Ludhiana College of Engineering and Technology,

Katani Kalan, Ludhiana – 141113

LECTURE NOTES
Course Name: Investment Analysis & Portfolio Management

Contact:
Mail: [email protected], [email protected]
[email protected]
Phone: 0161-2834307 Mobile: 94785-03999,
94785-03666
 I.K.G. Punjab Technical University
MBA Batch 2018 onwards
MBA 911-18 Investment Analysis and Portfolio Management
Course Objective: This course aims to acquaint students with the market microstructure of
financial markets and understanding of economic, industrial and company analysis. It shall also
enable them to understand the valuable linkage between modern theories of finance and the
analytical techniques used by investors for valuing securities and construct portfolios to achieve
investor’s investment goals.

Unit I
Introduction: Concepts of investment, objectives of investment, various alternatives of
investments, investment process, financial investments vs. real investments, differentiate
investment, speculation and gambling. Risk and Return: Concept, types and measurement of
risk and return.
Financial Markets - Primary and secondary markets. Introduction to primary market, design of
primary market, its role and functions, types of offers in the primary market, SEBI guidelines on
primary market
Secondary Market: Introduction, participants, trading and settlement Mechanism, types of
orders, stop Loss, margin trading, short selling, price freeze, hair-cut, market wide circuit
breakers, insider trading, bulk deals, block deals and arbitrage opportunity in the market
Unit II
Fundamental Analysis: Meaning, scope and introduction to concept of intrinsic value. Process of
conducting economic analysis; industry analysis and company analysis by using E-I-C and C-I-E
approaches. Valuation of securities using fundamental analysis.
Unit III
Technical Analysis: introduction, terminology of technical analysis, Dow theory, characteristic
phases of Bull and Bear trends, critical appraisal of Dow theory, various types of charts, concept
of trend, trend lines: support and resistance, Importance of trading volume, reversal patterns,
continuation pattern, moving averages, other market indicators Portfolio Management:
Meaning, importance and approaches of portfolio management, portfolio analysis, portfolio
evaluation and revision techniques.
Unit IV
Portfolio Theory: Markowitz Model, Capital Asset Pricing Model, Single-index model, Arbitrage
Pricing Theory. Market Efficiency and Behavioral Finance Derivatives: Introduction, features,
derivative instruments, difference between forward and futures contracts, types of option
contracts, computing payoffs of forward, futures and option contracts.
 CHARACTERISTICS OF AN INDUSTRY ANALYSIS

In an industry analysis, the following key characteristics should be considered by the

analyst. These are explained as below:

1. Post sales and Earnings performance: The historical performance of sales and
earnings should be given due consideration, to know how the industry have reacted
in the past. With the knowledge and understanding of the reasons of the past
behavior, the investor can assess the relative magnitude of performance in future.
The cost structure of an industry is also an important factor to look into. The higher
the cost component, the higher the sales volume necessary to achieve the firm’s
break-even point, and vice-versa.
2. Nature of Competition: The top firms in the industry must be analyzed. The demand
of particular product, its profitability and price of concerned company scrip’s also
determine the nature of competition. The investor should analyze the scrip and
should compare it with other companies. If too many firms are present in the
industry, this will lead to a decline in price of the product.
3. Raw Material and Inputs: We need to have a look on industries which are dependent
on raw material. An industry which has limited supply of raw material will have a less
growth. Labor in also an input and problems with labor will also lead to growth
difficulties.
4. Attitude of Government towards Industry: The government policy with regard to
granting of clearance, installed capacity and reservation of the products for small
industry etc. are also factors to be considered for industry analysis.
5. Management: An industry with many problems may be well managed, if the
promoters and the management are efficient. The management has to be assessed
in terms of their capabilities, popularity, honesty and integrity. A good management
also ensures that the future expansion plans are put on sound basis.
6. Labor Conditions and Other Industrial Problems: The industries which depend on
labor, the possibility of strike looms as an important factor to be reckoned with.
Certain industries with problems of marketing like high storage costs, high transport
costs etc leads to poor growth potential and investors have to careful in investing in
such companies.
7. Nature of Product Line: The position of industry in the different stages of the life
cycle is to be noted. And the importance attached by planning commission on these
industries assessment is to be studied.
8. Capacity Installed and Utilized: If the demand is rising as expected and market is
good for the products, the utilization of capacity will be higher, leading to bright
prospects and higher profitability. If the quality of the product is poor, competition is
high and there are other constraints to the availability of inputs and there are labor
problems, then the capacity utilization will be low and profitability will be poor.
9. Industry Share Price Relative to Industry Earnings: While making investment the
current price of securities in the industry, their risk and returns they promise is
considered. If the price is very high relative to future earnings growth, the investment
in these securities is not wise. Conversely, if future prospects are dim but prices are
 low relative to fairly level future patterns of earnings, the stocks in this industry might
be an attractive investment.
10. Research and Development: The proper research and development activities help in
increasing economy of an industry and so while investing in an industry, the
expenditure should also be considered.
11. Pollution Standards: These are very high and restricted in the industrial sector.
These differ from industry to industry, for example, in leather, chemical and
pharmaceutical industries the industrial effluents are more.

