MMPF-004 Economy Analysis

Indira Gandhi
Security Analysis and
National Open University Portfolio Management
School of Management Studies

Block

2
SECURITY ANALYSIS
UNIT 5 91
Economy Analysis

UNIT 6 108
Industry Analysis

UNIT 7 120
Company Analysis

UNIT 8 134

UNIT 9 152
Valuation of Securities

89
Security Analysis
BLOCK 2 SECURITY ANALYSIS
This block comprises of five Units.
Unit 5 : Economy Analysis defines Fundamental Analysis and introduces
Economy- Industry Company (EIC) framework of analysis. It then Explains the
nature and techniques of economy analysis and points out their relevance for
equity investment decisions.
Unit 6 : Industry Analysis discusses the industry life cycle and describes the
features of an industry. The unit also discusses the techniques of industry analysis
and gives an overview of structural analysis.
Unit 7 : Company Analysis , begins by stating the need for and the importance
of company analysis for equity investment decisions. It then explains and
illustrates the techniques of quantitative and qualitative analysis and methods of
forecasting Earnings per Share (EPS), which is the most critical variable of equity
valuation.
Unit 8 : compares and contrasts “Technical Analysis with
‘Fundamental Analysis’ and discusses the origin and development of Technical
Analysis. It also explains Dow Theory and its basic tenets and discusses the
techniques of Classical and Modern technical analysis. It also illustrates some of
the popular market indicators like, breadth of the market, short interest, odd lot
trading, mutual fund cash ratio, etc. This unit concludes by pinpointing limitations
of technical analysis.
Unit 9: Valuation of Securities discusses the fundamental of valuation of
securities. This unit presents a general valuation framework of securities and the
various models involved in it. In addition, the unit also elaborates various models
of valuation of fixed income securities, equities and preference shares.

90
 Economy Analysis
UNIT 5 ECONOMY ANALYSIS
Objectives
After reading this unit you should be able to:
• Explain the relevance of fundamental and economy analyses for equity
investment decision;
• Discuss the importance of the fundamental analysis in an efficient market
setup;
• Understand the EIC framework;
• Discuss various techniques to measure economic activities.
Structure
5.1 Introduction
5.2 Fundamental Analysis
5.3 Fundamental Analysis and Efficient Market
5.4 Economy-Industry-Company (EIC) Framework
5.5 Economy Analysis
5.6 Measures of Economic Activity
5.7 Economic Forecasting
5.8 Summary
5.9 Key Words
5.10 Self-Assessment Questions
5.11 Further Readings

5.1 INTRODUCTION
There is no point in investing in stocks or any other form of risky investments
when the future performance of the economy is not expected to be good. For
instance, stock market all over the world suffered major loss during covid
pandemic and did slowdown the economic growth. Economy analysis assumes
importance for allocation of capital between equity investments and
government securities. Many of us would like to invest in government
securities or schemes of government, which are not exposed to price variation
risk during the period of economic downtrend. In this unit, we will discuss
more techniques used in evaluating future economic performance. Another
critical factor taken by the investors while investing is the outlook of different
industries. While economic performance in general influence the outlook of
industries, its impact on industries differs from industry to industry.We will
begin our discussion with a broader framework of these analyses called
fundamental analysis.
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Security Analysis
5.2 FUNDAMENTAL ANALYSIS
Investment decision-making being continuous in nature should be attempted
systematically. Broadly, two approaches are suggested. These are:
(i) Fundamental Analysis, and
(ii) Technical Analysis
In the first approach, the investor attempts to look at fundamental factors that
affect risk return characteristic of the security. In the second approach, the
investor tries to identify the price trends, which reflect these characteristics.
The technical analysis concentrates on demand and supply of security and
prevalent trend in share price measured by various market indices in the stock
market.
Economy and industry analyses are part of fundamental analysis. In the
fundamental approach, various fundamental or basic factors that affect the risk-
return of the securities are examined. Effort, here, is to identify those securities,
which are perceived to be mispriced in the stock market. The assumption in
this case is that the ‘market price’ of the security and the price as justified by its
fundamental factors called‘intrinsic value’ are different and the market place
provides an opportunity for a discerning investor to detect such discrepancy.
The moment such a discrepancy is identified the decision to invest or disinvest
is taken. The decision rule under this approach is as follows:
If the price of a security at the market place is higher than the one, which is
justified by the security’s fundamentals, sell that security. This is because, it
is expected that the market will sooner or later realise its mistake and reduce
its price. Therefore, before the market realises its mistake and price that
security properly, a deal to sell this security should be struck in order to reap
the profits. But, if the price of that security is lower than what it should be
based on its fundamentals, it should be bought before the market corrects its
mistake by increasing the price of security in question. The price prevailing
in the market is called ‘market price’ (MP) and the one justified by its
fundamental is called ‘intrinsic value’ (IV) as shown in table 5.1.
Table 5.1: Buying and Selling of the security

Decision Rule Recommendation

(1) If IV > MP, Buy the Security
(2) If IV < MP, Sell the Security
(3) If IV = MP, No action
The fundamental factors mentioned above may relate to the economy or
industry or company or all/some of them. Thus, economy fundamentals,
industry fundamentals and company fundamentals are considered while
analysing the security for taking investment decision. In fact the Economy-
Industry-Company framework forms an integral part of this approach. As
explained earlier, the analysis requires collection of large amount of data
92 relating to economy, industry and company for any meaningful analysis. This
framework can be properly utilized by suitable adjustments in a particular Economy Analysis
context. For instance, a fund manager of a large mutual fund can move from
economy to industry and then company analysis whereas a small investor can
spend more time on fundamental analysis. Such analysis helps the investors
to take an informed and considered investment decision.

5.3 FUNDAMENTAL ANALYSIS AND EFFICIENT

MARKET
Fundamental analysis is not free from criticism. It is pertinent to mention that
doubts are expressed about the utility of this approach in the context of efficient
stock market, which already incorporates the information about the economy,
industry and company in the share price. It is claimed that stock market
incorporates such information in the share price rather instantaneously. The
result of this assumption is that price prevailing at the market place can be
taken to represent the price of the share justified by its fundamental i.e.,
intrinsic value (IV). The equality of MP and IV makes the fundamental analysis
or any other analysis useless or redundant. The above given view about share
market efficiency implies that no one would be able to make abnormal gains
given such a set up. Some research studies in the literature also support the
above view. Practitioners, however, do not agree to such conclusions of
empirical nature.
Once again let us clear at this stage that the truth lies in between these two
extreme position-denouncing security analysis as totally redundant to the one
that would bring us profits. In fact, stock market is not efficient to the extent
the researchers proclaim. There are many operational inefficiencies and
structural deficiencies in stock market. Though the market is fairly efficient
in the long run in a sense that only information leads price changes, operational
and structural inefficiencies cause time lag between arrival of information
and its impact on the security prices. In this context, analysis still has an
important role to play. It is paradoxical but correct to say that one has to
assume that stock market is inefficient to make it efficient. It is only then the
processing of information relating to economy-industry company would take
place that would allow the stock market to reflect the information in the price
quickly if not instantaneously. It is a fact of life that earning abnormal profits
is not the only and final goal for most of the investors. Rather, it has been
observed that earning the normal returns, (i.e., the return commensurate with
risk prevalent in the market) is a worthwhile objective to pursue, which most
of the investors are not even able to achieve. In nutshell, fundamental analysis
has an important role to play for making investment decisions in an efficient
set up, too.

5.4 ECONOMY-INDUSTRY-COMPANY (EIC)

FRAMEWORK
The analysis of economy, industry and company fundamentals are the main
ingredient of fundamental approach. The analysis should take into account
all the three constituents which form different but crucial steps in making
93
Security Analysis investment decision. These can be looked at as different stage in the investment
decision making process and are depicted graphically with three concentric
circles as shown in figure 5.1. The process of investment analysis starts with
an evaluation of economic outlook. After getting some confidence on economic
outlook, the analysis is moved to industry specific to identify industries, which
are worth for further analysis to pick up good stocks. The last stage is
identifying specific stocks from selected industry. Operationally, to base the
investment decision on various fundamentals, all the three stages must be
taken into account.

Figure 5.1: Investment Decision Making Process

THE THREE-STEP VALUATION PROCESS

We have learnt that investment decision is made by comparing the expected
or estimated return with the required rate of return. This investment decision
process is similar to any purchasing decision you make in your day-to-day
life. For instance, when you visit a fruit shop to buy apples or automobile
showroom to buy a vehicle, you always compare the price with the value,
which you are going to receive by such purchases. There are two general
approaches to the valuation process when you make an investment decision:
(1) the top-down, three-step approach and
(2) the bottom-up stock valuation, stock picking approach.
The difference between the approaches is the perceived importance of economy
and industry influence on individual firms and stocks. The three-step approach
believes that a firm’s revenue is considerably affected by the performance of
economy and industry and thus, the first step in valuation of process is to
examine the economy and industry and their impact on the firm’s cash flow.
On the other hand, bottom-up approach believes that it is possible to find
stocks that offer superior returns regardless of the market or industry outlook.
Under this approach, the performance of economy is first looked into to
understand its impact on industries. Then the analysis progress to industry
94 level analysis to understand the likely performance of the industries during
the investment horizon. Once industries are picked up, the analysis moves to Economy Analysis
individual stocks to examine the outlook of firms in the selected industries.
Thus, the three-step approach is also called Economy-Industry-Company (E-
I-C) approach. Figure 5.2 illustrates the E-I-C framework.

Analysis of Economic Conditions

Allocate amounts available to different
Countries and different securities
Analysis of Industries
Classify industries like growth,
matured and allocate funds
Analysis of Stocks
Estimation of
cash flow and
value

Figure 5.2: EIC framework

Economy Analysis
All firms are parts of the overall system known as the ‘general economy’,
which witnesses ups and downs. It is logical to begin the valuation process
with projections of the ‘macro economy’. What you should grasp is the vast
number of influences that affect the ‘general economy’. To give only a few
examples: Fiscal policy affects spending both directly and through its
multiplier effects. For example, tax cuts can encourage spending whereas
additional taxes on income or products can discourage spending. Similarly,
an increase or decrease in government spending also influence the economy.
For example, improving road infrastructre increases the demand for
earthmoving equipment and concrete materials.
Employment created in road construction, earthmoving equipment
manufacturing and concrete materials manufacturing will in turn increase
higher consumer spending. This multiplier effect increase overall economic
activity and thus many investors and analysts consider government spending
on plan expenditure is critical for industrial activity.
Monetary policy affects the supply and cost of funds available to business
units. For instance, a restrictive monetary policy reduces money supply and
thus reduces the availability of working capital to business units. Such policy
also increases interest rates and thus increases the cost of funds to business
units and also increases required rate of return for the investors. Of course, it
will also reduce inflation and thus reduces the required rate of return. Monetary
policy therefore affects all segments of the economy and that economy’s
relationship with other economies.
In addition to fiscal and monetary polices, political uncertainty, war, balance
of payments crisis, exchange rates, monetary devaluations, world opinion,
and several other international factors affect the performance of the economy.
It is difficult to conceive any industry or company that can avoid the impact
of macroeconomic developments that affect the total economy. A well- 95
Security Analysis informed investor will first attempt to project the future course of the economy.
If her/his projections indicate conditions of boom, the investor should select
industries most likely to benefit from the expected prosperity phase. On the
other hand, if the outlook is not good or a recession is expected, investor
should defer investments in stocks or identify industries, called defensive
industry, which are less affected by the poor performance of the economy for
investment in equities. Investment in fixed income securities, particularly
government securities, is preferred in such scenario. Thus, the economy
analysis helps investors first to allocate available surplus amount between
different types of securities (like government bonds, corporate bonds and
equities) and then select industries, which are expected to do well in a given
economic condition. Investors, like Foreign Institutional Investors (FIIs)
operating in several countries can use economic analysis to allocate funds to
different countries based on the economic outlook.
Industry Analysis
All industries are not influenced equally by changes in the economy nor they
are affected by business cycles at just one single point of time. For example,
in an international environment of peace-treaties and resolution of cold war,
profits of defence-related industries would wane. The upturn in construction
industry generally lags behind the economy. Similarly, a boom or expansion
of the economy is not likely to benefit industries subject to foreign competition
of product obsolescence. The equipment manufacturing industry will perform
well towards the end of economic cycle because the buyer firms typically
increase capital expenditure when they are operating at full capacity. On the
other hand, cyclical industries such as steel and auto, typically do much better
than aggregate economy during expansion but suffer more during contractions.
In contrast, non-cyclical industries like food processing or drugs would show
neither substantial increase nor substantial decline during economic expansion
and contraction.
In general, an industry’s prospects within a global business environment will
determine how well or poorly an individual firm will fare. Thus industry
analysis should precede company analysis. A weak firm in booming industry
might prove more rewarding than a leader in a weak or declining industry. Of
course, the investor would continuously be through a search process so that
the best firms in strong industries are identified, and narrow down the area of
search for investment outlets. Industry analysis is also useful for investors to
allocate funds for different industries taking into account the future potential
and current valuation.
Company Analysis
After determining that an industry’s outlook is good, an investor can analyze
and compare individual firms’ performance within the entire industry. This
involves examining the historical performance of the company, the firm’s
standing in the industry and future prospects. The last one is critical for
estimation of cash flows and hence value. It should be noted that a good
Stock or Bond for investment need not come from the best firm or market
leader in the industry because the Stock or Bond of such firms may be fully
96
valued or overvalued and hence there is no scope for earning additional return. Economy Analysis
Thus, investors always look for firms which are undervalued for investments
than looking for firms, which are best in respective industries.
At this stage you may ask a question: “Why should the `company-level’ be
the last stage in the valuation sequence?” The valuation sequence can be
defended and your question aptly answered if it could be shown that earnings,
rates of return, prices, and risk levels of a company bear relationships with
the economy or with the market which is used as a substitute factor for the
`general economy’.

5.5 ECONOMY ANALYSIS

All investment decisions are made within the economic environment after
taking into account the economic prospect of the country. This environment
varies as the economy goes through stages of prosperity. Why economy fails
to have prosperity forever? There are several reasons. Often, when the
economy is booming, companies after invest in projects and create excess
capacity and thus lead-to slow down of the economy. Further, government
policies and external pressures also create complications to the economy. For
instance, increase in oil prices on account of ukraine war or war with
neighboring countries creates pressures to the domestic economy. Government
also can create problems to the economy by following wrong policies or failure
to adopt right policies like failure in meeting disinvestment target. Different
stages of economic prosperity are also referred to as the business cycle. The
term cycle doesn’t mean that there is some orderliness in the economic
sequence such as the seasons of the year. The economy doesn’t follow a
regularly repeated sequence of events. It simply means how economic output
and growth moves from period one to next periods. If the initial period is a
period of rapid growth, it peaks out at some point of time and a recession sets
in subsequently. After some point of slow growth, the economy bottoms out
but by then, new demand accrues and fresh activities emerge. The economy
now sets into recovery mode and then gets into expansion. The cycle moves
on without any definite length of time between the stages because government
and other agencies would like to extend the expansion stage while trying to
cut down the recession or speed up the recovery phase. Figure 5.3 illustrates
the common characteristics that are applicable to different business cycles.
National Output

Peak

Expansion Recovery/Expansion

Through
Time
t1 t 2 t3
Figure 5.3 : Phases of a Business Cycle 97
Security Analysis Starting from a point of neutrality (t1), the economy expands and reaches
peak (t2). The economy then declines, reaching a trough at t3 and subsequently
starts to rebound to repeat the pattern. As mentioned earlier, economists all
over the world have developed a fair amount of understanding on factors
leading to different phases of the economy and also developed necessary
monetary and fiscal policies to speed up the process of recovery and extend
the period of expansion. Despite such efforts, the government fails to achieve
desired results because of new factors emerging in the economy and ever-
changing social and political events.

5.6 MEASURES OF ECONOMIC ACTIVITY

The critical issue before investors is to assess the future of economic activity
so that s/he can take an investment decision. It is possible by forecasting a
few widely used economic measures. A discussion on such economic measures
will be useful before discussing the forecasting techniques.
Gross Domestic Product(GDP): Economic activity is measured by aggregate
indicators such as the level of production and national output. The most widely
and commonly quoted measure is Gross Domestic Product (GDP), which is
the total value of all final good and services newly produced within the
country’s boundaries with domestic factors of production. Cars made within
the country are included in the GDP.
Gross National Product (GNP): A similar measure is Gross National Product,
which measures the total value of all final goods and services newly produced
by an economy and includes income generated abroad.
GDP or GNP and particularly the growth rate of GDP or GNP are relevant for
investment for two reasons. One, a good GDP growth means continuous
income for individuals and hence surplus money can be deployed for
investments. Two, corporate growth is directly influenced by the GDP growth.
In figure 5.4 India’s GDP growth rate form 1961-2023 is given. The growth
rate is showing high level of volatility reflecting economic cycles. After the

Figure 5.4: India GDP Growth Rate (1961-2023)

Source: World Bank (2023)
You can refer to https://www.macrotrends.net/countries/IND/india/gdp-growth-rate and
98 www.rbi.org for latest trends.
initiation of economic reforms in 1992, the growth rate has picked up Economy Analysis
initially.You can see that the growth rate slumped in 2020 due to Covid
pandemic and is now in the recovery phase.
Measures of Consumer Confidence: Consumer confidence index is one of
the strong short-term economic indicators used by the investors to assess
whether there is any change of direction in the economy. Consumer confidence
affects spending, which has an impact on corporate profit and levels of
employment. A positive change in the consumer confidence index or consumer
sentiment index indicates a strong impact on the profitability of firms in general
and in particular for firms dealing with consumer items. Figure 5.5 shows the
trend in the consumer confidence survey from November 2018 -2023.

