Chapter Five

Security Analysis

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 Introduction
 The primary motive of buying a share is to sell it at a higher
price and dividend expectation.
 Consequently, an investor would be interested to:
the dividends to be paid on the share in the future and
also the future price of the share.
 These values can only be estimated and not predicted with
certainty.
 This values are primarily determined by the performance of:
 the industry to which the company belongs
 the general economic condition and
 socio political scenario of the country.
 In addition, all securities are associated with risks.
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 So, it becomes necessary for investor to analyze the securities
from the view point of their:
 prices,
returns and
 risks.
 This analysis is useful:
 in understanding the fluctuations of prices of securities
and
the behavior pattern of the market before one decide to
invest in securities.

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 Approaches to security analysis
1. Fundamental analysis

a. Economic analysis
b. Industry analysis

c. Company analysis

2. Technical analysis

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 Fundamental Analysis (EIC Analysis)
 In order to make a rational and scientific investment
decision:
 an investor has to evaluate a lot of information about:
 the past performance and
 the expected future performance of
 companies,
 industries and
 the economy as a whole before taking the investment decision.
 Such evaluation or analysis is called fundamental analysis.
 It is based on the basic premise that security price is determined
by a number of fundamental factors relating to the economy,
industry and company.
 The purpose of fundamental analysis is to evaluate:
 the present and future earning capacity of a security based on
EIC fundamentals and then assess the intrinsic value of the security.
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 The investor can then compare the intrinsic value with
market price to arrive at investment decision.
 If the MP < intrinsic value, underpriced, then investor would
decide to buy a security.
 The price of such a security is expected to move up in the
future to match with its intrinsic value.
 If the MP > intrinsic value, its perceived to be over price, then the
investor decide to sell such a security..
 This is b/c of that the market price of such a security is
expected to come down in the future
 Fundamental analysis thus provides an analytical frame
work(EIC frame work) for rational investment decision making.

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 Three Steps of Top-Down Fundamental
Analysis
1.Macroeconomic analysis: evaluates current economic
environment and its effect on industry and company fundamentals,
such as fiscal, monetary policy

2. Industry analysis: evaluates outlook for particular

3. Company analysis: evaluates company’s strengths and

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 Economic analysis

Industry analysis

Company analysis

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 1. Economic Analysis
 The performance of a company depends much on the
performance of the economy.
 If the economy is BOOM, the industries and companies in
generally said to be prosperous.
 On the other hand, if the economy is in RECESSION, the
performance of companies will be generally poor.
 Investors are interested in studying those economic varieties, which
affect the performance of the company in which they proposed to
invest.
 An analysis of economic variable would give an idea about:
 future corporate earnings
 the payment of dividends and
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 interest to investors. 5/6/2023
 key economic variables that can investor must
monitor as part of this fundamental analysis:
GDP
Savings and Investment
Inflation
Rates of Interest
Govt. Revenue, Expenditure & Deficits
Infrastructure
Monsoon and Agriculture
Political Stability

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 1. GDP
 GDP indicates the rate of growth of the economy.
 It represents the aggregate value of goods and
services produced in the economy.
 The growth rate of economy points out the prospects
for the industrial sector and the return investors
can expect from investment in shares.
 The higher growth rate is more favorable to the stock
market.

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 2. Saving and Investment
 Savings and investments represent that portion of GNP which is
saved and invested.
 It is obvious that growth requires investment which in turn
requires substantial amount to domestic savings.
 Stock market is a channel through which the savings of the
investors are made available to the corporate bodies.
 A higher level of savings and investments, accelerates
the pace of growth of the stock market.

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 3. Inflation
 Inflation has considerate impact on the performance of companies.
 Higher rates of inflation upset business plans and reduce
purchasing power in the hands of consumers.
 This will result in lower demand for products.
 Thus high rates of inflation in an economy are likely to affect the
performance of companies adversely.
 However, industries and companies prosper during periods of low
inflation.
 Hence, an investor has to evaluate:
 the inflation rates prevailing in the economy currently &
 the trend of inflation likely to prevail in the future.

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 4. Interest Rates
 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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 5. Gvt. Revenue, Expenditure & Deficits
 Government is the largest investor and spender of money.
 So the trends in gvt revenue, expenditure & deficits have a
significant impact on the performance of industries and
companies.
 Fiscal and Monetary policies.
 So the investor has to evaluate these carefully to assess
their impact on his investments.

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 6. Infrastructure Facilities
 The dvt. of an economy depends very much on the availability
of infrastructure.
 It includes 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 in the economy before finalizing his
investment avenues.
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 7. 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.
 When the monsoon is bad, agricultural and power production
would suffer. They cast a shadow on the share market.

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 8. Political Stability
 A stable political environment is necessary for
steady and balanced growth.
 No industry or company can grow and prosper when the
country is passing through political instability.
 The long term economic policies are needed for industrial
growth.
 Stable policies can be framed only by stable political
systems.

