Chapter 4

Security Analysis
Introduction
Generally all securities are associated with risks. The actual return an investor receives from the
securities is related to the risk. So, it becomes necessary for investor to analyze the securities
from the view point of their prices, returns and risks. Therefore,
 The aim of the analysis is to determine what stock to buy and at what price.
 Security analysis comprises of an examination and evaluation of the various factors affecting
the value of a security.
 This analysis is useful in understanding the fluctuations of prices of securities and the
behavior pattern of the market before one decide to invest in securities.
 There are two basic analysis methods; i.e. fundamental analysis and technical analysis
 Investors can use any or all of these different but somewhat complementary methods for
stock picking.
 For example many fundamental investors use technical for deciding entry and exit points.
 Many technical investors use fundamentals to limit their universe of possible stock to 'good'
companies.
 The choice of stock analysis is determined by the investor's belief in the different paradigms
for "how the stock market works".

Fundamental analysis is the cornerstone of investing. In fact, some would say that you are not
really investing if you aren't performing fundamental analysis. Because the subject is so broad,
however, it's tough to know where to start. There are an endless number of investment strategies
that are very different from each other, yet almost all use the fundamentals. Fundamental
analysis maintains that markets may misprice a security in the short run but that the "correct"
price will eventually be reached. Profits can be made by trading the mispriced security and then
waiting for the market to recognize its "mistake" and re-price the security.
Technical analysis maintains that all information is reflected already in the stock price. It
considers the trends that are your friend' and sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to recognizable price chart
patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions
are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for stock
picking. For example many fundamental investors use technical for deciding entry and exit
points. Many technical investors use fundamentals to limit their universe of possible stock to
'good' companies. The choice of stock analysis is determined by the investor's belief in the
different paradigms for "how the stock market works".
6.1 Types of Security Analysis
Security analysis can be broadly classified into two types: Fundamental analysis and Technical
analysis.
I. Approaches to Fundamental Analysis

There are two basic approaches followed in fundamental analysis. The first approach is the ‘Top
down Approach' also known as the 'Economy-Industry-Company Approach' (E-I-C approach). The
second is the 'Bottom up Approach' or the 'Company - Industry - Economy Approach (C-I-E
approach)'. In the E-I-C approach, we start with the economy to identify the trends and make an
estimate of the economic parameters. Based on this, we identify the industries which are promising
and then zero in on the companies for investing. In the C-I-E approach, we start with a shortlist of
companies which are promising and then analyze these with reference to the trends in the respective
industry and economy. This approach requires a good understanding of the market in order to start
with a short list of companies that are promising.

 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.
 It is the method of evaluating the securities by attempting to measure intrinsic value of a particular
stock. At company level, it involves examination of financial data, management, business
concept and competition.
 At industry level, there is examination of demand and supply forces of products offered.
 For national economy, fundamental analysis focuses on economic data to assess present and
future growth of economy and its effect on stock market.
Fundamental analysis includes three kinds of analysis:
 (a) Economy analysis
(b) Industry analysis
(c) Company analysis
This can be presented diagrammatically as follows:

 The intrinsic value of a security is defined as the present value of all future cash payments to be
Figure 2.1. Fundamental Analysis

paid on the security to the investor.

 The cash payment to the investor may be in the form of dividends, interest, liquidation proceeds
or repayment of the principal amount.

 The intrinsic value of a stock is estimated by discounting the company's prospective earnings
stream or the shareholder's prospective dividend stream.

 In order to estimate the intrinsic value of security, we need to forecast the earnings and dividends
on the security.

 The intrinsic value is that value which is justified by the facts, e.g. assets, earnings, dividend,
definite prospects including the factor of management.

 Fundamental analysis focuses on valuation and the estimation of intrinsic value of a security.

 The objective is to estimate what ought to be price based on the intrinsic value of the security.
This is used to identify the under-priced and over-priced securities in the market.
 These depend on the economic and industrial environment, relative importance of the company
within its industry, the company's financial strength, its policies, quality of assets and
management.

