READING NOTE CH-4
SECURITY ANALYSIS: is the basis for rational investment decisions. If a security's estimated value is
above its market price, the security analyst will recommend buying the stock. If the estimated value is
below the market price, the security should be sold before its price drops. However, the values of the
securities are continuously changing as news about the securities becomes known. The search for the
security pricing involves the use of fundamental analysis.
FUNDAMENTAL ANAYSIS comprises the following:
1. Economic Analysis
2. Industry Analysis
3. Company Analysis
MACRO ECONOMIC FACTORS
The macro economy is the study of all the firms operates in economic environment. The key variables to
describe the state of economy are explained as below:
1. Growth rate of Gross Domestic Product (GDP): GDP is a measure of the total production of final
goods and services in the economy during a year. The growth rate of GDP points out the
prospects for the industrial sector and the returns investors can expect from investment in
shares. The higher the growth rate of GDP, other things being equal, the more favorable it is for
stock market.
2. Savings and Investment: If there are more saving means more investment. Stock market is an
important channel to mobilize savings, from the individuals who have excess of it, to the
individual or corporate, who have deficit of it. The demand for corporate securities has an
important bearing on stock prices movements. Greater the allocation of equity in investment,
favorable impact it have on stock prices.
3. Industry Growth rate: The stock market analysts focus on the overall growth of different
industries contributing in economic development. The higher the growth rate of the industrial
sector, other things being equal, the more favorable it is for the stock market.
4. Price level and Inflation: If the inflation rate increases, then the growth rate would be very little.
The increasingly inflation rate significantly affect the demand of consumer product industry.
High rate of inflation is harmful to the stock market.
5. Agriculture: Agriculture is directly and indirectly linked with the industries. Hence increase or
decrease in agricultural production has a significant impact on the industrial production and
corporate performance. Companies using agricultural raw materials as inputs or supplying
inputs to agriculture are directly affected by change in agriculture production. For example-
Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw material.
If agriculture production is decreased then it will also affect stock market.
6. Interest Rate: Interest rate affects the cost of financing to the firms. A decrease in interest rate
implies lower cost of finance for firms and more profitability and it finally leads to decline in
discount rate applied by the equity investors, both of which have a favorable impact on stock
prices. At lower interest rates, more money at cheap cost is available to the persons who do
business with borrowed money, this leads to speculation and rise in price of share.
7. Government Budget and Deficit: The excess of expenditure over revenue leads to budget
deficit. For financing the deficit the government goes for external and internal borrowings. Thus,
the deficit budget may lead to high rate of inflation and adversely affects the cost of production
and surplus budget may results in deflation. Hence, balanced budget is highly favorable to the
stock market.
8. The tax Structure: The business community eagerly awaits the government announcements
regarding the tax policy every year. The type of tax exemption has impact on the profitability of
the industries. Concession and incentives given to certain industry encourages investment in
that industry and have favorable impact on stock market.
9. Balance of Payment, Forex Reserves and Exchange rate: Balance of payment is the record of all
the receipts and payment of a country with the rest of the world. This difference in receipt and
payment may be surplus or deficit. Balance of payment is a measure of strength of local
currency on external account. The surplus balance of payment augments forex reserves of the
country and has a favorable impact on the exchange rates; on the other hand if deficit increases,
the forex reserve depletes and has an adverse impact on the exchange rates.
The industries involved in export and import are considerably affected by changes in foreign
exchange rates. The volatility in foreign exchange rates affects the investment of foreign
institutional investors in Stock Market. Thus, favorable balance of payment renders favorable
impact on stock market.
10. Infrastructural Facilities and Arrangements: Infrastructure facilities and arrangements play an
important role in growth of industry and agriculture sector. A wide network of communication
system, regular supply or power, a well-developed transportation system (railways,
transportation, road network, inland waterways, port facilities, air links and telecommunication
system) boost the industrial production and improves the growth of the economy. For foreign
investment. Thus, good infrastructure facilities affect the stock market favorable.