Figure 5.5: Consumer Confidence Survey

Source: RBI (2023)

Inflation or Consumer Price Index: In addition to aggregate measures of

economic activity and leading indicators, measures of inflation can have an
important impact on investors’ behavior. Inflation in general denotes a general
change in the price levels and measured in terms of index. Two commonly
used indexes are Consumer price index (CPI) and the Wholesale price index
(WPI). You can see the weekly measures of WPI on every Monday in any
economic dailies with a descuption. Inflation in general is not bad as long as
it comes along with the growth of the economy. When the economy is
expanding fast, it is natural that money supply also increases along with
disposable personal income of individuals and thus cause an increase in prices.
Under this condition, stock market is favourably affected on account of
increase in profitability of firms. Nevertheless, inflation affects interest rates
and hence adversely affects the stock prices. An increase in rate of inflation
will cause an increase in rate of interest of all kinds of securities. An increase
in interest rate affects the value of stock as well as other securities in two
ways. One, it affects adversely the profitability of firms because of higher
outflow on interest cost. Two, it also increases the expected rate of return of
investors and directly affects the discount rate. An increase in discount rate
has an adverse impact on value of securities of different types. Such an adverse
impact may ultimately lead to a recession and hence governments and central
banks are concerned with inflation. A typical reaction from the central banks
(in our case Reserve Bank of India) is controlling money supply through
appropriate monetary policies. A reduction in money supply through increase
in CRR or SLR or increasing bank rate will reduce the heat of the economy 99
Security Analysis and thus cool down the prices. After reaching necessary correction, the central
bank of the country relaxes the norms so that the economic activity continues
without any break.
Interest Rates : The level of interest rates is perhaps the most important
macro economic factor to consider in one’s investment analysis. Forecasts of
interest rates directly affect the forecast of returns in the fixed income market.
Suppose you expect the interest rates to decline in the near future. Under this
situation, you will shy away from investing in long-term debt instruments.
Thus, a superior technique to forecast rates would be of immense value to an
investor attempting to determine the best asset allocation for her or his
portfolio. The following factors would help investors in forecasting the future
direction of the interest rates:
1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance physical
investments in plant, equipment, and inventories.
3. The monetary policy of the Reserve Bank of India.
4. The expected rate of inflation.
There is a close linkage between the above variables. For instance, the supply
of funds from savers depends on the level of economic growth. The same
economic growth determines the demand for funds from businesses. The
monetary policy of RBI is the outcome of inflation and inflation of the country
is influenced by monetary policy as well as economic performance. The
Government and the Central Bank influence the interest rates significantly.
For example, an increase in the government’s budget deficit increases the
government borrowings. An increase in the demand for funds pushes the
interest rates. The Central Bank can reduce the impact of government
borrowing by increasing the supply of money through monetary policy. While
this will temporarily arrest an increase in the interest rates, increased money
supply pushes the inflation, which in turn increases the interest rates. Many
times, the Central Bank also uses interest rates directly to control the economy.
Though an increase in interest rate should have an adverse effect on the market
and vice versa, the impact of interest rate changes on stock prices in the real
world is difficult to forecast.
Government Policy: The government has two broad classes of macro
economic tools - those that affect the demand for goods and services and
those that affect their supply. For most of postwar history, demand-side policy
has been of primary interest. The focus has been on government spending,
tax levels, and monetary policy. Since 1980s, however, increasing attention
has been focused on supply-side economics. Broadly interpreted, supply-side
concerns have to do with enhancing the productive capacity of the economy,
rather than increasing the demand for the goods and services the economy
can produce. In practice, supply-side economists have focused on the
appropriateness of the incentives to work, innovate, and take risks that result
from the system of taxation. The thrust is creating infrastructure and skills
100 among people to increase the economic activity. Such polices may have little
impact in the short run but they produce sustainable long-run growth in the Economy Analysis
economy.
Fiscal Policy: Fiscal policy refers to the government’s spending and tax action
and is part of demand-side management. It is the most direct way to influence
the economy. For instance, when the government increases spending, it creates
more demand in the economy and similarly, when the government reduces
spending, it causes slow down in the economy. It must be noted that
government is a major’ direct buyer of several core sector products. The
government can also increase or decrease t h e demand for the products by
reducing or increasing the tax rates. Changes in tax rates directly increase or
decrease the disposable income of the public. Though fiscal policy has a direct
and immediate impact on the economy, it takes a long time to frame such
policies on account of political compulsion. For instance, it took several years
for the Indian policy makers to reduce tax rates and fiscal deficit.
Monetary Policy: Monetary policy, in the form of changing CRR and SLR is
also demand-side management of economy. The Central Bank changes the
money supply (rather adjust the growth rate of money supply) through variety
of polices and thus influence the economy. One of the reasons for inflation
being under control during the last two years is slow down in the growth of
money supply. If it increases the money supply, it will fuel the growth in the
short-run but causes inflation and higher interest rate in the long-run. Similarly,
the Central Bank by reducing the money supply can slow down the growth
and prevent the economy to create over capacity in several industries.
However, monetary policy affects the economy in more roundabout way than
fiscal policy.
You can visit www.rbi.org for all the latest information regarding the fiscal
and monetary policies of the country.

5.7 ECONOMIC FORECASTING

In order to perform economy analysis, it is essential to forecast economic
performance with the help of some of the economic factors discussed in the
previous section. Depending upon the duration, forecasting can be made for
short term, intermediate and long term. Short term refers to a period up to
three years. Sometimes, it can also refer to much shorter period, such as quarter
or a few quarters. Intermediate period refers to a period of three to five-year
period. Long term forecasting refers to the forecasting made for more than
five years. This may mean a period of ten years or more. We will discuss
some short term forecasting techniques in the following sections:
1. Anticipatory Surveys
This is a very simple method through which investors can form their opinion
with respect to the future state of the economy. As is generally understood,
this is the survey of expert opinions of those who are prominent in the
government, business, trade and industry. Generally, it incorporates expert
opinion with regard to construction activities, plant and machinery
expenditures, level of inventory, etc., which have important bearing on the
101
Security Analysis economic activities. Anticipatory surveys can also incorporate the opinion or
future plan of consumer with regard to their spending. So long as people plan
and budget their expenditure and implement their plans accordingly such
surveys should provide valuable input as a starting point. Despite the valuable
inputs provided by this method, care must be exercised in using the information
generated through this method. Precautions are needed because:
x Survey results cannot be regarded as forecasts per se. A consensus of
opinion may be used by the investor in forming his own forecasts.
x There is no guarantee that the intentions of surveys would certainly
materialize. To this extent, the investors cannot rely solely on these.
2. Barometric or Indicator Approach
In this approach, various types of indicators are studied to find out how the
economy is likely to perform in the future. For meaningful interpretations,
these indicators are classified into leading, roughly coincidental, and lagging
indicators.
Leading Indicators: As the name suggests, these are indicators that lead the
economic activity in terms of their outcome. That is, these are those time
series data of the variables that reach their high points as well as their low
points in advance of the economic activity.
Lagging Indicators: These are time series data of variables that lag behind
in their consequence viz-a-viz the economy. That is, these reach their turning
points after economy has already reached its own.
Roughly Coincidental Indicators: These are the indicators that reach their
peaks and the troughs at approximately the same time as the economy.
Indicator approach is quite useful in suggesting the direction of a change in
the aggregate economic activity. However, it tells nothing about the magnitude
of change. In developed countries, data relating to various indicators are
published at short intervals Table 5.2 and 5.3 shows the key macroeconomic
indicators and the annual forecast for 2022-23 and 2023-24 respectively.
Table 5.2: Annual forecast (2022-23)
Annual Forecasts for 2022-23
Key Mscrceconomic Indicators Mean Median Max Min 1st 3rd
Quartile Quartile
1 GDP at constant (2011-12) prices: Annual Growth (per cent) 6.9 7.0 7.2 6.5 6.8 7.0
a Private Final Consumption Expenditure (PFCE) at constart 8.0 7.9 10.2 7.1 7.3 8.3
(2011-12) prices: Annual Growth (per cent)
b Gross Fixed Capital Formalion (GFCF) at constant (2011-12) 10.6 11.2 16.0 1.2 104 11.2
prices: Annual Growth (per cent)
2 Private Final Consumption Expenditure (PFCE) at current 15.7 15.5 19.2 13.1 14.8 16.4
prices: Annual Growth (per cent)
3 Gross Capital Formation Rate (per cert of GDP at current 30.0 31.1 33.0 15.0 29.9 31.5
market prices)
4 GVA at ccnstarit (2011-1 2) pricee: Annual Growth (per cent) 6.5 6.6 6.8 6.0 8.5 6.1
a Agriculture & Allied Adivities at constant (2011-1 2) prices: 3.2 3.3 3.5 2.3 3.2 3.3
Annual Growth (percent)
b industry at constant (2011-12) prices: Annual Growth (percert) 3.3 2.4 11.6 1.1 1.8 3.6
c Services at constant (2011-12) prices: Annual Growth (per cent) 8.9 9.1 9.9 7.1 8.9 9.4
5 Gross Saving Rate (per cent of Gross National Disposable 29.3 29.2 31.2 27.5 28.0 30.5
102 income) -at current prices
6 Fiscal Deildt of Central Govt. (per cent or GDP at current 6.4 6.4 7.0 6.4 6.4 6.4 Economy Analysis
market prices)
7 CombIned Gross Fiscal Deficit (per cart to GOP at current 9.2 9.5 10.1 3.1 9.2 9.7
market prices)
8 Bank Credit of Scheduled commercial banks: Annual Growth 14.8 15.0 16.1 7.7 14.7 15.7
(per cent)
9 ‘Wield on 10-Year G-Sec of Cenfral Govt. (end-period) 7.4 7.4 7.6 7.3 7.3 7.4
10 Yield on 91-day T-Biil or Centrsl Govt. (end-period) 6.7 6.7 7.2 6.2 8.6 6.9
11 Merchandise Exports (B0P basis in USS terms): Annual Growth 5.1 4.1 40.5 0.0 2.1 5.5
(per cent)
12 Merchandise imports (BoP basis in I.JS$ temie): Annual Growth 17.9 16.0 60.1 12.0 15.4 19.0
(percent)
13 Cunent Account Balance in USS bn. -86.6 -86.8 -29.9 -119.1 -954 -80.6
a Current Account Balance (per cent to GDP at current market -2.6 -2.8 -1.5 4.5 -2.9 -2.4
prices)
14 Overall BoP in USS do. -184 -20.0 45.2 41.8 42.3 -10.0
15 Inflation based on CPI Combined: HeadlIne 6.6 6.7 6.6 5.0 6.6 6.7
16 Inflation based on CP1 Combined: excluding Food and 6.2 6.3 6.6 5.7 6.1 6.3
Beverages, Pan, Tobacco and Intoxicants end Fuel and Light
17 Inflation based on WPI: All Commodities 9.6 9.6 10.8 7.5 9.5 9.6
18 Inflation based on WPI: Non-food Manufactumd Products 6.2 6.0 8.5 5.6 5.9 8.1

Source: RBI (2023)

Table 5.3: Annual forecast (2023-24)

Annual Forecasts for 2023-24
Key Mscrceconomic Indicators Mean Median Max Min 1st 3rd
Quartile Quartile
1 GDP at constant (2011-12) prices: Annual Growth (per cent) 6.0 6.0 6.8 5.2 5.9 6.1
a Private Final Consumption Expenditure (PFCE) at constart 5.9 6.1 8.0 3.6 5.4 6.5
(2011-12) prices: Annual Growth (per cent)
b Gross Fixed Capital Formalion (GFCF) at constant (2011-12) 7.3 7.1 11.7 0.3 6.3 9.0
prices: Annual Growth (per cent)
2 Private Final Consumption Expenditure (PFCE) at current 112 11.4 16.4 5.4 10.2 12.4
prices: Annual Growth (per cent)
3 Gross Capital Formation Rate (per cert of GDP at current 30.7 30.0 33.4 26.2 29.5 32.0
market prices)
4 GVA at ccnstarit (2011-1 2) pricee: Annual Growth (per cent) 5.7 5.0 0.6 5.0 5.5 5.9
a Agriculture & Allied Adivities at constant (2011-1 2) prices: 3.2 3.1 4.2 1.9 3.0 3.3
Annual Growth (percent)
b industry at constant (2011-12) prices: Annual Growth (percert) 4.6 4.9 7.0 1.3 4.4 5.5
c Services at constant (2011-12) prices: Annual Growth (per cent) 7.1 6.9 9.4 5.6 6.7 7.4
5 Gross Saving Rate (per cent of Gross National Disposable 29.6 29.7 31.6 27.8 28.5 30.7
income) -at current prices
6 Fiscal Deildt of Central Govt. (per cent or GDP at current 5.9 5.9 6.5 5.8 5.9 5.9
market prices)
7 CombIned Gross Fiscal Deficit (per cart to GOP at current 8.7 8.9 10.0 2.9 8.6 9.1
market prices)
8 Bank Credit of Scheduled commercial banks: Annual Growth 11.5 12.0 15.0 7.7 11.0 12.6
(per cent)
9 ‘Wield on 10-Year G-Sec of Cenfral Govt. (end-period) 7.2 7.2 8.0 0.5 7.0 7.4
10 Yield on 91-day T-Biil or Centrsl Govt. (end-period) 6.4 6.5 7.3 5.8 6.0 6.8
11 Merchandise Exports (B0P basis in USS terms): Annual Growth -22 -2.3 8.0 -15.0 -5.9 2.3
(per cent)
12 Merchandise imports (BoP basis in I.JS$ temie): Annual Growth -2.1 -3.8 10.1 -15.0 -6.6 1.9
(percent)
13 Cunent Account Balance in USS bn. -73.3 -74.3 -27.5 -135.3 45.1 42.2
a Current Account Balance (per cent to GDP at current market -2.0 -2.0 -0.8 -3.5 -2.3 -1.7
prices)
14 SoP In USS tar. 6.7 4.2 52.5 43.3 -3.7 19.3
15 Inflation based on CPI Combined: HeadlIne 5.2 5.3 5.6 4.6 5.1 5.4
16 Inflation based on CP1 Combined: excluding Food and 5.4 5.4 6.0 4.7 5.2 5.6
Beverages, Pan, Tobacco and Intoxicants end Fuel and Light
17 Inflation based on WPI: All Commodities 2.9 2.6 6.2 1.4 2.2 3.3
18 Inflation based on WPI: Non-food Manufactured Products 2.4 2.1 4.8 0.5 1.5 3.0

Source: RBI (2023) 103

Security Analysis Examples of leading, lagging and coincident indicators in Indian economy
are as follows:
Leading Indicators
x Bank Credit growth
x Capacity Utilization
x Yield curve
x Durable goods consumption
x Confidence index
Lagging Indicators
x Gross domestic product
x Unemployment rate
x Balance of trade
Coincident Indicators
x Manufacturing activity
x Short term interest rates
x Inflation
A word of caution would not be out of place here as forecasting is based
solely on leading indicators in hazardous business. One should be quite careful
in using them. In any case, there are practical difficulties in operationalizing
it as data collection is not done well in advance. There is always a delay in it,
with the result that interpretation even if correctly performed cannot be
fruitfully utilized. Further, problems with regards to their interpretation as
well exits. Various indicators under broad category of leading indicators, its
various measuring may give conflicting signals in terms of future direction
of the economy.
To overcome these limitations, the use of diffusion index or composite index
had been suggested. This takes care of the problems by combining several
indicators into one index in order to measure the strength or weaknesses in the
movement of a particular kind of indicators. Care has to be exercised even in
this case because diffusion indices are not without problems either. Apart from
the fact that its computations are difficult, it does not eliminate the irregular
movements in the series. Despite these limitations, indicators approach/ diffusion
index can be a useful tool in the hands of a skillful forecaster.
Money and Stock price
It is widely recognized that money supply in the economy plays a crucial part
in the investment decision making. The rate of change in the money supply in
the economy affects the GNP, corporate profits, interest rates and stock prices.
Accordingly, monetarists argue that total money supply in the economy and
its rate of change play an important part in influencing that stock price. Too
much money in the economy, it is argued, fuels the inflation. And as investment
in the stock is considered as hedge against inflation, stock price increases
104 during inflationary times.
3. Econometric Model Building Approach Economy Analysis

This is another approach in determining the precise relationship between the

dependent and the Independent variables. In fact, econometrics is a discipline
where in application of mathematics and statistical techniques is made to economic
theory. It presupposes the precise and clear relationship between the dependent
and independent variables. One of such well-defined relationship with its attendant
assumptions rest with analyst. Thus by using econometrics, the analyst is able to
forecast a variable more precisely than by any other approach. But forecasts thus
derived would be as good as the data inputs used and assumptions made.
Opportunistic Model Building or GNP Model Building or Sectional Analysis
is frequently used in practice and is most eclectic method. It borrows from the
methods discussed earlier. It uses national accounting framework in order to
achieve short-term forecasts. Various steps while using this approach are:
x Hypothesize the total demand in the economy as measured by its total
income (GNP) based on likely scenarios in the country like war, peace,
political instability, economic changes level and rate of inflation, etc.
x Forecast the GNP figure by estimating the levels of its various components
like:
• Consumption expenditure
• Gross private domestic investment
• Government purchases of goods and services
• Net exports
x After forecasting the individual components of GNP, the analyst adds
them up and gets a figure of the forecasted GNP.
x Forecast of GNP tests, the overall forecast for internal consistency is done
to ensure that both the total forecast and subcomponents’ forecast of make
sense and fit together in a reasonable manner.
Thus opportunistic model building involves all the details described above
with a vast amount of judgment and inequity.
Activity 2
a) Distinguish between leading and lagging indicators.
............................................................................................................
............................................................................................................
............................................................................................................
b) List out six indicators, which you consider useful to know the future
direction of Indian economy. Also, classify them, into leading,
coincidental and lagging indicators.
............................................................................................................
............................................................................................................
............................................................................................................
105
Security Analysis
5.8 SUMMARY
In this Unit, we have discussed the relevance of economy analysis for equity
investment decision and introduced the economy-industry-company
framework of fundamental analysis. We have also noted the usefulness of
fundamental analysis in efficient market set up. This unit also explains that
nature of economy analysis and discusses economic forecasting techniques
viz., anticipatory surveys, barometric or indicators approach and the
econometric model building approach.

5.9 KEY WORDS

Economic Forecasting : forecasting economic performance with the help
of some of the economic factors.
Economy Analysis : analysis of themacroeconomic factors.
EIC framework : is a three-step approach and is also called
Economy-Industry-company (E-I-C) approach.
Fundamental Analysis : analysis of the fundamental factors that affect risk
return characteristic of the security.

5.10 SELF-ASSESSMENT QUESTIONS

1. Define ‘Fundamental Analysis’. Bring out its relevance for equity
investment decision.
2. Discuss the relevance of fundamental analysis in efficient market set up.
3. ‘Economic-Industry-Company (EIC) framework provides a useful
approach to equity investments decision’. Explain and illustrate.
4. ‘Economic forecasting is the heart of economy analysis’. Comment and
briefly explain various techniques of economic forecasting.
5. ‘Fundamental analysis is application only in the hands of institutional
investors. Individual investors would find it too time taking and costly to
adopt’ Critically examine the above statement.
6. Write short notes on the following:
a) Economy Analysis
b) Techniques of Economic Forecasting
c) Anticipatory Surveys.

5.11 FURTHER READINGS

Amling, F. (1984), Investment -An Introduction to Analysis and Management,
5th ed. PHI. New Delhi.
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
106 McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis Industry Analysis
Portfolio Management (7th ed.). Pearson Education.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-13 Economic Analysis - I
[Video]. YouTube. https://www.youtube.com/watch?v=rey19R8ng0A
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-14 Economic Analysis - II
[Video]. YouTube. https://www.youtube.com/watch?v=IGOqwQcBlIM
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Singh, J. P., [IIT Roorkee]. (2021). Lecture 33: Fundamental Analysis [Video].
YouTube. https://www.youtube.com/watch?v=qqNSrDSbIaE
Singh, J. P., [IIT Roorkee]. (2021). Lecture 34: Balance Sheet Analysis I
[Video]. YouTube. https://www.youtube.com/watch?v=MA7ANUU3bR4
Singh, J. P., [IIT Roorkee]. (2021). Lecture 35: Balance Sheet Analysis II
[Video]. YouTube. https://www.youtube.com/watch?v=43NKp8Phq_Q
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.
World Bank (2023). India Growth Rate 1961-2023https://www.macrotrends.net/
countries/IND/india/gdp-growth-rate

107
Security Analysis
UNIT 6 INDUSTRY ANALYSIS
Objectives
After reading this unit you should be able to:

x Explain the relevance of industry analysis in investment decision;

x Explain the concept of industry life cycle;
x Discuss various techniques to evaluate industry related factors;
x Understand the concept of structural analysis.

Structure
6.1 Introduction
6.2 Structural Analysis
6.3 Industry Analysis
6.4 Industry life cycle
6.5 Characteristics of Industry
6.6 Techniques of Industry Analysis
6.7 Summary
6.8 Key words
6.9 Self Assessment Questions
6.10 Further Readings

6.1 INTRODUCTION
After conducting analysis of the economy and identifying the direction it is
likely to take in the short, intermediate and long term, the analyst must look
into various sectors of the economy in terms of various industries. An industry
is a homogenous group of companies. That is, companies with the similar
characteristic can be grouped into one industrial group. There are many other
bases on which grouping of companies can be done. For example, traditional
classification is generally done product wise like pharmaceutical, cotton,
textile, synthetic fibre industry, etc. Such a classification though useful does
not help much in investment decision making. Some of the more useful bases
for classifying industries from the investment decision point of view are as
follows:

Growth industry: This is the industry, which is expected to grow persistently

and its growth is likely to exceed the average growth of the economy.

Cyclical industry: In this category of the industry, the firms included are
those which move closely with the rate of industrial growth of the economy
108 and fluctuate cyclically as the economy fluctuates.
Defensive industry: It is a grouping that includes firms which move steadily Industry Analysis
with the economy and decline less than the average decline of the economy
in a cyclical downturn.

Declining industry: This is that category of firms, which either generally

decline absolutely or grow less than the average growth of the economy.

In this unit we will discuss various aspects of industry analysis and also try to
understand the concept of structural analysis.

