Chapter Five

5. Security Analysis
5.1. Introduction

Deciding where to invest your money is not an easy task. One of the steps to simplify this is to
understand the many different approaches to stock investing.

Fundamental investing and technical investing are the two main schools of thought that have
emerged in the stock investing world. Which one is the best for you? And which style would be
the safest? These are some of the questions you should ask when trying to figure out which style
works best for you.

Traditional investment analysis, when applied to securities, emphasizes the projection of prices
and dividends. That is, the potential price of a firm’s common stock and the future dividend
stream are forecasted, then discounted back to the present. This intrinsic value is then compared
with the security’s current market price. If the current market price is below the intrinsic value, a
purchase is recommended, and if vice versa is the case sale is recommended.
Although modern security analysis is deeply rooted in the fundamental concepts just outlined,
the emphasis has shifted. The more modern approach to common stock analysis emphasizes
return and risk estimates rather than mere price and dividend estimates.
Security Analysis: is an examination of expected returns and accompanying risks and involves:
1. Technical analysis
2. Fundamental analysis

5.2. What is technical analysis?

Technical analysis is the study of financial market action. The technician looks at price changes
that occur on a day-to-day or week-to-week basis or over any other constant time period
displayed in graphic form, called charts. Hence the name chart analysis.
A chartist analyzes price charts only, while the technical analyst studies technical indicators
derived from price changes in addition to the price charts.
Technical analysts examine the price action of the financial markets instead of the fundamental
factors that (seem to) effect market prices. Technicians believe that even if all relevant

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information of a particular market or stock was available, you still could not predict a precise
market "response" to that information. There are so many factors interacting at any one time that
it is easy for important ones to be ignored in favor of those that are considered as the "flavor of
the day."
The technical analyst believes that all the relevant market information is reflected (or discounted)
in the price with the exception of shocking news such as natural distasters or acts of God. These
factors, however, are discounted very quickly.
Watching financial markets, it becomes obvious that there are trends, momentum and patterns
that repeat over time, not exactly the same way but similar. Charts are self-similar as they show
the same fractal structure (a fractal is a tiny pattern; self-similar means the overall pattern is
made up of smaller versions of the same pattern) whether in stocks, commodities, currencies,
bonds. A chart is a mirror of the mood of the crowd and not of the fundamental factors. Thus,
technical analysis is the analysis of human mass psychology. Therefore, it is also called
behavioral finance.
This analysis method mainly uses bar chart and line chart of the past data.
Technical analysis is based on the belief that the market is not efficient.
Technical analysts use indicators that are independent of the company’s financial condition.
This technique is based on three assumptions:

1. Price reflects everything

The assumption here is that price reflects everything that has or could affect a company
including the fundamentals. Therefore a technical investor believes there’s no need to
assess these core factors individually.
2. History repeats itself
Investors tend to react similarly to certain situations. This psychology is what causes
repetition in the market.
3. Movement in Trends
Trend causes fluctuations in price. Once it’s set in motion, a trend is likely to continue in
the same upward or downward spiral.

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On the flip side of technical analysis, there are a couple of points to consider:

 By the time a trend is spotted, it might already be on its last legs, so the rewards might
not be much.
 The belief in the accuracy of patterns is what causes investors to react in a certain way, so
its trader psychology, rather than the value of stock, which creates a trend.
 Past price doesn’t necessarily impact future movement.

5.3. What is Fundamental Analysis?

Fundamental Analysis is the study of a company’s health and performance. Frequently,

accounting metrics such as Return on Assets, Sales and Valuations are used to conduct the
analysis.
Fundamental Analysis helps traders and investors identify likely trends in the long-term
performance of a company’s stock price. Long term planning may be enhanced by Fundamental
Analysis because of the possibility that stock prices could eventually reflect company health and
performance.

Fundamental analysts focus on the financial health of companies.

•Fundamental analysis chooses stocks to buy; technical analysis chooses when to buy for
analysts who use both. Proponents of strong form efficient market theory and technical analysts
are at opposite ends of the philosophical spectrum.
On the opposite side, a technical analyst subscribes to a completely different school of thought.
Here the focus is on two main factors – price and volume. The investor uses tools like charts and
indicators to spot market patterns which should, according to theory, re-occur. Better for short-
term traders, the goal here is to make a quicker rather than bigger buck.

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The fundamental school of thought appraises the intrinsic value of shares through this three main
factors.

o Macro economic Analysis

o Industry Analysis
o Company Analysis
2) Macro economic Analysis
 The level of economic activity has an impact on investment in many ways.
 If the economy grows rapidly, the industry can also expected to show rapid growth.
 Growth Rate of National Income (GDP Growth Rate)
 Savings and Investment environment (demand for securities)
 Inflation(consumer goods demand)
 Interest rates(cost of Financing)
 The tax structure
 Fiscal Policy: refers to government’s spending and tax actions.
 Monetary Policy: refers to the manipulation of the money supply to affect the macro
economy.
 Monetary policy works largely through its impact on interest rates.
 Money supply increase results to lower Interest rates, enhance investment and
demand(consumption) but with inflationary pressures


2) Industry Analysis
 Analyzing the industry in term of its elasticity to economic activities
o Cyclical industry - performance is positively related to economic activity
o Defensive industry - performance is insensitive to economic activity.
o Growth industry - characterized by rapid growth in sales, independent of the
business cycle
 Qualitative Issues under industry analysis
 Vulnerability to external shocks (foreign competition)
 Regulatory and tax conditions
 Competitive Structure

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 3) Company Analysis: Quantitative Issues
 We can make analysis in detail for companies by making financial ratio analysis and it
includes:
A. Liquidity ratio
B. Debt ratio
C. Profitability ratio
A. Liquidity ratio
 Measure ability to pay maturing obligations
 Current ratio = Current assets / current liabilities
 Quick ratio = (Current assets less inventories) / current liabilities
B. Debt ratio
 Measure extent to which firm uses debt to finance asset investment (risk attribute)
 Debt-equity ratio = Total long-term debt / total equity
 Total debt - total assets ratio = (Current liabilities + long-term debt) / total assets
C. Profitability ratio
 ROA = Net Profit / Total Assets
 ROE = Net Profit / Stockholder Equity
 Gross profit margin ( % ) = Gross profit / sales
Fundamental analysis versus technical analysis

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