CHAPTER-6

SECURITY ANALYSIS
Security Analysis
• Security analysis refers to the detail examination of
securities in light of different factors to determine
price of securities and thus make investment
decision.
• There are two methods of security analysis known
as fundamental analysis and technical analysis.

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Fundamental Analysis
Fundamental Analysis
• The fundamental analysis of a security investigates
fundamental factors that affect the performance of
companies.
• The basic objective of fundamental analysis is to
find out the intrinsic value of a security.
• Intrinsic value is the present value of future cash
flows related to the security discounted at required
rate of return.

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Fundamental Analysis
• Determining intrinsic value enables the investor to
know whether the security is undervalued (current
market price is less than the intrinsic value) or
overpriced (current market price is more than the
intrinsic value). This in turn enable to make trading
decisions – to buy undervalued securities and to sell
overpriced securities.
• Fundamental analysis involves a three step examination:
1. Economic analysis
2. Industry analysis
3. Company analysis

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Economic Analysis
• Companies are a part of the industrial and business sector,
which in turn is a part of the overall economy. Thus, the
performance of a company depends on the performance of
the entire economy.
• If the investor want to invest on companies that are
involved in international trade it is important to consider
the global economy because the global economy has a
bearing on the export prospects of the firm, the
competition it faces from international competitors, and the
profitability of its overseas investments.
• The following are key economic variables that an investor
must monitor as part of his fundamental analysis.
A - Inflation: Inflation leads to erosion of purchasing power
in the hands of consumers, this will result in lower the
demand of products of a company.
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Economic Analysis
B - Interest rates: Interest rates determine the cost and
availability of loan. A low interest rate stimulates investment
by making credit available easily and cheaply. On the contrary,
higher interest rates result in higher cost of production which
may lead to lower profitability and lower demand.
C - Exchange rates - The profitability of companies that are
major importers or exporters are considerably affected by
the exchange rates of the local currency against major
currencies of the world.
D – Infrastructure - The development of an economy
depends much on availability of infrastructure. A good
infrastructure facilities have favorable effect on stock market.
E - Political stability - A stable political environment is
necessary for steady and balanced growth.
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Economic Analysis
F - Business Cycle - The growth stage of economy affects
the performance of companies. GDP is an indicator of
economic growth and an economy typically passes through
four stages of economic growth collectively known as
business cycle.
• The four stages of an economic cycle are:
1. Depression: This is the worst of the four stages. During a
depression, demand is low and declining. Inflation is often high and so
are interest rates.
2. Recovery stage: The economy begins to recover after a
depression. Demand picks up leading to more investments in the
economy. Production, employment and profits are on the increase.
3. Boom: The phase of the economic cycle is characterized by high
demand. Investments and production are maintained at a high-level
to satisfy the high demand. Companies generally post higher profits.
4. Recession: The boom phase gradually slows down. The economy
slowly begins to experience a downturn in demand, production
employment, etc.; the profits of companies also start to decline.
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Economic Analysis
• If the economy is in recession or depression,
ceteris paribus, the performance of companies will
be bad in general. On the other hand, if the
economy is booming, incomes are rising and the
demand is good, then the industries and the
companies in general may be prosperous.
G - Government Policy – Govts. put two policies
in practice to affect the economy. The first is fiscal
policy which is concerned with the spending and tax
initiatives of the government. The other is monetary
policy which is concerned with the manipulation of
money supply in the economy.
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Economic Analysis
• Fiscal policy is the most direct tool to stimulate or
dampen the economy. An increase in government
spending and decrease in tax rate stimulates the
demand for goods and services, whereas a decrease
in government spending and increase in tax rate
deflates the demand for goods and services.
• The monetary affects the economy mainly through
its impact on interest rates. An expansionary
monetary policy lowers short-term interest rates,
thereby stimulating investment and consumption
demand. A contractionary monetary policy has the
opposite effects.
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Industry Analysis
• The main purpose of industry analysis is to seek
industry that are expected to grow faster.
• An industry is a group of firms producing reasonably
similar products which serve the same needs of
common set of buyers.
• The following are key industry related variables that an
investor must monitor as part of his fundamental
analysis.
A - Industry Life Cycle Stage
• Every industry has to go through four stages
throughout its life: the pioneering stage, the expansion
stage, the stagnation stage, and the decay stage.

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Industry Analysis
1. Pioneering stage - is the first stage in the industrial
life cycle, where the technology as well as the products
are relatively new and have not reached a state of
perfection. The stage is characterized by rapid growth in
demand for the output of the industry but negative or
low profit.
2. Expansion stage - once an industry has established
itself, it enters the second stage which is called expansion
or growth stage. The stage is characterized by high
demand of product. Companies in the expansion stage of
an industry are quite attractive for investment purposes
because investors can get high return at low risk since
demand exceed supply.
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Industry Analysis
3. Stagnation stage - In this stage, the growth of
the industry stabilizes and the ability of the industry
to grow appears to have been lost.
4. Decay stage – It occurs when the products of
the industry are no longer in demand. This may be
because new products and new technologies have
come to the market or customers have changed
their life style and habits. As a result, the industry
become obsolete and gradually ceases to decay of an
industry.