 Investors using this approach hold a large number of undervalued stocks in their portfolio with the
hope that, on average, these portfolios will do better than the market.

 The basic approach followed in fundamental analysis is to estimate the intrinsic value of the
security. A firm is a part of an industry which is a component of the economy. Thus, the status and
trends in the economy have a bearing on the performance of the firm.

 The fundamental analysts seek to establish relationships between economic, industrial and
company indicators with a view to forecast the earnings and dividends of the company.

A. Economy Analysis

 Companies are a part of industrial and business sector which in turn is a part of overall economy.
Thus, performance of a company depends on performance of economy as a whole. If the economy
is in recession or stagnation, ceteris paribus, the performance of company will be bad in general.
On the other hand, if economy is booming, companies may be prosperous. From this, we can
understand the importance of studying the forces operating in the overall economy, as well as
influences peculiar to industries while estimating stock price changes.

 The objective of economic analysis is to study the impact of important macroeconomic factors on
the stock market as well as to study the trends of these factors.

 The important macroeconomic indicators that influence stock market are as follows:

 GDP growth
 Gross domestic product (GDP) is a measure of the total production of final goods and services in
the economy during a specified period of time.
 It is the important indicator of the performance of economy of the country.
 It represents the average of the growth rates of three important sectors of the economy i.e. service
sector, industrial sector and agricultural sector.
 The higher the growth rate of GDP, the more it is favorable for the stock market.
 Trends in public investment and savings
 The investment level in the economy is addition of domestic savings and inflow of foreign capital
minus investments made abroad.
 The higher the level of savings and investment, and the greater the allocation of same to equities,
the more it is favorable for the stock market.

 Interest rates
 Interest rates affect the present value of future cash flows – high interest rates reduce the
attractiveness of investment opportunities, and low interest rates increase the appeal of investment
opportunities.
 A low interest rate environment is aimed at promoting business investment expenditures and,
subsequently, higher growth rates.
 Mortgage payments and high-priced consumer durable goods such as automobiles are also
sensitive to interest-rate movements. When interest rates are high, consumers spend less.

 Inflation
 The effect of inflation on the corporate sector tends to be uneven. While certain industries may
benefit, others may suffer.
 Inflation also affects the real value of the equity shares. Therefore, the real growth of GNP
without inflation is always favorable and desirable.

 Employment
 The unemployment rate is the percentage of the labor force that is actively looking for work.
 The unemployment rate measures the level to which an economy is operating at full capacity.
 A rising unemployment figure can point to a slowdown in the economy.

 Budget deficit
 The budget deficit of a government is the difference between government expenditure and
government revenues.
 Shortfalls in the budget must be offset by government borrowing.
 If government borrowing is excessive, interest rates may be forced to go up and total demand for
credit in the economy will increase.
 Higher interest rates are negative for business investment and, consequently, company growths.

 Current account deficit

The current account is the difference between imports and exports, including merchandise, services,
and transfers such as foreign aid. If the current account shows a deficit, this means that the country
imports more than it exports; a surplus indicates that the country exports more than it imports. Current
account deficits have to be funded somehow. Sometimes, foreign direct investment into a country will
offset a current account deficit, or high interest rates may attract capital flow into a country. The level
of the current account is affected by changes in the exchange rate. If a currency depreciates exports
may increase, as it becomes less costly for foreigners to purchase domestically produced goods.

 Exchange rates
 The exchange rate is the rate at which domestic currency can be converted into foreign currency.
 Movements in exchange rates can affect the international competitiveness of domestically
produced products. Sharp currency devaluation can lead to a rise in exports. Exchange rates can
also have an effect on inflation rates.
 Depreciation of a currency increases the cost of imported goods, which results in an increase in
local prices and consequently, the inflation rate.

