Chapter 5

CHAPTER 5: SECURITY ANALYSIS

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INTRODUCTION

The actual return an investor receives from the

securities is related to the risk. So, it becomes necessary
for investor to analyze the securities from the view
point of their prices, returns and risks.

Understand the fluctuations of prices of securities and

the behavior pattern of the market before investment .
There are various approaches to security analysis which are as follows:
1. Fundamental analysis
a. Economic analysis
b. Industry analysis
c. Company analysis
2. Technical analysis

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 FUNDAMENTAL ANALYSIS

• to make a rational and scientific investment decision, an

investor has to evaluate a lot of facts as to the part as
well as the expected future performance of companies,
industries and the economy as a whole in advance-
known as fundamental analysis.
• Fundamental Analysis thus involves in 3 steps

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 5.1.1 Macro-Economic Analysis

•Evaluates current economic environment and its effect on industry and company
fundamentals.
• The macro-economy is the environment in which all firms operate.
•Any macro-economic forecast should include estimates of all of the important
economic numbers, including:
 The performance of a company which depends much on the performance of the
economy.
 If the economy is BOOM/prosperous, if the economy is in RECESSION/poor,
 Investors are interested in studying those economic varieties, which affect the
performance of the company in which they proposed to invest.
 An analyzed of those economic variables- would give an idea about future
corporate earnings and the payment of dividends and interest to investors.

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Key economic variables that can investor must monitor as part of
this fundamental analysis:

1) GDP
2) Savings and Investment
3) Inflation
4) Agriculture
5) Rates of Interest
6) Govt. Revenue, Expenditure & Deficits
7) Infrastructure
8) Monsoon and Agriculture
9) Political Stability
10)Foreign exchange (Global Economy)

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 GDP (Gross Domestic Product)

• GDP is measure of the economy’s total production of goods

and services (aggregate g/s) and indicates the rate of growth
of the economy.
• Rapid growth in GDP indicates an expanding economy and
higher sales for the firms.
• The higher growth rate is more favorable to the stock market.
Savings and Investment
 represent that portion of GNP (gross national product) which
is saved and invested.
 growth requires investment – and in turn requires domestic
savings.
 A higher level of savings and investments accelerates the pace
of growth of the stock market.
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 Rates of Interest

•The cost and availability of credit for companies are determined by the
rates of interest prevalent in an economy.
• A low interest rate stimulates investment by making credit available
easily and cheaply.
•As a result cost of finance for companies decreases which assures
higher profitability.
•On the other hand, higher interest rates result in higher cost of
production, which may lead to lower profitability and lower demand.
•Hence an investor has to consider the interest rates prevailing in the
economy and evaluate their impact on the performance and profitability
of the companies.
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Government Revenue, Expenditure & Deficits
•Government is the largest investor and spender of money.
•This investment have a significant impact on the performance of
industries and companies.
•So the investor has to evaluate these carefully to assess their impact
on his/her investments.
•Large deficit means more borrowing, which implies higher interest
rate.
•Budget Deficit
•Budget deficit is difference between government spending and
revenues.
•The deficit should be closed by borrowing.
•The government borrowing can increase interest rates and crowd-out
the private borrowing and decrease investment and affect economic
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growth negatively.
 Infrastructure Facilities
•The development of an economy depends on the availability of
infrastructure.
•Ex. electricity, roads and railways, communication channels,
sound banking and financial sectors etc.
•The availability of infrastructural facilities affects the
performance of companies.
•While inadequate infrastructure leads to inefficiencies, lower
productivity, wastage and delays and vice versa.
•Thus an investor should assess the status of infrastructural
facilities available.
•Monsoon and Agriculture
•Agriculture is directly and indirectly linked with the industries.
Ex:- Sugar, Cotton, Textile and Food processing industries depend
upon agriculture for raw-material.
• A good monsoon leads to higher demand for input and results in
bumper crop; this would lead to good spirit in the stock market. 9
 Political Stability

•A stable political environment is necessary for steady and

balanced growth.
•The long term economic policies are needed for industrial
growth.
•Stable policies can be framed only by stable political systems.

