixed asset turnover,
Total asset turnover and Creditors asset turnover.
 Profitability Ratios - Profitability ratios can be of two types. The first one is the ratio
between profit and sales. The second type is the ratio between profit and
investments. These are called rate of return measures. It includes Gross profit ratio,
Net profit ratio, Return on equity ratio, Return on capital employed ratio and Return
on asset ratio. Gross Profit Margin ratio indicates the margin available after meeting
the manufacturing expenses. It is a measure of the efficiency of production and the
price realization.
 Market Value Ratios - Valuation Ratios are measures of how the equity stock of the
company is assessed in the capital market. The widely used market value ratios are
Price-Earnings Ratio and Market Value to Book Value Ratio.
For detail discussion of these ratios please refer your Financial Management I module.
(b) Trend Analysis
In addition to analyzing the ratios for a given year, it is useful to look at the trend of
different ratios for a number of years. This gives an idea about the areas where there is a
favorable trend or improvement and areas where there may not be an improvement.
This can be in either of the following methods:
c. Index Analysis

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Considering the various elements of a Balance Sheet and Profit and Loss Statement
during a particular year as a base we can find out the respective values during different
years relative to the base year. This gives an indication of growth or decline in values
over the duration of study.
d. Common size Analysis
Common size analysis is useful for comparing the financial statements of different firms
of varying sizes. The different elements of Income Statement are computed relative to
Net Sales considering the value of Net Sales as 100. Similarly, the Balance Sheet figures
are computed relative to the Total Assets considering the value of Total Assets as 100.

II. Technical Analysis

A technical analyst believes that share prices are determined by the demand and supply
forces operating in the market. These demand and supply forces in turn are influenced by a
number of fundamental forces as well as certain psychological or emotional factors. Many of
these forces cannot be quantified. The combined impact of all these factors is reflected in the
share price movements. A technical analysis therefore concentrates on the movement of
share prices. This analysis is the name given to forecasting techniques that utilize historical
share price data. The rationale behind technical analysis is that share price behavior repeats
itself over time and analysts attempt to derive methods to predict this repetition. The analyst
looks at the past share price data to see if he can establish any patterns. Thus, extrapolations
can be made to predict the future price movements.

The basic premise of technical analysis is that prices move in trends or waves which may be
upward or downward. It is believed that the present trend are influenced by the past trends
and the projection of future trends is possible by an analysis of past price trends. Therefore it
analyzes the price and volume movements of individual securities as well as the market
index.

BASIC PRINCIPLES OF TECHNICAL ANALYSIS

1) The market value of a security is related to demand and supply factors operating in
the market.
2) There are both rational and irrational factors which surround the supply and
demand factors of a security.
3) Security prices behave in a manner that their movement is continuous in a particular
direction for some length of time.
4) Trends in stock prices have been seen to change when there is a shift in the demand
and supply.
5) The shifts in demand and supply can be detected though charts prepared specially to
show market action’

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 6) Patterns which are projected by charts record price movements and these recorded
patterns are used by analysts to make forecasts about the movement of prices in
future.
Technical Analysis vs. Fundamental Analysis

Fundamental analyst tries to estimate the intrinsic value of a security by evaluating the
fundamental factors affecting the macro economy, industry and company. This is a tedious
process and takes a rather long time to complete the process.

Technical analysis studies the price and volume movements in the market and by carefully
examining the pattern of these movements, the future price of the stock is predicted. Since
the whole process involves much less time and data analysis, compared to fundamental
analysis, it facilitates timely decision.

Fundamental analysis helps in identifying undervalued or overvalued securities. But

technical analysis helps in identifying the best timing of an investment, i.e. the best time to
buy or sell a security identified by fundamental analysis as undervalued or overvalued.
Thus, technical analysis may be used as a supplement to fundamental analysis rather than
as a substitute to it. The two approaches however, differ in terms of their databases and
tools of analysis. Fundamental analysis and technical analysis are two alternatives
approaches to predicting stock price behavior. Neither of them is perfect nor complete by
itself.

Technical analysis has several limitations. It is not an accurate method of analysis. It is often
difficult to identify the patterns underlying stock price movements. Moreover, it is not easy
to interpreter the meaning of patterns and their likely impact on future price movements.

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