6.2 STRUCTURAL ANALYSIS

Structural analysis is a key component of security analysis. It involves
examining the underlying financial and operational structure of a company
or security to determine its investment potential. This analysis looks at a
company’s financial statements, management team, industry position, and
other key factors to evaluate its strengths and weaknesses.

Some of the key components of structural analysis in security analysis include:

1. Financial Statement Analysis: This involves analyzing a company’s

income statement, balance sheet, and cash flow statement to determine
its financial health and performance. This analysis can help investors
identify trends in revenue, profit margins, debt levels, and other key
financial metrics.For example, an investor may analyze a company’s
revenue growth rate, profit margins, return on equity, debt levels, and
liquidity ratios to assess its financial health and performance.

2. Management Analysis: This involves evaluating the company’s

management team, including their experience, track record, and strategic
vision. This analysis can help investors determine the quality of the
management team and their ability to execute on the company’s business
plan.For example, an investor may examine the CEO’s vision and strategy,
the experience of the board of directors, and the overall corporate
governance structure to assess the quality of the management team.

3. Industry Analysis: This involves assessing the competitive landscape

and growth prospects of the industry in which the company operates. This
analysis can help investors identify potential risks and opportunities
associated with investing in the company’s security.For example, an
investor may review industry trends, market share, competition, and
regulatory environment to assess the growth potential and risks associated
with investing in the industry.

4. Company Valuation: This involves determining the value of a company’s

securities based on its financial performance and growth prospects. This
analysis can help investors determine whether a security is overvalued or
undervalued relative to its intrinsic value.For example, an investor may
use a discounted cash flow analysis to estimate the present value of the
109
Security Analysis company’s future cash flows and determine whether the company’s
securities are undervalued or overvalued.

To conduct a thorough structural analysis, investors may use a range of

analytical tools and techniques, such as financial ratio analysis, discounted
cash flow analysis, and SWOT analysis. The analysis may also involve
gathering information from a range of sources, such as company filings,
industry reports, and news articles.

Structural analysis is a critical component of security analysis as it provides

investors with a comprehensive understanding of the underlying financial
and operational structure of a company or security. By conducting a thorough
structural analysis, investors can make informed investment decisions and
manage risk in their investment portfolios.It aims to provide a comprehensive
understanding of the company’s strengths, weaknesses, opportunities, and
threats, and to assess its investment potential.

Process of Structural Analysis

The process of structural analysis in security analysis typically involves the

following steps:

1. Define the objective: The first step in the process is to define the objective
of the analysis. The objective should be clearly defined and align with
the investor’s investment strategy and goals.

2. Collect data: The next step is to gather data on the company and the
industry in which it operates. This data can be sourced from financial
reports, company filings, industry reports, news articles, and other sources.

3. Conduct financial statement analysis: The analysis of financial

statements involves reviewing the income statement, balance sheet, and
cash flow statement to assess the company’s financial performance and
financial health. This includes examining key financial ratios, such as
profitability ratios, liquidity ratios, and solvency ratios.

4. Conduct management analysis: In this step the quality of the company’s

management team is evaluated which includes their experience,
qualifications, and track record. The analysis assesses the quality of the
management team.

5. Conduct industry analysis: This involves assessing the competitive

position and growth prospects of the industry in which the company
operates. The analysis includes analyzing the industry trends, market share,
competition, and regulatory environment.

6. Company valuation: In this step the intrinsic value of the company based
on its financial performance and growth prospects is analysed. This may
involve using a range of valuation techniques, such as discounted cash
flow analysis or comparable company analysis.
110
 7. Synthesize the analysis: The final step involves synthesizing the data Industry Analysis
and analysis conducted in the previous steps. This includes identifying
the company’s strengths, weaknesses, opportunities, and threats, and
determining whether the company’s security is undervalued or
overvalued relative to its intrinsic value.

The process of structural analysis in security analysis is a rigorous and

systematic approach to evaluating the underlying financial and operational
structure of a company or security. It aims to provide investors with a
comprehensive understanding of the investment potential of the security and
to identify potential risks and opportunities associated with the investment.
Structural analysis provides abase for decision making.

6.3 INDUSTRY ANALYSIS

Industry analysis is the process of examining the current and future trends
and conditions of a particular industry to identify opportunities and potential
challenges. This analysis typically includes studying the competitive
landscape, market trends, customer preferences, and regulatory factors that
may impact the industry’s growth and profitability.

There are several approaches to conducting industry analysis, including the

following:

1. Porter’s Five Forces Analysis: This framework examines the competitive

forces that shape an industry, including the threat of new entrants, the
bargaining power of suppliers and buyers, the threat of substitute products
or services, and the intensity of rivalry among existing competitors.

2. SWOT Analysis: This analysis looks at the strengths, weaknesses,

opportunities, and threats facing an industry. This can help companies
identify areas where they can improve and leverage their strengths to
gain a competitive advantage.

3. PEST Analysis: This framework looks at the political, economic, social,

and technological factors that impact an industry. This can help companies
anticipate changes in the business environment and adjust their strategies
accordingly.

Industry analysis is important for companies to understand their industry’s

competitive dynamics, identify potential opportunities for growth, and make
informed business decisions. It plays an important role in security analysis
for decision making. We know that security analysis involves analyzing and
evaluating various securities, such as stocks, bonds, and mutual funds, to
determine their investment potential. In the context of security analysis,
industry analysis is used to assess the performance of the industry in which
the security operates.

By conducting an industry analysis, security analysts can gain a better

understanding of the industry’s growth prospects, competitive framework, 111
Security Analysis and regulatory environment. This information can be used to evaluate the
potential risks and opportunities associated with investing in a particular
security.For example, if an industry is experiencing strong growth due to
favourable market conditions and increasing demand, the securities of
companies operating in that industry may have higher investment potential.
On the other hand, if an industry is facing challenges, such as increasing
competition or regulatory changes, the securities of companies operating in
that industry may be riskier investments.

In addition to evaluating individual securities, industry analysis can also be

used to construct a diversified investment portfolio. By investing in securities
from different industries with varying growth prospects, an investor can spread
their risk and potentially improve their investment returns. Industry analysis
is an important tool for security analysts to make informed investment
decisions and manage risk in their investment portfolios.

Steps in Industry Analysis

Industry analysis is a systematic examination of the factors that influence an

industry’s performance and prospects. It is an important tool for businesses
to understand their industry’s competitive dynamics, identify potential
opportunities for growth, and make informed business decisions. An industry
analysis typically involves the following steps:

1. Defining the Industry: The first step in industry analysis is to define the
industry being analyzed. This involves identifying the products or services
produced by the industry, the target market for these products or services,
and the key players in the industry.
2. Gathering Industry Data: The next step is to gather data about the
industry. This includes information about market size, growth rates,
industry trends, and the competitive landscape. This data can be gathered
from a variety of sources, including industry reports, government statistics,
and company filings.
3. Analyzing Industry Trends: Once the data has been gathered, it is
important to analyze industry trends. This involves identifying patterns
and changes in the industry over time, such as shifts in consumer
preferences or changes in government regulations.
4. Conducting Competitive Analysis: Competitive analysis involves
assessing the strengths and weaknesses of the industry’s key players, as
well as their strategies and positioning in the market. This can help
businesses identify potential competitors and opportunities for
differentiation.
5. Assessing Opportunities and Threats: Based on the data and analysis
conducted, it is important to assess the opportunities and threats facing
the industry. This includes identifying potential risks, such as changes in
consumer behavior or technological disruptions, as well as potential
112 growth opportunities.
 6. Making Informed Business Decisions: The final step in industry Industry Analysis
analysis is to use the information gathered to make informed business
decisions. This may involve identifying areas for investment or
divestment, adjusting marketing strategies, or developing new products
or services.

It is an important tool for businesses to gain a deeper understanding of their

industry and make informed decisions about their strategy and operations.
By conducting a thorough industry analysis, businesses can identify potential
opportunities and risks and position themselves for long-term success.

6.4 INDUSTRY LIFE CYCLE

Another useful criterion to classify industries is the various stages of their
development. Industries with different stages of their life cycle development
exhibit different characteristics. In fact, each development stage is unique.
Grouping firms with similar characteristics of development helps investors
to properly evaluate different investment opportunities in the companies.
Basing on the stage in the life cycle, industries may be classified as follows
(Figure 6.1):

Start-up Stage: This is the first stage in the industrial life cycle of a new
industry. Being the first stage, the technology and its products are relatively
new and have not reached a stage of perfection. Experimentation is the order
both in product and technology. However, there is a demand for its products
in the market, thereby, the profit opportunities are in plenty. This is a stage
where the venture capitalists take a lot of interest and enter the industry and
sometimes organize the business. At this stage, the risk of many firms being
out of the industry is also more; hence, mortality rate is very high in the
industry, with the result that if an industry withstands the risk of being out of
the market, the investors would reap the rewards substantially or else
substantial risk of loss of investment exist. A very pertinent example of this
stage of industry in India was leasing industry which was trying to come-up
during mid eighties. There was a mushroom growth of companies in this
period. Hundreds of companies came into existence. Initially, lease rental
charged by them was very high. But as the competition grew among firms,
lease rental reduced and come down to a level where it became difficult for a
number of companies to survive. This period saw many companies that could
not survive the onslaught of competition. Only those which tolerate this
onslaught of price war could remain in the industry. Leasing industry today
in India is much pruned compared to mid-eighties.

Growth stage: This is the second stage when the chaotic competition and
growth that were the hallmark of the first stage is more or less over. Firms
that could not survive this onslaught have already died down. The surviving
large firms now dominate the industry. The demand for its products still grows
faster in the market leading to an increase in profits to the companies. This is
the stage where companies grow orderly and rapidly. These companies provide 113
Security Analysis a good investment opportunity to the investors. In fact, as the firms during
this stage of development grow faster, they sometimes break the records in
various areas like payments of dividends, etc., thus becoming more and more
attractive for investments.

Maturity stage: This third stage where industries grow roughly at the rate of
the economy and are fully developed to reach a stage of stabilization. Looked
at differently, this is a stage where the ability of the industry to grow appears
to have more or less lost. As compared to the competitive industries, rate of
growth in the industry is slower. Sales may still be rising, but at a lower rate.
It is at this stage that the industry is facing the problem of what Grodinsky
called “latent obsolescence” a term used to describe a situation where earliest
signs of decline has emerged. Investors have to be very cautions to examine
and interpret these signs before it is too late.

Decline stage: The fourth stage of industrial life cycle development is the
relative decline stage. Industry at this stage has grown old. New products and
new technology have come in the market. Customers have changed their habits,
styles, liking, etc. Its products are not much in demand as was in the earlier
stages. Still, the industry can continue to exist for some more time.
Consequently, the industry would grow less than the average growth of the
economy during the best of the times of the economy. But as it expected, the
industry would decline much faster than the decline of the economy in the
worst of times.

The specific characteristics of different stages of life cycle development of

industries have a number of implications for investment decision. For example,
Pioneering stage is very risky stage. As you know that risk and returns are
positively correlated, investment at this stage is quite rewarding. However,
for an investor looking for steady long-term returns with risk aversion, it is
suggested that he should in general avoid investing at this stage. These are
good for venture capitalists. But if s/he is still keen to invest, s/he should try
to diversify or disperse her/ his investment in companies that are in the second
stage of development i.e., fast growth. This probably explains the prevalent
higher stock prices of the companies of this industry.

From the investment point of view, selection of the industries at the third
stage of development is quite crucial as it is the future growth of the industry
that is relevant and not its past performance. There are a number of examples
where the share prices of companies in a decline industry have been artificially
hiked up in the market. This is justified on the basis of good record of its
performance. But the fact of the matter is that a company in a declining industry
would sooner or later feel the pinch of its features and an investor investing
in companies at this stage would experience reduction in the value of his
investment in due course.

After having discussed various investment implications, it may be pointed

out that one should be careful while using this classification. This is because
114
the above discussion assumes that the investor would be able to identify various Industry Analysis
stages in the industry life cycle. In practice, it is a very difficult proposition
to detect which stage of development an industry is at a given point of time.
Needless to say, it is only a general framework that is presented above and he
can use it for meaningful analysis with suitable modifications. In order to
strengthen the analysis further, it is essential to study the unique feature of
the industry in detail. Due to its unique characteristics, unless the specific.
industry is studied properly and in depth with regard to these, it will be very
difficult to form an opinion for profitable investment opportunities. Given
below are some of the features that could be considered for a detailed
investigation while selecting an industry for investment. These features broadly
relate to the operational and structural aspects of the industry.

Figure 6.1: Industry Life Cycle

6.5 CHARACTERISTICS OF INDUSTRY

Every industry has some characteristics. Some of them are as follows:

i) State of Competition in the industry

Competition is a way of life that increases, as barriers to enter the industry

are loosened/ removed. It is an important input in investment decision making.
Knowing about the state of competition in a particular industry, therefore, is
a must. Questions those are relevant in this context are:

x Which firm in the industry plays a leadership role and how firms compete
among themselves?

x How is the competition among domestic and foreign firms both in the
domestic and the foreign markets? How do the domestic firms perform
there? 115
Security Analysis x Which type of products are manufactured in this industry? Are these
homogenous in nature or highly differentiated?
x What is the nature and prospect of demand for the industry? This may
also incorporate the analysis of classifying major markets of its products:
customer-wise and geographical area-wise, identifying various
determinants of the demands of its products, and assessing the likely
demand scenarios in the short, intermediate and long run.
x Which type of industry is it: growth, cyclical, defensive or relative decline
industry?

ii) Cost conditions and profitability

The worth of a share depends on its return and the return depends on
profitability of the company. Interestingly growth is an essential variable but
its mere presence does not guarantee profitability. Profitability depends upon
the state of competition prevalent in the industry, cost control measure adopted
by its constituent units and the growth in demand for its products. While
conducting an analysis from the point of view of cost and profitability, some
relevant aspects to be investigated are:

x How is the cost allocation done among various heads like raw materials,
wages and overheads?

Knowledge about the distribution of costs under various heads is very essential
as this gives an idea to the investors about the controllability of costs. Some
industries have overhead costs much higher than others. Likewise, labour
cost is another area that requires close scrutiny. This is because finally whether
labour is cheap or expansive depends on the wage level and labour productivity
is taken into account.

x Price of the product of the industry.

x Capacity of production-installed, used, unused, etc.
x Level of capital expenditure required to maintain or increase the productive
efficiency of the industry.

Profitability is another area that calls for a thorough analysis on the part of
investors. No industry can survive in the long run if is not making profits.
This requires a thorough investigation into various aspects of profitability.
However, such an analysis can be done by having a bird’s eye view of the
situation. In this context ratio has been found quite useful. Some of the
important ratios often used are:

x Gross Profit Margin ratio

x Operation Profit Margin ratio
x Rate of Return on Equity
x Rate of Return of Total Capital
116
Ratios are not an end in themselves. But they do indicate possible areas for Industry Analysis
further investigation.

iii) Technology and Research

Due to increase in competition in general, technology and research play a

crucial part in the growth and survival of a particular industry. However,
technology itself is subject to change; sometimes, very fast, leading to
obsolescence. Thus only those industries which are updating themselves in
the field of technology could have a competitive advantage over others in
terms of the quality, pricing of products, etc.

The relevant questions to be probed further by the analyst in this respect

could include the following:

x What is the nature and type of technology used in the industry?

x Are there any expected changes in the technology in terms of offering

new products in the market leading to increase in sales?

x What has been the relationship of capital expenditure and the sales over
time? Whether more capital expenditure has led to increase in sales or
not?

x What has been the amount of money spent on the research and development
activities of the firm? Does the amount on the research and development
in the industry relate to its redundancy and long run?

x What is the assessment of this industry in terms of its sales and profitability
in the short, intermediate and long run?

The impact of all these factors have to be finally translated in terms of two
most crucial numbers i.e., sales and profitability - their level and expected
rate of change during short, intermediate and long run.

6.6 TECHNIQUES OF INDUSTRY ANALYSIS

We have discussed about various factors that are to be taken into account
while conducting industry analysis. Now we turn our attention to various
techniques that helps us evaluate that factors mentioned above:

End Use and Regression Analysis: It is the process whereby the analyst or
investor attempts to diagnose the factors that determine the demand for the
output of the industry. This is also known as end-use or product-demand
analysis. In this process, the investor hopes to uncover the factors that explain
the demand. Some of the factors found to be powerful in explaining the demand
for the industry are: GNP, disposable income, per capita, consumption, price
elasticity techniques like regression analysis and correlation have been often
used. These help to identify the important factors/variables. However, one
should be aware of their limitations.
117
Security Analysis Inputs Output Analysis: This analysis helps us understand demand analysis in
greater detail. Input output analysis is very useful technique that reflects the flow
of goods and services through the economy. This analysis includes intermediate
steps in the production process as the good proceed from the raw material stage
through final consumption. This information is reflected in the input-output table
reflects the pattern of consumption at all stages- not just at the final stage of
consumption of final goods. This is done to detect any changing pattern or trends
that might indicate the growth or decline of industries.

6.7 SUMMARY
In this unit we have discussed the concept of structural analysis and how it
involves the industry analysis as part of its process.

As part of industry analysis, it is pointed out that more than product wise
classification, life cycle stage-wise classification of industries is more useful
for equity investment decisions making. This unit concludes by introducing
techniques of industry analysis viz., end or regression analysis and input-
output analysis.

6.8 KEY WORDS

Company Valuation : This involves determining the value of a
company’s securities based on its financial
performance and growth prospects.

Financial Statement Analysis : This involves analyzing a company’s

income statement, balance sheet, and cash
flow statement to determine its financial
health and performance.

Industry Analysis : This involves assessing the competitive

landscape and growth prospects of the
industry in which the company operates.

Management Analysis : This involves evaluating the company’s

management team, including their
experience, track record, and strategic
vision.

Structural Analysis : It involves examining the underlying

financial and operational structure of a
company or security to determine its
investment potential.

6.9 SELF ASSESSMENT QUESTIONS

1. What is structural analysis?

118 2. What is industry analysis?

3. What is the importance of industry analysis? Industry Analysis

4. How does industry analysis helps organizations to assess the external

environment?

5. What are the various techniques to perform industry analysis?

6.10 FURTHER READINGS

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.

Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis

Portfolio Management (7th ed.). Pearson Education.

IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-15 Industry Analysis - I [Video].

YouTube. https://www.youtube.com/watch?v=Qz7CA52WQ2w

IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-16 Industry Analysis - II

[Video]. YouTube. https://www.youtube.com/watch?v=_jX0bkBv55s

Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.

Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan

Chand & Sons.

Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann

Publications Private Limited.

119
Security Analysis
UNIT 7 COMPANY ANALYSIS
Objectives
After reading this unit you should be able to:
x Highlight the need for and importance of company analysis;
x Explain the process of estimation of equity price;
x Discuss and illustrate quantitative and qualitative methods to value equity;
and
x Discuss methods of forecasting earnings per share.
Structure
7.1 Introduction
7.2 Company analysis
7.3 Valuation of stocks
7.4 Forecasting EarningsPer Share (EPS)
7.5 Financial analysis
7.6 Summary
7.7 Key words
7.8 Self Assessment Questions
7.9 Further Readings

7.1 INTRODUCTION
In the previous units, we have discussed the relevance of economy and industry
analysis and how it can be conducted. In this unit, we will discuss the company
level analysis. In order to provide a proper perspective of this analysis, let us
begin by discussing the way investor takes the investment decision given
her/his goal of return maximization. For earning profits, investors apply a
simple and common sense decision rule i.e.
x Buy the share at a low price, and
x Sell the share at a high price
The above decision rule is very simple to understand but difficult to apply in
actual practice. Despite this, efforts are generally made to operationalize it
by using proper formal and analytical framework. To begin with, the problems
faced by the investors are:
x How to find out whether the price of a company’s share is high or low?
x Which benchmark to use to compare the price of the share?