Exchange rate
•Exchange is the rate at which domestic currency can be
converted into foreign currency.
• It affects the international competitiveness of the country.
• The depreciation of domestic currency makes the domestic
products cheaper in foreign countries and increases the exports
and hence the GDP growth. 10
 5.1.2 Industry Analysis

•Indicates to an investor whether the industry is a growth industry

or not.
•It gives an investor a choice of the industry in which the
investments should be made and refers the relative strength and
weakness of particular industries which can be divided in to three
parts:
1. Life cycle of an industry
2. Characteristics of an industry
3. Profit potential of an industry

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 1. Life cycle of an industry
•Marketing experts believe that each product has a life cycle. In
the same way industry is also said to have a life cycle.

•Pioneering Stage:

•Growth and Expansion stage

•Stagnation Stage

•Decay stage

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 Pioneering Stage:

•In this stage technology and product are newly introduced, severe competition and only
fittest companies survive this stage.
•The producers try to develop brand name, differentiate the product, create a product
image, incur major development costs, modest sales and face negative profits
•The severe competition often leads to the change of position to the firms in terms of
market shares and profit.
In this situation, it is difficult to select companies for investment because the survival
rate is unknown.
Growth and Expansion stage
•This stage starts with the appearance of surviving firms from the pioneering stage.
•Companies in this stage stabilize their prices, develop a market of their own and
follow their own strategies.
•, the firms are able to maintain their position in the market.
• This is the best time for the investor to make an investment in companies passing
through the expansion stage.
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• The investors can get high returns because demand exceeds supply of the product .
 Stagnation Stage

•the growth of the industries stabilizes, sales increases at slower

rate, industry cannot expand further.
•To keep going, technological innovations in the production
process and products should be introduced.
•So, the companies which have taken note of the arrival of
stagnation stage have to change their course of action.
•Likewise, investors too should evaluate their investment.
Decay stage
•Demand for the product and the earnings of the companies in the
industry decline.
•The specific future of the declining stage is that even in the boom
period; the growth of the industry would be low and decline at a
higher rate during the recession.
•It is better to avoid investing
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 2. Characteristics of an industry

•In an Industry analysis the analyst should consider a number of

key characteristics:
 Relationship between Demand & supply
 Nature of the product
 Nature of the competition
 Growth of the industry
 Labor
 Government policy
 Availability of Raw Material
 Research and development
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 3. Profit potential of an industry

•Specifically, a critical factor affecting the profit potential of an

industry is the intensity of competition in the industry, as Porter has
discussed in a series of books and articles.

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a) Threat new entrants:

•New entrants inflate cost, push down the prices and reduce
profitability.

•An industry which is well protected from the entry of new firms
would be ideal for investment.

a) Competitions among existing firms:

• Competition on the basis of price, quality, promotion, service,
warranties and so on.
• If the competition between the firms in an industry is strong
average profitability of the industry may be discouraged
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 C. Pressure from substitute products:

•Each firm in an industry faces competition from other firms in the same industry
producing substitute products. Ex: - Sony T.V, Samsung T.V etc..
•Substitute products may affect the profit potential of the industry badly.
The pressure from the substitute products is found to be high
a) When the price of the products is attractive
b) When the cost for the prospective buyers to switch over to a substitute product is
minimum.
c) When the substitute products are earning greater profits.

d) Bargaining power of buyers

Buyers can bargain for price reduction, asks for better quality and better service.
•The bargaining power of a buyer group is said to be high:
a) If its capacity to buy is more than the capacity of the seller to sell.
b) If the cost of the switch over to a substitute product is low.
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e) Bargaining Power of Suppliers

•Suppliers can suppress the profitability of the industries to which

they sell by raising prices or reducing the quality of the
components they provide.

•If a supplier reduces the quality of the components it supplies, the

quality of the finished product will suffer, and the
manufacturer will eventually have to lower its price.

•If the suppliers are powerful relative to the firms in the industry to
which they sell, industry profitability can suffer.
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 5.1.3 Company Analysis

•It involves a close investigative scrutiny of the company’s

financial and non-financial aspects with a view to identifying its
strength, weaknesses and future business prospects.
•The financial and non-financial aspects are as follows:
 Marketing success
 Accounting Policies
 Profitability
 Capital Structure
 Financial Analysis
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Marketing success

•The success of the market of the firm depends on

(a) The market share of annual sales
(b) Growth of annual sales
(c) The stability of annual sales.
(d) Sales forecast
Accounting Policies
•While analyzing a company, the investor should carefully consider the
accounting policies followed by the company.
a) Inventory Pricing- Generally, the prices of inventory change over a period
of time Ex:- FIFO and LIFO
b) Depreciation methods- The amount of depreciation varies depending upon
the method employed.
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c) . Ex. Straight line method and Diminishing balance method .
c) Non-operating income- Non-operating incomes are those items of
incomes which are not earned in the routine business of the company.