PROFIT POTENTIAL OF INDUSTRIES: PORTER MODEL

Michael Porter (Harvard Business School Management Researcher) designed various

vital frameworks for developing an organization’s strategy. One of the most renowned

among managers making strategic decisions is the five competitive forces model that

determines industry structure. According to Porter, the nature of competition in any

industry is personified in the following five forces:

 Threat of new potential entrants
 Threat of substitute product/services
 Bargaining power of suppliers
 Bargaining power of buyers
 Rivalry among current competitors

The five forces mentioned above are very significant from point of view of strategy

formulation. The potential of these forces differs from industry to industry. These forces

jointly determine the profitability of industry because they shape the prices which can be

charged, the costs which can be borne, and the investment required to compete in the

industry. Before making strategic decisions, the managers should use the five forces

framework to determine the competitive structure of industry.

Forces driving industry competition

 Let’s discuss the five factors of Porter’s model in detail:

Risk of entry by potential competitors: Potential competitors refer to the firms which

are not currently competing in the industry but have the potential to do so if given a

choice. Entry of new players increases the industry capacity, begins a competition for

market share and lowers the current costs. The threat of entry by potential competitors

is partially a function of extent of barriers to entry. The various barriers to entry are-
 Economies of scale
 Brand loyalty
 Government Regulation
 Customer Switching Costs
 Absolute Cost Advantage
 Ease in distribution
 Strong Capital base

Rivalry among current competitors: Rivalry refers to the competitive struggle for

market share between firms in an industry. Extreme rivalry among established firms
 poses a strong threat to profitability. The strength of rivalry among established firms

within an industry is a function of following factors:

 Extent of exit barriers
 Amount of fixed cost
 Competitive structure of industry
 Presence of global customers
 Absence of switching costs
 Growth Rate of industry
 Demand conditions

Bargaining Power of Buyers: Buyers refer to the customers who finally consume the

product or the firms who distribute the industry’s product to the final consumers.

Bargaining power of buyers refer to the potential of buyers to bargain down the prices

charged by the firms in the industry or to increase the firms cost in the industry by

demanding better quality and service of product. Strong buyers can extract profits out of

an industry by lowering the prices and increasing the costs. They purchase in large

quantities. They have full information about the product and the market. They

emphasize upon quality products. They pose credible threat of backward integration. In

this way, they are regarded as a threat.

Bargaining Power of Suppliers: Suppliers refer to the firms that provide inputs to the

industry. Bargaining power of the suppliers refer to the potential of the suppliers to

increase the prices of inputs( labor, raw materials, services, etc) or the costs of industry

in other ways. Strong suppliers can extract profits out of an industry by increasing costs

of firms in the industry. Supplier’s products have a few substitutes. Strong suppliers’

products are unique. They have high switching cost. Their product is an important input

to buyer’s product. They pose credible threat of forward integration. Buyers are not

significant to strong suppliers. In this way, they are regarded as a threat.

 Threat of Substitute products: Substitute products refer to the products having ability

of satisfying customer’s needs effectively. Substitutes pose a ceiling (upper limit) on the

potential returns of an industry by putting a setting a limit on the price that firms can

charge for their product in an industry. Lesser the number of close substitutes a product

has, greater is the opportunity for the firms in industry to raise their product prices and

earn greater profits (other things being equal).

The power of Porter’s five forces varies from industry to industry. Whatever be the

industry, these five forces influence the profitability as they affect the prices, the costs,

and the capital investment essential for survival and competition in industry. This five

forces model also help in making strategic decisions as it is used by the managers to

determine industry’s competitive structure.

Porter ignored, however, a sixth significant factor- complementary. This term refers to

the reliance that develops between the companies whose products work is in

combination with each other. Strong complementors might have a strong positive effect

on the industry. Also, the five forces model overlooks the role of innovation as well as

the significance of individual firm differences. It presents a stagnant view of competition.