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 2. INDUSTRY ANALYSIS
 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.
 Industry analysis refers to an evaluation of the relative strength
and weakness of particular industries which can be
divided in to three parts, viz.,
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 (IG
MD).
 In the same way industry is also said to have a life cycle. They are
a. Pioneering Stage:
 Technology and product are newly introduced.
 There would be severe competition and only fittest companies
survive this stage.
 The producers try to develop brand name, differentiate the
product and create a product image.
 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 b/c the survival rate is unknown. 5/6/2023
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 Cont…
b. Growth and Expansion stage:
 This stage stars 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.
 Ultimately, by showing their competitive strength, 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.
 The investors can get high returns because demand exceeds
supply of the product.
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 c. Stagnation Stage:
 In this stage the growth of the industries Stabilizes.
 Moreover, sales increases at slower rate.
 The industry realizes that it cannot expand further.
 To keep going, technological innovations in the
production process and products should be
introduced.
 So, the companies who have taken note of the arrival of
stagnation stage have to change their course of action.
 Likewise, investors too should evaluate their
investment in such industry on a continuous basis.

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d. Decay/Declining stage:
 In this stage, demand for the particular 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 in the shares of the low
growth industry even in the boom period.
 Investment in the shares of these companies leads to
erosion of capital.

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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
It depends on the following factors:
(i) 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.
(ii) Competitions among existing firms:
 The firm competes with each other 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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(iii) Pressure from substitute products:
 Each firm in an industry face competition from other firms
in the same industry producing substitute products.
 Ex:- Sony TV, Samsung T.V etc..
 Substitute products may affect the profit potential of the
industry badly.
 The pressure from the substitute products is high
when:
the price of the products is attractive
the cost for the prospective buyers to a substitute product
is minimum.
the substitute products are earning greater profits
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(iv) Bargaining power of buyers:

 Buyers can bargain for price reduction, asks for better

quality and better service.

high:
 If its capacity to buy is more than the capacity of the seller
to sell.
 If the cost of the switch over to a substitute product is low.

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 3. COMPANY ANALYSIS
 It involves a close investigation of the companies 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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 Cont…
 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

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 Cont…
 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.
Due to changes in the prices of the inventory, the value of
inventory changes during an accounting year.
Ex:- FIFO and LIFO
B. Depreciation methods
The amount of depreciation varies depending upon the method
employed. Higher amount of depreciation reduces profit while
the lower amount of depreciation increases profit.
 Straight line method
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 Declining balance method 5/6/2023
 Cont…
C. Non operating income
Non-operating incomes are those items of incomes which are
not earned in the routine business of the company.
• Dividend
• Interest
D. Tax Carry over
 A company must take adequate provisions 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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 Cont…
 Profitability
 When an investor buys a security, he is buying the right
to the future earnings of the company.
 A prudent investor is always interested in stability and
growth of the earnings from security.
(a) Gross profit Margin
(b) Net profit Margin
(c) Earning power
(d) Return on equity
(e) Earning per share

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 Cont…
 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 holders return can be increased by using more debts
than equity capital.
 So the investor should study the company’s capital structure
before take decision.

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 Cont…
 Financial Analysis
 The financial statement of the a company provide the
best possible information about the profitability and
financial soundness of the company.
 This is the primary source of information for evaluating
the prospects of the investment in company’s stock.
 The statement gives the historical and current
information about the company’s operations.
Income statement Analysis
Balance Sheet Analysis

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 Cont…
 The analysis of financial statements reveals the nature of relationship
between income and expenditure and the sources and application of
funds.
 To know much about the profitability and the management’s policy
regarding the dividend, the investor can use the following simple
analysis:
 Comparative statement analysis
 Trend analysis
 Common size statements
 Fund flow analysis
 Cash flow analysis ratio analysis

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 Technical Analysis
 Technical analysis can be defined as the use of specific market-
generated data for the analysis stock prices.
 It involves the analysis of market prices in an attempt to predict
future price movements for the particular financial asset traded on
the market.
 This analysis examines the trends of historical prices and
 It is based on the assumption that these trends or patterns repeat
themselves in the future.
 Technical analysis is sometimes called market or internal analysis, because
it utilizes the record of the market itself to attempt to assess the
demand for, and supply of, shares of a stock or the entire market.
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 Cont…
 Thus, technical analysts believe that the market itself is its own best
source of data as they say, let the market tell its own story.

 Technical analyst believes that using data from the market itself is a
good idea because “the market is its own best predictor.”

 Therefore, technical analysis is an alternative method of making the

 What securities should an investor buy or sell?

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 Cont…
 Technical analysts says no need to study the multitude of
economic, industry, and company variables to arrive at an
estimate of future value because they believe that past price
movements will signal future price movements.
 Fundamental analysis is a method of evaluating securities by
attempting to measure the intrinsic value of a stock.
 Fundamental analysts study everything from the overall economy
and industry conditions to the financial condition and management
of companies.
 Technical analysis is the evaluation of securities by means of studying
statistics generated by market activity, such as past prices and
volume.

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 Cont..
 Technical analysts do not attempt to measure a security's
intrinsic value but instead use stock charts to identify
patterns and trends that may suggest what a stock will do
in the future.
 The field of technical analysis is based on three
assumptions:
1 the market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself

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 Home work: Differentiate between Technical analysis
and Fundamental Analysis?

Thank You!!!
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