DTU ACFN DEP’T

Chapter Six
Security analysis
Chapter outlines:
Fundamental analysis
Macro economic analysis
Industry analysis
Company analysis
Technical analysis
Security analysis
Security analysis is an examination and evaluation of the various factors affecting the value of
a security. Investors use security analysis to determine how to invest in a particular market, how
much to invest, and when to invest Technical or Fundamental school of thought may be used to
analysis securities.
6.1 Fundamental analysis
– Fundamental analysis is a technique that attempts to determine a security ‘s value
by focusing on underlying factors that affect a company's actual business and its
future prospects. Fundamental analysis seeks to identify the fundamental

economic and political factors that determine a security price. Fundamental

analysts attempt to study everything that can affect the security's value, including
macroeconomic factors (like the overall economy and industry conditions) and
individually specific factors (like the financial condition and management of
companies).

The end goal of performing fundamental analysis is to produce a value that an

investor can compare with the security's current price in hopes of figuring out what sort
of position to take with that security (underpriced = buy, overpriced = sell or short).
Thus, fundamental analyst considers:
– Financial statements
– Industry conditions
– Prospects for the economy

This approach requires:

Gathering substantial amount of economic data & political intelligence, – assessing the
expectations of market participants, and – analyzing this information to predict futures price
movement. Fundamental analysis focuses on cause and effect — causes external to the securities
markets that are likely to affect prices
in the market.

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DTU ACFN DEP’T

Fundamental analysis answers the following question

Is the company’s revenue growing? Is it actually making a profit?
Is it in a position strong-enough to outrun its competitors in the future?
Is it able to repay its debts? Is management trying to "cook the books"?

Valuation Process
Two approaches

.
– 1 Top-down, three-step approach
– 2. Bottom-up, stock valuation, stock picking Approach
The difference between the two approaches is the perceived importance of economic and
industry influence on individual firms and stocks.

Three Steps of Top-Down Fundamental Analysis:

The fundamental school of thought appraises the intrinsic value of shares through:

Macroeconomic analysis: evaluates current economic environment and its effect on industry
and company fundamentals, Industry analysis: evaluates outlook for particular industries
Company analysis: evaluates company’s strengths and weaknesses within industry.

6.1.1Macro economic analysis

The level of economic activity has an impact on investment in many ways. If the economy
grows rapidly, the industry can also expect to show rapid growth.

The first step to this type of analysis includes looking at the macroeconomic situation.
GDP/growth rate, Inflation, Interest rates, Exchange rates, Agricultural production/monsoon&
FDI/FII, Inflation (consumer goods demand), Interest rates (cost of Financing), Budget
(government revenue and spending), The tax structure (Concessions and incentives),The
balance of payments (effect on exchange rate, investment), Infrastructure facilities,
Demographical factors ,Business Cycles: the recurring pattern of recession and recovery
of the economy.
• Fiscal Policy: refers to government’s spending and tax actions.
• Monetary Policy: refers to the manipulation of the money supply to affect the
macro economy.
• Monetary policy works largely through its impact on interest rates.
– Money supply increase results to lower Interest rates, enhance
investment and demand (consumption) but with inflationary pressures
– Reserve requirements (commercial banks)
– Margin requirements (brokerage accounts)

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DTU ACFN DEP’T

6.1.2Industry analysis
Industry analysis is a type of investment research that begins by focusing on the status of an
industry or an industrial sector.
Industry analysis looks at:
Past sales and earnings performance, Labor condition within the industry, Attitude of
government towards industry, Competitive condition, Stock prices of firm in the industry

Classifying industries:
– Cyclical industry - performance is positively related to economic activity.
– Defensive industry - performance is insensitive to economic activity.
– Growth industry - characterized by rapid growth in sales, independent of the business cycle.

