CHAPTER EIGHT

SECURITY ANALYSIS CONCEPT

INTRODUCTION
Security analysis involves the process of finding a value for a stock. There are basically two
approaches to security analysis. These are the technical analysis and fundamental analysis. This
chapter takes a look at these two approaches of finding a price of a stock. Also considered in this
chapter is the efficient market hypothesis.

TECHNICAL ANALYSIS
Technical analysis is essentially the search for recurrent and predictable patterns in the stock
prices. Analysts and market technicians examine prior price and volume data as well as other
market-related indicators to determine part trends in the belief that they will help forecast future
ones. One broad definition of technical analysis includes the use of stock prices, trading volume
and other market data to formulate rules telling the technician when to buy or sell stocks.
Technical analysts place much emphasis on charts and graphs of internal market data than on
such fundamental factors as earnings reports, management capability or new product
development. They believe that even when important fundamental information is uncovered; it
may not lead to profitable trading because of timing consideration and market imperfections.
Although technicians recognise the value of information regarding future prospects of the firm,
they believe that such information is not necessary for a successful trading strategy. This is
because whatever the fundamental reason for a change in stock price, if the change is slow
enough, the technical analyst will be able to identify a trend that could be explicated during the
adjustment period.
The technical analysts are sometimes called chartists because they study records and charts of
past stock prices hoping to find patterns they can exploit to make profit. Many of these
technicians do not even conside4r the influence of other market or company information to make
their investment decision. They believe that stock prices and volume data are all an investor
needs, and extra information only clouds their ability to make relevant buy or sell decision.
Many technicians can apply their techniques to forecasting the direction of both the stock market
and individual stocks. They typically use market indicators to measure the strength of the
markets or the economy. Technical analysis is based on a number of basic assumptions:

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 1. Market value is determined by the interaction of demand and supply.
2. It is assumed that though there are minor fluctuations in the market, stock prices tend
to move in trends that persist for long periods.
3. Reversals of trends are caused by shifts in demand and supply
4. Shifts in demand can be detected sooner or later in charts.
5. Many chart patterns tend to repeat themselves
One major tool use by technical analysts is charting. The chartist may draw lines connecting the
high and low prices for the day to examine any trends in the prices. This is called a search for
memorandum. The figures show some of the type of pattern a chartist might hope to identify
(fig. 1A, 1B) or head and shoulders (fig 1C) are believed to convey clear buy or sell signals. The
head and shoulders are named for its rough resemblance of a portrait with head and surrounding
shoulders. Once the right shoulder is penetrated (known as piercing the neckline), chartists
believe the stock is on the verge of a major price decline.
Charting is often linked to Dow Theory. The Dow Theory named after its Greater Charles Dow,
the founder of Wall Street Journal, is the grandfather of most technical analysis. The aim of the
Dow Theory is to identity long-term trends in stock prices. The theory maintains that there are
three major movements in the market, daily fluctuations, secondary movements and primary
trends. The primary trend is the long-term movement of prices lasting for several months to
several years.
The secondary (intermediate) trends are caused by short-term deviations of prices from the
underlying trend line. These deviations are eliminated via corrections when prices revert back to
trend values Tertiary (minor) trends are daily fluctuations of little importance. The important
facet of the secondary movement is that each low is higher than the previous low and each high
is higher than the previous high. This pattern of upward-moving ‘tops’ and ‘bottoms’ is one of
the key ways to identify the underling primary trend (bullish). Despite the upward primary
trend, immediate trends still can lead to short periods of declining prices. Under the Dow theory
it is assumed that the primary trend will continue for a long period and the analyst should not be
confused by secondary movements. However, an upward movement must ultimately end. This
is indicated by a new pattern in which a recovery fails to exceed the previous high and a new low
penetrates a previous low. A change from a bear to a bull market will require similar pattern of
confirmation.

