Chapter Six Security Analysis» OUTLINE » Macro-economic analysis ° Industry analysis ° Company analysis ° Technical analysisINTRODUCTION > The primary motive of buying a share is to sell it at a higher price and dividend expectation. » Consequently, an investor would be interested to: ¥ the dividends to be paid on the share in the future and ¥ also the future price of the share. > These values can only be estimated and not predicted with certainty. » This values are primarily determined by the performance of: Y the industry to which the company belongs ¥ the general economic condition and ¥ socio political scenario of the country. » In addition, all securities are associated with risks.» So, it becomes necessary for investors to analyze the securities from the view point of their: Y prices, ¥ returns and Y risks. » This analysis is useful: Yin understanding the fluctuations of prices of| securities and ¥ the behavior pattern of the market before one decide to invest in securities.Approaches to security analysis 1. Fundamental analysis a, Economic analysis b. Industry analysis c. Company analysis 2. Technical analysisFundamental Analysis (EIC Analysis) » In order to make a rational and scientific investment decision: » an investor has to evaluate a lot of information about: ¥ the past performance and v the expected future performance of * companies, + industries and * the economy as a whole before taking the investment decision. » Such evaluation or analysis is called fundamental analysis. » It is based on the basic premise that security price is determined by a number of fundamental factors relating to the economy, industry and company. » The purpose of fundamental analysis is to evaluate: >the present and future earning capacity of a security based on EIC fundamentals and then assess the intrinsic value of the security.» The investor can then compare the intrinsic value with market price to arrive at investment decision. If the MP < intrinsic value, underpriced, then investor would decide to buy a security. The price of such a security is expected to move up in the future to match with its intrinsic value. If the MP > intrinsic value, it’s perceived to be over price, then the investor decide to sell such a security. This is b/c of the market price of such a security is expected to come down in the future Fundamental analysis thus provides an analytical frame work(EIC frame work) for rational investment decision making.Three Steps of Top-Down Fundamental Analysis [Link] analysis: evaluates current economic environment and its effect on industry and company fundamentals, such as fiscal, monetary policy 2. Industry analysis: evaluates outlook for particular industries 3. Company analysis: evaluates company’s strengths and weaknesses within industry.Economic analysis Industry analysis Company analysis1. ECONOMIC ANALYSIS ~The performance of a company depends much on the performance of the economy. » If the economy is BOOM, the industries and companies in general said to be prosperous. » On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor. » Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. » An analysis of economic variable would give an idea about: ¥ future corporate earnings ¥ the payment of dividends and ¥ interest to investors.» key economic variables that can investor must monitor as part of this fundamental analysis: ¥ GDP ¥ Savings and Investment ¥ Inflation v Rates of Interest ¥ Govt. Revenue, Expenditure & Deficits ¥ Infrastructure ¥ Monsoon and Agriculture ¥ Political Stability» GDP indicates the rate of growth of the economy. ~It represents the aggregate value of goods and services produced in the economy. » The growth rate of economy points out the prospects for the industrial sector and the return investors can expect from investment in shares. » High growth rate is more favorable to the stock market.2. Saving and Investment ~ Savings and investments represent that portion of GNP which is saved and invested. » It is obvious that growth requires investment which in turn requires substantial amount to domestic savings. » Stock market is a channel through which the savings of the investors are made available to the corporate bodies. - A higher level of savings and investments, accelerates the pace of growth of the stock market.3. Inflation ~ Inflation has considerate impact on the performance of companies. » Higher rates of inflation upset business plans and reduce purchasing power in the hands of consumers. > This will result in lower demand for products. > Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. » However, industries and companies prosper during periods of low inflation. ~ Hence, an investor has to evaluate: ’ the inflation rates prevailing in the economy currently & ¥ the trend of inflation likely to prevail in the future.4. Interest Rates ~The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. ~ A low interest rate stimulates investment by making credit available easily and cheaply. » As a result cost of finance for companies decreases which assures higher profitability. » On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. » Hence an investor has to consider: y the interest rates prevailing in the economy and v evaluate their impact on the performance and profitability of the companies.5. Government Revenue, Expenditure & Deficits ~ Government is the largest investor and spender