TECHNIQUES FOR EVALUATING RELEVANT INDUSTRY FACTORS

The techniques (long term and short term) for evaluating industry factors are explained

in the following sections. These are:

1. End-Use and Regression Analysis: End-use analysis for product demand analysis
refers to a process whereby the analyst attempts to diagnose the factors that
determine the demand for output of the industry. In a single product firm, units
demanded multiplied by price will equal sales revenue. The analyst frequently
forecast the factors like disposable income, per capita consumption, price elasticity
of demand etc. that influence the demand of the product. For studying the
 relationship between various variables simple linear regression analysis and
correlation analysis is used. Industry sales against time, industry sales against
macro economic variables like gross national product, personal income disposable
income and industry earnings over time may be regressed. When two or more
independent variables are better able to explain variability in the dependent
variables, the multiple regression analysis is used.
2. Input-Output Analysis: Input-output analysis is an economics term that refers to the
study of the effects that different sectors have on the economy as a whole, for a
particular nation or region. This type of economic analysis was originally developed
by Wassily Leontief (1905 – 1999), who later won the Nobel Memorial Prize in
Economic Sciences for his work on this model. Input-output analysis allows the
various relationships within an economic system to be analyzed as a whole, rather
than individual components. Input-output analysis seeks to explain how one industry
sector affects others in the same nation or region. The analysis illustrates that the
output of one sector can in turn become an input for another sector, which results in
an interlinked economic system. The analysis is represented as a matrix, where
different rows and columns are filled with values representing the inputs and outputs
of various sectors.
3. Growth Rate: The growth rate of different industry should be forecasted by
considering historical data. Once the growth rate is estimated, future values of
earnings or sales may be forecast. Since the growth rate is such an important factor
in determining the stock prices, not only its size but its duration must be estimated.
Sometimes, patents expire, competition within an industry becomes more
aggressive because foreign firms begin to compete, economically depressed
periods occur or other factors cause growth rate to drop.

COMPANY ANALYSIS

In company analysis analysts consider the basic financial variables for the estimation of
the intrinsic value of the company. These variables contain sales, profit margin, tax rate,
depreciation, asset utilization, sources of financing and other factors. The conduction of
further analysis of company include the competitive position of the company in the
industry, technological changes, management, labor relations, foreign competition and
so on.

How to do the Company Analysis

Company analysis actually provides the indication of the estimated value & potential of
the company along with the comprehension of its financial variables. Common
stock can be valued by the investors by using dividend discount model. Similarly
earnings multiplier model can be used for estimation of intrinsic value for a short run.
Intrinsic value (or estimated value) is the product of expected multiplier or P/E ratio and
the estimated earnings per share (EPS).

Estimated Value of Stock = Vo = Estimated EPS x Expected P/E Ratio

Relative valuation techniques are used by many investors in which comparison of P/E
ratio, P/S ratio and P/B ratio of the company is made with many benchmarks in order to
ascertain the relative value of the company. Another effective way adopted by investors
is to find out whether the stock is properly valued, undervalued or overvalued without
being much exact about the absolute amount.

Majority of investors considers the P/E ratio and the Earning Per Share while
accessing the value of the stocks of company.

The Financial Statements

Major financial data about company is obtained from its financial statements while
doing the process of company analysis. Following are included in the category of
financial statements.

 Balance Sheet
 Income Statement
 Cash Flow Statement

The Balance Sheet

The balance sheet represents the Portfolio of assets and liabilities & owner’s equity of a
company at particular point of time. The accounting conventions dictate the amounts at
which items are carried on the balance sheets. Cash is the real dollar amount while
marketable securities can be at market value or cost. Assets and stockholders equity
are based on the book value. The careful analysis of the balance sheet of a company is
important for the investors. The investors want to know those companies which are
really profitable and are different from the ones which pump up their performance by
taking too much debt whose recovery is a big issue. Balance sheet is really important to
analyze while doing company analysis for making investment.

Income Statement

In Company analysis process Investors frequently use income statement to evaluate the
current performance of management and forecasting of the future profitability of the
company. The flows for certain period (one year) are represented by the income
statement.

The investors are more interested for the After-tax net income item of the income
statement which is divided by the number of common shares outstanding to ascertain
the earnings per share. The success of the company is viewed from the earnings from
its continuing operations and these earnings are mostly reported as earnings in the
financial press. Nonrecurring income is kept separate from the continuing income.

The Cash Flow Statement

The cash flow statement is the third financial statement of the company which includes
the items of the balance sheet and income statement as well as other ones. It provides
the picture of the travelling of the cash in and out of the company. There are three part
of cash flow statement which are

1. Cash from operating activities

2. Cash from investing activities
3. Cash from financing activities

The quality of earnings is examined by the investors with the help of cash flow
statement. For example if inventories are increasing more quickly than sales this
indicate serious problem by likely softening of the demand. Similarly cutting back of
capital expenditures by a company indicate problem. Moreover it is also problematic if
the accounts receivables increase more quickly than the sales which shows the poor
recovery of the debts by the company.