 Government policy
The government uses the tools of fiscal policy and monetary policy to promote GDP growth, regulate
employment levels, and stabilize prices. These policies are described below.
a) Fiscal policy
Fiscal policy refers to the taxation and spending policies of the government designed to calibrate the
economy. Government can stimulate growth in real GDP by creating tax incentives for investment.
Likewise, increases in general tax rates immediately divert income from consumers and result in
decreases in consumption. Decreases in government spending reduce the demand for goods and
services. Fiscal policy is a direct way to stimulate or slow down an economy. One way to examine the
net impact of a fiscal policy is to look at the government’s budget deficit. If a large deficit is present,
this means the government is spending more than it is taking in by the way of taxes. The net effect
will be an increase in the demand for goods (through spending) by more than it reduces the demand
for goods (through taxes). As a result, the economy will experience a push towards growth. Bud dfget
deficits are, however, associated with increased interest rates.

b) Monetary policy
Monetary policy refers to actions taken by a central bank to control interest rates and the money
supply (the supply of money in the economy). Increases in the money supply lower short-term interest
rates, subsequently encouraging investment and consumption demand. Over a longer period of time,
however, many economists believe that a higher money supply will lead only to higher prices and
inflation, and will not have a permanent effect on economic growth levels. Tools that the central bank
has at its disposal include: buying and selling bonds for its own account to increase or decrease the
money supply in the system; the interest rate charged to banks on short-term loans; and reserve
requirements dealing with the amount of deposits that banks must hold as cash on hand or as deposits
with the central bank. The ability of a central bank to maintain stable prices and interest rates whilst
stimulating growth and maintaining a high level of employment is essential for providing an
environment conducive to running profitable businesses.

 Infrastructural facilities and arrangements

The infrastructural bottlenecks have always been a hurdle for the industries in Ethiopia. The facilities
such as electricity and water supply, transportation facilities, telecommunication systems, assured
supply of basic raw-material to the industry affects the performance of industries and thereby affect
stock market as well.

B. Industry Analysis
The performance of any company depends 50% on the factors of economy and remaining 50% on the
factors of industry in which company operates. At any point of time, there may be industries which
are on upswing of the cycle called as sunshine industries and those which are on the decline called
sunset industries. Industry analysis takes into account three important aspects:

1) Industry life cycle analysis

Every industry goes through a life cycle with four distant phases, though the duration of each of the
stages may be different for different industries. The development of any industry may be analyzed in
terms of its life cycle phases. These phases are:
a) Pioneering stage is a period of slow sales growth as the product is introduced in
the market. Profits are non-existent in this stage because of the heavy expenses
incurred with product introduction.
b) Expansion (growth) stage is a period of rapid market acceptance and substantial
profit improvement.
c) Stagnation (mature) stage is a period of slowdown in sales growth because the
product has achieved acceptance by most potential buyers. Profits stabilize or
decline because of increased competition.
d) Decline stage is the period when sales show a downward drift and profits erode.

For an investor, it is prudent to invest in an industry that is in the growth stage. While an industry in
the pioneering stage could be promising, an investor should exercise caution because many of the
companies may not survive this stage. When an industry enters the maturity stage, it is advisable to
moderate one's investment and disinvest from industries which are entering the decline stage.

2) Analysis of the structure and characteristics of industry

Every industry is one of its kind having distinct characteristics and features. Detailed analysis of
these helps in correct decision making and proper security analysis. These include following factors:

a) Product line - The position of the industry in its various life cycle stages should be noted. It is
also necessary to know the industries with high growth potential like computers, electronics,
chemicals, etc. and whether industry is in priority. Product may be new one or an import
substitution product which has a good fortune.
b) Raw (material and other inputs) - Under this head, we have to look for the
industries depending on import of scarce raw-materials, import and export restrictions,
scarcity of other inputs, etc. Industries which has limited supply of raw -material domestically
and where imports are restricted have dim growth prospects. Labor and other input problems
also serve as an obstacle in growth.
c) Nature of demand - Whether the industry is cyclical, fluctuating or stable has to be looked
into. If the demand for the product is seasonal then it leads to problems in growth. The
 demand for the product should be expanding and its price should not be controlled by
government. Thus, nature of demand for the product and industry is an important factor that
determines the scope of operations and profitability.
d) Permanence – permanence, which is a phenomenon related to the products and
technology of the industry and relative permanence is an important factor to be considered. If
the need for the particular industry is likely to vanish in an extremely short period of time, it would
not be wise investing in this industry. In this age of rapid technological advance, the degree
of permanence of an industry is an important aspect in industry analysis.
e) Labor conditions - The labor conditions in an industry can play an important part in
industry analysis. Healthy labor conditions in an industry can lead to higher productivity
levels and better utilization of assets. If the labor is highly unionized and the industrial
relations climate is not healthy, it can have a negative impact on the industry.
f) Past sales and earnings performance - The two important factors that determine
the success of any firm are sales and earnings. Therefore, in order to get a perspective about
the future, the starting point is the historical performance of sales and earnings. If the
industry has a short history, it indicates that the industry has not proved its ability to
weather a variety of economic growth prospects. Investment in such an industry would
demand an element of caution. The historical record of industry is useful for calculating the
average levels and growth rates for sales and earnings. Though
the past performance may not repeat in the future, it is useful, in order to make estimates of
the future trends. An important factor that determines the earnings performance of an
industry is the cost structure. We need to know whether the industry is investment
intensive, raw material intensive or labor intensive. If it is investment intensive, the fixed
costs are likely to be higher and the breakeven levels of sales will also be higher.
g) Attitude of government towards industry - Policies of the government and the
attitude of the Government towards an industry can have considerable influence on the
industry. If the government feels that the domestic industry needs protection it can impose
restrictive import quotas or tariffs that would assist the domestic industry. On the other hand
if the government feels that the domestic industry is well developed and does not need
protection, it can remove barriers and thus encourage foreign competition. Besides,
government can assist selected industries through favorable tax legislation.
3) Analysis of competitive conditions and the influence on industry attractiveness: Porter’s
Model
Competitive conditions in an industry dictate the price levels and profitability levels in an industry.
The analysis of competitive conditions and the influence on industry attractiveness can be done with
the help of Porter's model. Michael Porter identified five forces that determine the intrinsic long-run
profit attractiveness of a market or market segment i.e. industry competitors, potential entrants,
substitutes, bargaining power of buyers and suppliers. Porter’s five forces of competition
framework can be depicted as shown in the following figure

Figure: 2.2. Porter’s five.

The detailed description of these forces is as under:

(a) Industry competitors - A segment is unattractive if it contains numerous, strong or

aggressive competitors. It is even more unattractive if the segment is stable or declining, if
plant capacity additions are done in large increments, if fixed costs are high, if exit barriers
are high, or if competitors have high stakes in staying in the segment. These conditions will
lead to frequent price wars, advertising battles, and new product introductions and will make
it expensive to compete.