120
The first question becomes easier if some benchmark is agreed upon with Company Analysis
which the prevailing market price can be compared. Fundamental analysis in
fact helps theinvestor in this respect by providing a benchmark in terms of
intrinsic value. This value is dependent upon economy, industry and company
fundamentals. Out of these three, company analysis provides a direct link
between investor’s action and her/his investment goal in operational terms.
This is because an investor buys the equity share of company and not that of
industry and economy. Industry and economy framework indeed provide her/
him with proper background against which s/he buys the shares of a particular
company. This setting is nevertheless very important, but for action to take
place it is the company that provides investors actual key settings. A careful
examination of the company with its quantitative and qualitative fundamentals
is, therefore, very essential. If the economic outlook suggests purchase at this
time, the economic analysis along with the industry analysis will aid the
investor in selecting their proper industry in which to invest.Nonetheless,
knowing when to invest and in which industry is not enough. It is also
necessary to know which companies in which industries should be selected.

7.2 COMPANY ANALYSIS

Company analysis is the process of evaluating a company’s financial and
operational performance to determine its strengths, weaknesses, opportunities,
and threats and is like structural analysis. This analysis helps investors,
financial analysts, and other stakeholders make informed decisions about the
co121mpany.
There are several aspects of a company that can be analyzed, including:
1. Financial performance: This includes evaluating a company’s revenue,
profitability, cash flow, and financial ratios such as the debt-to-equity
ratio, return on equity, and current ratio.
2. Competitive positioning: This involves analyzing a company’s market
share, its competitors, and its ability to compete in the industry.
3. Management team: This includes evaluating the leadership team’s track
record, experience, and ability to execute the company’s strategy.
4. Industry trends: This involves understanding the trends in the industry
in which the company operates, including technological advancements,
regulatory changes, and customer behaviour.
5. Growth potential: This involves assessing the company’s potential for
growth, including its expansion plans, new product offerings, and potential
for market penetration.
6. Corporate governance: This includes evaluating the company’s board
of directors, executive compensation, and shareholder rights.
By analyzing these aspects of a company, stakeholders can gain a better
understanding of the company’s overall health and potential for future success.

121
Security Analysis
7.3 VALUATION OF STOCKS
A common valuation measure is Book Value, which is the net worth of a
company as shown in the balance sheet. Book value can be expressed on per
share basis and in such a case, the book value per share is equal to net worth
divided by the number of shares outstanding. The book value is derived based
on certain accounting assumptions. These are:
x Assets are valued after deducting the depreciation value from the
acquisition cost.
x Depreciation amount of an asset for a period is computed based on the
initial estimated life of the machine. There is no guarantee that the amount
provided as depreciation is equal to loss in the value of the asset and it
may be either more or less than the actual loss in the value of the asset.
x The market price of a stock takes into account the market value of the
asset.
Nevertheless, book value is a starting point in any valuation exercise and
unless there is a window-dressing in accounting, the intrinsic value of an
asset is at least equal to the book value of the asset. In many cases, the market
value is greater than book value.
Another measure close to book value is liquidation value per share. This
represents the amount of money that could be realized by breaking the firm,
selling its assets, repaying debt and then distributing remainder to the
shareholders. If there is an active takeover market, the price of the stock should
be at least equal to liquidation value. Otherwise, corporate raiders would find
it profitable to acquire the firm and then take up liquidation.
Value of a firm can also be measured by computing the replacement cost of
the asset less debt. Replacement cost can be measured if you could find out
what is the current cost of putting up a similar plant. For many industries, the
cost per unit of capacity (like cost of one million ton of cement plant) is
available. If the market price is below to this replacement cost level, then
firms intending to expand will find it easier to acquire the firm than putting
up one more plant.
All the above measures fail to look into the earning capability of the firm by
using the assets. It is quite possible that firms can use the assets and earn
superior return because of several other advantages or skills available within
the firm. On the other hand, market value of the firm takes into account such
future income arising out of the use of assets. The ratio of market price to
replacement cost popularly calledTobin’s q, after the Nobel Prize-winning
economist James Tobin, is another popular value measure among the
economists.
The Dynamic Valuation Process
Estimates of present value, riskiness and discount rates, future income, and
buy-sell action have to be reviewed from time to time in response to new bits
122 and sets of information. Figure 7.1 depicts the dynamic valuation process
which is an ever continuing phenomenon. The investors start with their Company Analysis
estimates of intrinsic value using the present value procedure. Working on
the trading rules, they buy sell or don’t trade. In the process, buying and
selling pressures are generated and prices either move up or down. In either
case, future return will be influenced by the latest market price reacting to
buying/selling pressures. This will require present values to be reworked.
The process will thus go on.

Figure 7.1 : The Dynamic Valuation Model

7.4 FORECASTING EARNING PER SHARE

Earnings is the most important number in valuing the stock. The most important
and the principle source of getting information about the earnings of the
company is its financial statements. Out of the two statements, namely, Balance
Sheet and Income Statement, it is the income statement that is more often
used in order to assess the future state of the firm. The income statement of
the past few years shows the kind of growth that the company is witnessing
on sales and earnings. A comparison of income statement of the company
viz-à-viz income statement of the industry shows the market share of the
firm. While the historical data culled out from the income statement is useful
for estimating the earnings, one has to look into the current and future
prospects. For instance, quarterly information will be extremely useful in this
context. In addition, analysts can develop techniques linking company’s
fortune with a few other economic variables. Now-a-days, it is possible to get
investment analysts expected information and they are published in several
web sites and newspaper.
There are various methods employed to assess the future outlook of the
revenue, expenses and earnings of the firm given the economic and industry
outlook. These methods can be broadly classified into two categories, namely,
traditional and modern. Under the traditional approach, the forecaster obtains
the estimate of single value of the variable. While in the case of modem
approach, s/he gets the range of values with the probability of each occurrence.
Let us discuss these two approaches in detail.
123
Security Analysis TRADITIONAL METHODS OF FORECASTING EPS
Under the traditional approach the following methods of forecasting are
adopted:
x ROI approach
x Market share approach
x Independent estimates approach
Before starting the discussion on the forecasting techniques, it will not be out
of place to briefly mention the way the earnings per share is measured from
the financial statements. This will provide us an understanding of its changes.
Broadly, changes in earnings are affected by operating and financing decisions.
Both these decisions are, however, interdependent. But attempts are generally
made to separate the two decisions so that the effect of each is studied
separately. Given below is the format which analysts use to calculate the
earnings per share.
Income Statement for the year ended.........................
Sales Revenue
Less: Operating Expenses

Less: Interest Expenses

Earnings Before Tax (EBT)
Less:Taxes
Earnings After Tax (EAT)
Number of Shares Outstanding
EPS=EAT/Number of Shares Outstanding
Let us now explain the RO1 approach to forecast earnings per share.
ROI Approach
Under this approach, attempts are made to relate the productivity of assets
with the earnings i.e. returns earned on the total investment (assets) are
calculated and estimates regarding earning per share are made. Simply stated,
Return on Assets = EBIT/Assets
Return on assets (ROA) is a function of the two important variables viz.,
turnover of assets, and margin of profit. In other words,
Return on Assets = Assets Turnover x Profit Margin
where, Asset Turnover = Sales/Assets
Profit Margin = EBIT/Sales Therefore, ROA = (Sales/Assets) x (EBIT/Sales)
124
ROA is thus a function of Company Analysis

(1) number of times the asset base is utilised and converted into sales (asset
turnover) and
(2) profits earned on the sales (Profit margin).
This is a simple but crucial relationship. The above two equations can be
further decomposed. For instance, the asset turnover ratio can be decomposed
further to fixed asset turnover and current assets turnover. Profit margin can
be further decomposed to expenses ratio. Such kind of decomposing helps
the analysts to forecast the earning more accurately. For instance, asset
turnover ratio of the firm can be forecasted if we are able to get some idea
about the growth rate of the industry. Profit margin can be forecasted by
looking into the cost structure and the impact of recent changes in the prices
of critical raw materials. Once an analyst or investor forecasts the individual
components of ratio, it is possible to forecast the ROA. ROA will be useful to
forecast the EBIT. EBIT requires a minor adjustment before getting earnings
per share. The adjustment is on account of debt used by the firms.
Leverage is the use of borrowed funds in the enterprise with a fixed cost. The
more is the use of such funds, the higher is said to be the leverage. As borrowed
funds are of a fixed rate/cost and if the firm is earning profits, it is profitable
to use more of borrowed funds. However, there is limit beyond which use of
borrowed funds can increase the risk associated with the earnings per share
and in certain cases may also reduce the earnings per share. It is often said
that as borrowed funds increase in relation to equity funds in the total financing
mix, borrowing costs would not only increase; but increase more rapidly than
the amounts borrowed. This happens because the suppliers of funds now
perceive the business more risky when borrowed funds are utilised beyond a
certain point. The relationship between Return On Equity (ROE), ROA and
debt can be explained as follows:
Rate of Return on Equity = R + (R-I)L/E
Where, R = Return on Assets
I = Effective interest rate
L/E = Total outside liabilities/equity
If we multiply the above equation with equity capital, we can find out the
earnings before taxes.
Thus, EBT = (R+(R-I)L/E)E
As forecasting of earnings is the central theme in the company level analysis,
it requires an understanding of the earnings formation process. The ROI
approach provides a framework for analyzing the effects and interaction
between the return a firm earns on its assets and the manner it is financed.
Once this return generating power is understood by the analyst, he can forecast
the key variables in the model and substitute the forecasted values into the
model and forecast Earnings After Tax (EAT).
125
Security Analysis Based on the chemistry of earnings, the analyst can further use the following
equations to calculate the earnings per share:
EPS = [(1-T){R+(R-I)L/E}E]

Number of shares outstanding

Earnings per share and its changes a re a function of:
1. Utilisation of asset base
2. Productivity of sales (Profit Margin)
3. Effective cost of borrowed fuunds (I) = Interest expenses
–––––––––––––
Total outside liabilities
4. Debt equity ratio (L/E)= total outside liability/equity
5. Equity base (E)
6. Effective tax rate (T)= Tax expenses/EBT
7. Return on assets = EBIT/Assets
The above model is quite simple but its importance will be realised if we
keep the variables in the functional forms as shown below:
The model can be used to forecast earnings in the future holding period. For
this purpose, the analyst has to collect the information relating to the following
variables:
Net sales Taxes

Other Incomes EAT

Cost of Sales Average Shares Outstanding

EBIT Earnings per share (EPS)

Interest Expenses 10 Dividend per share (DPS)

Other relevant information with regard to the financial position is as follows:
1. Total Assets
2. Current Debt
3. Long term Debt
4. Equity shares
5. Total Debt and Equity
After collecting the above information, it can be summarised and the following
key variables can be calculated and arranged in the tabular form for the purpose
of analysis. The following table gives the picture relating to the information
as required for the application of this model:
126
Summary Table Company Analysis

Earnings per share

Return on Assets

Profit Margin

Asset Turnover

Effective Interest Rate

Total Equity/Outside Liabilities

Number of Shares Outstanding

Effective Rate of Interest

Earnings per Share

10 Dividend per Share

11 Retention Rate(1-10)

12 Costof Equity

13 Growth rate of Dividend (2)x(11)

14 Value per share

The intrinsic value of the share can be computed with the help of Dividend
Discount Model (DDM) explained earlier by using the key variables.
Market Share Approach
This approach emanates from the industry analysis. Once the estimate about
the future prospects of the industry is completed, the analyst would then look
into the firms, which are the leaders and pacesetters in the industry and would
then find out the market share of the firm to be analysed. The following steps
can be adopted to implement this method:
1. Estimate the industry’s total sales
2. Estimate the firm’s share in the total sales in industry i.e. market share
3. Estimate the profit margin
4. Multiply sales by profit margin to get total earnings
5. Divide earnings by number of shares outstanding to get EPS.
6. Multiply EPS by P/E ratio.
In order to estimate the profit margin under this approach, the analyst has to
understand the mark up and behaviour of cost and prices during the relevant
range of activity. This calls for having an understanding of profit-volume
relationship of the firm. The analyst should look into various component of
costs like:
127
Security Analysis 1. Fixed and variable cost (or operating leverage), and
2. The level of sales volume the firm is likely to attain during the forecast
period.
Independent Estimates Approach
Under this approach, each and every item of revenue and expense is estimated
separately and summed up to arrive at the future EPS. All the three approaches
are traditionally utilised by security analysts. However, these are not mutually
exclusive approaches. But one important and common limitation of these
approaches is that they indicate point estimate of EPS and HPY and therefore,
attach 100% probability of outcome.
MODERN METHODS OF FORECASTING EPS
Under modern approaches to forecasting earnings of a company, statistical
techniques are used. The following techniques are generally included in this
category:
x Use of regression and correlation analyses
x Use of trend analysis
x Decision tree analysis
Let us briefly discuss each of these.
Regression and Correlation Analyses
In order to find out the interrelationships of relevant variables, the techniques
of regression and correlation analyses are used. When the inter-relationship
covers two variables, simple regression is used and for more than two variables,
multiple regression technique is used. Using this approach, security analysts
may find out the inter-relationship between the variables belonging to the
economy, industry and the company. For instance, if the analyst believes that
the sales of the firm depends on GDP growth rate, monsoon, and population
growth rate, then it is possible to set a relationship between sales and other
independent variables by collecting the data pertaining to sales and other
variables for the last few years, say 20 years. Once the data is ready, a
regression model can be set out to find the relationship and can be used to
predict the sales. Major advantages in its application relate to deriving the
forecasted value as well as testing the reliability of the estimates.
Trend Analysis
While using this technique, the relationship of only one variable is tested
over time using the regression technique. In a way, it is the simple regression
technique where the inter-relationship of a particular variable is tested viz-à-
viz time. That is why the name trend analysis. It is quite useful to understand
the historical behaviour of the variable for the purpose of the security analysis.
Decision Tree Analysis
The above two methods are considered superior to the traditional methods
128 employed to forecast the value of earnings per share. However, an important
limitation remains. Both these methods provide only point estimate of the Company Analysis
forecast value. In order to improve decision making process, information
relating to the probability of occurrence of the forecast value is quite useful.
Thus a range of values of the variable with the probabilities of occurrence of
each value will go a long way to improve decision by the investor. To overcome
these limitations, decision tree and simulation techniques are used. Under the
decision tree analysis, the decision is assumed to be taken sequentially with
probability of each sequence. Thus, in order to find out the probability of the
final outcome, given various sequential decisions along with probabilities,
the probabilities of each sequence is to be multiplied and summed up. In
practice, whenever security analyst attempts to use decision tree analysis in
conducting analysis of the securities, s/he starts with estimating the sales.
The application of the decision tree analysis is illustrated below by taking a
simple example.
1. Sales(Lakhs) Probability
10.0 .3
12.0 .5
11.0 .2
2. Expenses Probability
6.0 .6
7.0 .4
3. P/Eratio Probability
10 .4
20 .3
25 .3
4. Number of shares outstanding is one lakh.
A) Estimation of EPS by Decision Tree Approach
Probability Sales in Probability Expenses Estimated No. of Estimated
crores in crores earnings Equity EPS (` )
( `) (` ) in crores (` ) shares

0.30 10 0.60 6 3.0-3.6 = 0.6 + 1= -0.60

0.40 8 3.0-3.2 = -0.2 + 1= -0.20

0.50 12 0.60 6 6.0-3.6= +2.4 1= +2.40

0.40 8 6.0-3.2 = +2.8+ 1= +2.80

0.20 11 0.60 6 2.2-3.6= -1.4+ 1= -1.40

0.40 8 2.2-3.2= -1.0+ 1= -1.00

Total 2.00

129
Security Analysis B) Estimation of Share Price
EstimatedEPS () P/ERatio Probability Estimated SharePrice()

10 0.40 2xl0x0.40 =

20 0.30 2x20x0.30 = 12

25 030 2x25x0.30 = 15

Total 35

The above approach provides us the information with a range of values with
the probabilities of their occurrence instead of a point estimate. This is quite
helpful in forming expectations with regard to the likelihood of the events to
improve the decision making process.
Activity 1
a) List out traditional methods of forecasting EPS.
.........................................................................................................
.........................................................................................................
.........................................................................................................
b) Compare and contrast traditional method of forecasting EPS with
modern methods.
.........................................................................................................
.........................................................................................................
.........................................................................................................

7.5 FINANCIAL ANALYSIS

Financial analysis is the process of evaluating the financial health and
performance of a company by examining its financial statements and other
financial data. Financial analysis is an important tool for investors, creditors,
and other stakeholders to make informed decisions about a company’s
investment potential and creditworthiness.
Financial analysis typically involves the following steps:
1. Reviewing financial statements: Financial statements, such as income
statements, balance sheets, and cash flow statements, provide a detailed
picture of a company’s financial performance over a period of time.
Reviewing these statements is the first step in financial analysis.
2. Calculating financial ratios: Financial ratios are used to analyze the
relationship between different financial statement items. Common
financial ratios include profitability ratios, liquidity ratios, solvency
ratios, and efficiency ratios.
130
3. Conducting trend analysis: Trend analysis involves examining financial Company Analysis
data over time to identify trends and patterns in a company’s financial
performance. This helps investors and other stakeholders to identify areas
of strength and weakness in a company’s financial performance.
4. Comparing financial data: Comparing a company’s financial data with
its peers in the industry can provide valuable insights into its financial
health and performance. Investors and analysts may use benchmarking
techniques to compare a company’s financial ratios with industry
averages.
5. Conducting sensitivity analysis: Sensitivity analysis involves testing
the impact of changes in key financial variables, such as interest rates or
commodity prices, on a company’s financial performance. This helps
investors and other stakeholders to assess the potential impact of external
factors on a company’s financial health.
Financial analysis is an important tool for investors, creditors, and other
stakeholders to make informed decisions about a company’s investment
potential and creditworthiness. By conducting a thorough financial analysis,
investors can investors can identify potential risks and opportunities associated
with investing in a company’s securities and make informed decisions about
their investment portfolios.

7.6 SUMMARY
The analysis of a company is important as it is in the shares of a company that
an investor invests. This requires forecasting both future price of the share as
well as dividends. Future price of the share can be calculated using two
approaches: discounted dividend model and WE ratio approach. Earnings per
share is the most important and widely used variable in valuing equity share.
Forecasting EPS is very crucial for investment decision making. There are
traditional as well as modern methods of forecasting EPS.Traditional methods
are ROI approach, Market share approach, and independent estimation
approach.These methods provide a point estimate of the forecasted variable.
Modern forecasting methods are regression and correlation analysis, trend
analysis and decision tree analysis. Decision tree and simulation methods
provide a range of values with probability of their outcomes. Such information
is quite useful in making investment decisions. However, this calls for
generating information regarding probabilities of occurrence of various
outcomes. The common limitation of these approaches is that these are
quantitative in nature. Investor must try to find how reasonable of the value
of the share by taking into account the qualitative factors. Company
management constitutes most difficult, yet most critical,qualitative factor to
be analysed by the investor or investment analyst. Past track record of the
company management would come handy here. However to analyse a new
management, without having past trackrecord, perhaps the skills of the venture
capitalist are needed.

131
Security Analysis
7.7 KEY WORDS
Company analysis : is the process of evaluating a company’s financial
and operational performance to determine its
strengths, weaknesses, opportunities, and threats
Financial analysis : the process of evaluating the financial health and
performance of a company by examining its financial
statements and other financial data.
Trend Analysis : it is the simple regression technique where the inter-
relationship of a particular variable is tested viz-à-
viz time.