Industry Life Cycle Theory:

– Birth (heavy R&D, large losses - low revenues) – Growth (building market share and
economies of scale) – Mature growth (maximum profitability) – Stabilization (increase in unit
sales may be achieved by decreasing prices) – Decline (demand shifts lead to declining sales and
profitability - losses).
• Life Cycle of an Industry (Marketing view)
– Start-up stage: many new firms; grows rapidly (example: genetic
engineering)
– Consolidation stage: shakeout period; growth slows (example: video
games)
– Maturity stage: grows with economy (example: automobile industry)
– Decline stage: grows slower than economy (example: railroads)

6.1.3Company Analysis:
Company analysis is a process carried out by investors to evaluate securities, collecting info
related to the company’s profile, products and services as well as
profitability. A company analysis incorporates basic info about the company, like the mission
statement and apparition and the goals and values. During the process of company analysis, an
investor also considers the company’s history, focusing on events which have contributed in
shaping the company.

Company analysis it includes:

• Sales Revenue (growth)
• Profitability (trend)
• Product line (turnover, age)
– Output rate of new products
– Product innovation strategies
– R&D budgets
• Pricing Strategy

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DTU ACFN DEP’T

• Patents and technology

Company Analysis: Qualitative Issues

Organizational performance
– Effective application of company resources – Efficient accomplishment of company goals

Management functions
– Planning - setting goals/resources – Organizing - assigning tasks/resources – Leading -
motivating achievement – Controlling - monitoring performance.

Evaluating Management Quality

– Age and experience of management
– Strategic planning• Understanding of the global environment • Adaptability to external
changes
– Marketing strategy • Track record of the competitive position • Sustainable growth • Public
image
– Finance Strategy - adequate and appropriate
– Employee/union relations
– Effectiveness of board of directors

Company Analysis: Quantitative Issues

Operating efficiency
– Productivity
– Production function
•Importance of Q.A. – Understanding a company’s risks
• Financial, operating, and business risks
• Financial Ratio Analysis – Past financial ratios – With industry, competitors, and
• Regression analysis – Forecast Revenues, Expenses, Net Income
– Forecast Assets, Liabilities, External Capital Requirements.

Financial Ratio Analysis

– Liquidity (ability to pay bills) – Debt (financial leverage) – Profitability (cost controls)
– Efficiency (asset management)
• DuPont Analysis
– Top-down analysis of company operations
– Objective: increase ROE

DuPont Analysis of ROE

ROE= Net profit after taxes/ common stockholders’ equity = Net profit/ common
equity

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DTU ACFN DEP’T

ROE= Net profits/ equity = Net profits/ sales *Sales/ total assets * total
assets/equity. Ratio1 Ratio 2
Ratio 3

Ratio1 = NPM Ratio 2 = TATO Ratio 3 = Equity kicker

The DuPont System suggests that ROE (which drives stock price) is a function of cost control,
asset management, and debt management.

6.2Technical Analysis:
Technical analysis is the study of historical prices for the purpose of predicting prices in the
future. Technical analysts frequently utilize charts of past prices to
identify historical price patterns. These price patterns are then used to forecast prices in the
future. A basic belief of technical analysts is that market prices themselves contain useful and
timely information.

Role of Technical Analysis

Identify and predict changes in direction of price trends. Determine the timing of action – entry
and exit decisions.

Chart Analysis

Chart Analysis is the basic tool of technical analysis. A price chart is a sequence of prices
plotted over a specific time frame. In statistical terms, charts are referred to as time series
Plots. Chart analysts plots historical prices in a two-dimensional graph
in order to identify price patterns which can then be used to predict the futures direction of prices
– The goal of any chart analyst is to find consistent, reliable, and logical price patterns with
which to predict future price movements
• Chart analysts rely primarily on three bodies of data
– Prices (monthly, weekly, daily, and intra-day)
– Trading volumes, and
– Open interest.

Price Pattern Recognition Charts

The most commonly used price pattern recognition charts are: bar charts, line charts,
candlestick charts, and point-and-figure
Charts. On these charts, the Y-axis (vertical axis) represents the price scale and the X-axis
(horizontal axis) represent the time scale. Prices are plotted from left to right across the X-axis
with the most recent plot being the furthest right.

Bar Charts:

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DTU ACFN DEP’T

Bar charts mark trading activity of a specified trading period (e.g., day) by a single vertical line
on the graph. This line connects the high and low prices for the trading period. The closing price
is indicated by a horizontal bar

Investment analysis & portfolio Mgt Compiled by: Hailu S & Melkamu