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Advantages of Technical Analysis
Many investors use technical analysis. Some investors are technical analysis exclusively while
others combine it with fundamental analysis. Technical analysis offers the following advantages.
1. It is objective: Once the technician has determined the particular role to use in the
technical strategy, making the actual investment decision is easy. If technical
criterion for a buy recommendation exists, then technician buys. The decision
requires no thought, forecasts or other subjective judgements.
2. Technical analysis is easy to learn and requires no specialised financial knowledge.
Constructing a chart of a stock’s price is easy task. Computing market indicators
usually requires only a simple calculation. On the other hand, conducting
fundamental analysis requires knowledge in accounting, present value, finance and
other topics that take long period to study.
3. Technicians have access to all the information they require in their analysis. Stock
prices and volume of activities are easily accessible through the press or the Internet.
Fundamental analysts have to rely on companies as their primary source of
information. This information may be difficult to get and several months old by the
time analysts get them.

Criticism of the Technical Analysis

The most evident criticism of technical analysis is the controversy over the efficacy of its
strategies. Opponents of technical analysis claim that there is no real objective, substantial
evidence that it works. Indeed, the wealth of information supporting the weak form of efficient
market hypothesis (EMH) rejects technical analysis.
Another criticism of the technical analysis is that it is self-fulfilling prophecy. Consider several
hundreds of technicians using the same information and arriving of some decision. For example,
if all the technicians follow ABC stock and the trend shows an upward move in the stock price.
They will all call their brokers and place an order to buy. The increase in demand for ABC
shares will force the price up, thus fulfilling the upward move.
Critics point out that technicians often act too late to be able to take advantage of the self-
fulfilling prophecy situations. By the time they have processed the stock price information and

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acted, other technicians will have done same, the stock price will have reached its new
equilibrium and it will be too late to make trading profit.
The final criticism deals with the difficulty of discerning chart patterns as they develop. A good
instructional manual of charting will show nice examples of all the standard chart patterns,
identifying the buy or sell points. However, actually identifying these patterns as they develop is
not easy or simple.

FUNDAMENTAL ANALYSIS
Before a security analyst can determine a proper price for a firm’s stock, he/she has to forecast
the earnings and dividend that can be expected from the firm. This is the heart of fundamental
analysis, i.e. the analysis of the determinants of value of such as earnings prospects. Ultimately,
the success of a business determines the dividend it will pay to shareholders and the price its
shares will command in the security market. To determine the value of a firm, fundamental
analysis relies on long-run forecast of the economy, the industry and the company’s financial
prospects. Short-run changes in business conditions are also important because they influence
investors’ required rate of return and expectation of corporate earnings and dividends.
Fundamental analysis uses earnings and dividend prospects of a firm, expectation of future
interest rates and risk evaluation of the firm to determine stock prices. Fundamental analysis
starts with a study of past earnings and the examination of a company’s balance sheet, ordinarily
including an evaluation of the quality of management of the firm, the firm’s standing in the
industry and prospect of the industry as a whole. Because the prospects of the firm are tied to
those of the broader economy, fundamental analysis must consider the business environment in
which the firm operates. For some firms macroeconomic and industry performance might have a
greater influence within the industry. Therefore, the financial statement analysis of the firm
should be combined with economic and industry analysis before a final judgement is made to
purchase or sell specific security.
Fundamental analysis is therefore conducted on three levels: the economy, the industry and the
firm. There are two types of fundamental analysis namely top-down analysis and bottom-up
analysis. The top-down analysis starts with the broad economic environment, examining the
state of the aggregate economy and even the international economy. Having analysed the broad
economy, the analyst moves the analysis to the industry level, looking at which industries are

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best positioned to be successful and profitable given the economic situation. Finally, the firm’s
position within the industry is examined by looking at which firm(s) within the industry will
maximise investment return.
The bottom-up analysis on the other hand, begins at the micro-level (firm’s level) expand the
analysis to the company’s industry or sector and end with the analysis of the economic
environment. The top-down analysis will be discussed in this book starting with the economic
environment and ending with the analysis of the firm.

ECONOMY ANALYSIS
Economic analysis will be considered by looking at both global and the domestic economies.