7.8 SELF ASSESSMENT QUESTIONS

1. Why do you think company analysis is important for equity investment
decision?
2 What are different methods of forecasting EPS? Which one do you consider
the best and why?
3. Using hypothetical data explain and illustrate decision tree analysis for
forecasting EPS.
4. Write short notes on the following?
a) Price-Earnings Approach
b) ROI Approach
c) Market Share Approach
d) Independent Estimates Approach

7.9 FURTHER READINGS

Amling, F. (1984), Investment - An Introduction to Analysis and
Management, ed., PHI; New Delhi.
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
Francis J.C., (1983). Management of Investment, McGraw-Hill
(International Student Edition)
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-17 Company Analysis - I
[Video]. YouTube. https://www.youtube.com/watch?v=eq5REGWHb_A
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-18 Company Analysis - II
[Video]. YouTube. https://www.youtube.com/watch?v=ZGvnwWNkZxQ
132
IIT Roorkee July 2018. (2021q, September 7). Lecture 37: Balance Sheet Technical Analysis
Analysis IV [Video]. YouTube. https://www.youtube.com/
watch?v=DG1GQXe-YzM
IIT Roorkee July 2018. (2021r, September 7). Lecture 38: Balance Sheet
Analysis V [Video]. YouTube. https://www.youtube.com/
watch?v=yX1Y6TU9QtQ
IIT Roorkee July 2018. (2021s, September 7). Lecture 39: Balance Sheet
Analysis VI [Video]. YouTube. https://www.youtube.com/
watch?v=WImMZUaNxx4
IIT Roorkee July 2018. (2021t, September 7). Lecture 40: Income
Statement, Cash Flow Statement, Ratio Analysis [Video]. YouTube. https://
www.youtube.com/watch?v=6EtaPd9YWow
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F.
(2019). Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

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Security Analysis
UNIT 8 TECHNICAL ANALYSIS
Objectives
After reading this unit you should be able to:
• Explain the meaning of technical analysis and distinguish it from
fundamental analysis;
• Discuss the origin and development of technical analysis;
• Explain the Dow Theory and its basic tenets and illustrate classical
formations and the related rules;
• Explain and illustrate modern technical analysis;
• Highlight market indicators, as different from individual stock indicators.
Structure
8.1 Introduction
8.2 Meaning of Technical analysis
8.3 Difference between Technical and Fundamental analysis
8.4 Types of charts and patterns
8.5 Methods of technical analysis
8.6 Market indicators
8.7 Elliot wave theory
8.8 Limitations of technical analysis
8.9 Fibonacci Analysis
8.10 Summary
8.11 Key words
8.12 Self Assessment Questions
8.13 Further Readings

8.1 INTRODUCTION
Investors can use broadly two approaches, namely, Fundamental Approach
or Technical Approach in taking investment decision. Fundamental approach
or analysis involves detailed examination of data pertaining to the company,
industry and economy. It requires considerable skill of the analysts to examine
such massive data to get a value for the firm and then compare the value with
the market price to take investment decision. If the value is more than the
market price, the investor buys the Stock. An alternative approach called
technical approach or analysis, ignores all data other than data generated in
the stock market. Technical analysts believe that there are enough number of
investors and analysts in the market, who constantly examine the stocks and
134 derive the price. There is no point in doing or repeating such exercise.
It is adequate to watch them because whatever superior analytical techniques Technical Analysis
such investors have, they have to come to the market ultimately to cash their
efforts.
Technical analysis is thus reading the minds and activities of the major players
in the market by observing their behavior in the market place through price,
volume and several other market data. Technical analysis typically involves
charting the market data and using a number of oscillators. With the easy
accessibility of computers and internet, technical analysis is now become much
easier since several web sites offer free charting facilities.

8.2 MEANING OF TECHNICAL ANALYSIS

Technical Analysis is concerned with a critical study of the daily or weekly
price and volume data of the Index comprising several shares, like Bombay
Stock Exchange Sensitive Index (SENSEX), or of a particular Stock. The
objective of the technical analysis is to predict or forecast the short,
intermediate and long term price movements. It uses only the data generated
from the market. Such market generated data includes price, volume, number
of trades, 52-week high or low price, intra-day spread, dealers buy-sell quote
spread, number of advances and declines, number of Stocks hitting the new
high and low, open interest, etc. Some of the basic assumptions of the technical
analysis are:
1. Market value is determined solely by the interaction of supply and demand.
2. Supply and demand is governed by numerous factors, both rational and
irrational.
3. Stock prices tend to move in trends, which persists for an appreciable
length of time.
4. Changes in trend are caused by shifts in demand and supply.
5. Shifts in demand and supply can be detected through chart analysis and
some chart patterns repeat themselves.
To appreciate technical analysis, one has to understand the above assumptions
clearly. Technical analysis assumes that there is a sufficient lag between the
arrival of information and its ultimate impact on the Stock prices. The analysis
fails if the information is never incorporated in the prices (inefficient market)
or instantaneously reflected in the prices (efficient market). The perfect set
up is temporarily inefficient such that initially a few investors or analysts are
able to understand the impact of information on prices and entering into the
Stock. Subsequently, more and more people are entering into the Stock.
Technical analysts believe that charts will give them a clue about entry of
more and more investors into the Stock and hence they can also enter into the
Stock without doing such analysis. They are primarily moving with the crowd
and exit from the market the moment the Stock prices started moving down.
As such they are no long-term investors in a particular Stock though they

135
Security Analysis invest in the market for a longer period. They move from one security to
another security.

8.3 DIFFERENCE BETWEEN TECHNICAL AND

FUNDAMENTAL ANALYSIS
There are few basic differences between technical and fundamental analysis,
which are listed below in table 8.1.
Table 8.1: Difference between Technical and Fundamental analysis

Technical Analysis Fundamental Analysis

Focus on timing and likely price Focus on valuation of intrinsic value
changes; Not bothered about and through such value, identifying
the intrinsic value. stocks which are underpriced or over-
priced.
Focus on internal factors - Focus on external factors - factors that
factors that are available in the are outside the market (annual reports,
market (price, volume etc.). industry report, economic estimates,
etc.).
Focus is generally on near (short) Focus is on long-term expected price.
term changes in the prices though Typically follows buy-hold-sell
intermediate and long term strategy once the stock is identified
forecasts also done. and investment period is defined.
Focus is more on price direction Focus is on price target; bothered
than price target or forecast. for short-term price changes.
Easier and faster voluminous Requires considerable time for
data. analyzing.
Simultaneously applied to many Difficult to apply for a large number of
stocks. stocks unless a big analysts team is set
up.

Technical analysis is often criticized as a blind and irrational method of

investment whereas fundamental analysis is more scientific and systematic.
In a way, it is true that there is no strong theoretical basis for technical analysis.
It doesn’t mean that it is irrational. It uses a simple philosophy that the market
is a place where a large number of investors of different kind buy and sell
securities and it believes that it is possible to find some pattern in their trading
and can be exploited for buying and selling stocks. Thus, it is difficult for
anyone to read a textbook on technical analysis and then start doing it. It
requires considerable exposure to market and understanding of how a typical
crowd behaves when an important information about the company is released.
They also read the type of price reaction when the insiders enter into the
stock. Technical analysts on the contrary never complain against fundamental
analysts. They simply believe that is time consuming and too costly affair.

136
 Technical Analysis
Activity 1
a) What is technical analysis?
........................................................................................................
........................................................................................................
........................................................................................................
b) List out two points of difference between fundamental analysis and
technical analysis.
........................................................................................................
........................................................................................................
........................................................................................................
c) Why should technical analysis confirm findings based on fundamental
analysis?
........................................................................................................
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........................................................................................................

8.4 TYPES OF CHARTS AND PATTERNS

Charting represents a key activity for the technical analyst. The two oldest
and most widely used charting procedures are point-and-figure (P&F)
charting and bar charting. The major features of P&F charting are:
(1) it has no time dimension;
(2) it disregards small changes in the stock price; and
(3) it requires a stock to reverse direction a predetermined number of points
before a change in direction is recorded on the chart.
P&F charts were used earlier because it is easier to graph manually because it
considers only prices on days when there is a major change and in that process,
it uses roughly about 20% of total number of prices.
On the other hand, bar chart contains measures on both axis - price on the
vertical axis and time on the horizontal axis. On the bar charts, rather than
just plotting a point on the graph, the analyst plots a vertical line to represent
the range of prices of the stock during the period. The length of the bar
represents high and low price of the day whereas the open and close prices
are shown as a small ticker on both sides of the bar. Generally, bar charts also
show at the bottom volume information for the period of which price
information is depicted. Figure 8.1 shows a sample of the interactive bar chart.
A stock chart type that is used to show price is a bar chart. The price bars
used now resemble the pricing charts from the business section of the
137
Security Analysis newspaper when they are shown in black. The composition of a price bar and
several bar chart types are covered in the information that follows.

Figure 8.1: Interactive Bar Chart of BSE with technical Indicator

Source: topstockresearch (2023)

Components of Price bar

The four main components of price bar are:
x Open price: The price at which the stock opens (shown on the left)
x High price: The highest price of the day
x Low price: The lowest price of the day
x Close price: The price at which the stock closed for the day (shown on
the right)
The abbreviation to this chart style is OHLC Bar (OHLC is an acronym for
open-high-low-close).
A different kind of bar chart, which is less popular, only uses high-low-close
(HLC) data and ignores the open on each bar. Instead of only placing a line
on the right side of the pricing bar, it now crosses the entire bar. Without the
opening price information, the price bar displays the price movement and the
closing price.
The third and most popular type of chart in recent days is candle stick charts.
It uses bar chart as a basis but put a small box using open and closer ticker of
the bar charts. In order to distinguish whether close is higher or lower. than
opening price, the body of the candle stick is colored. Normally, a black color
indicates a bearish candle stick, meaning the closing price of the day is less
than opening price of the day. On the other hand, a white candle indicates,
bullish candle meaning closing price is higher than opening price. There is
yet another simple charting method, where only one of the four prices (open,
high, low and close) is used. It is a line chart where you can witness some
continuity in the price line (figure 8.2).
138
 Technical Analysis

Figure 8.2: Candlestick Chart of BSE

Source: topstockresearch (2023)

DOW THEORY AND ITS BASIC TENETS

To start with, the Dow’s Theory put forward six basic tenets as follows:
1. THE AVERAGES DISCOUNT EVERYTHING: Daily prices reflect
the aggregate judgment and emotions of all stock market participants.
This process discounts (takes into account) everything known and
predicable that can affect the demand-supply relationship of the stocks.
2. THE MARKET HAS THREE MOVEMENTS: Primary movements,
secondary reactions, and minor movements. The primary movement is
the long range cycle that carries the entire market up or down. The
secondary reactions act as a restraining force on the primary movement
and tends to correct deviations from it. Secondary reactions usually last
from several weeks to several months in length. The minor movements
are the day-to-day fluctuations in the market. Minor movements have
little analytic value because of their short duration and variations in
amplitude.
3. PRICE BAR CHARTS INDICATE MOVEMENTS.
4. PRICE/VOLUME RELATIONSHIPS PROVIDE BACKGROUND.
5. PRICE ACTION DETERMINES THE TREND.
6. THE AVERAGES MUST CONFIRM: The movement of two different
market indices must confirm each other to confirm the trend.

8.5 METHODS OF TECHNICAL ANALYSIS

Technical analysts broadly use two methods to analyze the stocks to find
whether it is worth to buy the stock or sell the stock or hold the stock. In the
first analysis, the analyst uses the price chart as it is to find trends and patterns.
In the second approach, the analysts convert the market information into certain
139
Security Analysis statistical figures and draw conclusion. We will first discuss the pattern before
moving into statistical analysis.
Analysis of Price Patterns and Trends
As mentioned in the previous sections, the analysts use the charts made up of
historical price, volume and other market generated data to understand the
minds of major players in the market and the demand and supply positions of
the stock. It is also assumed that the prices react to the news but the reaction
is not instantaneous but takes some time to fully reflect the value of the
information on the prices. Though the time and speed of the adjustment process
differ depending on the type of the information and its availability to the
investors, they could be broadly classified into certain patterns and this
knowledge could be used subsequently to predict the future behaviour of the
prices. The analysis of patterns is the first principle in the technical analysis
and the success of this method of analysis of stock prices depends on the
ability of the user in recognizing the patterns.
There are three basic patterns in the stock price movements. They are: uptrend,
downtrend and sideways patterns.
x The uptrend pattern is recognized the moment the stock prices form a
new high (ascending top) and some times it is also preferred to wait for
the formation of ascending bottom. The uptrend pattern once emerged
will continue till the time a downtrend pattern is seen in the prices.
x The downtrend pattern is recognized once the price fails to create a new
high and some times it may be preferred to wait for the formation of
descending bottoms. The purchase decision can be effected once the
uptrend pattern is seen and stocks could be hold till the time the downward
pattern is noticed. The investor can also go short in the downward pattern.
The duration of these two trends for many stocks in the Indian market is
fairly long and consistent investment decision on the basis of pattern
recognition offers a substantial gain to the investors.
The technical analysts also usually draw lines by connecting the bottoms and
tops of uptrend and downtrend respectively. These lines are used to get early
warning signal for the reversal of the trend. For instance, an upward trend
line is drawn by connecting two descending bottoms and the line is extended
further. It is presumed that the price of the stock which is moving upward
will see periodic corrections and during the correction phase, the price will
come closer to the trend line and get support from the trend line. If this support
fails to take place, it is the first signal for the reversal of the uptrend. In the
subsequent days, the price may not reach a new high giving a clear bearish
pattern but the confirmation may be delayed. Similarly, bearish trend lines
are drawn by connecting two descending tops and extending the line further
downward. Against the normal expectation of resistance, if the price line
penetrated the trend line, it is an indication for the reversal of the downtrend.
There are several variations in trend line pattern. Typically, analysts use more
than one trend line to draw such new patterns like Head and shoulders,
140 triangles, double tops or bottoms.
Head and Shoulders : The formation is encountered when a bar chart forms Technical Analysis
a hump followed by a peak, and then another hump. A line joining the lowest
points of the humps and the peaks products a resistance line which foresees a
bearish market. A reversed head and shoulders formation is the opposite of
this, and depicts an on coming bullish tendency.
Triangles : These are formed when the peak point of descending tops fall on
a line, as well as the ascending bottoms fall on a different line, and both the
lines join up at a point in the future. If the prices break out of this triangle
Upwards, it indicates bullishness, and if the prices break out on the downside,
it indicates bearishness. The odds are that the new move will proceed in the
same direction as the one prior to the triangle’s formation.
Flags and Pennants : These are forms when, in the midst of a big bull run,
the price chart indicates a halt and the boundaries of this consolidation form
a flag (parallel lines) or pennant (lines sloping down and up to meet at a point
in future). These are formed almost exactly half-way between the bottom and
the top, signaling bullish conditions.
A few other important patterns like ‘rounding tops and bottoms’, ‘triangle’
and ‘double and triple tops and bottoms’ are also useful in investment decision
making.
Rounding tops and bottoms : Shows a gradual reversal of the trend from
downtrend to uptrend or uptrend to downtrend. The pattern which looks like
a Bowl or Saucer moves forward with higher momentum after the formation
of pattern. Though a safe pattern in view of availability of sufficient time to
recognise and initiate action, they are less frequent in actively traded stocks.
Actively traded stocks change trend without moving sideways. However, this
pattern can be seen in weekly charts and charts of small value stocks.
Double and triple tops and bottoms : Pattern is a horizontal pattern that
forewarns reversal in the trend. A ‘double or triple tops’ pattern is formed
when the uptrend in a stock is resisted at a particular level. In a normal market,
this pattern shows that a group of traders who had earlier accumulated stocks
at lower levels is waiting to liquidate their position once the price reaches the
specific level. If the supply at that level is of small quantity and the underlying
demand is sufficient, then the stock will easily break the resistance and create
a new peak above the previous one. The absence of this break in the resistance
level gives way to the formation of double or triple tops pattern and stock
price moves downward on the formation of this pattern. The double or triple
bottoms pattern indicates strong demand at a particular level and the stock
bottoms out at this level.
Analysis of Oscillators or Price Indicators
The modern technical analysis deals with indicators, such as moving averages,
exponential moving averages, weighted moving averages, moving averages
cross over, various types of bands around the moving averages like the bands
in terms of standard deviations, Bollinger bands, etc, and the rate of change,
etc. Several oscillators are also used, like stochastic, relative strength index
141
Security Analysis (RSI), strength relative to a market index, moving average conversance
divergence (MACD) technique. The basic difference between price trends
and oscillators is, price trends are often difficult to interpret and what action
has to be followed is not defined clearly. On the other hand, oscillators clearly
define the investment decision rule. For instance, if you use Moving average,
the simple decision rule is buy the stock, the moment the stock price crosses
the moving averages. We will discuss some of the important oscillators.
a) Moving Average
An average is the sum of prices of a share over some weekly periods divided
by the number of weeks. This point is marked on the latest date for which a
price bar has been plotted. This process is repeated for the previous dates.
The points thus obtained are connected together to give the Moving Average
line.
An example of the calculation of a 5-week Moving Average is given in Table
8.1.
Table 8.1: Calculation of five week moving average

There is another type of moving average called exponential moving average.

In an Exponential Moving Average, more weight is given on the most recent
data and less weight is given to the older data. Moving Averages smoothen
out the apparent erratic movement of share prices and highlight the underlying
trend. Moving averages are fairly simple to interpret. The decision rule is:
Buy: When the price line crosses the pre-determined moving averages from
bottom, buy the stock and hold it as long as the price line is above the moving
average line.
Sell: When the price line crosses the pre-determined moving averages from
the top, sell the stock. If short selling is allowed, take short position and hold
it as long as price line is below moving averages.
Though moving averages helps investors to take such decision, one has to
experiment with different moving averages to find which is suitable for the
stock and do lot of mock trading before started using them in the real world.
This warning is given because some of you might get tempted to invest in the
stocks based on such simple tools.
142
 Technical Analysis
Activity 2
i) What do the following formations signify?
a) Triple Top
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b) Head and Shoulder
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c) Flag and Pennats
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b) Moving Average Convergence Divergence (MACD) Indicator

MACD is also based on moving averages and used normally for intermediate
trend analysis. The MACD is the difference between a 26-day and 12-day
exponential moving average. A 9-day exponential moving average, called the
“signal” (or “trigger”) line is plotted on top of the MACD to show buy/sell
opportunities. The MACD proves most effective in wide-swinging trading
markets. There are three popular ways to use the MACD: crossovers,
overbought/oversold, and divergences.
Crossovers: The basic MACD trading rule is to sell when the MACD falls
below its signal line. Similarly, a buy signal occurs when the MACD rises
above its signal line. It is also popular to buy/sell when the MACD goes
above/below zero.
Overbought/Oversold Conditions: The MACD is also useful as an
overbought/oversold indicator. When the shorter moving average pulls away
dramatically from the longer moving average (i.e., the MACD rises), it is
likely that the security price is overextending and will soon return to more
realistic levels. MACD overbought and oversold conditions exist vary from
security to security.
Divergences: An indication that an end to the current trend may be near occurs
when the MACD diverges from the security. A bearish divergence occurs
when the MACD is making new lows while prices fail to reach new lows. A
bullish divergence occurs when the MACD is making new highs while prices
fail to reach new highs. Both of these divergences are most significant when
they occur at relatively 143
Security Analysis MACD is equally efficient indicator for those who don’t want to buy and sell
stocks frequently. For instance, a person who follows MACD may have to
buy and sell stocks around four to five times in a normal year.

Figure 8.3: MACD daily chart of NASDAQ 100 ETF

Source: Tradermatt (2023)

Example of historical stock price data (top half) and the MACD (12,26,9)
indicators normal presentation (bottom half) is shown in figure 8.3. The
difference between the prices 12-day and 26-day EMAs, represented by the
blue line, is the MACD series proper. The average or signal series, represented
by the red line, is a 9-day EMA of the MACD series. The divergence series,
or difference between those two lines, is displayed in the bar graph.
c) Relative Strength Index
This index emphasizes market moves before they occur. When the price of a
stock advances, the closing price is higher than the closing price of the previous
day. When the price of the stock declines, the closing price is lower than the
closing price of the previous day. However, the rise or fall of a market is not
smooth. During the rising phase, the price falls several times, while during
the falling phase, the price rises several times. Relative Strength Index tells
us whether the net difference between the closing prices is increasing or
decreasing.
During the rising phase of the market, the prices move up fast, and the
differences between the recent close and the previous close are large. When
the market reaches the top, these differences reduce. When the market declines,
the difference again become large. RSI is computed either on 14-days or 14-
week basis.
The formula for 14 - week Relative Strength Index (RSI) is
RSI = 100- [100 / (1 + RS)]
Where
144
RS = Average of 14 weeks up closing prices Average of 14 weeks down closing Technical Analysis
prices
This is a powerful indicator and pinpoints buying and selling opportunities
ahead of the market. It ranges in value from 0 to 100. Values above 70 are
considered to denote overbought conditions, and values below 30 are
considered to denote oversold conditions.

