Chapter Six

Security Analysis
Introduction

Security analysis refers to analyzing the value of securities like shares and other instruments to
assess the business's total value, which will be useful for investors to make decisions. Security
analysis can be broadly classified into two types: Fundamental analysis and technical analysis. If
security analysis is based on fundamental analysis, then it takes into account the scenario of the
economy, the condition of the industry to which the company belongs and the strengths and
weaknesses of the company - its management, promoters, tax planning, financial results, etc. to
determine the future price of share. Thus, we can say fundamental analysis involves three stages
of analyses namely: Economy analysis, Industry analysis and Company analysis. If the security
analysis is based on technical analysis, then it helps in forecasting the future price of share on
basis of historical price movements i.e. it is concerned with the study of stock trading patterns by
using charts, trend lines and many other mathematical analysis tools. It deals with finding the
proper value of individual securities (i.e., stocks and bonds).
6.1 Fundamental Analysis
Fundamental analysis is one of the important approaches to security analysis. When an investor wants
to make an investment decision, he makes detailed analysis of the securities issued by the companies in the
market. In doing this he either rely on fundamentals of the company or on the past price movements.
Sometimes an investor considers both price trends and fundamental of the company. Fundamental
analysis is really a logical and systematic approach to estimating the future dividends and share
price. The purpose of fundamental analysis is to evaluate the present and future earning capacity
of a share based on the economy, industry and company fundamentals and there by assess the
intrinsic value of the share. If the market price of the share is lower than its intrinsic value, the
investor would decide to buy the share as it is underpriced. The price of such a share is expected
to move up in future to match with its intrinsic value. On the contrary, when the market price of
a share is higher than its intrinsic value, it is perceived to be overpriced. The market price of such
a share is expected to come down in future and hence, the investor would decide to sell such a
share. It is based on the basic premise that share price is determined by a number of fundamental
factors relating to the economy, industry and company. Thus, we can say that fundamental analysis
includes three kinds of analysis

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 a. Macroeconomic analysis
b. Industry analysis
c. Company analysis

6.1.1 Macroeconomic Analysis

Companies are a part of industrial and business sector which in turn is a part of overall economy.
Thus, performance of company depends on performance of economy as a whole. Fluctuations in
security markets are related to changes in expectations for the aggregate economy. The prices of
government and investment-grade corporate bonds are determined by the level of interest rates,
which is influenced by overall economic activity and Federal Reserve policy. An economic
analysis is a process in which business owners gain a clear picture of the existing economic
climate, as it relates to their company's ability to thrive. Economists, statisticians, and
mathematicians often carry out this analysis on behalf of for-profit and nonprofit businesses.

The performance of a company depends on the performance of the economy. If the economy is
booming, incomes rise, demand for goods increases, and hence the industries and companies in
general lend to be prosperous. On the other hand, if the economy is in recession, the performance
of companies will be generally bad. Investors are concerned with those variables in the economy
which affect the performance of the company in which they intend to invest. A study of these
economic variables would give an idea about future corporate earnings and the payment of
dividends and interest to investors.

Let us look at some of the key macroeconomic variables that an investor must monitor as part of
his fundamental analysis.

a. Growth Rates of National Income

The rate of growth of the national economy is an important variable to be considered by an

investor. GNP (gross national product) NNP (net national product) and GDP (gross domestic
product) are the different measures of the total income or total economic output of the country as
a whole. The growth rates of these measures indicate the growth rate of the economy. The
estimates of GNP, NNP and GDP and their growth rates are made available by the government
from time to time.

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The estimated growth rate of the economy would be a pointer towards the prosperity of the
economy. An economy typically passes through different phases of prosperity, known as the
different stages of the economic or business cycle. The four stages of an economic cycle are
depression, recovery, boom and recession. The stage of the economic cycle through which a
country passes has a direct impact on the performance of industries and companies.

Depression is the worst of the four stages. During a depression, demand is low and declining.
Inflation is often high and so are interest rates. Companies are forced to reduce production, shut
down plant and lay off workers.

During the recovery stage, the economy begins to revive after a depression. Demand picks up
leading to more investments in the economy. Production, employment and profits are on the
increase. The boom phase of the economic cycle is characterized by high demand. Investments
and production are maintained at a high level to satisfy the high demand. Companies generally
post higher profits. The boom phase gradually slows. The economy slowly begins to experience
a downturn in demand, production, employment, etc. The profits of companies also start to
decline. This is the recession stage of the business cycle.

While analyzing the growth rate of the economy, an investor would do well to determine the
stage of the economic cycle through which the economy is passing and evaluate its impact on his
investment decision.

b. Inflation

Inflation prevailing in the economy has considerable impact on the performance of companies.
Higher rates of inflation: upset business plans, lead to cost escalation and result in a squeeze on
profit margins. On the other hand, inflation leads to erosion of purchasing power in the hands of
consumers. This will result in lower demand for products. Thus, high rates of inflation in an
economy are likely to affect the performance of companies adversely. Industries and companies
prosper during times of low inflation. Inflation is measured both in terms of wholesale prices
through the wholesale price index (WPI) and in terms of retail prices through the consumer price
index (CPI). These figures are available on weekly or monthly basis. As part of the fundamental
analysis, an investor should evaluate the inflation rate prevailing in the economy currently as
also the trend of inflation likely to prevail in the future.