The Global Economy

A top-down analysis must start with the global economy. The international economy might
affect a firm’s export prospects, the price competition it faces from imported goods (competitors)
or the profit it makes from investment abroad. In addition, the global environment presents
political risks of far greater magnitude than is typical in home-based investments. Political
unrest can adversely affect an investment abroad. Similarly, the global environment may present
a business opportunity for firms. For example, the NEPAD initiative by the international
community and AU can impact positively on firm’s exports.
The turmoil of several Asian countries, in 1997 and 1998 impacted negatively on international
trade. Political developments offer significant opportunities to make or lose money. Other
political issues that are less sensational but of extreme importance to economic growth and
investment return is the issue of protectionism, trade policies, and free flow of capital.
One major factor that affects international competitiveness of a country’s industry is the
exchange rate between the country’s currency and other currencies. As the exchange rate
fluctuates the value of goods price in foreign currency also fluctuates. An appreciation of the
cedis will make our exports expensive in the international market making our exports less
competitive pricewise. On the other hand, firms which use foreign components and raw material
will suffer when the cedis depreciates because their cost of production will go up. This will
ultimately increase the price of their product(s). The end result will be either loss of market
share or profit which invariably affects the value of the firm.

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The Domestic Economy
The economic environment has great influence over the performance of the individual groups
and units that compose the economic system. There is a relationship between stock price and
economic activity, increased earnings as a result of economic prosperity result in higher, values
for stocks.

In analysing the domestic economy, the following must be considered:

(1) Gross Domestic Product (GDP)
GDP measures values of all goods and services produced domestically irrespective of who
owns the resources used in production. Rapidly growing GDP indicates an expanding
economy with ample opportunity for a firm to increase sales. Therefore, GDP is more
related to predicting sales of intermediate products (raw materials).

(2) Gross National Product (GNP)

It is a measure of valve of all goods and services produced by resources owned by a nation.
In a way it is a measure of income and can be used for forecast sales.

(3) Employment
The unemployment rate of a country is the total labour force yet to find job. The
unemployment rate measures the extent to which the economy is operating at capacity. In
addition to considering the unemployment rate; analysts also look at the factory capacity
utilization rate which is the ratio of actual output from factories to potential output.
(4) Inflation
Inflation is the rate at which the general level of price is rising. High rate of inflation is
generally associated with ‘overheat’ economies, i.e. economies where demand exceed
supply.
(5) Interest Rates
High interest rate reduces the present value of future cash flows thereby reducing
attractiveness of investment opportunities. It also makes borrowing very expensive to the
firm. Thus, high interest rates adversely affect firms.

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 (6) Sentiments
Consumer and producer sentiments (optimism or pessimism) concerning the economy is an
important determinant of economic performance. If consumers have confidence in their
future income levels, they will be willing to spend more. Similarly, businesses will increase
their production and inventory levels if they anticipate high demand for their products. In
this very sentiment influences how much consumption and investment will be pursued and
affect the aggregate demand for goods and services.
(7) Monetary Policy
Monetary policy is the government’s control of money supply in the economy. Tools that
are used in monetary policy include open market operations (buying and selling of T-bills)
and discount rates (rates that are changed banks on short term loans). Monetary policy works
largely through its impact on interest rates. Increasing money supply lower short-term
interest rates, ultimately encouraging investment and consumption demand. In the long run
however, most economists believe this can lead to inflation. There is a direct relationship
between money supply and the price of stocks. Increase in money supply leads to increase in
stock prices and vice versa.
(8) Fiscal Policy
It refers to government spending and tap actions (policies). Fiscal policy is probably the
most direct way to stimulate or show down the economy. Decrease in government spending
directly reduces demand for goods and services. Similarly, increase in taxes siphon income
from consumers and results in decrease in consumption. Increase in taxes also adversely
affects the earnings of firms.
Different industries react differently to economic changes. For example, consumer staples (food,
drugs) industries are less sensitive to economic changes than luxury goods industries. Therefore,
the impact of the factors above will depend on the industry in which a particular firm finds itself.

INDUSTRY ANALYSIS
Industry analysis is the second step in the top-down analysis. Just as it is difficult for industries
to perform well in an ailing economy, it is unusual for a firm in troubled industry to perform
well. The discussion here will focus on industry life cycles, and industry structure.