8.6 MARKET INDICATORS

Technical indicators help not only to predict individual stock price behaviour
but also the trend of the market. Some important Price, Volume and other
indicators of market are highlighted below:
Price Advances vs Declines : By comparing number of shares which advanced
and those declined during a certain period of time, one may know what the
market is really doing. The difference between the advances and declines is
called ‘breadth of the market’. The technician is generally more interested in
change in breadth than in absolute level. Further, breadth may be compared
with a stock-market index. Normally, breadth and the stock market index will
move in unison. However, when they diverge, a key signal occurs. During a
bull market if breadth declines to new lows while the stock market index
makes new highs a peak in the average is suggested. The peak will be followed
by major downturn in stock prices generally.
High, low or Differential index can be used as a supplementary measure to
‘breadth of the market’ to predict market. In theory, a rising market will
generally be accompanied by an expanding number of stocks attaining new
highs and a dwindling number of new lows. The reverse will hold true for a
bearish market.
The volume of short selling which refers to selling shares that are not owned,
can be useful indicator of the market as well as for individual stocks. Short
selling, or as it is called short interest also, can be related to average daily
volume. The short interest for a period say a month, divided by average daily
gives a ratio. This ratio indicates for many days of trading it would take to
use up total short interest. Historically, on the New York Stock Exchange
(NYSE) and the American Stock Exchange (AMEX), the ratio has varied
between one-third of a day and four days. In general, when the ratio is less
than 1.0, the market is considered weak or weakening. It is common to say
that the market is overbought. A decline should follow sooner or later. The
zone between 1.0 and 1.5 is considered a neutral indicator. Values above 1.5
indicate bullish territory with 2.0 and above highly favorable. This market is
said to be ‘oversold’. A rise should follow sooner or later as ‘oversold’ state
will lead to buying pressure (to cover short position) in the market.
Odd-lot trading which can be measured by constructing an odd-lot index by
relating odd-lot purchase to odd-lot sales (Purchase + Sales), can indicate the
direction of the market, as technicians feel that the odd lotters are inclined to
do the wrong thing at critical turns in the market. Rising index indicates rising
market and falling index indicates falling market which, in effect, mean selling
145
Security Analysis proportionately less at or near the market peak and selling proportionately
more before a rise in the market.
Mutual-funds cash as a Percentage of Net Assets on a daily or weekly or
monthly basis has been a popular market indicator. The theory is that a low
cash ratio, saya bout 5% would indicate a reasonably fully invested position
leaving negligible buying power indicating that the market is due for climb
down. High cash ratio indicates possibilities of market climb up.
In the U.S. two confidence indicators have been quite popular with market
analyst. One is Barron’s ratio of higher-to lower grade bond yield. The second
is Standard and Poor’s low priced and high grade common stocks. A rise in
Barron’s ratio indicates narrowing of the spread between high and low grade
bonds which is considered indicative of the rising markets. A fall in the ratio
would indicate declining markets.

8.7 ELLIOT WAVE THEORY

The Elliott Wave Theory is a technical analysis tool used by traders to forecast
financial market trends and identify potential trading opportunities. It was
developed by Ralph Nelson Elliott in the 1930s and is based on the idea that
market trends and movements follow a repeating pattern of waves.
According to Elliott’s theory, markets move in five waves in the direction of
the larger trend, followed by three corrective waves against the trend. These
waves are labeled as impulse waves and corrective waves respectively, and
are named with numbers and letters (e.g. 1, 2, 3, 4, 5, A, B, C).
The impulse waves (1, 3, and 5) represent the direction of the trend, and tend
to be longer and stronger than the corrective waves (2 and 4), which move
against the trend. The corrective waves (A, B, and C) represent a counter-
trend move, which is usually shorter in duration and less powerful than the
impulse waves.
Elliott Wave Theory can be used to identify potential entry and exit points in
the market based on the direction of the trend and the waves that have been
completed or are currently in progress. However, it is important to note that
the theory is based on subjective interpretations of market movements, and
should not be used as the sole basis for making trading decisions. It is a
technical analysis tool used to analyze financial markets, including stocks,
commodities, and currencies. It is based on the idea that market trends and
movements follow a repeating pattern of waves, which can be identified and
predicted with a high degree of accuracy.
The five impulse waves and three corrective waves form a complete Elliott
wave cycle. The pattern can repeat itself in a self-similar way, with smaller
waves composing larger ones.
Here’s a breakdown of the individual waves:
Impulse Waves

146 Wave 1: This is the first wave in an Elliott wave cycle and marks the
 beginning of a new trend. This wave is usually not very strong, as Technical Analysis
many traders are still cautious and hesitant.
Wave 2: This is a corrective wave that moves against the trend established
by Wave 1. It is usually shorter in duration and less powerful than
Wave 1.
Wave 3: This is the most powerful and longest wave in an Elliott wave cycle,
as it marks the continuation of the trend established in Wave 1. It
often marks the point where most traders become convinced of the
new trend.
Wave 4: This is a corrective wave that moves against the trend established
by Wave 3. It is often characterized by lower volume and volatility
than Wave 3.
Wave 5: This is the final wave in an Elliott wave cycle, and it marks the end
of the trend established by Wave 1. It is usually the strongest and
most powerful wave in the cycle.
Corrective Waves
Wave A: This is the first corrective wave in an Elliott wave cycle and moves
against the trend established by Wave 5. It is usually a sharp, fast-
moving wave.
Wave B: This is a corrective wave that follows Wave A and moves in the
opposite direction. It is often characterized by a complex pattern
and higher volatility than Wave A.
Wave C: This is the final corrective wave in an Elliott wave cycle and moves
in the opposite direction of the larger trend. It is usually the strongest
and most powerful wave in the corrective sequence.
The Elliott Wave Theory can be a powerful tool for identifying potential trading
opportunities, as traders can use the patterns and waves to determine entry
and exit points in the market. However, it should be noted that the theory is
based on subjective interpretations of market movements and is not always
accurate. Therefore, traders should use other technical analysis tools and
strategies to confirm the signals provided by the Elliott Wave Theory before
making trading decisions.

8.8 LIMITATIONS OF TECHNICAL ANALYSIS

The Dow’s theory serves only as a starter so far as Indian conditions are
concerned. Let us review each of the basic tenets of Dow theory, one by one.
THE AVERAGES DISCOUNT EVERYTHING: This is valid even in India.
The most popular depictions of averages are simple moving average (average
of close, high or low price of a given period) and exponential moving averages
(which extend the average over the entire record, assigning more weight to
the most recent data). Moving averages of 30 days or 5 weeks depict short-
term trend and moving averages of 200 days or 14 to 40 weeks depict long
term trend. The crossovers of two averages indicate that the trend is changing
147
Security Analysis direction. For instance, if the 5-weeks moving average crosses the 14-week
moving average from below to above, it indicates beginning of bullish phase,
and may define buying opportunities. The reverse is true if crossing is from
above to below.
THE MARKET HAS THREE MOVEMENTS: There are Primary,
Secondary and Minor. Elliot Wave Theory is the most popular depiction of
this principle. It states that the market moves up in five waves i.e., five up or
down, e.g., three moves up and two down, while it moves down in three to
five waves. These waves are primary, secondary and tertiary superposed on
each other, and it takes experience to separate the three movements. For
instance, an upward movement of a primary wave comprises five secondary
waves, and so on.
PRICE BAR CHARTS INDICATE MOVEMENT: This is true, but moving
averages recordthe daily or weekly fluctuations and bring out the trend more
reliably.
PRICE/VOLUME RELATIONSHIPS PROVIDE BACKGROUND:
Unfortunately volume data are not reported in India, and the volume data of
specified group shares, where in forward trading is allowed by the exchanges,
is published after delay of several weeks. Since forward trading is no indicator
of the actual market activity, these relationships are of little value in India.
PRICE ACTION DETERMINES THE TREND: This is true in India as well.
THE AVERAGES MUST CONFIRM: This is based on the premise that if
one group of activity, say manufacturing, does not trend in the direction of
another group, say transportation, it indicates an oncoming change of trend
of the market. In USA data about different activities is regularly published,
for instance, utilities average and transportation average. However, in practice,
there is no widespread acceptance to such analysis and typically the focus is
on individual stocks.
Insider manipulations are rampant in the Indian Stock Market. Such
manipulations are encountered in USA also, but they are few in numbers and
the culprits are caught and punished. In the Indian Stock Market, it is not
unusual to find that the price of a share doubled in few days, and fall back to
its original value a few days later. All these malpractices leave their mark on
the prices of stocks. Thus one can suspect whether the charts represent the
true balance of the demand and the supply forces. Hence, it is possible that
some of the technical analysis techniques suitable in other market may not be
suitable in India and indicators evolved for American conditions may lead to
erroneous conclusions. It is always desirable to do extensive research and
experience before taking up technical analysis based investment decision.
Alternatively, one can subscribe some of the technical analysis services offered
by experts in the field.

8.9 FIBONACCI ANALYSIS

Fibonacci analysis is a popular technical analysis tool used to identify potential
148 support and resistance levels in financial markets. It is based on the
mathematical sequence discovered by Leonardo Fibonacci, an Italian Valuation of Securities
mathematician, in the 13th century. In Fibonacci analysis, traders use the Fibonacci
sequence to identify levels of potential support and resistance in a market. The
sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.
Each number in the sequence is the sum of the two preceding numbers.
The Fibonacci sequence is used in technical analysis to calculate Fibonacci
ratios, which are key levels in a market. These ratios are calculated by dividing
one number in the sequence by the number that precedes it.
The most commonly used Fibonacci ratios in technical analysis are:
x 0.236 (23.6%)
x 0.382 (38.2%)
x 0.50 (50%)
x 0.618 (61.8%)
x 0.786 (78.6%)

8.10 SUMMARY
In this unit, we have discussed the technical analysis approach to predicting
share price behaviour. This approach differs from fundamental approach in
as much as it is based on the analysis of movements of price and volume of
stocks, while fundamental analysis is focused on economy, industry and
company variables affecting share price. The two approaches are, however,
complementary to each other rather than substitutes. In this unit, we have
also explained the origin and development of technical analysis. The Dow
Theory, which takes its name from Dow-The originator of technical analysis,
dated 1902-04, and its basic tenets have been discussed and classical charting
techniques viz. Point and figure chart and bar chart and classical formations
viz, triple top, ,head and shoulder, triangle, flag and pennant and support and
resistance, etc., have been explained. The techniques of modern technical
analysis viz., price bar charts, moving average,exponential moving average,
oscillators, Rate of Change (ROC), Relative Strength Index (RSI) and Moving
Average Convergence Divergence (MACD) techniques have been explained
and illustrated. Market indicators, as different from individual stock indicators,
have also been highlighted.

8.11 KEY WORDS

Technical Analysis : A critical study of the daily or weekly price
and volume data of the index comprising
several share.
Fundamental Analysis : a method of assessing the intrinsic value of a
stock.
Moving average : is a trend-following momentum indicator that
convergence/divergence shows the relationship between two
(MACD, or MAC-D) exponential moving averages (EMAs) of a
security’s price. 149
Security Analysis
8.12 SELF ASSESSMENT QUESTIONS
1. Define ‘Technical Analysis; and ‘Fundamental Analysis’. Between the
two which one do you consider superior and why?
2. Write a brief note on the origin and development of technical analysis.
3. Compare and contrast fundamental and technical analysis.
4. Compare and contrast ‘Point-and-Figure-Charting; and the ‘Bar-Chart’.
Which one do you consider superior and why?
5. Write short notes on the following:
a) Technical Analysis
b) Dow Theory
c) Charting
d) Market indicators
e) Fibboncci analysis

8.13 FURTHER READINGS

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Charles, Le Beau and Gavid, W Lucas, Technical Traders Guide to Computer
Analysis of the Futures Market, Business-Irwin, Illinois, USA.
Clifford, P. (1992). Technical Analysis. Vision Books, New Delhi.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
https://www.topstockresearch.com/INDIAN_STOCKS/MISCELLANEOUS/
InteractiveChartOfBSE_Ltd.html (2023)
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-19 Technical Analysis - I
[Video]. YouTube. https://www.youtube.com/watch?v=0LZgVDNvLxE
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-20 Technical Analysis - II
[Video]. YouTube. https://www.youtube.com/watch?v=abHvVseh7eA
Martin, J. (1985), Technical Analysis. McGraw Hill.
Murphy J. (1986), Technical Analysis of the Futures Market, Prentice Hall,
New Delhi.
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., & Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
150
Tradermatt at the English-language Wikipedia, CC BY-SA 3.0, https:// Valuation of Securities
commons.wikimedia.org/w/index.php?curid=17936449 (2023)
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

151
Security Analysis
UNIT 9 VALUATION OF SECURITIES
Objectives
After reading this unit you should be able to;
x Understand the concept of time valuation of money;
x Differentiate between present value and future value;
x Discuss the concept of yield;
x Understand the valuation of different securities.
Structure
9.1 Introduction
9.2 Time value of money
9.3 Valuation of bond
9.4 Valuation of preference share
9.5 Valuation of equity shares
9.6 Price-Earnings approach
9.7 Summary
9.8 Key words
9.9 Self Assessment Questions
9.10 Further Readings

9.1 INTRODUCTION
Valuation of securities is the process of determining the intrinsic value of a
financial instrument, such as a stock, bond, or derivative, in order to make
informed investment decisions. The intrinsic value is the true worth of the
security, based on factors such as the company’s financial health, economic
conditions, and market trends.
The valuation of securities is an essential part of the decision-making process
for investors, as it helps them to determine whether a security is overvalued,
undervalued, or fairly valued. If a security is overvalued, it may be too
expensive to buy, while an undervalued security may present a buying
opportunity.
There are several methods that can be used to value securities, including
discounted cash flow analysis, price-to-earnings ratio, and price-to-book ratio.
Each method has its strengths and weaknesses, and the choice of method will
depend on the nature of the security being valued and the purpose of the
analysis. The valuation of securities is an important tool for investors who
seek to make informed investment decisions. By understanding the true worth
152 of a security, investors can identify buying and selling opportunities and make
decisions that align with their investment objectives and risk tolerance. In Valuation of Securities
this unit we will study different aspects of valuation of securities.

9.2 TIME VALUE OF MONEY

The time value of money is a financial concept that recognizes the fact that
money available at different times has different value or worth. It is the idea
that a rupee received today is worth more than a rupee received in the future
because money today can be invested or earn interest, while money in the
future cannot.The time value of money is based on the concept of opportunity
cost, which is the idea that the cost of using money is the opportunity to earn
a return on that money. For example, if you have 100 today, you could invest
it and earn a return, whereas if you don’t have that 100 until a year from now,
you miss out on the opportunity to earn a return during that year.
In finance, the time value of money is used to calculate the present value and
future value of cash flows, to determine the net present value of investments,
and to determine the appropriate interest rates for loans and other financial
products. It is a fundamental concept in finance, and understanding it is
essential for making informed financial decisions.
Present value
Value of an asset is equal to present value of its expected returns. This is true
particularly when you expect that the asset you own, provides a stream of
returns during the period of time. This definition of valuation also applies to
value of security. To covert this estimated stream of return to value a security,
you must discount the stream of cash flows at your required rate of return.
This process of estimation of value requires
(a) the estimated stream of expected cash flows and
(b) the required rate of return on the investment.
The required rate of return varies from security to security on account of
differences in risk level associated with securities.
Present value (PV) is a financial concept that represents the current value of
a future sum of money, discounted to reflect its value in today’s money. In
other words, present value is the amount of money that would need to be
invested today in order to equal a future sum of money, assuming a certain
interest rate or discount rate.
The calculation of present value is based on the time value of money principle,
which holds that a rupee today is worth more than a rupee in the future due to
the ability to invest and earn interest. As such, future sums of money must be
discounted to reflect their current value.
The formula for present value involves three variables: the future sum of
money (FV), the interest rate or discount rate (r), and the number of periods
(n) over which the future sum will be received. The formula for calculating
present value is:
PV = FV / (1 + r)n 153
Security Analysis Suppose you are promised a payment of 10,000 in two yea If the discount
rate is 5%, the present value of that payment would be:
PV = 10,000 / (1 + 0.05)2 = 8,762.89
This means that the present value of the 10,000 payment, discounted at a 5%
rate, is 8,762.89.
Future value
Future value (FV) is a financial concept that represents the value of a current
sum of money at a future point in time, after it has earned interest or grown
due to investment. In other words, future value is the amount of money that
an investment will be worth at a specified future date, assuming a certain
interest rate or growth rate.
The calculation of future value is based on the time value of money principle,
which holds that a rupee today is worth more than a rupee in the future due to
the ability to invest and earn interest. As such, future sums of money will be
larger than their present value due to the effects of compounding interest.
The formula for calculating future value involves four variables: the present
value (PV) of the investment, the interest rate (r) or growth rate, the number
of periods (n) over which the investment will grow, and any additional periodic
contributions (PMT) to the investment. The formula for calculating future
value is:
FV = PV x (1 + r)n + PMT x [(1 + r)n - 1] / r
Suppose you invest 5,000 today for five years at an interest rate of 7%, with
no additional periodic contributions. The future value of your investment at
the end of the five-year period would be:
FV = 5,000 x (1 + 0.07)5 = 7,326.10
This means that your 5,000 investment, earning 7% interest per year, would
grow to 7,326.10 at the end of the five-year period.
Basic valuation model
Given a risk-adjusted discount rate and the future expected earnings flow of
a security in the form of interest, dividend earnings, or cash flow, you can
always determine the present value as follows:
= CF1/1+r + CF2/(1+r)2+ CF3/(1+r)3+——+ CFn /(1+r)n
Where, PV = Present value
CF = Cash flow, interest, dividend, or earnings per time period upto ‘n’ number
of periods.
r = risk-adjusted discount rate (generally the interest rate)
Expressed in the above manner, the model looks simple. But practical
difficulties do make the use of the model complicated. For instance, it may be
quite difficult to assume that every investor in the market exactly measures
154
the value of cash flows and risk adjusted required rate of return. Further, Valuation of Securities
investors’ expectation on compensation for risk may also differ between
different types of investors. A small change in these measures will also cause
a change in the value. Thus, it may not be possible to generate a single value.
You will realize that market operations would become tedious with a range of
values. Secondly, return, risk, and value would tend to change over time.
Thus, security prices may rise or fall with buying and selling pressures
respectively (assuming supply of securities does not change) and this may
affect capital gains and hence returns expected. Consequently, estimates of
future income will have to be revised and values reworked. Similarly, the risk
complexion of the security may change over time. The firm may over borrow
(and face financial risk) or engage in a risky venture (and face operating risk).
An increase in risk would raise the discount rate and lower value. It would
then seem to be a continuous exercise. Every new information will affect
values and the buying and selling pressures, which keep prices in continuous
motion, would drive them continuously close to new values. The last part of
this section portrays this dynamic valuation model with ever- changing
information inputs.