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c. Interest Rates

Interest rates determine the cost and availability of credit for companies operating in and
economy. A low interest rate stimulates investment by making credit available easily and
cheaply moreover, it implies lower cost of finance for companies and thereby assures higher
profitability. On the contrary, higher interest rates result in higher cost of production which may
lead to lower profitability and lower demand.

The interest rates in the organized financial sector of the economy are determined by the
monetary policy of the government and the trends in money supply. These rates are thus
controlled and vary within certain ranges. But the interest rates in the unorganized financial
sector are not controlled and may fluctuate widely depending upon the demand and supply of
funds in the market. Further, long-term interest rates differ from short-term interest rates. An
investor has to consider the interest rates prevailing in the different of the economy and evaluate
their impact on the performance and profitability of companies.

d. Government Revenue, Expenditure and Deficits

As the government is the largest investor and spender of money, the trends in government
revenue, expenditure and deficits have a significant impact on the performance of industries and
companies. Expenditure by the government stimulates the economy by creating jobs and
generating demand. Since a major portion of demand in the economy is generated by
government the spending the nature of government spending is of great importance is
determining the fortunes of many an industry.

However, when government expenditure exceeds its revenue, there occurs a deficit. This deficit
is known as budget deficit. All developing countries suffer from budget deficits as governments
spend large amounts of money to build up infrastructure. But budget deficit is an important
determinant of inflation, as it leads to deficit financing which fuels inflation. The budget
document contains detailed information on each item of government expenditure and revenue
and the resulting deficit. An investor has to evaluate these carefully to assess their impact on his
investments.

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e. Exchange Rates

The performance and profitability of industries and companies that are major importers or
exporters are considerably affected by the exchange rates of the rupee against major currencies
of the world. A depreciation of the rupee improves the competitive position of Indian products in
foreign markets, thereby stimulating exports. But it would also make imports more expensive. A
company depending heavily on imports may find devaluation of the rupee affecting its
profitability adversely.

The exchange rates of the rupee are influenced by the balance of trade deficit, the balance of
payments deficit and also the foreign exchange reserves of the country. The excess of imports
over exports is called balance of trade deficit. The balance of payments deficit represents the net
difference payable on account of all transactions such as trade, services and capital transactions.
If these deficits increase, there is a possibility that the rupee may depreciate in value.

A country needs foreign exchange to meet several commitments such as payment for imports and
servicing of foreign debts. Balance of payment deficit typically leads to decline in foreign
exchange reserves as the deficit has to be met from the reserve. The size of the foreign exchange
reserve is a measure of the strength of the rupee against other currencies.

The exchange rates of the rupee against the major currencies of the world are published daily in
the financial press. An investor has to keep track of the trend in exchange rates of rupee. An
analysis of the balance of trade deficit, balance of payments deficit and the foreign exchange
reserves will help to project the future trends in exchange rates.

f. Infrastructure

The development of an economy depends very much on the infrastructure available. Industry
needs electricity for its manufacturing activities, roads and railways to transport raw materials
and finished goods, communication channels to keep in touch with suppliers and customers. The
availability of infrastructural facilities such as power, transportation and communication systems
affect the performance of companies. Bad infrastructure leads to inefficiencies, lower

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productivity, wastage and delays. An investor should assess the status of the infrastructural
facilities available in the economy before finalizing his investment plans.

g. Economic and Political Stability

A stable political environment is necessary for steady and balanced growth. No industry or
company can grow and prosper in the midst of political turmoil. Stable long-term economic
policies are what are needed for industrial growth. Such stable policies can emanate only from
stable political systems as economic and political factors are inter linked. A stable government
with clear cut long-term economic policies will be conducive to food performance of the
economy.
6.1.2 Industry analysis
Industry analysis looks at:
 Past sales and earnings performance, Labor condition within the industry, Attitude of gov’t
towards industry, Competitive condition, Stock prices of firm in the industry
 Classifying industries:
 Cyclical industry: performance positively related to economic activity
 Defensive industry: performance 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)

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6.1.3 Company Analysis:
 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 mission statement
and apparition and the goals and values.
During the process of company analysis, 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 (research & development) budgets, Pricing
Strategy and 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

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 – 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,
• 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
6.2 Technical Analysis
This type of security analysis is a price forecasting technique that considers only historical
prices, trading volumes, and industry trends to predict the security’s future
performance. Technical analysis is the study of the market based on chart of its price data. The
technical approach to investment is essentially a reflection of the idea that prices move in trends
which are determined by the changing attitudes of investors towards a variety of economic, monetary,
political and psychological forces. It uses past price structure to predict future price and this is done
by studying the structure of price over a period of time. The technical analysis predicts only short-term
price movements. Their focus is mainly on the internal market data. It appeals mainly to short-term
traders.
6.3 Quantitative Analysis
This security analysis is a supporting methodology for both fundamental and technical analysis,
which evaluates the stock’s historical performance through calculations of basic financial ratios,
e.g., Earnings Per Share (EPS), Return on Investments (ROI), or complex valuations
like Discounted Cash Flows (DCF).

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