CHAPTER FIVE SECURITY ANALYSIS Introduction Security analysis is

CHAPTER FIVE SECURITY ANALYSIS

Introduction • Security analysis is the means of determining the prices of shares. It follows three security analysis approaches: 1. Market efficiency hypothesis 2. Fundamental analysis and 3. Technical analysis The Efficient Market Hypothesis • An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security.

Efficient Market Hypothesis/Theory (EMH) and Its Implication • • • This topic/section deals with the efficient market hypothesis and its implication for determination of share prices. There are various theories which seek to provide a rationale for share price movement. The most important of these is the efficient market hypothesis, which provides theoretical underpinning for how markets take into account new information. The chapter also looks at practical issues. Definition of Efficient Markets: An efficient capital market is a market that is efficient in processing information. We are talking about an “informationally efficient” market, as opposed to a “transactionally efficient” market. In other words, we mean that the market quickly and correctly adjusts to new information. In an informationally efficient market, the prices of securities, such as share, observed at any time are based on “correct” evaluation of all information available at that time. Therefore, in an efficient market, prices immediately and fully reflect available information.

Definition of Efficient Markets • Professor Eugene Fama, defined market efficiency as follows: – "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic/true value. " that fully reflects the available information. • Fama, Eugene, "Random Walks in Stock Market Prices, ” Financial Analysts Journal , 1965.

Cont’d • The theory behind share price movements can be explained by the three forms of the efficient market hypothesis. 1. Weak form efficiency implies that prices reflect all relevant information about past price movements and their implications. 2. Semi-strong form efficiency implies that prices reflect past price movements and publicly available knowledge. 3. Strong form efficiency implies that prices reflect past price movements, publicly available knowledge and inside knowledge. • The efficient market hypothesis provides a rationale for explaining how share prices react to new information about a company, and when any such change in share price occurs. • Stock market reaction to new information depends on the strength of the stock market efficiency.

Strong form efficiency • The strong form says that prices fully reflect all information, whether publicly available or not. • Even the knowledge of material, non-public information cannot be used to earn superior results. • Most studies have found that the markets are not efficient in this sense. – Studies have shown that insiders and specialists often earn excessive profits, but mutual funds do not.

The Weak Form • The weak form of the EMH says that past prices, volume, and other market statistics provide no information that can be used to predict future prices. • If stock price changes are random, then past prices cannot be used to forecast future prices. • Most research supports the notion that the markets are weak form efficient. Nisar and Muhammad Testing Weak Form of Efficient Market Hypothesis: Empirical Evidence from South. Asia World Applied Sciences Journal 17 (4): 414 -427, 2012 47

The Semi-strong Form • The semi-strong form says that prices fully reflect all publicly available information and expectations about the future. • This suggests that prices adjust very rapidly to new information, and that old information cannot be used to earn superior returns. • Most studies find that the markets are reasonably efficient in this sense, but the evidence is somewhat mixed. Raja, Sudhahar, Selvam Testing the Semi-Strong form Efficiency of Indian Stock Market with Respect to Information Content of Stock Split Announcement – A study in IT Industry International Research Journal of Finance and Economics 25, 7 -20, 2009

Features of efficient markets • Stock markets that are efficient (or semi-efficient) are therefore markets in which: (a) The prices of securities bought and sold reflect all the relevant information available to the buyers and sellers, and share prices change quickly to reflect all new information about future prospects. (b) No individual dominates the market. (c) Transaction costs of buying and selling are not so high as to discourage trading significantly. (d) Investors are rational and so make rational buying and selling decisions, and value shares in a rational way. (e) There are low, or no, costs of acquiring information.

Cont’d • Impact of efficiency on share prices: If the stock market is efficient, share prices should vary in a rational way. (a) If a company makes an investment with a positive net present value (NPV), shareholders will get to know about it and the market price of its shares will rise in anticipation of future dividend increases. (b) If a company makes a bad investment, shareholders will find out and so the price of its shares will fall. (c) If interest rates rise, shareholders will want a higher return from their investments, so market prices will fall.