9.3 VALUATION OF BOND

Debt securities issued by governments, government and quasi-government
organizations, and private business firms are fixed-income securities. Bonds
and debentures are the most common examples. The intrinsic value of a bond
or debenture is equal to the present value of its expected cash flows. The
coupon interest payments, and the principal repayment are known and the
present value is determined by discounting these future payments from the
issuer at an appropriate discount rate or market yield.
The valuation of a bond involves determining its fair market value based on
various factors, such as the bond’s coupon rate, maturity date, and credit rating.
The most common method used to value a bond is the present value method,
which calculates the value of the bond based on its future cash flows discounted
back to their present value.
The present value of a bond is the sum of the present values of its future cash
flows, which include coupon payments and the final payment of the principal
at maturity. To calculate the present value of each cash flow, the cash flow is
discounted back to its present value using a discount rate that reflects the
bond’s risk.
The formula for calculating the present value of a bond is as follows:
PV = C/(1+r)1 + C/(1+r)2 + … + C/(1+r)n + F/(1+r)n
where: PV = Present value of the bond C = Coupon payment r = Discount rate
n = Number of periods (usually years) F = Face value or principal payment at
maturity
The discount rate used to value a bond depends on the bond’s risk. Generally,
the higher the risk of default, the higher the discount rate used to value the
bond.Bond valuation is important for investors, who need to know the fair 155
Security Analysis value of a bond before making investment decisions. A bond that is
undervalued may be a good investment opportunity, while an overvalued bond
may not provide a good return on investment.
Illustration
The valuation methodology implicit in the above equation can be illustrated.
Consider a bond (Bond-A) with a face value of 1,000 was issued with a
maturity of five years at par to yield 10%. Interest is paid annually and the
bond is newly issued. The value of the bond would be as follows:
PVA = 100/1+.10+ 100/(1+.10)2 + 100/(1+.10)3 + 100/(1+.10)4 + 100/
(1+.10)5 + 1000
= 100×.9091+100×.8264+100×.7513+100×.6830+1100×.6209
= 90.91+82.64+75.13+68.30+682.99
= 999.97 or 1,000 approx.
You should recognize that the present value of the bond viz. 1,000 estimated
above is equal to the issue price because the bond has just been sold at par of
1,000.
Now, consider another bond (Bond-B) with a face value of 1,000 issued five
years ago at a coupon of 6%. The bond had a maturity period of ten years and
as of today, therefore, five more years are left for final repayment at par. The
current discount rate is 10 per cent as before. All other characteristics of bond-
B are identical with bond-A.
It is obvious that the present value of bond-B will not be 1,000 because
investors will not pay this price and agree to receive 60 per year as interest
for the next five years when bond-A with similar characteristics provides
annual interest payments of 100 for the next five yea The present value of
bond-B will be determined as follows:
PVB = 60/1+.10 + 60/(1+.10)2+ 60 /(1+.10)3+ 60/(1+.10)4 + 60/(1+.10)5 +
1000
= 60×.9091+60×.8264+60×.7513+60×.6830+1060×.6209
= 54.55+48.59+45.08+40.98+658.15
= 847.35
Any one, who buys the bond, will pay only 847.35. You will observe that the
numerator of the PV equation will be given at the time of issuance of the
bond or the debenture. The maturity period, timing of interest payments, and
maturity value will also be specified. What remains to be determined is the
denominator of the equation viz. the discount rate. You may notice that the
discount rate is the current market interest rate, which investors can earn on
comparable investments such as new bonds with the same features. In other
words, it is an opportunity cost. Thus, the discount rate incorporates the effect
of interest rates and reflects the current market yield for the issue.
156
Should interest payments be semi-annual, the PV equation will have to be Valuation of Securities
modified as follows: divide ‘C’, and `r’ both by 2 and multiply `n’ by 2. The
resultant equation will be:

PV = 6 2n
i=1
C 1/2/ (1+ r / 2)t + F/(1+ r / 2)2n
Assuming semi-annual payments, present values of bonds A and B in the
above examples can be solved as under
PVA = PV = 610
i=1
50/( =1.05)1 + 1000/ 1.05)10

=999.98 or 1,000 approx.

PVB 6 10
i=1
30/( =1.05)1 + 1000/ 1.05)10

=845.55
Holding period return
The holding period refers to the length of time that an asset is held by an
investor before it is sold or disposed of. It is an important concept in investing,
as the length of the holding period can impact the taxes owed on capital gains
or losses.In general, the holding period for an asset begins on the day it is
acquired and ends on the day it is sold or disposed of. For example, if an
investor buys a stock on January 1st and sells it on June 1st, the holding period
for that stock is 5 months.
The length of the holding period is important for tax purposes, as capital
gains and losses are taxed differently depending on the length of time the
asset was held. Usually assets held for more than one year are subject to
long-term capital gains tax rates, which are generally lower than short-term
capital gains tax rates.In addition to tax implications, the holding period can
also affect investment strategies. Some investors may have a short-term
investment horizon and prefer to hold assets for a short period of time to take
advantage of price fluctuations, while others may have a long-term investment
horizon and prefer to hold assets for an extended period of time to benefit
from long-term growth potential.
Current return
Current return is a measure of the income generated by an investment,
expressed as a percentage of the current market price. It is often used in fixed-
income securities, such as bonds, and is calculated by dividing the annual
income received from the investment by the current market price of the
security.
The formula for calculating current return is as follows:
Current return = (Annual Income / Current Market Price) x 100%
where: Annual Income = the total income earned from the investment over a
year, such as interest payments or dividends and Current Market Price = the
current market price of the security
For example, if a bond with a face value of 1,000 pays an annual interest of
157
Security Analysis 60 and is currently trading in the market at 950, the current return would be:
Current return = (60 / 950) x 100% = 6.32%
This means that the investor can expect to earn a current return of 6.32% on
their investment in the bond, based on the current market price.
Current return is a useful metric for comparing the income generated by
different fixed-income securities, as it takes into account the current market
price of the security. However, it should be noted that current return only
represents the income generated by the investment, and does not reflect any
capital gains or losses that may occur if the security is sold in the future.
Yield
Yield refers to the return generated by an investment, usually expressed as a
percentage of the amount invested. It represents the income earned on an
investment over a certain period of time.
There are several different types of yield, depending on the type of investment:
1. Bond yield: This refers to the interest paid by a bond over its term. The
bond yield is typically expressed as a percentage of the bond’s face value,
known as the coupon rate.
2. Stock yield: This refers to the dividend paid by a company on its stock.
The stock yield is typically expressed as a percentage of the stock’s price.
3. Real estate yield: This refers to the income generated by a rental property,
expressed as a percentage of the property’s value.
4. Mutual fund yield: This refers to the income generated by a mutual fund’s
investments, typically expressed as a percentage of the fund’s net asset
value.
In general, a higher yield indicates a higher return on investment, but it may
also indicate a higher level of risk. It is important to evaluate the risk and
potential return of an investment before making a decision based solely on its
yield.
Yield to maturity
Yield to maturity (YTM) is a measure of the total return that an investor can
expect to earn on a fixed-income security, such as a bond, if they hold the
security until it matures. It takes into account the current market price of the
bond, its face value, the coupon rate, and the time remaining until maturity.
The formula for calculating yield to maturity is more complex than for other
yield measures, such as current yield, because it takes into account the time
value of money and the fact that the bond’s coupon payments may be reinvested
at different rates over the life of the bond. The formula involves solving for
the interest rate that makes the present value of the bond’s cash flows equal
to its current market price.
Yield to maturity can be calculated using financial calculators or software, or
158
through trial and error using a spreadsheet. However, the formula can be Valuation of Securities
expressed as follows:
YTM = (C + (F - P) / n) / ((F + P) / 2) ......equation 1
where: C = the annual coupon payment F = the face value of the bond P = the
current market price of the bond n = the number of years remaining until
maturity
For example, if a bond has a face value of 1,000, a coupon rate of 5%, and is
currently trading in the market at 950 with 5 years remaining until maturity,
the yield to maturity would be:
YTM = (50 + (1,000 - 950) / 5) / ((1,000 + 950) / 2) = 5.77% ......equation 2
This means that if the investor holds the bond until maturity, they can expect
to earn a total return of 5.77% per year, including both the coupon payments
and any capital gains or losses that may occur.
This is the most widely used measure of return on fixed income securities. It
may be defined as the indicated (promised) compounded rate of return an
investor will receive from a bond purchased at the current market price and
held to maturity. Computing YTM involves equating the current market price
of a bond with the discounted value of future interest payments and the terminal
principal repayment; thus YTM equates the two values, viz., the market price
and the present value of future payments including the principal repayment.
You may note that the compounding intervals may be annual, semi-annual or
quarterly. Equations 1 or 2, the latter being modified for compounding intervals
more frequent than one year, are generally used. The YTM is IRR of initial
investment (market price) and periodic payments including principal amount
received at the end of the period.
Assume that an investor purchases a 15%, 500 fully secured bonds at the
current market price of 400. The debenture is to be repaid at the end of five
years from today. The yield-to-maturity can be estimated as follows:
MP= Ci/(1+YTM)i + F /(1+ YTM)n
Where MP is market price ,YTM is yield to Maturity and F is the face value.
Therefore,
400 = 75 /(1+YTM)t + 500 /(1+YTM)5
What is required in this case is a value of YTM which equates 400 with the
sum of present values of 75 per year for 5 years and of 500 receivable at the
end of the fifth year. Clearly, a process of trial-and-error is indicated. Several
values of YTM can be tried till the equating value emerges. Trials can be
started with the coupon rate with the next trial rate increased if the present
value of the preceding trial exceeds the current market price and vice versa.
Thus, trying at 15%, the following present value of the right hand side cash
flows is estimated.
PV15% = 75 per annum × PVIFa,5yrs, 15% +500 × PVIF15%, 5yrs
159
Security Analysis = 75 × 3.3522 + 500 × .4972 = 251.42 + 248.60
= 500.08
Since the PV of 500.08 exceeds 400, a higher discount rate must be tried.
The second trial may be made at 20%.
PV20% = 75 × 2.9906 + 500 × .8333
= 224.295 + 200.95
= 425.245
Even the second trial has failed to equate the two values. Hence, you can go
over to the third trial at, say, 24%.
PV24% = 75 × 2.7454 + 500 × .3411
= 205.91 + 170.55
= 376.46
The third trial has lowered the present value to 376.46 which is less than
400. Hence, the required YTM must lie between 20% and 24%. The estimate
can be obtained by interpolating, thus :
YTM = 20% + 425.245-400.00/425.245-376.46 x(24%-20%) = 20% + 25.245/
48.785 x4%
= 20% + 2.07% = 22.07%
The YTM concept is a compound interest concept with the investor earning
interest-on-interest at YTM throughout the holding period till maturity. You
should understand that if intermediate cash flows are not reinvested at YTM,
the realized yield actually earned will differ from the promised YTM. For
instance , after the purchase of the above bond, if the interest rates decline in
the market, then the interest received at the end of each year (75) can be
invested only at a lower rate and thus affect the YTM, which you have just
now calculated under the assumption that all interest received can be reinvested
at the same rate of YTM. At the same time, you may note that investors may
not lose much because the value of bond (market price) will increase and the
bond will be attractive for investment as it carries more interest rate than
current interest rate available.
Investors must make specific assumption about future re-investment rates in
order to gain ideas about realized returns. Zero coupon bonds eliminate the
reinvestment rate risk because investors know at the time of purchase itself
the YTM that will be realized when the bond is held to maturity.
YTM can be approximated and tedious calculations be avoided using the
following formula:
Approximate YTM = Coupon Interest + [(MPn - MPt )] /N

[MPn - MPt]/2
160
where MPn ismarket price at maturity and MPt, is market price (or cost) at Valuation of Securities
beginning. In the above example, the approximate YTM is
75 + [(500 - 400) / 5] 95
= = 21.11%
(500 -+ 400) / 2 450
Yield to call
Yield to call (YTC) is a measure of the total return that an investor can expect
to earn on a bond if it is called, or redeemed, by the issuer before its maturity
date. It is calculated based on the assumption that the bond will be called on
the first possible call date, and takes into account the current market price of
the bond, the call price, the coupon rate, and the time remaining until the call
date.
The formula for calculating yield to call is similar to the formula for yield to
maturity, but uses the call price rather than the face value of the bond. The
formula involves solving for the interest rate that makes the present value of
the bond’s cash flows equal to its current market price, assuming that the
bond is called on the first possible call date.
Yield to call can be calculated using financial calculators or software, or
through trial and error using a spreadsheet. However, the formula can be
expressed as follows:
YTC = ((C + (Call Price - Current Market Price) / n) + ((Call Price - Current
Market Price) / n)) / ((Call Price + Current Market Price) / 2)
where: C = the annual coupon payment Call Price = the price at which the
bond can be called Current Market Price = the current market price of the
bond n = the number of years remaining until the call date
For example, if a bond has a call price of 1,050, a coupon rate of 5%, and is
currently trading in the market at 1,025 with 2 years remaining until the call
date, the yield to call would be:
YTC = ((50 + (1,050 - 1,025) / 2) + ((1,050 - 1,025) / 2)) / ((1,050 + 1,025) /
2) = 4.75%
This means that if the bond is called on the first possible call date, the investor
can expect to earn a total return of 4.75% per year, including both the coupon
payments and any capital gains or losses that may occur.

9.4 VALUATION OF PREFERENCE SHARE

Preference shares are a hybrid security. They have some features of bonds
and some of equity shares. Theoretically, preference shares are considered a
perpetual security but there are convertible, callable, redeemable and other
similar features, which enable issuers to terminate them within a finite time
horizon. In the case of redeemable preference shares, legal mandates require
creation of redemption sinking funds and their earmarked investments to
ensure funds for repayment.
161
Security Analysis Preference dividends are specified like bonds. This has to be done because
they rank prior to equity shares for dividends. However, specification does
not imply obligation, failure to comply with which may amount to default.
Several preference issues are cumulative where dividends accumulate over
time and equity dividends require clearance of preference arrears first.
Preference shares are less risky than equity because their dividends are
specified and all arrears must be paid before equity holders get dividends.
They are, however, more risky than bonds because the latter enjoy priority in
payment and in liquidation. Bonds are secured also and enjoy protection of
principal, which is ordinarily not available to preference shares. Investors’
required returns on preference shares are more than those on bonds but less
than on equity shares. In exceptional circumstances when preference shares
enjoy special tax-shields (like in U.S., inter- corporate holdings of preference
shares get exemption on 80% of preference dividends) required returns on
such shares may even be marginally below those on bonds.
Preference shares are a type of equity security that generally pay a fixed
dividend to shareholders and have a preference over common shares in terms
of dividends and liquidation preferences. The valuation of preference shares
involves determining the present value of future expected cash flows to
shareholders.
One approach to valuing preference shares is to use the dividend discount
model (DDM), which is similar to the discounted cash flow (DCF) model
used to value other types of securities. The DDM calculates the present value
of future dividend payments by discounting them back to their present value
using a required rate of return, which represents the minimum rate of return
an investor expects to earn on their investment.
The formula for the DDM is:
PV = D / (r - g)
where: PV = present value of the preference share D = expected annual
dividend payment (perpetuity), r = required rate of return on the preference
share g = expected growth rate of dividends
The required rate of return is typically calculated based on the riskiness of
the investment, as well as the prevailing market interest rates. The expected
growth rate of dividends may be estimated based on historical trends or future
projections.
For example, if a preference share pays an annual dividend of 2 and the
required rate of return is 8%, with no expected growth in dividends, the present
value of the preference share would be:
PV = 2 / (0.08 - 0) = 25
This means that the preference share would be valued at 25 in the current
market.
It’s important to note that there are other methods of valuing preference shares,
162 and the appropriate method may depend on the specific characteristics of the
security and the preferences of the investor. Additionally, market conditions Valuation of Securities
and investor sentiment can also impact the valuation of preference shares.
Perpetuity
Since dividends from preference shares are assumed to be perpetual payments,
the intrinsic value of such shares will be estimated from the following equation
valid for perpetuities in general:
Vp = C/ (1 + Kp) + C / (1 + K p) 2 + …..= C/Kp
Where Vp = the value of a perpetuity today
C = the constant annual payment to be received
Kp = the required rate of return appropriate for the perpetuity.
You have only to substitute preference dividend (D) for ‘C’ and the appropriate
required return (Kps) for ‘Kp’ and obtain the following equation for valuing
preference shares:
Vps = D/ Kp s
You may note that ‘D’ is perpetuity and is known and fixed forever. A
perpetuity does not involve present value calculations and the equation
provides for computing any of the three variables viz., value of the perpetuity
(Vp s), preference dividend (ID), required rate of return (Kp s) only if the
remaining two variables are known. Thus, the value of a preference share can
be calculated if the dividend per share and the required rate of return are
known. Similarly, the required rate of return (or yield) can be known if the
value of the perpetuity and dividend per share are known.
A hypothetical example can be used to illustrate the valuation process of a
preference share. Consider Firm-A issuing preference shares of 100 each with
a specified dividend of 11.5 per share. Now, if the investors’ required rate of
return corresponding to the risk-level of Firm-A is 10% the value today of the
share would be:
Vp s =1.50/.10 = 115.00
If the required of return increases (say in the wake of rising interest rates, and
in consequence, the higher opportunity costs) to 12%, value will be
Vp s = 11.50/ .12 = 95.83
You may note that the value changes inversely to the required rate of return.
If you are an observer of market prices, you may notice the price of any
preference share on any day and calculate its yield on that day using the above
formula. Thus, if the current market price of the preference share in question
is 125.00, then the required rate of return or yield can be calculated as under:
Thus, the yield declines after issue of the shares by the Firm - ‘A’. May be,
interest rates declined or other factors changed to produce the downward shift
in the yield.
163
Security Analysis You can observe price shifts over various ranges of time, say weeks, months,
and years and examine causes for shifts in yields of preference shares:
Activity 1
Examine and write a brief report on any one of the preference shares
issues of a public limited company? Also, contact a stockbroker and find
out the reasons for low popularity of preference shares in India.
.............................................................................................................
.............................................................................................................
.............................................................................................................