(b) Potential entrants - A segment's attractiveness varies with the height of its
 entry and exit barriers. The most attractive segment is one in which entry barriers are high
and exit barriers are low. Few new firms can enter the industry, and poor-performing firms
can easily exit. When both entry and exit barriers are high, profit potential is high, but firms
face more risk because poorer-performing firms stay in and fight it out. When entry and exit
barriers are both low, firms easily enter and leave the industry, and the returns are stable and
low. The worst case is when entry barriers are low, and exit barriers are high. Here, firms
enter during good times but find it hard to leave during bad times. The result is chronic over
capacity and depressed earnings.
(c) Substitutes - A segment is unattractive when there are actual or potential
substitutes for the product. Substitutes place a limit on prices and on the profits that a
segment can earn. If technology advances or competition increases in these substitute
industries, prices and profits in the segment are likely to fall.
(d) Bargaining power of the buyers - A segment is unattractive if the buyers
possess strong or growing bargaining power. Buyers will try to force prices down, demand
more quality or services and set competitors against each other, all at the expense of seller
profitability. Buyers' bargaining power grows when they become more concentrated or
organized, when the product represents a significant fraction of the buyer's costs, when the
product is undifferentiated, when the buyers' switching costs are low, when buyers are price
sensitive because of low profits, or when buyers can integrate upstream.
(e) Bargaining power of the suppliers - A segment is unattractive if the company's suppliers
are able to raise prices or reduce quantity supplied. Suppliers tend to be powerful when they
are concentrated or organized, when there are few substitutes, when the supplied product is
an important input, when the cost of switching suppliers are high, and when the suppliers can
integrate downstream.
C. Company Analysis
Having completed the economic analysis and industry analysis, the next step is to carry out an
analysis of the companies in the identified industry. The specific market and economic
environment may enhance the performance of the company for a period of time but ultimately it
is the firm's own capabilities that will judge its performance in the long run. For this reason, the
firms in the same industry are to be compared with one another to find out the best performer.
The following factors are significant to company analysis:
(1) Marketing policies
This is most important variable; it influences future earnings in terms of both quality and
quantity. This in turn is determined by the share of the company in the industry, growth of its
sales. Strong competitive position will provide greater earnings with more certainty then a
company with poor competitive position.
(2) Accounting policies
There is a risk of faulty interpretation of the corporate earnings and consequently wrong decision
making. The accounting variations in the reporting costs, expenses and extraordinary items could
change earnings to a greater extent, the accounting policies related to inventory pricing methods,
depreciation methods, non-operating income, tax carry over affect company to greater extent and
should be critically examined.
(3) Profitability
When we put a security we are buying the right to future earnings. We are interested in income
stability and growth of these earnings. To study relationship between expense and sales, one
need to study trends of profitability ratios namely gross profit margin, net profit margin, earning
per share, etc.
(4) Dividend policy
It is observed that management tries to maintain stable dividend policy with increased dividends.
This is possible only when a company expects increased rate of earnings in future.
(5) Capital structure
Capital structure of the company is to be studied before making an investment in that company.
Return on equity holder's investment can be magnified by using debt financing along with equity
instead of equity financing only. The mixing of fixed cost of funds such as debt and preference
capital maximizes earnings available to shareholders and hence should be carefully examined.
(6) Management
The company capability depends on the efficiency of its management. The functions of
management are to plan, organize, control and co -ordinate activities of the company to achieve
desired results. Therefore, it is necessary to judge the ability of management. The ability of
management is judged by:
 Ability to maintain competitiveness of the firm.
 Ability to work with employees and union.
  Ability to finance company when required and maintain efficient production.
 Ability to maintain profits margins and cut down costs.
 Ability to expand firm's activities.
(7) Financial statement analysis
It is the process of analyzing financial strengths and weaknesses of the company through various
techniques. Financial statement analysis may be done: as ratio analysis and trend analysis. The
former type includes internal and external analysis and the later type includes horizontal and
vertical analysis. There are various tools of financial statement analysis which are as follows:
(a) Ratio Analysis
Financial ratio analysis is one of the important tools used for analyzing financial statements. It
helps in analysis of the financial statements with the help of ratios. Based on the specific
characteristics being highlighted, ratios are categorized into:
 Liquidity Ratio - Liquidity ratio tell us about the ability of a firm to meet its short term
financial obligations. It includes Current ratio, Acid-test ratio or Quick ratio and Cash ratio.
 Leverage Ratios - A firm uses a combination of equity and debt for financing its assets.
Leverage ratios help us in assessing the risk arising from the use of debt capital. Leverage
ratios include Debt equity ratio, Interest coverage ratio and debt service coverage ratio.
 Turnover Ratios - Turnover Ratios help us to measure the efficiency of utilization of the
assets of a firm. These are also called activity ratios or asset management ratios. It includes
Inventory turnover ratio, Debtors turnover ratio, fixed asset turnover, Total asset turnover
and Creditors asset turnover.
 Profitability Ratios - Profitability ratios can be of two types. The first one is the ratio
between profit and sales. The second type is the ratio between profit and investments. These
are called rate of return measures. It includes Gross profit ratio, Net profit ratio, Return on
equity ratio, Return on capital employed ratio and Return on asset ratio. Gross Profit Margin
ratio indicates the margin available after meeting the manufacturing expenses. It is a measure
of the efficiency of production and the price realization.
 Market Value Ratios - Valuation Ratios are measures of how the equity stock of the
company is assessed in the capital market. The widely used market value ratios are Price-
Earnings Ratio and Market Value to Book Value Ratio.
For detail discussion of these ratios please refer your Financial Management handout.