of money. ~ So, the trends in gvt revenue, expenditure & deficits have a significant impact on the performance of industries and companies. » Fiscal and Monetary policies. ~So the investor has to evaluate these carefully to assess their impact on his investments.6. Infrastructure Facilities ~ The development of an economy depends very much on the availability of infrastructure. ~ It includes electricity, roads and railways, communication channels, sound banking and financial sectors etc. ~ The availability of infrastructural facilities affects the performance of companies. > While inadequate infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. ~ Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.7. Monsoon and Agriculture - Agriculture is directly and indirectly linked with the industries. Ex:- Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw- material. » A good monsoon leads to higher demand for input and results in bumper crop. ~ This would lead to good spirit in the stock market. » When the monsoon is bad, agricultural and power production would suffer. They cast a shadow on the share market.8. Political Stability ~ A stable political environment is necessary for steady and balanced growth. ~ No industry or company can grow and prosper when the country is passing through political instability. » The long term economic policies are needed for industrial growth. » Stable policies can be framed only by stable political systems.2. INDUSTRY ANALYSIS » Industry analysis indicates to an investor whether the industry is a growth industry or not. » It gives an investor a choice of the industry in which the investments should be made. + Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts: 1. Life cycle of an industry 2. Characteristics of an industry 3. Profit potential of an industry1. Life cycle of an industry - Marketing experts believe that each product has a life cycle . » In the same way industry is also said to have a life cycle. They are: A. Pioneering Stage: Technology and product are newly introduced. There would be severe competition and only fittest companies survive this stage. The producers try to develop brand name, differentiate the product and create a product image. The severe competition often leads to the change of position to the firms in terms of market shares and profit. In this situation, it is difficult to select companies for investment b/c the survival rate is unknown.Cont... b. Growth and Expansion stage: - This stage stars with the appearance of surviving firms from the pioneering stage. » Companies in this stage stabilize their prices, develop a market of their own and follow their own strategies. » Ultimately, by showing their competitive strength, the firms are able to maintain their position in the market. » This is the best time for the investor to make an investment in companies passing through the expansion stage. >The investors can get high returns because demand exceeds supply of the product.c. Stagnation Stage: » In this stage the growth of the industries Stabilizes. » Moreover, sales increases at slower rate. >» The industry realizes that it cannot expand further. >To keep going, technological innovations in the production process and products should be introduced. » So, the companies who have taken note of the arrival of stagnation stage have to change their course of action. » Likewise, investors too should evaluate their investment in such industry on a continuous basis.d. Decay/Declining stage: ~In this stage, demand for the particular product and the earnings of the companies in the industry decline. » The specific feature of the declining stage is that even in the boom period, the growth of the industry would be low and decline at a higher rate during the recession. » It is better to avoid investing in the shares of the low growth industry even in the boom period. ~Investment in the shares of these companies leads to erosion of capital.2. Characteristics of an industry »In an Industry Analysis, the analyst should consider a number of key characteristics: » Relationship between Demand & supply » Nature of the product » Nature of the competition » Growth of the industry » Labor » Government policy » Availability of Raw Material » Research and development3. Profit potential of an industry It depends on the following factors: (i) Threat new entrants: > New entrants inflate cost, push down the prices and reduce profitability. » An industry which is well protected from the entry of new firms would be ideal for investment. (ii) Competitions among existing firms: ~ The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. - If the competition between the firms in an industry is strong average profitability of the industry may be discouraged.