Chapter Three

Security Analysis
3.1 Introduction
 Security analysis is the basis for rational investment decisions.
 If a security’s estimated value is above its market price, buy
the stock unless the security should be sold before its price
drops.

3.2 Fundamental analysis

 Fundamental analysis is primarily concerned with determining
the true value of a security.
 fundamental analysis comprises.
– Economic Analysis
– Industry Analysis
– Company Analysis
1. Economic Analysis
 For the security analyst or investor, the anticipated economic
forecast, is important for making decisions concerning both
the timings of an investment and the relative investment
desirability among the various industries in the economy.
 The success of the economy will ultimately include the
success of the overall market.
 For studying the Economic Analysis, the Macro Economic
Factors and the Forecasting Techniques are studied in
following paragraphs.

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.
 It is indicator of economic growth.
 It consists of:-
personal consumption expenditure,
gross private domestic investment,
government expenditure on goods and services and
net export of goods and services.
 Generally, GDP growth rate ranges from 6-8 percent.
 The higher the growth rate of GDP, other things being equal,
the more favorable it is for stock market.
2. Savings and investment:
 Growth of an economy requires proper amount of investments which in
turn is dependent upon amount of domestic savings.
 The amount of savings is favorably related to investment in a country.
 The level of investment in the economy and the proportion of
investment in capital market is major area of concern for investment
analysts.
The level of investment in the economy= Domestic savings + inflow
of foreign capital - investment made abroad.
3. Industry Growth rate:
 The GDP growth rate represents the average of the growth rate of
agricultural sector, industrial sector and the service sector.
 The current contribution of industry sector in GDP in the year 2004-05
is 6.75 percent approximately.
 The stock market analysts focus on the overall growth of different
industries contributing in economic development.
4. Price level and Inflation:
 If the inflation rate increases, the growth rate would be
very little.

 The increasing of inflation rate significantly affect the

demand of consumer product industry.

 The industry which have a weak market and come

under the purview of price control policy of the
government may lose the market, like sugar industry.

 On the other hand the industry which enjoy a strong

market for their product and which do not come under
purview of price control may benefit from inflation.
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.

6. Interest Rate:
 Interest rates vary with maturity, default risk, inflation
rate, productivity of capital etc.
 The interest rate on money market instruments like
Treasury Bills are low, long dated government securities
carry slightly higher interest rate and interest rate on
corporate debenture is still higher.
Conti--

 With the deregulation interest rates are softened, which

were quite high in regulated environment.
 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.
7. Government budget and deficit:
 Government plays an important role in the growth of any
economy.
 The government prepares a central budget which provides
complete information on revenue, expenditure and deficit
of the government for a given period.
Conti--
 Government revenue come from various direct and indirect
taxes and government made expenditure on various
developmental activities.
 The excess of expenditure over revenue leads to budget
deficit.
 For financing the deficit the government goes for external
and internal borrowings.

8. The tax structure:

 The business community eagerly awaits the government
announcements regarding the tax policy in March every
year.
 The type of tax exemption has impact on the profitability of
the industries.
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 which is a
measure of strength of birr on external account .
 This difference in receipt and payment may be surplus or
deficit.
 The surplus balance of payment augments forex reserves of
the country and if deficit increases, the forex reserve
depletes and has an adverse impact on the exchange rates.
10. Infrastructural facilities and arrangements:
 Infrastructure facilities and arrangements play an important
role in growth of industry and agriculture sector.
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.