11. Demographic Factors: The demographic data details about the population by age, occupation,
literacy and geographic location. These factors are studied to forecast the demand for the
consumer goods. The data related to population indicates the availability of work force. The
cheap labor force in a country has encouraged many multinationals to start their ventures.
Population, by providing labor and demand for products, affects the industry and stock market.
12. Sentiments (view or attitude towards situation): The sentiments of consumers and business
can have an important bearing on economic performance. Higher consumer confidence leads to
higher expenditure and higher business confidence leads to greater business investments. All
this ultimately leads to economic growth. Thus, sentiments influence consumption and
investment decisions and have a bearing on the aggregate demand for goods and services.
ECONOMIC FORECASTING TECHNIQUES
To estimate the stock price changes: an analyst has to analyze the macroeconomic environment.
All the economic activities affect the corporate profits, investor's attitudes and share price. For
the purpose of economic analysis and in order to decide the right time to invest in securities
some techniques are used. These are explained as below:
1. Anticipatory Surveys
Under this prominent people in government and industry are asked about their plans with
respect to construction, plant and equipment expenditure, inventory adjustments and the
consumers about their future spending plans. To the extent that these people plan and budget
for expenditure in advance and adhere to their intentions, surveys of intentions constitute a
valuable input in forecasting process.
It is necessary that surveys of intentions be based on elaborate statistical sampling procedures,
the greatest short coming of intentions, surveys is that the forecaster has no guarantee that the
intention will be carried out. External shocks, such as strikes, political turmoil or government
action can cause changes in intentions.
2. Barometric or Indicator Approach
Barometric technique is based on the presumption that relationship can exist among
various economic time series. For example, industrial production overtime and industrial loans
by commercial banks over time may move in same direction.
There are three kinds of relationships among economic time series:
a) Leading series
Leading series consists of the data that move ahead of the series being compared.
For example-applications for the amount of housing loan over time is a leading series for the
demand of construction material, birth rate of children is the leading series for demand of seats
in schools etc.
b) Coincident series
When data in series moves up and down along with some other series, it is known as coincident series. A
series of data on national income is often coincident with the series of employment in an economy (over a
short-period).
c) Lagging series
Where data moves up and down behind the series being compared, example, and data on industrial
wages over time is a lagging series when compared with series of price index for industrial workers. They
reach their turning points after the economy has already reached its own.
3. Diffusion Indexes
A diffusion index copes with the problem of differing signals given by the indicators. In this method a group of
leading indicators is initially chosen. Then the percentage of the group of chosen indicators which have fallen (or,
risen) over the last period is plotted against time to get the diffusion index. For example, if there are say 9 leading
indicators for forecasting the construction activity of dwelling units and if by plotting we find that say, 6 indices
show a rise, then we can calculate that diffusion index is (6/9*100) = 66.7 percent. When the index exceeds 50
percent, we can predict a rise in forecast variable.
4. Money and Stock Prices
Monetary theory in its simplest form states that fluctuations in the rate of growth of money supply are of utmost
importance in determining GNP, corporate profits, interest rates, stock prices etc. Monetarists contend that
changes in growth rate of money supply set off a complicated series of events that ultimately affects share prices.
5. Econometric Model Building
This is the most precise and scientific of the different forecasting techniques. This technique makes use of
Econometrics. Econometrics is a discipline that applies mathematical and statistical techniques to economic
theory. In the economic field we find complex interrelationship between the different economic variables. The
precise relationship between the dependent and independent variables are specified in a formal mathematical
manner in the form of equations. For example, Single equation regression serves the purpose of forecasting in
many cases.
6. Opportunistic Model Building
This is one of the most widely used forecasting techniques. It is also known as GNP model building or sectoral
analysis. Initially, an analyst estimates the total demand in the economy, and based on this he estimates the total
income or GNP for the forecast period.This initial estimate takes into consideration the prevailing economic
environment such as the existing tax rates, interest’s rates, rate of inflation, fiscal policies, etc.
After initial forecast is arrived at, the analyst now begins building up a forecast of the GNI figure by estimating the
levels of various components of GNP such as consumption expenditure, gross private domestic investment,
government purchase of goods and services and net exports.