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Industry Life Cycle
Industry life cycle is created because of economic growth, competition, availability of resources
and the resultant market situation by the particular goods and services offered. The particular
phase in the life cycle of an industry determines the growth of earnings, dividends, capital
expenditure and market demand for products. An industry analysis helps place an industry on the
life cycle curve and in turn guides the analyst towards decision on industry growth, the duration
of growth, profitability and potential rate of return. The analyst can determine where all
companies in the industry are in the stage of the life cycle and translate company differences into
various assumptions that will affect their valuation.
The life cycle of an industry is divided into 5 stages:
Stage 1: Development
The development stage includes companies that are getting started in business with new product
development or production technique that makes them unique. At this stage it is difficult to
predict which firms will emerge as industry leaders. Some firms will turn out to be successful
and others will fail altogether. Therefore, there is considerable risk in selecting one particular
firm within the industry.
At this stage sales and earnings of the industry grows at an extremely rapid rate because the new
product has not yet saturated the market. Firms in the first stage of the industry life cycle hardly
pay dividend.

Stage II: Growth

It represents an industry or company that has achieved a degree of market acceptance for its
products. At this stage earnings would be retained for reinvestment. In general companies in
stage 2 become profitable and in early stage of growth, they want to acknowledge to their
shareholders that they have achieved profitability. Since they need their internal capital (retained
earnings) they normally pay stock dividend.

Stage III: Expansion

At the expansion stage, sales and earnings expansion continues at a decreasing rate. Industrial
leaders begin to emerge. The survivors in the industry are more stable and market share is easier
to predict. The performance of the surviving firms more closely tracks the performance of the

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overall industry. At this stage, the dividend pay-out ratio increases from a low level to a
moderate level. Some firms in the industry continue to use stock dividend and stock splits.

Stage IV: Mature

At this stage the product has reached its full potential for use by consumers. The product has
become standardised and producers compete on the basis of price. This leads to narrower profit
margin and further pressure on profit.
Sales grow at a rate equal to the economy as measured by long-term trend in GDP. The
automobile industry is a typical example of mature industry. By the time industries (firms) reach
maturity stage, plant and equipment are in place, financing alternatives are available and cash
flow from operations are more than enough to meet growth requirements of the firm. Such firms
are characterised as cash cows, having reasonably stable cash flow but offering little opportunity
for profitable expansion. The cash flows are best milked from rather than reinvested in the
company. Therefore, firms in mature industries normally pay high dividend to shareholders.

Stage V: Decline
At this stage, the industry might grow at a rate lower than the economy or it might even shrink.
Industries suffer decline in sales as a result of competition from new products. It should be noted
that it might not be the whole industry that goes into decline but rather weak firms within the
industry.
The question to answer is at which stage in the industry life cycle is investment profitable or
more attractive?
Conventional wisdom is that investors should seek firms in high-growth industries. This recipe
for success is simplistic. If the security prices already reflect the likelihood for high growth, then
it may be too late to make money from such stocks. Moreover, the growth and high profit
attracts competitors and new sources of supply that eventually reduce prices. This is the
dynamism behind the progressive from one stage of the industry life cycle to another. The
famous portfolio manager Peter Lynch makes this point when he said,
“Many people prefer to invest in a high-growth industry where there’s

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a lot of sound and fury. Not me. I prefer to invest in a low-growth industry to especially one
that is boring and upset people, there’s no problem with competition. You don’t have to protect
your flanks firm potential rivals and this gives you the leeway to continue to grow”.

Industry Structure
The structure of the industry is another area of importance for the analyst. Industry structure
determines whether the companies in the industry are profitable, whether there are specific
considerations such as government regulations that might positively or negatively affect the
industry and whether cost advantages and product quality create a dominant company within the
industry. Factors to consider under the industry structure are the following:

Economic structure
Economic structure of industry determines how companies compete in the industry. The analyst
has to find out whether the industry structure is monopoly, oligopoly or pure competition. If the
industry is monopoly, it may be subject to government regulation with regards to rate of return
on equity and assets and approval of consumer fees. This sets the limit for growth and
profitability and creates a minimums and maximums for the analyst. Oligopolistic industries
have few competitors but they face international competition, which affect profitability of such
industries.
Government regulations
Most industries are affected by government regulations, for example the automobile industry
where safety and exhaust emissions are regulated. In Ghana the food industry is regulated by the
Food and Drugs Board. Most industries are affected by government expenditure, for example
education, health, transportation and the agricultural industry to some extent are affected by
government spending. Therefore, it is very important for the analyst to understand each industry
and how such industries are affected by government regulations.
Competitive structure
Industry consists of competing firms. Some industries have few firms whereas others have
many firms. The firm in an industry compete with each another and employ different strategies
for success. It should be noted that just that an industry is in a certain stage of life cycle does

