Investment Analysis and Portfolio

Management
Chapter Five

Security Analysis the

5.1. The Role of Investment Analysis
analysis of tradable

financial instruments

Finding the proper value of individual securities

 A great deal of information is available when making an investment decision.

 There is market and economic data, stock charts, industry and company characteristics,
and a wealth of financial statistical data. The amount of this information can be
overwhelming and, at the same time, can add clarity and perspective to the investment-
making process.

 For investors and advisors, there are different branches of analysis which helps to
organize the information. Some analysis focuses relatively narrowly on companies
themselves, while some looks more broadly, using an international and market
perspective.

 Our focus here is to gain a better understanding of how analysts use the information
available to value a security and make a recommendation on its purchase or sale.

 An advisor or investor considering an investment based on an analyst’s interpretation of

these techniques, or on their own analysis, must have a clear understanding of what the
techniques measure, how they are determined, and how they are interpreted.

5.2. Market Theories

Three theories have been developed to explain the behavior of stock markets. The following table
describes these theories and their unique assumptions and conclusions.

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Stock market theories

Table 2.1 stock market theories

 The efficient market hypothesis, the random walk theory and the rational expectations
hypothesis all suggest that stock markets are efficient.
 This means that at any time, a stock’s price is the best available estimate of its true value.
Many studies have been conducted to test these theories. Some evidence supports the
theories, while other theories support market inefficiencies.
 Since stock markets are often inefficient, a better understanding of how macroeconomic
factors, industry factors, and company factors influence stock valuation should lead to
better investment results.
 These three factors all help to determine changes in interest rates and in the actual or

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expected profitability of companies. In the following section we examine some pricing
models based on these factors.

5.3. The Methods of Investment Analysis

5.3.1. Fundamental Analysis

 Fundamental analysis involves assessing the short, medium- and long-range prospects
of different industries and companies.
 It involves studying capital market conditions and the outlook for the national economy

1. The top-down approach (also called three-step approach) is a process by which one
examines a particular investment opportunity.

 First, one examines the general economy, then a particular industry and, finally,
individual firms within a particular industry. It assumes that both economy/market
and the industry have a substantial impact on individual stocks.

2. bottom-up approach analyzes the individual companies to find undervalued stocks,

regardless of the economy/market and the industry.

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 fundamental analysis means studying everything, other than the trading on the
securities markets, which can have an effect on a security’s value: macroeconomic
factors, industry conditions, individual company financial conditions, and qualitative
factors such as management performance. By far the most important single factor
affecting the price of a corporate security is the actual or expected profitability of the
issuer.

I. Fundamental Market/Macroeconomic Analysis

 Sudden unpredictable events can affect – favorably or unfavorably – the country’s

economy and the prices of its securities. Such events include international crises such as
war, unexpected election results, regulatory changes, technological innovation, debt
defaults, and dramatic changes in the prices of important agricultural, metal and energy
commodities.
 Many commodity price swings can be predicted by examining supply/demand conditions.
Other price changes may not be easy to predict because they depend on price-setting
agreements or on the action of cartels such as the Organization of the Petroleum
Exporting Countries (OPEC), which sets oil prices.

 Many factors affect investor expectations and therefore play a part in determining the
price of securities. These factors:

a. The Fiscal Policy Impact

The two most important tools of fiscal policy are levels of government expenditures and
taxation. They are important to market participants because they affect overall economic
performance and influence the profitability of individual industries. They are usually disclosed in

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federal and provincial budgets.

Tax Changes: By changing tax levels, governments can alter the spending power of individuals
and businesses

Government Spending: Governments can affect aggregate spending in the economy by

increasing or decreasing their own spending on goods, services and capital programs.
Government Debt: The main problem with a large government debt is that it restricts both fiscal
and monetary policy options. Fiscal and monetary policy choices affect the general level of
interest rates, the rate of economic growth and the rate of corporate profit growth, and all of them
affect the valuation of stocks. With high levels of government and consumer indebtedness, the
government’s ability to reduce taxes or increase government spending is impaired.
b. The Monetary Policy Impact
It is the responsibility of the central bank to maintain the external value of the country’s currency
and encourage real, sustainable economic growth by keeping inflation low, stable and
predictable.

c. The Flow of Funds Impact

The flow of funds is important to stock valuation. These shifts are caused largely by changes in
interest rate levels.

d. The Inflation Impact

Inflation creates widespread uncertainty and lack of confidence in the future. These factors tend
to result in higher interest rates, lower corporate profits, and lower price-earnings multiples.