(b) Trend Analysis

In addition to analyzing the ratios for a given year, it is useful to look at the trend of different
ratios for a number of years. This gives an idea about the areas where there is a favorable trend
or improvement and areas where there may not be an improvement. This can be in either of the
following methods:
c. Index Analysis
Considering the various elements of a Balance Sheet and Profit and Loss Statement during a
particular year as a base we can find out the respective values during different years relative to
the base year. This gives an indication of growth or decline in values over the duration of study.
d. Common size Analysis
Common size analysis is useful for comparing the financial statements of different firms of
varying sizes. The different elements of Income Statement are computed relative to Net Sales
considering the value of Net Sales as 100. Similarly, the Balance Sheet figures are computed
relative to the Total Assets considering the value of Total Assets as 100.

II. Technical Analysis

A technical analyst believes that share prices are determined by the demand and supply forces
operating in the market. These demand and supply forces in turn are influenced by a number of
fundamental forces as well as certain psychological or emotional factors. Many of these forces cannot
be quantified. The combined impact of all these factors is reflected in the share price movements. A
technical analysis therefore concentrates on the movement of share prices. This analysis is the name
given to forecasting techniques that utilize historical share price data. The rationale behind technical
analysis is that share price behavior repeats itself over time and analysts attempt to derive methods to
predict this repetition. The analyst looks at the past share price data to see if he can establish any
patterns. Thus, extrapolations can be made to predict the future price movements.

The basic premise of technical analysis is that prices move in trends or waves which may be upward
or downward. It is believed that the present trend are influenced by the past trends and the projection
of future trends is possible by an analysis of past price trends. Therefore it analyzes the price and
volume movements of individual securities as well as the market index.

BASIC PRINCIPLES OF TECHNICAL ANALYSIS

1) The market value of a security is related to demand and supply factors operating in the market.
2) There are both rational and irrational factors which surround the supply and demand factors of
a security.
3) Security prices behave in a manner that their movement is continuous in a particular direction
for some length of time.
4) Trends in stock prices have been seen to change when there is a shift in the demand and
supply.
5) The shifts in demand and supply can be detected though charts prepared specially to show
market action’
6) Patterns which are projected by charts record price movements and these recorded patterns are
used by analysts to make forecasts about the movement of prices in future.

Technical Analysis vs. Fundamental Analysis

Fundamental analyst tries to estimate the intrinsic value of a security by evaluating the fundamental
factors affecting the macro economy, industry and company. This is a tedious process and takes a
rather long time to complete the process.

Technical analysis studies the price and volume movements in the market and by carefully examining
the pattern of these movements, the future price of the stock is predicted. Since the whole process
involves much less time and data analysis, compared to fundamental analysis, it facilitates timely
decision.

Fundamental analysis helps in identifying undervalued or overvalued securities. But technical analysis
helps in identifying the best timing of an investment, i.e. the best time to buy or sell a security
identified by fundamental analysis as undervalued or overvalued. Thus, technical analysis may be
used as a supplement to fundamental analysis rather than as a substitute to it. The two approaches
however, differ in terms of their databases and tools of analysis. Fundamental analysis and technical
analysis are two alternatives approaches to predicting stock price behavior. Neither of them is perfect
nor complete by itself.

Technical analysis has several limitations. It is not an accurate method of analysis. It is often difficult
to identify the patterns underlying stock price movements. Moreover, it is not easy to interpreter the
meaning of patterns and their likely impact on future price movements.