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not mean that stage of a life cycle. A firm may have chosen a poor competitive strategy or an
excellent competitive strategy which put them in different position.
Though the industry outlook is important, a firm may be able to create a competitive position
that shapes the industry environment. There are profitable firms in poor industries and
unprofitable firms in a good industry.
Threat of entry
New entrants to an industry put pressure on price and profits. Even if a firm has not entered an
industry, the potential for it to do so put pressure on prices because high profit margins
encourage new competitors to enter. Therefore barrier to enter can be a key determinant to
industry profitability. Barriers can take many forms including brand loyalty of customers to
existing producer (goodwill) and long term relationship with customers and suppliers which
makes it difficult for new entrants to know whether the industry under consideration is easy to
enter or not.

COMPANY ANALYSIS
The last leaf in the fundamental analysis is company analysis. Company analysis basically
involves the analysis of the financial statements of the firm: the income statement, the balance
sheet and the cash flow statement.
The financial statements are normally analysed using ratios. Since the main aim of the analysis is
to determine the value of the firm, analysts are interested in certain category of ratios, which
include profitability ratios, efficiency ratios and liquidity ratios.
Ratios by themselves are meaningless unless compared to a benchmark. Two such methods of
comparison are the time series comparison and cross sectional comparisons. Time series
comparison involves comparing current ratio with past ratios. Deviations from trend should be
examined in line with policy changes to determine whether the change is intentional or
unintentional. Cross sectional comparison involves comparing with peers. Deviations from
industrial average should be examined for change in policy or performance reason. We review
below some of the ratios mentioned above.

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Profitability Ratios
These ratios are used to determine the profitability or other wise of a firm. It shows how earnings
of a firm are growing. For example, a decline in return on equity (ROE) ratio is evidence that a
firm’s investments have offered a low ROE than its previous investments. Some ratios under
profitability are:
1. ROE = Earning before tax and interest (EBIT)
Net Assets
2. Profit to turnover Ratio = EBIT
Turnover
3. Gross Profit ratio = Gross Profit
Turnover

4. Return on shareholders fund = Attributable Profit

Shareholders fund
Where attributable profit is earnings after tax, interest and preference share dividend and
shareholders fund consist of equity plus retained earnings.
5. Earnings per share (EPS) = Profit after tax
Number of common shares outstanding
6. Dividend yield = Gross Dividend
Total market value of equity

7. Dividend Cover = Profit available for dividend

Dividend paid

Efficiency Ratios
These ratios show how management is effectively and efficiently utilizing the assets (resources)
of the firm. For example, the fixed asset ratio measures sales per cedi of the firm’s money tied up
in fixed assets. The average collection period, which shows the number of days it takes a firm to
collect credit sales from customers, indicates the total credit extended to customers per cedi of

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daily sales. It also indicates the number of days’ worth of sale tied up in accounts receivable.
Efficiency ratios include:
1. Fixed Asset Turnover = Sales
Fixed Assets
2. Capital turnover = Turnover
Net Assets
3. Stock Turnover = Average Stock
Cost of Sales
4. Average Collection Period = Average Accounts Receivable x 365 days
Sales
5. Average Payment Period = Average Accounts Payable x 356 days
Purchases
Liquidity/ Leverage Ratios
These ratios measure the financial strength of the firm. The liquidity ratios measure the firm’s
ability to meet its current obligations. Leverage ratios, on the other hand, are used to measure the
long-term financial position of the firm. In a way, these ratios indicate the riskiness of the firm as
far as bankruptcy is concerned. Some of the ratios in this category are:
1. Current Ratio = Current Assets
Current Liabilities
2. Quick (Acid Test) Ratio = Current Asset – Stock
Current Liabilities
3. Gearing Ratio = Long-term Debt
Long-term debt + Equity
4. Debt to Equity Ratio = Long-term Debt
Equity

CONCLUSION
After undertaking economic, industry and company analysis, the analyst or investor will be
equipped to make meaningful investment decision with regards to security selection. This is
because all the information needed to make sound investment decision might have been available
to the investor or the analyst.