Inflation also means higher inventory and labor costs for manufacturers.

II. Fundamental Industry Analysis

Classifying Industries by Stage of Growth

a. Emerging Growth Industries

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New products or services are being developed at all times to meet society’s needs and demands. t

b. Growth Industries

A growth industry is one in which sales and earnings are consistently expanding at a faster rate
than most other industries. A growth company should have an above-average rate of earnings on
invested capital over a period of several years.

c. Mature Industries

Industry maturity is characterized by a dramatic slowing of growth to a rate that more closely
matches the overall rate of economic growth. Therefore, price competition increases, profit
margins usually fall, and companies may expand into new businesses with better prospects for
growth.

Mature industries usually experience slower, more stable growth rates in sales and earnings.

d. Declining Industries

As industries move from the mature/stable to the declining stage, they tend to stop growing and
begin to decline.

III. Fundamental Company Analysis

The analysis of a company requires looking closely at the company’s financial history and recent
events, with a goal of assessing the future prospects of the company. The types of information
that an analyst must gather include:

 Financial statement data and related disclosures;

 Major news items in recent years;
 Position and market share in industry;
 International investment;
 Where the company is in its life cycle (i.e. high growth/developmental, maturing,
declining);
 Contributions of major product, divisions, or subsidiaries to the company’s performance;

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 Research and development efforts;
 Sensitivity of company to commodity prices (e.g., oil); and
 Major litigation.

Analyzing a Company’s profitability

Profitability can generally be described as how well a company can get a return on the
investments they make. If a company is bringing in more revenue than it costs to create those
revenues, then a company can be called profitable.

Thus, we have three groups of profitability ratios. These are listed below.

1. Profitability related to sales

a) Gross Profit (Sales−Cost of goods sold)

Gross profit margin = Sales

b) Operating margin = EBIT

Sales

c) Earnings after tax(EAT)

Net profit margin = Sales

2. Profitability Related to Investment

a) Return on assets = Earnings after tax

Total assets

EBIT
b) Return on capital employed =
Total capital employed

c) Earnings after tax (EAT)

Return on equity= shareholders′eaquity

3. Profitability related to equity shares (EPS)

a) Net profit available to equity shareholders

Earnings per share = number of equity shares

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b) Earnings yield= EPS
Market price pershare

c) Dividend per share(DPS)

Dividend yield = Market price per share

d) Dividend payout ratio=DPS

EPS

e) Price earnings ratio(P/E ratio)=Market price per share

EPS

4. Overall profitability (or earning power)

EAT
a) Return on investment =
Sales Sales EAT
x Total assets or Total assets

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The overall profitability is measured by the return on investment, which is the product of net
profit ratio and investment turn over. It is a central measure of the earning power of or operating
efficiency of a company.

2.1.1. Technical Analysis

Technical analysis is the process of analyzing historical market action in an effort to determine
probable future price trends.

Technical analysis is based on three assumptions:

 All influences on market action are automatically accounted for or discounted in price
activity.
 Prices move in trends and those trends tend to continue for relatively long periods of time.
 The future repeats the past. Technical analysis is the process of analyzing an asset’s historical
prices in an effort to determine probable future prices. Technicians believe that markets
essentially reflect investor psychology and that the behavior of investors tends to repeat
itself. Even if history does not repeat itself exactly, technical analysts believe that they can
learn a lot from the past.

Commonly Used Tools in Technical Analysis

The four main methods used by a technical analyst to identify trends and possible trend turning
points are chart analysis, quantitative analysis, analysis of sentiment indicators and cycle
analysis. They are often used in conjunction with one another.

A. Chart analysis

It is the use of graphic representations of relevant data.

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B. Quantitative analysis

It is a form of technical analysis that has been greatly enhanced by the growing sophistication of
computers. statistical tools: moving averages

Table 2.2. Calculation of five-week moving average for a particular stock closing price.

An amount of $18.37 would be plotted on a chart at the end of Week Five.

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