9.5 VALUATION OF EQUITY SHARES

Valuing equity involves determining the fair market value of a company’s
ownership interest, which represents the residual claim on the company’s assets
after all other claims, such as debt and preference shares, have been satisfied.
Equity valuation is important for investors, analysts, and other stakeholders
in evaluating the potential returns and risks associated with investing in a
particular company.
There are several approaches to valuing equity, including the following:
1. Price-to-Earnings (P/E) Ratio: This approach compares a company’s
current market price per share to its earnings per share (EPS). A higher
P/E ratio typically suggests that investors are willing to pay a premium
for the company’s expected future earnings growth.
2. Price-to-Book (P/B) Ratio: This approach compares a company’s market
price per share to its book value per share, which represents the value of
its assets minus liabilities. A lower P/B ratio may suggest that the company
is undervalued relative to its assets.
3. Discounted Cash Flow (DCF) Analysis: This approach estimates the present
value of a company’s future cash flows, using a discount rate that reflects
the time value of money and the risk associated with the investment. The
DCF model requires detailed projections of the company’s future cash flows,
which can be challenging to estimate accurately.
4. Dividend Discount Model (DDM): This approach estimates the present
value of a company’s future dividend payments, using a discount rate
that reflects the time value of money and the risk associated with the
investment. The DDM assumes that dividends are paid out to investors,
and therefore may not be suitable for companies that do not pay dividends.
5. Comparable Company Analysis (CCA): This approach compares a
company’s valuation multiples, such as P/E and P/B ratios, to those of
other similar companies in the same industry or market. The CCA assumes
that the market prices of similar companies are indicative of the fair value
of the company being analyzed.
164
Each of these approaches has its strengths and weaknesses, and the appropriate Valuation of Securities
method may depend on the specific characteristics of the company and the
preferences of the investor. Additionally, market conditions and investor
sentiment can also impact the valuation of equity. It is important to note that
equity valuation is not an exact science and involves a certain degree of
subjectivity and uncertainty.
Dividend valuation model
The Dividend Valuation Model is a method of valuing equity securities that
relies on the present value of future dividend payments. This model is also
known as the dividend discount model (DDM).
The DDM assumes that the value of a stock is equal to the sum of the present
value of all future expected dividends. The formula for the DDM is:
P0 = (D1 / (1 + r) 1) + (D2 / (1 + r) 2) + ... + (Dn / (1 + r n)
where: P0 = current stock price ,D1, D2, ..., Dn = expected future dividend
payments, r = required rate of return
Under dividend valuation model, future dividends are discounted at the
required rate to get the value of share. There are three possible situations on
future dividend.
a) Dividends do not grow in future i.e., the constant or zero growth
assumption,
b) Dividends grow at a constant rate in future, i.e., the constant-growth
assumption,
c) Dividends grow at varying rates in future time periods i.e., multiple-
growth assumption.
The dividend valuation model is now discussed under the above three
situations
a) The zero-growth Case : The growth rate of dividend D at time ‘t’
will be known by solving for ‘g’ the following:
Dt = Dt -1 (1 + gt ) ………. (1)
Or
Dt -Dt -1 /Dt -1 = gt? ………. (2)
You can easily see that when gt = 0, equation 1 will yield Dt = Dt -1 which
means all future dividends would be equal to be current dividend (i.e., the
dividend of the immediately preceding period available as one date).
Now, the present value of dividends for an infinite future period would
be:
V = 6in= 1 D1/ 1+K + D2/1+K+ D3/1+K +…..f ............(3)
V = D1/ 1+Ki
165
Security Analysis Since, Do = D1 = D2 = D3, under the zero-growth assumption, the numerator
Dt in equation (3) is replaced by Do to get
V = 6in= 1 D0/ 1+Ki
Taking the uniform ‘D0’ out of summation, we obtain:
V = 6if= 1 D0 (1/ (1+K)i) ...........(4)
You will appreciate that discounting cash flows over a very distant long future
period would, be meaningless. And mathematics tells us that if K>0 then the
value of an infinite series like the one in equation (4) is reduced to ‘1/K’so
that equation (4) results in the following

ª1º D0
...........(5)
V D0
«¬ K »¼ K0

and since Do = D1, equation (5) can also be written as

V = Dt
K
You may recall that equation (5) was used for the valuation of preference
shares. This is one case for the application of the zero-growth assumption.
The calculation underlying the zero-growth model can be illustrated. Consider
a preference share on which the company expects to pay a cash dividend of 9
per share for an indefinite future period. The required rate of return is 10%
and the current market price is 80.00. Would you buy the share at its current
price?
This is zero-growth case because the dividend per share remains ` 9 for all
future time periods. You may find the intrinsic value of the share using equation
(4) or (5) as follows:
V = ` 9.00
= ` .90
.10
Since the intrinsic value of 90 is more than the market price of 80, you
would consider buying the share.
b) The Constant Growth Case : When dividends grow in all future periods
at a uniform rate ‘g’,
Substituting ‘D ’ in equation (3) by the value of D in equation (6), we get
Dt = D0 (1 + g)t
f D (1  g) t
V ¦ 0 …….(3.10)
t 0 (1  K) t
Being a constant amount, ‘D0’ can be written out of summation to obtain the
following equation :
ª º
« f
(1  g ) t »
» …….(3.11)
«
0 « ¦
V D
t 0 (1  K ) »t
« »
166 ¬ ¼
Using the mathematical properties of infinite series, if K>g, then it can be Valuation of Securities
shown that
f (1g)t 1g
¦ …..(3.12)
t 1(1K)t Kg
Substituting equation 3.12 into equation 3.11 yields the valuation formula for
the constant growth situation as follows:

§ 1 g · …….(3.13)
V D0 ¨ ¸
©Kg¹
Equation 3.13 can be re-written as follows:

D0 (1  g ) Dt …….(3.14)
V
Kg Kg
Example
Alfa Ltd., paid a dividend of 2.00 per share for the year ending March 31,
2002. A constant growth of 10% per annum has been forecast for an indefinite
future period. Investors required rate of return has been estimated to be 15%.
You want to buy the share at a market price of 60 quoted on July 1, 2002.
What would be your decision?
Solution
This is a case of constant-growth-rate situation. Equation 3.14 can be used to
find out the intrinsic value of the equity share as under :
D1 Rs.` 2(1.10) Rs.
` 2.20
V Rs.
` 44.00
Kg .15  .10 .05
The intrinsic value of 44 is less than the market price of 60.00. Hence, the
share is overvalued and you would think before investing in the stock.
c) The Multiple-Growth Case : The multiple-growth assumption has to be
made in a vast number of practical situations. The infinite future time-period
is viewed as divisible into two or more different growth segments. The investor
must forecast the time ‘T’ upto which growth would be variable and after
which only the growth rate would show a pattern and would be constant. This
would mean that present value calculations will have to be spread over two
phases viz., one phase would last until time ‘T’and the other would begin
after ‘T’ to infinity.
The present value of all dividends forecast upto and including time ‘T’ VT(i)
would be:
T
Dt …………(3.15)
VT (i) ¦ (1  K)
t 1
t

The second phase present value is denoted by VT(2) and would be based on
constant- growth dividends forecast after time ‘T’. The position of the investor
167
Security Analysis at time ‘T’ after which the second phase commences can be viewed as a point
in time when he is forecasting a stream of dividends for time periods T+1,
T+2, T+3, and so on which grow at a constant rate. The second phase dividends
would be :
DT+1 = DT (1 + g)
D T+2 = DT+1 (1 + g) = DT (1 + g)2
DT+3 = DT+2 (1 + g) = DT (1 + g)3
And so on. The present value of the second phase stream of dividends can,
therefore, be estimated using equation 3.14 at time ‘T’:

§ 1 · …………(3.16)
VT D T1 ¨ ¸
©Kg¹
You may note that ‘VT’ given by equation 3.16 is the present value at time ‘T’
of all future expected dividends. Hence, when this value has to be viewed at
time ‘zero’, it must be discounted to provide the present value at ‘zero’ time
for the second phase present value. The latter can also be viewed at time
‘zero’ as a series of cash dividends that grow a constant rate as already stated.
The resulting second phase value V T(2) will be given by the following
equation:

ª 1 º
VT(2) VT « T»
¬ (1  K ) ¼
D T 1
(K  g)(1  K)T ………….(3.17)
Now, the two present values of phase 1 and phase 2 can be added to estimate
the intrinsic value of an equity share that will pass through a multiple growth
situation. The following describes the summation procedure of the two phases:
V0 = VT(1) + VT(2)
T
Dt D T 1
¦ (1  K)
t 1
t

(K  g) (1  K) T ……(3.18)

Example
A Ltd., paid dividends amounting to 0.75 per share during the last year. The
company is expected to pay 2.00 per share during the next year. Investors
forecast a dividend of 3.00 per share in the year after that. At this time, the
forecast is that dividends will grow at 10% per year into an indefinite future.
Would you buy/sell the share if the current price is 50.00? The required rate
of return is 15%.
Solution
This is a case of multiple growth. The values VT and VT can be calculated
(1) (2)
as follows:
168
 Valuation of Securities
` 2.0 ` 3.0
VT(1)  ` 4.10
(1  .15) (1  .15) 2
1

` 3.30
VT(2) ` 49.91
(.15  .10)(1  015) 2

Since Vo = VT(1) + VT(2) , the two values can be summed to find the intrinsic
value of a Cromecon equity share at the time ‘zero’. This is given below:
Vo = Rs. 4.01 + Rs. 49.91 = Rs. 53.92
At the current price of Rs. 50.00, the share is under-priced and hence you will
buy the stock.
The expected future dividend payments are typically based on historical trends
or future projections. The required rate of return is the minimum rate of return
an investor expects to earn on their investment, and it reflects the riskiness of
the investment and the prevailing market interest rates.
One limitation of the DVM is that it assumes that dividends are paid out to
investors, which may not always be the case. Additionally, the model may
not be appropriate for companies that do not pay dividends or have inconsistent
dividend payment histories. In these cases, other valuation methods such as
the discounted cash flow (DCF) analysis may be more appropriate.
It is important to note that the DVM is just one approach to valuing equity
securities and may not provide a complete picture of a company’s valuation.
Other methods, such as the price-to-earnings (P/E) ratio or comparable
company analysis (CCA), may be used in conjunction with the DVM to provide
a more comprehensive valuation of a company’s equity.
Discounted Dividend Model
The discounted Dividend Model (DDM) is a variation of the dividend valuation
model or dividend discount model that incorporates the concept of present
value by discounting future dividends at a required rate of return. The DDM
assumes that the value of a stock is equal to the present value of all expected
future dividend payments.
The formula for the DDM is similar to that of the regular dividend valuation
model, but it includes a discounting factor:
P0 = (D1 / (1 + r) 1) + (D2 / (1 + r) 2) + ... + (Dn / (1 + r) n)
where: P 0 = current stock price,D1, D2 ..., Dn = expected future dividend
payments, r = required rate of return
The discounting factor reflects the time value of money, which means that a
rupee received in the future is worth less than a rupee received today, due to
inflation and other factors. The required rate of return, or discount rate, reflects
the investor’s minimum required rate of return, and it takes into account the
risk of the investment and the prevailing market interest rates.
169
Security Analysis The discounted dividend model can be used to estimate the fair value of a
company’s stock, based on its future dividend payments. However, it is
important to note that the model relies on several assumptions, including the
stability and predictability of the company’s dividend payments, and the
accuracy of the estimated discount rate.
Additionally, the model may not be appropriate for companies that do not pay
dividends or have inconsistent dividend payment histories. In these cases,
other valuation methods such as the discounted cash flow (DCF) analysis
may be more appropriate.
Overall, the discounted dividend model can provide a useful framework for
valuing dividend-paying stocks, but it should be used in conjunction with
other valuation methods and careful analysis of the company’s financial
performance and prospects.
On the basis of the above model, the following inferences can be drawn
1. If the return on investment is equal to discounting rate, changes in payout
ratio fail to have an impact on the value of the firm.
2. If the return on investment is greater than discounting rate, then value is
positively affected if the company cuts the payout ratio.
3. If the return on investment is less than discounting rate, then value is
positively affected if the company increases the payout ratio.
While applying this approach, one has to be careful about using the discount
rate, K.
A higher value of discount rate would unnecessarily reduce the value of an
equity while a lower value would unreasonably increase it, that will have
implications to invest/ disinvest the shares. A discount rate is based on the
risk free rate and risk premium. That is,
Discount Rate = Risk Free Rate + Risk Premium
K = Rf + R P
Thus, higher the risk free interest rate with RP remaining the same would
increase the discount rate, which in turn would decrease the value of the equity.
In the same way, higher risk premium with Rf remaining the same would
increase the overall discount rat and thus decrease the value of the equity.
One of the critical assumption in the above model is dividend shows a constant
growth. In reality some companies like software companies in India may show
a superior return but it may not be sustainable in the long run. For instance, if
you expect that dividend to show a growth rate of 40% during the next 5
years and there after it will stabilize around 10%, then you can use DDM
with a slight modification. This model is called multi-period dividend discount
model. Under this model, it is first necessary to compute the dividend
receivable upto sixth year. The first five year dividends are discounted to
present value. Dividend received from sixth year to infinity can be used to
value the stock at the end of fifth year using constant DDM. The value of the
170
stock at the end of fifth year can be discounted further to get the present value Valuation of Securities
of the stock today and added with the discounted value of first five years.
A numerical example will be useful. Suppose the expected dividend from a
software company for the next year is 10 per share. It is expected to show a
growth rate of 40% in the next five years. That is dividend for year 2 to year
5 will be 14, 9.6, 27.44, and 38.42 respectively. Thereafter the dividend is
expected to show a growth rate of 10% and it means the dividend for the sixth
year will be 42.26. The present value of first five-year dividends discounted
at 20% is equal to 58.07. The value of the stock at the end of fifth year is Rs,
422.58. The present value of 422.58 is 169.82. Together, the value of the
firm is 227.89.
Year Dividend Amount (`) PV of Dividend (`) P

1 10.00 8.33
2 14.00 9.72
3 19.60 11.34
4 27.44 13.23
5 38.42 15.44
PV of first 5year dividend 58.07
6 42.26
Value of share at the end of fifth year 422.58
PV of value of share 169.82

Total value of share 227.89

Activity 2
I. You have the following information:
Expected Earnings per share : 10 Current Payout Ratio : 40% Expected
Dividend per share : 4 Return on Investments
(ROI) : 20%
Cost of Equity : 20%
Growth rate of dividend : 12% [ROl (20%) x Retained Earnings
(60%* )]
Value per share
(based on constant DDM) : 50
(a) Using the DDM equation given above and assuming a ROI of 20%, find
the equity value for the following combinations of payout ratio and cost
of capital.

171
Security Analysis
Cost of Capital Payout Ratio
20% 40% 60%
16%
20% 50*
24%
* This value was already computed. Fill up the remaining cells.
Growth model
The growth model is a method of valuing equity securities that takes into
account the expected growth rate of a company’s earnings or dividends. This
model is also known as the Gordon growth model or the dividend growth
model.
The growth model assumes that the value of a stock is equal to the present
value of all expected future dividends, but it also incorporates a growth rate
component. The formula for the growth model is:
P0 = (D1 / (r - g))
where: P0 = current stock price, D1 = expected next year dividend payment, r
= required rate of return and g = expected dividend growth rate
The growth rate (g) is the rate at which the company’s dividends are expected
to grow in the future. The required rate of return (r) reflects the minimum rate
of return an investor expects to earn on their investment, and it takes into
account the riskiness of the investment and the prevailing market interest
rates.
The growth model assumes that the company’s earnings or dividends will
continue to grow at a steady rate indefinitely. However, in practice, companies
may experience fluctuations in growth rates over time, and there may be other
factors that affect the company’s value, such as changes in industry trends or
macroeconomic conditions. The growth model can provide a useful framework
for valuing stocks that are expected to grow their earnings or dividends at a
steady rate over time, but it should be used in conjunction with other valuation
methods and careful analysis of the company’s financial performance and
prospects.

9.6 PRICE EARNINGS APPROACH

The price-earnings (P/E) approach is a method of valuing equity securities
that compares the price of a stock to its earnings per share (EPS). The P/E
ratio is calculated by dividing the current stock price by the EPS.The P/E
ratio provides an indication of the market’s perception of the company’s growth
prospects and profitability. A high P/E ratio may indicate that the market
expects the company to experience strong growth in the future, while a low
P/E ratio may indicate that the market has lower expectations for future growth.
172
The P/E ratio can be used to compare a company’s valuation to its peers or to Valuation of Securities
the broader market. However, it is important to note that the P/E ratio should
not be used in isolation to make investment decisions, as it can be influenced
by a variety of factors, such as changes in interest rates, inflation, and industry
trends.Additionally, the P/E ratio may not be appropriate for companies with
volatile or inconsistent earnings, as the ratio can fluctuate widely depending
on the company’s earnings performance. The P/E approach can provide a
useful framework for valuing stocks based on their earnings performance and
growth prospects, but it should be used in conjunction with other valuation
methods and careful analysis of the company’s financial performance and
prospects.
According to this method, the future price of an equity is calculated by
multiplying the P/E ratio by the expected EPS. Thus,
P = EPS x P/E ratio
The P/E ratio or multiple is an important ratio frequently used by analyst in
determining the value of a share. It is frequently reported in the financial
press and widely quoted in the investment community. In India too, you could
verify its popularity by looking at various financial magazines/newspapers.
The P/E ratio essentially reflects the amount that the shareholders are willing
to pay for every Rupee of earnings. As such it should reflect the risk associated
with the earnings. For instance, if the P/E ratio is 5 for a company and 10 for
another company, then investors perceive that risk associated with the earnings
of first company is relatively higher than risk associated with the earnings of
second company. That is the reason, if you examine the P/E of firms in the
market, you will observe that P/E of multinational companies are much higher
than the Indian firms.
The inverse of P/E is equal to capitalization rate. For instance, if the P/E is 5,
it means that the market is willing to capitalize the earnings by 20%. As in
DDM, the P/E model also fails to consider the future potential of earnings of
the company since growth rate of earnings is not deducted from the
capitalization rate to get the value of the firm. For instance, in the above
example, we find that the EPS is discounted at 20% to get the value without
considering any growth rate in the earnings. If the EPS is expected to grow at
5% in the future, the discounting rate should be 15% but there is no provision
for such adjustment under the P/E model.
This approach seems to be quite straight and simple. There are, however,
important problems with respect to the calculation of both P/E ratio and EPS.
Pertinent questions often asked are:
• How to calculate the P/E ratio?
• What is the normal P/E ratio?
• What determines P/E ratio?
• How to relate company P/E ratio to market P/E ratio?
The problems often confronted in calculating this ratio are: which of the
173
Security Analysis earnings- past, present or future to be taken into account in the denominator
of this ratio? Like wise, which price should be put in the numerator of this
ratio? These questions need to be answered while using this method.
You will appreciate that the usefulness of the above model lies in understanding
the various factors that determine P/E ratio. P/E ratio is broadly determined
by:
x Dividend pay out
x Growth
x Risk free rate
x Business risk
x Financial risk
Thus, other things remaining the same,
1 Higher would be the P/E ratio, if higher is the growth rate or dividend
payout or both.
2 Lower would be P/E ratio, if higher is
a) Risk free rate,
b) Business risk,
c) Financial risk.
However, there still remains the problem of estimating earning per share,
which has been used in both the methods discussed above. This is a key
number, which is being quoted, reported and used most often by company
management, investors, analysts, financial press, etc. It is this number every
body is attempting to forecast.

9.7 SUMMARY
Valuation of securities is the process of determining the fair value of a financial
asset, such as stocks, bonds, and other investments. There are several methods
of valuing securities, each with its own strengths and weaknesses.
Some of the most common methods include discounted cash flow analysis,
which calculates the present value of expected future cash flows; the price-
to-earnings (P/E) approach, which compares the stock price to its earnings
per share; and the dividend discount model, which estimates the value of a
stock based on its expected future dividend payments.
For bonds, the most common valuation method is the discounted cash flow
analysis, which calculates the present value of future coupon payments and
the principal repayment.
It is important to note that valuation is not an exact science and requires
careful analysis of the financial and economic conditions that affect the
174 underlying asset. Different valuation methods may produce different results,
and it’s often useful to use a combination of methods to arrive at a more Valuation of Securities
accurate estimate of the fair value of a security.

9.8 KEY WORDS

Security Analysis : A component of the investment process that
involves determining the prospective future
benefits of a security.
Yield : Yield refers to the return generated by an
investment, usually expressed as a
percentage of the amount invested.
Dividend Valuation Model : a method of valuing equity securities that
relies on the present value of future dividend
payments.
P/E ratio : The P/E ratio or multiple is an important ratio
frequently used by analyst in determining the
value of a share

9.9 SELF ASSESSMENT QUESTIONS

1. Describe the concept of time value of money?
2. How is the valuations of securities done?
3. Is the Dividend valuation model and discounted dividend model same?
Explain.
4. What do you understand by P/E ratio?
5. Describe the concept of yield to maturity.

9.10 FURTHER READINGS

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis Portfolio
Management (7th ed.). Pearson Education.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-11 Valuation of Equity Shares - I
[Video]. YouTube. https://www.youtube.com/watch?v=PROdGBUvbjs
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-12 Valuation of Equity Shares - II
[Video]. YouTube. https://www.youtube.com/watch?v=Y7uxhL3rMoI
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan Chand
& Sons.

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Security Analysis Singh, J. P., [IIT Roorkee]. (2021). Lecture 16: Holding Period Yield etc. [Video].
YouTube. https://www.youtube.com/watch?v=dY7a1nwiG48
Singh, J. P., [IIT Roorkee]. (2021). Lecture 09: Money Market Instruments, Bond
Terminology [Video].
YouTube. https://www.youtube.com/watch?v=yMnNA1BSCZI
Singh, J. P., [IIT Roorkee]. (2021). Lecture 10: Intrinsic Value of Bonds [Video].
YouTube. https://www.youtube.com/watch?v=bGDa-mVSSWI
Singh, J. P., [IIT Roorkee]. (2021). Lecture 11: Yield to Maturity I [Video].
YouTube. https://www.youtube.com/watch?v=fLM-4gsq3Zk
Singh, J. P., [IIT Roorkee]. (2021). Lecture 12: Yield to Maturity II [Video].
YouTube. https://www.youtube.com/watch?v=LPGvb3Pk7D0
Singh, J. P., [IIT Roorkee]. (2021). Lecture 13: Yield to Maturity III [Video].
YouTube. https://www.youtube.com/watch?v=hQwydaTtb58
Singh, J. P., [IIT Roorkee]. (2021). Lecture 14: Yield to Maturity IV [Video].
YouTube. https://www.youtube.com/watch?v=_-E9iZbGceQ
Singh, J. P., [IIT Roorkee]. (2021). Lecture 15: Yield to Maturity V [Video].
YouTube. https://www.youtube.com/watch?v=joCxqE7w-NE
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann Publica-
tions Private Limited.

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