CHAPTER-FOUR

4. Security Analysis

Fundamental and Technical Analysis

 WHAT IS 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
• The fundamental school of thought appraises
the intrinsic value of shares through
 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
 Top-Down Valuation Approach (Three-
Step Process)

1. General economic influences

– Decide how to allocate investment funds among countries,
and within countries to bonds, stocks, and cash
2. Industry influences
– Determine which industries will prosper and which
industries will suffer on a global basis and within countries
3. Company analysis
– Determine which companies in the selected industries will
prosper and which stocks are undervalued
 Does the Three-Step Process Work?

• Studies indicate that most changes in an

individual firm’s earnings can be attributed to
changes in aggregate corporate earnings and
changes in the firm’s industry
• Studies have found a relationship between
aggregate stock prices and various economic
series such as employment, income, or
production
 Does the Three-Step Process Work?
• An analysis of the relationship between rates of
return
• for the aggregate stock market,
• alternative industries,
• and individual stocks
• showed that most of the changes in rates of
return for individual stock could be explained by
changes in the rates of return for the aggregate
stock market and the stock’s industry
 Three Steps of Top-Down Fundamental
Analysis
• 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
 4.1.ECONOMY ANALYSIS
 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
 4.1. Macroeconomic Analysis
• Business Cycles
– Expansion, Peak, Contraction, Trough
– Impact of Inventory and Final Sales

• Economic Indicators
 Fiscal & Monetary Policy
• Fiscal Policy (Keynesians)
– Government expenditures (demand)
– Tax & Debt policies
• Monetary Policy (Monetarists – M. Friedman)
– Interest rates (discount, fed funds)
– Money supply (Open market operations)
– Reserve requirements (commercial banks)
– Margin requirements (brokerage accounts)
 4.2. Industry analysis
• Industry analysis is a type of investment research that
begins by focusing on the status of an industry or an
industrial sector.
Why is this important?
• Each industry is different, and using one cookie-cutter
approach to analysis is sure to create problems.
• Imagine, for example, comparing the P/E ratio of a
tech company to that of a utility. Because you are, in
effect, comparing apples to oranges, the analysis is
next to useless.
 Industry Analysis

• INDUSTRY ANALYSIS LOOKS AT

a) Past sales and earning performance
b) Labor condition within the industry
c) Attitude of government towards industry
d) Competitive condition
e) Stock prices of firm in the industry
 Industry Analysis
• 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 Analysis
• 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)
 Industry Analysis
• 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)
 Industry Analysis
• Qualitative Issues
– Competitive Structure
– Permanence (probability of product obsolescence)
– Vulnerability to external shocks (foreign
competition)
– Regulatory and tax conditions (adverse changes)
– Labor conditions (unionization)
 Industry Analysis
• End use analysis
– identify demand for industry’s products
– estimates of future demand
– identification of substitutes
• Ratio analysis
– examining data over time
– identifying favorable/unfavorable trends
• Regression analysis
– determining the relationship between variables
 4.3. Company 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.
• It is also referred as ‘fundamental analysis.’ 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.
FUNDAMENTAL ANALYSIS OF A COMPANY
 Estimating Earnings and
Fair Market Value for Equity
• Five Steps
1. Estimate next year’s sales revenues
2. Estimate next year’s expenses
3. Earnings = Revenue - Expenses
4. Estimate next year’s dividend per share
• = Earnings Per Share * dividend payout ratio
5. Estimate the fair market value of stock given next
years earnings, dividend, ROE, and growth rate for
dividends.
• Using Gordon Growth model or P/E Model
 4.4.Technical analysis
• What is Technical Analysis ?
• Technical Analysis is the forecasting of securities
future financial price movements by analysing
statistics generated about the past price
movements by market activity.
• Like weather forecasting, technical analysis does
not result in absolute predictions about the
future. Instead, technical analysis can help
investors anticipate what is "likely" to happen to
prices over time.
 Technical Analysis and EMH

• Attempts to exploit stock price patterns for profit.

• Assumes prices adjust slowly to their true
equilibrium values

• Technical analysis clashes with the EMH

hypothesis.
• EMH predicts rapid adjustment of prices with the
onset of new information.
• Evidence for the success of technical analysis is
poor.