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EFFICIENT MARKET HYPOTHESIS (EMH)

Introduction
The interplay between investors in financial security and company managers responsible for
issuing securities takes place in the financial market. These markets exist to enable investors and
issuers of securities to make contact and transact business. When investors buy equity, they
undertake perpetual investment since equity has no maturity date. They encourage investors
make such commitment, they should have the assurance that a market exists where they could
sell their shares at a fair price sometime in the foreseeable future. This can only happen if there is
an efficient market which prices shares efficiently by incorporating into the price all information
currently available about the company and the economy as a whole. If this is the case, investors
will be encouraged to buy shares through the security market because they know they are paying
a fair price for the shares and would be able to sell at a fair price. Financial managers would be
able to obtain funds at the financial market at a cost that reflect the riskiness of the business
activities being undertaken. The notion of efficiency is therefore not only important to the
investor but also company managers. The efficient allocation of resources is an important
determinant of economic growth. In many countries, it is believed that the market provides the
best means of allocating resources. Funds are efficiently allocated from individuals/organizations
with few productive opportunities and greater wealth to those with many opportunities but
insufficient wealth.

The Efficient Market

An efficient capital market is the one in which prices of traded securities always fully reflect all
available information concerning those securities. Thus, by implication, security prices adjust
instantaneously and in an unbiased manner to any piece of information released to the market. A
capital market is, therefore, efficient if it does not neglect any information relevant to the
determination of security prices and also has rational expectation, i.e. it uses the information
correctly. This means that the market uses all available information and it understands the true
implication of this information to the joint distribution of payoffs. Thus, any change in price can

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only occur in the event of new information. In an efficient market therefore, investors would not
be able to use available information to make above-normal profits because as soon as any
information becomes known, it will quickly be implanted into the price of the security. The basic
intuition of efficient market is that individual traders process the information that is available to
them and take positions in assets in response to the information as well as their personal
situations.

Forms of Efficient Market Hypothesis

We have defined an efficient market as one in which the prices of securities reflect available
information. Within this general definition, three particular forms of markets efficiency were
defined by Fama (1970).

The Weak Form

The weak form of efficient market hypothesis (EMH) states that security prices fully reflect
information regarding the historical events (past prices, return and trade volumes) and investors
knowing the historical sequence of prices can neither abnormally enhance their investment return
nor improve their ability to select shares. In other words, the market is weak form efficient if the
information in past prices is fully incorporated in current stock prices so that no investor can earn
excess return by the use of trading rules based on this information. The weak form of EMH
suggests that there is no relationship between past and future prices of securities. They are
presumed to be independent. In other words, stock prices follow a random walk.

Semi-Strong Form
The semi-strong form of EMH maintains that all public information is impounded into the value
of a security and therefore one cannot use fundamental analysis to determine whether a stock is
undervalued or overvalued. Therefore, a market is semi-strong efficient if all public information
(company annual reports, newspapers, dividend declaration etc.) is fully incorporated in the
current price of the security so that no investor can make excess return based on this information.
Therefore, the semi-strong form is concerned with whether current prices of securities reflect
public knowledge about the underlying company and whether the speed of price adjustment to

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the public announcement of the information is fast enough to eliminate the possibility of
abnormal gain.
A number of researches have shown consistency with the semi-strong form of EMH. These
include Fama et al (1969) on stock splits in the U. S. A, Firth (1977) on stock split in U. K and
Marsh (1977) on right issue.

Strong Form
The strong from of EMH goes beyond the semi-strong form by stating that stock prices reflect
not only all public information but all information. Thus, a market is strong from efficient if
insider information is also fully incorporated in current prices so that no investor can earn excess
return by the use of trading rules. Unlike the weak and semi-strong forms, major research results
are not supportive of the strong form. It has been found out that professional analysts and certain
people within companies have access to privileged information or significant information, which
the general public (investors) don’t have and have earned superior return on invested capital.
Another research has shown evidence that ‘insiders’ do have what is called information
advantage (Finnerty 1976). This means that they are able to use this price-sensitive information
to earn abnormal return from their investment. Using insider information is known as insider
trading and is a crime in many countries.

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