(iii) Pressure from substitute products: » Each firm in an industry face competition from other firms in the same industry producing substitute products. ~ Ex:- Sony TV, Samsung TV, LG TY etc.. ~ Substitute products may affect the profit potential of the industry badly. » The pressure from the substitute products is high when: Y the price of the products is attractive ¥the cost for the prospective buyers to a substitute product is minimum. Y the substitute products are earning greater profits(iv) Bargaining power of buyers: » Buyers can bargain for price reduction, asks for better quality and better service. » The bargaining power of a buyer group is said to be high: v If its capacity to buy is more than the capacity of the seller to sell. Y If the cost of the switch over to a substitute product is low.3. COMPANY ANALYSIS ~It involves a close investigation of the companies financial and non financial aspects with a view to identifying its strength, weaknesses and future business prospects. » The financial and non financial aspects are as follows: » Marketing success » Accounting Policies » Profitability » Capital Structure »Financial AnalysisCont... Marketing Success The success of the market of the firm depends on: (a) The market share of annual sales (b) Growth of annual sales (c) The stability of annual sales. (d) Sales forecast- Accounting Policies » While analyzing a company, the investor should carefully consider the accounting policies followed by the company. A. Inventory Pricing Generally, the prices of inventory change over a period of time. Due to changes in the prices of the inventory, the value of inventory changes during an accounting year. Ex:- FIFO ,Weighted Average and LIFO B. Depreciation methods The amount of depreciation varies depending upon the method employed. Higher amount of depreciation reduces profit while the lower amount of depreciation increases profit. + Straight line method * Declining balance methodC. Non operating income Non-operating incomes are those items of incomes which are not earned in the routine business of the company. ° Dividend * Interest D. Tax Carry over ~ A company must take adequate provisions for payment of tax on its earnings. Further, excess tax paid in the previous year may be refunded in the current year and such refund may be adjusted against the tax due in the current year. » The incidence of corporate tax and tax carryover are the factors which the investor should carefully take into consideration» Profitability » When an investor buys a security, he is buying the right to the future earnings of the company. > A prudent investor is always interested in stability and growth of the earnings from security. (a) Gross profit Margin (b) Net profit Margin (c) Earning power (d) Return on equity (e) Earning per share» Capital Structure » Generally, companies raise long term funds through the issue of shares and other securities like bonds, debentures etc. >The capital structure affects return on the equity shareholder’s investment. ~ Equity holders return can be increased by using more debts than equity capital. »So the investor should study the company’s capital structure before take a decision.» Financial Analysis > The financial statement of the a company provide the best possible information about the profitability and financial soundness of the company. >This is the primary source of information for evaluating the prospects of the investment in company’s stock. ~The statement gives the historical and current information about the company’s operations. » Income statement Analysis » Balance Sheet Analysis» The analysis of financial statements reveals the nature of relationship between income and expenditure and the sources and application of funds. >To know much about the profitability and the management’s policy regarding the dividend, the investor can use the following simple analysis: » Comparative statement analysis ° Trend analysis » Common size statements ° Fund flow analysis ° Cash flow analysis » Ratio analysisTechnical Analysis » Technical analysis can be defined as the use of specific market-generated data for the analysis of stock prices. » It involves the analysis of market prices in an attempt to predict future price movements for the particular financial asset traded on the market. » This analysis examines the trends of historical prices and » It is based on the assumption that these trends or patterns repeat themselves in the future. » Technical analysis is sometimes called market or internal analysis, because it utilizes the record of the market itself to attempt to assess the demand for, and supply of, shares of a stock or the entire market.>» Thus, technical analysts believe that the market itself is its own best source of data as they say, let the market tell its own story. » Technical analyst believes that using data from the market itself is a good idea because “the market is its own best predictor.” » Therefore, technical analysis is an alternative method of making the investment decision and answering the questions: » What securities should an investor buy or sell? » When should these investments be made?» Technical analysts says no need to study the multitude of economic, industry, and company variables to arrive at an estimate of future value because they believe that past price movements will signal future price movements. » Fundamental analysis is a method of evaluating securities by attempting to measure the inirinsic value ofa stock. » Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. » Technical analysis is the evaluation of securities by means of studying statistics generated by market activity, such as past prices and volume.» Technical analysts do not attempt to measure a security's intrinsic value but instead use stock charts to identify patterns and trends that may suggest what a stock will do in the future. * The field of technical analysis is based on three assumptions: 1 the market discounts everything. 2. Price moves in trends. 3. History tends to repeat itselfThanks!!!