12. Sentiments:
 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.
2. Industry Analysis
 It is worthwhile for a security analyst to pinpoint growth
of industry, which has good investment prospects.
 The past performance of an industry is not a good
predictor of the future- if one look very far into the
future.
 For an industry analyst- industry life cycle analysis,
characteristics and classification of industry is
important.
A. Industry Life Cycle Analysis: Many industrial
economists believe that the development of almost
every industry may be analyzed in terms of following
stages.
 1. Pioneering stage:

During this stage:

the technology and product is relatively new.
The prospective demand for the product is promising in this
industry.
The demand for the product attracts many producers.
This lead to severe competition and only fittest companies
survive in this stage.
The severe competition often leads to change of position of the
firms in terms of market share and profit.
2. Rapid growth stage:
 This stage starts with the appearance of surviving firms from the
pioneering stage.
 The companies that beat the competition grow strongly in sales,
market share and financial performance.
Conti--
 The improved technology of production leads to low cost and
good quality of products.
3. Maturity and stabilization stage:
 After enjoying above-average growth, the industry now enters in
maturity and stabilization stage.
 The symptoms of technology obsolescence may appear.
 A close monitoring at industries events are necessary at this stage.
4. Decline stage:
 The industry enters the growth stage with satiation of demand,
encroachment of new products, and change in consumer
preferences.
 At this stage the earnings of the industry are started declining, the
growth of industry is low even in boom period and decline at a
higher rate during recession.
B. Classification of Industry
 Industry means a group of productive or profit making
enterprises or organizations that have a similar technically
substitute goods, services or source of income.
 These are classified as follows:
1. Growth Industries: These industries have special features of
high rate of earnings and growth in expansion, independent of
the business cycle. Example: electronics, computers, cellular
phones, engineering, petro-chemicals, telecommunication,
energy etc.
2. Cyclical Industries: The growth and profitability of the
industry move along with the business cycle. For example-
Fast Moving Consumer Goods (FMCG) commands a good
market in the boom period and demand for them slackens
during the recession.
Conti---
3. Defensive Industries: These are industries that have little
sensitivity to the business cycle.
 such as the food processing industry, which hurt least in the
period of economic downswing.
 For example- the industries selling necessities of
consumers withstands recession and depression.
4. Cyclical-growth Industries: These possess characteristics of
both a cyclical industry and a growth industry.
 For example, the automobile industry experiences period of
stagnation, decline but they grow tremendously.
3. Company Analysis and Stock Valuation
 Company analysis should occur in the context of the
prevailing economic and industry conditions.

 “Company Analysis and Stock Valuation” to convey the idea

that the common stocks of good companies are not necessarily
good investments.

 The stock of a wonderful firm with superior management and

strong performance measured by sales and earnings growth
can be priced so high that the intrinsic value of the stock is
below its current market price and should not be acquired.
Growth Companies and Growth Stocks
 Observers have historically defined growth companies as those that
consistently experience above-average increases in sales and
earnings.

 Financial theorists define a growth company as a firm with the

management ability and the opportunities to make investments that
yield rates of return greater than the firm’s required rate of return.

 This required rate of return is the firm’s weighted average cost of

capital (WACC).

 Growth stocks are not necessarily shares in growth companies.

 A growth stock is a stock with a higher rate of return than other

stocks in the market with similar risk characteristics.
Speculative Companies and Stocks
 Speculative Companies is one whose assets involve great risk
but also has a possibility of great gain.
 A good example of a speculative firm is one involved In oil
exploration.
 A speculative stock possesses a high probability of low or
negative rates of return and a low probability of normal or high
rates of return.
Value versus Growth Investing
 Some analysts also divide stocks into “growth” stocks and
“value” stocks.
 Value stocks are those that appear to be undervalued for
reasons other than earnings growth potential.
 Value stocks are usually identified by analysts as having low
price-earning or price-book value ratios.
3.3 Technical Analysis
Underlying assumptions of technical analysis
 Technical analysts base trading decisions on examinations of
prior price and volume data to determine past market trends
from which they predict future behavior for the market.
 Several assumptions lead to this view of price movements:
1) The market value of any good or service is determined solely by the
interaction of supply and demand.
2) Supply and demand is governed by numerous rational and irrational
factors. Included economic variables relied on by the fundamental
analyst opinions, moods, and guesses.
3) Disregarding minor fluctuations, the prices for individual securities
and the overall value of the market tend to move in trends, for
appreciable lengths of time.
4) Prevailing trends change in reaction to shifts in supply and demand
relationships.
THE END