Certifying the Statements

The Generally Accepted Accounting Principles (GAAP) provides the basis to derive
earnings from the balance sheet. Accounting professionals developed certain rules on
the basis of historical costs which are followed by the company. The earnings in the
financial statements are certified by an auditor from an independent accounting firm.

Reading Footnotes

There are certain foot notes at the end of the financial statements that should be
considered by the investors which mostly gives the information on the accounting
methods being used and how income is reorganized etc. These footnotes may easily
put the company analysis process in the right direction.

Analyzing Profitability of a Company

There are many factors that collectively provide basis for the culmination of the EPS in
the company. Key financial ratios are considered to examine these determining
factors. The increasing or decreasing profitability of a company is ascertained by
examining the components of the EPS.

EPS = ROE x Book Value per Share

Where book value per share is the accounting value of equity of shareholders on the
basis of per share and ROE is the return on equity. Book value changes slowly so ROE
is the main variable that should be focused. These ratios are calculated as follow.

EPS = Net Income after Taxes / Outstanding Shares

Book Value per Share = Shareholder’s Equity / Outstanding Shares

ROE = Net Income after Taxes / Stockholder’s Equity

ROE reflects the accounting rate of return that stockholders are in on their part of the
entire capital employed to finance the company. The accounting value of the
stockholder’s equity is measured by the book value per share.

The earnings growth and dividend growth is determined by the ROE which is the key
component. Many important variables collectively provide basis of ROE. The investors
and analysts try to split the ROE into its important components for the identification of
the severe effects on the ROE and forecasting of the future trends in ROE.

Analyzing Return on Equity (ROE)

ROE = ROA x Leverage

ROA is an important complement of return on investment (ROE) and is used to

measure the profitability of a company. ROE measures the return to stockholders while
ROA measures the return on assets. The effects of leverage must be considered by
going from ROA to ROE. The measure of how a company fiancé its assets, is referred
to as leverage ratio. The company can either takes debt or utilizes only equity for
financing its assets. The debt is although cheaper but more risky due to the associated
regular interest payments which must be paid consistently from preventing bankruptcy.
The returns to shareholders are either magnified with leverage or diminish with it. By the
judicious use of debt financing, certain ROA can be magnified into higher ROE. On the
other hand ROE is lowered than ROA by the injudicious use of Debt.

Leverage = Total Assets / Stockholder’s Equity

Analyzing Return on Assets (ROA)

One of significant measure of the profitability of the company is the ROA. ROA is
product of two factors

ROA = Net Income Margin x Turnover

Net Income Margin = Net Income / Sales

Turnover = Sales / Total Assets

The net income margin which affects the ROA measures earning power of a company
on its sales. Efficiency is measured by the asset turnover. The ROA measures the
profitability of a company by showing how efficiently & effectively the assets of a
company are used. It is clear that the return is better when there is higher net income
for a certain amount of assets.

Earnings Estimates

The estimated EPS is used by the investor to value the stock. Current stock price is a
function of the price earnings ratio (P/E) and the future earnings estimate. The investor
required following three things when conducting fundamental security analysis
using EPS.

 Ascertaining of how to get an earnings estimate

 Viewing the accuracy of any earning estimate acquired
 Comprehending the role of earnings surprises in influencing stock prices

P/E Ratio

The price earnings ratio is very important consideration in doing company analysis. The
P/E ratio shows how much of per dollar earnings investors presently are volitionally to
pay for a stock. The market’s summary evaluation of the prospects of the company is
reflected by P/E ratio.

Determinants of P/E Ratio

Conceptually the price earnings ratio (P/E) is a function of three factors

P/E = D1/E1

k–g

Where k = required rate of return for stock

g = Expected growth rate in dividends

D1/E1 = expected dividend payout ratio

These three factors and their likely changes should be considered by the investors who
are trying to determine the P/E ratio that will prevail for certain stock.

 The higher expected payout ratio indicates the higher the P/E ratio provided
other things being equal. In fact the others are rarely equal. The expected growth
rate in earnings & dividends (g) will likely decline if the payout ratio rises. This will
severely affect P/E ratio. The reason for this decline is the availability of the
lesser funds for the purpose of reinvestment in the company.
 There is inverse relationship between k and P/E ratio. The increase k will reduce
the P/E ratio and similarly decrease in the k will enhance the P/E ratio provided
other things being equal. The reason behind this is that required rate of return is
the discount rate. Discount rates and P/E ratio moves inversely to each other.
 g and P/E are directly related. The increase in the g will enhance the P/E ratio
provided other things being equal.