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Industry Analysis
B - Characteristics of industry – In an industry
analysis, there are a number of key characteristics that
should be considered by the analyst.
1. Sensitivity of industry to the Business Cycle:
Some industries are very sensitive to the business
cycle and some are not. E.g., During expansion phase,
the demand for automobiles tends to rise sharply and
vice versa. By contrast, the cigarette industry is more
or less independent of the business cycle.
2. Nature of demand and supply - An industry is
likely to experience under-supply and over-supply of
capacity at different times. Excess supply reduces the
profitability of the industry through a decline in the
unit price. On the contrary, insufficient supply tends
to improve the profitability through higher unit price

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Industry Analysis
3. Competitive conditions in the industry –The numbers
of the firms in the industry and the market share of the top
firms in the industry should be analyzed. If too many firms are
present in the industry, the competition would be severe and
this will lead to a decline in price of the product.
• Michael Porter argues that a firm can explore two generic
ways of gaining sustainable competitive advantage i.e., cost
leadership and product differentiation.
• An analyst should assess the following competitive forces in
the industry to determine whether a firm is likely to gain
competitive advantage or not:
• Barriers to entry
• The threat of substitution
• Bargaining power of the suppliers
• Bargaining power of Buyers
• The rivalry among competitors
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Industry Analysis
4. Supply of raw materials - This is also one of the
important factors that determines the profitability of an
industry. Some industry may have no difficulty in
obtaining the major raw materials as they may be
indigenously available in plenty. Other industries may have
to depend on a few manufactures within the country or
on imports from outside the country. An industry which
has a limited supply of raw materials domestically and
where imports are restricted will have weak growth
prospects.
5. Attitude of government - The government may
encourage certain industries and can assist such
industries through favorable legislation. On the contrary,
the government may look with disfavor on certain other
industries such as alcoholic drinks and cigarette
industries. A prospective investor should consider the
role that the government is likely to play in the industry.
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Industry Analysis
6. Cost structure
• The cost structure (fixed and variable cost) affect
the cost of production and profitability of the firm.
The higher the fixed cost, the higher sales volume
necessary to achieve breakeven point. Conversely,
the lower the fixed cost, the lower quantity would
be needed to reach breakeven point. So, an analyst
would consider favorably an industry that has a
lower breakeven point.

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Company Analysis
• Performance of firms differ within an industry. It is
important to select the profitable company in the
industry. The aim of company analysis is answering
which firm perform well with in the industry.
• The financial statements of a company help to assess
the profitability and financial health of the company.
Therefore, financial statement analysis (ratio analysis) is
the major tool of company analysis.
• Financial ratios help to assess whether the financial
performance of a company is improving or
deteriorating, with respect to the industry average or
through a time series analysis.

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Company Analysis
• The following are the major ratios used to understand
financial performance and position of a company;
• Profitability ratios – ROA (Return on Asset), ROE (Return on
Equity), NIM (Net Interest Margin), CIR (Cost to Income
Ratio), profit margin
• Liquidity ratios – Current ratio, cash ratio, and quick ratio
• Solvency (debt ratios) – DER (Debt to Equity Ratio), DAR
(Debt to Asset Ratio)
• Market ratio – EPS (Earning Per Share)
• Asset utilization ratios – Inventory turnover, receivable
turnover, fixed asset turnover, total asset turnover

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Technical Analysis
Technical Analysis
• This type of security analysis basically looks into
the short term factors to forecast security price
based on trends on historical prices.
• Unlike fundamental analysts, technical analysts do
not attempt to measure a security's intrinsic value,
instead they use charts and other tools to identify
patterns that can suggest future activity.
• The major goal of technical analysis is determining
of timing of investment (when to buy or when to
sell)

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Technical Analysis
• Technical analysis is based on three assumptions:
1. The Market Discounts Everything - At any given time,
a stock's price reflects everything that has or could
affect the company including fundamental factors.
2. Price Moves in Trends - In technical analysis, price
movements are believed to follow trends. This means
that, the future price movement is more likely to be
in the same direction as the trend.
3. History Tends To Repeat Itself - The repetitive nature
of price movements is attributed to market
psychology; in other words, market participants tend
to provide a consistent reaction to similar market
stimuli over time.
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Technical Analysis
• Tools of Technical Analysis
1. Dow Theory
• According to Dow Theory, the stock market does
not move on random basis, but is influenced by
three movements that guide its direction.
• The movements are the primary movements,
secondary reactions and minor movements.
• The primary movement is the long-range cycle that
carries the entire market up or down. This is the
long-term trend in the market.

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Technical Analysis
• The secondary reactions act as a restraining force
on the primary movement. These are in the
opposite direction to the primary movement and
last only for a short while and are known as
corrections.
• The third movement in the market is the minor
movements which are the day-to-day fluctuations in
the market. The minor movements are not
significant and have no analytical value as they are
of very short duration.

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Technical Analysis
2. Bullish Trend
• A bullish market (upward moving market) would be
indicated by the formulation of higher bottoms and
higher tops.
• The bull market is characterized by three phases. In
the first phase, the price would advance with the
revival of confidence in the future of business.
During the second phase, price would advance due
to improvements in corporate earnings, in the third
phase, prices advance due to inflation and
speculation.

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Technical Analysis
3. Bearish Trend
• A bearish market would be indicated by the
formulation of lower tops and lower bottoms.
• The bear market (downward moving market) is also
characterized by three phases, in the first phase, price
begin to fall due to abandonment of hopes. In the
second phase, companies start to reporting lower
profits and lower dividends, in the final phase, price falls
still further due to distress selling.
• 4. Chart Analysis - Chart analysts plots historical
prices in a two-dimensional graph in order to identify
price patterns which can then be used to predict the
futures direction of prices.
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-END-

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