Ex-Dividend and Interest

d) Tax Carry over- A company must take adequate provisions/benefits

for payment of tax on its earnings.
 Further, excess tax paid in the previous year may be refunded in the
current year and such refund may be adjusted against the tax due in
the current year.
 The incidence of corporate tax and tax carryover are the factors which
the investor should carefully take into consideration.

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 Organizational performance (profitability) and
Management functions

 Organizational performance
 Effective application of company resources
 Efficient accomplishment of company goals
 Management functions
 Planning - setting goals/resources
 Organizing - assigning tasks/resources
 Leading - motivating achievement
 Controlling - monitoring performance

•Evaluating Management Quality

 Age and experience of management
 Strategic planning
 Understanding of the global environment
 Adaptability to external changes

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 Marketing strategy

 Track record of the competitive position

 Sustainable growth
 Public image
 Finance Strategy - adequate and appropriate
 Employee/union relations
 Effectiveness of board of directors

•Capital Structure
Generally, companies raise long term funds through the issue of shares and other
securities like bonds, debentures etc.
•The capital structure affects return on the equity shareholder’s investment.
•Equity holder’s return can be increased by using more debts than equity capital.
•So the investor should study the company’s capital structure before taking a
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decision.
•Financial Analysis
 Balance Sheet
 Snapshot/overview of company’s Assets, Liabilities and Equity.
 Income statement
 Sales, expenses, and taxes incurred to operate
 Earnings per share
 Cash flow statement
 Sources and Uses of funds
 Are financial statements reliable?
 G.A.A.P.
 IFRS
 Financial Ratio Analysis
 Liquidity (ability to pay bills)
 Debt (financial leverage)
 Profitability (cost controls)
 Efficiency (asset management)
 DuPont Analysis
 Top-down analysis of company operations
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 Objective: increase ROE
5.2 TECHNICAL ANALYSIS

• Technical analysis -is a security analysis discipline

for forecasting the future direction of prices through
the study of past market data, primarily price and
volume.
• It is the attempt to forecast stock prices on the basis
of market-derived data.
• Technicians (also known as quantitative analysts or
chartists) usually look at price, volume and
psychological indicators over time.
 They are looking for trends and patterns in the data
that indicate future price movements.

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 Assumptions of Technical Analysis
 The market value of any good or service is determined solely by the
interaction of supply and demand.
 Supply and demand are governed by numerous rational and irrational
factors.
 Included in these factors are those economic variables relied on by the
fundamental analyst as well as opinions, moods, and guesses.
 Disregarding minor fluctuations[- the prices for individual securities and
the overall value of the market tend to move in trends/styles, which persist
for appreciable lengths of time.
 Prevailing trends change in reaction to shifts in supply and demand
relationships. -These shifts, no matter why they occur, can be detected
sooner or later in the action of the market itself.
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Advantages of Technical Analysis

 It is not heavily dependent on financial accounting statements

 Problems with accounting statements:

1. Lack information needed by security analysts
2. GAAP/IFRS allows firms to select reporting procedures, resulting in
difficulty comparing statements from two firms
3. Non-quantifiable factors do not show up in financial statements
 Fundamental analyst must process new information and quickly
determine a new intrinsic value, but technical analyst merely has to
recognize a movement to a new equilibrium.
 Technicians trade when a move to a new equilibrium is underway but a
fundamental analyst finds undervalued securities that may not adjust
their prices as quickly.
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Challenges to Technical Trading Rules:-

 That the past price patterns or relationships between specific market

variables and stock prices may not be repeated.
-As a result, a technique that previously worked might miss
subsequent market turns.
 The success of a particular trading rule will encourage many investors to
adopt it. This popularity and the resulting competition will eventually
neutralize the technique
 When we examine specific trading rules, they all require a great deal of
subjective judgment. The same price pattern may arrive at widely different
interpretations of what has happened and, therefore, will come to different
investment decisions.
 In connection with several trading rules, the standard values that signal
investment decisions can change over time. 29
• End of Chapter Five

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