Implications of efficient market hypothesis for the financial manager • • • If the markets are quite strongly efficient, the main consequence for financial managers will be that they simply need to concentrate on maximising the net present value of the company's investments in order to maximise the wealth of shareholders. Managers need not worry, for example, about the effect on share prices of financial results in the published accounts because investors will make allowances for low profits or dividends in the current year if higher profits or dividends are expected in the future. If the market is strongly efficient, there is little point in financial managers attempting strategies that will attempt to mislead the markets. (a) There is no point for example in trying to identify a correct date when shares should be issued, since share prices will always reflect the true worth of the company. (b) The market will identify any attempts to window dress the accounts and put an optimistic spin on the figures.

Cont’d (c) The market will decide what level of return it requires for the risk involved in making an investment in the company. It is pointless for the company to try to change the market's view by issuing different types of capital instruments. Similarly if the company is looking to expand, the directors will be wasting their time if they seek as takeover targets companies whose shares are undervalued, since the market will fairly value all companies' shares. Only if the market is semi-strongly efficient, and the financial managers possess inside information that would significantly alter the price of the company's shares if released to the market, could they perhaps gain an advantage. However attempts to take account of this inside information may breach insider dealing laws.

1. FUNDAMENTAL ANALYSIS In order to make a rational and scientific investment decision, an investor has to evaluate a lot of information as to the part as well as the expected future performance of companies, industries and the economy as a whole in advance such evaluation or analysis is known as fundamental analysis.

Fundamental Analysis thus involves in 3 steps Economic analysis Industry analysis Company analysis

1. Macroeconomic analysis • Macroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentals • The macro economy is the environment in which all firms operate. • Any macro economic forecast should include estimates of all of the important economic numbers, including:

Ø The performance of a company depends much on the performance of the economy. Ø If the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor. Ø Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. Ø An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors. Economic Analysis

Continued…. We shall now discuss some of the key economic variables that can investor must monitor as part of this fundamental analysis: (1) GDP (2) Savings and Investment (3) Inflation (4) Agriculture (5) Rates of Interest (6)Govt. Revenue, Expenditure & Deficits (7) Infrastructure (8) Monsoon (9) Political Stability (10)Foreign exchange (Global Economy)

(1) GDP Ø The measure of the economy’s total production of goods and services. Ø GDP indicates the rate of growth of the economy. Ø Rapid growth in GDP indicates an expanding economy and higher sales for the firms. Ø It represents the aggregate value of goods and services produced in the economy. Ø The growth rate of economy points out the prospects for the industrial sector and the return investors can expect from investment in shares. Ø The higher growth rate is more favorable to the stock market. Ø measures the economy’s total output of goods and services

(2) Savings and Investment Ø Savings and investments represent that portion of GNP which is saved and invested. Ø It is obvious that growth requires investment which in turn requires substantial amount to domestic savings. Ø Stock market is a channel through which the savings of the investors are made available to the corporate bodies. Ø A higher level of savings and investments, accelerates the pace of growth of the stock market.

(3) Inflation Ø The rate at which the general level of prices rise. Ø Inflation has considerate impact on the performance of companies. Ø Higher rates of inflation upset business plans and eat into purchasing power in the hands of consumers. Ø This will result in lower demand for products. Ø Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. Ø However industries and companies prosper during periods of low inflation. Ø Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.

(5) Rates of Interest Ø The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. Ø A low interest rate stimulates investment by making credit available easily and cheaply. Ø As a result cost of finance for companies decreases which assures higher profitability. Ø On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Ø Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.

(6) Govt. Revenue, Expenditure & Deficits Ø Government is the largest investor and spender of money. Ø So the trends in government revenue expenditure deficits have a significant impact on the performance of industries and companies. Ø So the investor has to evaluate these carefully to assess their impact on his investments. • large deficit means more borrowing, which implies higher interest rate.

Budget Deficit • –The difference between government spending and revenues. • –The deficit should be closed by borrowing. • –The government borrowing can increase interest rates and crowd-out the private borrowing and decrease investment and affect economic growth negatively.

(7) Infrastructure Facilities Ø The development of an economy very much on the availability of infrastructure. Ø It includes electricity, roads and railways, communication channels, sound banking and financial sectors etc. Ø The availability of infrastructural facilities affects the performance of companies. Ø While inadequate infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Ø Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.

(8) Monsoon and Agriculture Ø Agriculture is directly and indirectly linked with the industries. and Textile Cotton, Sugar, Ex: Food processing industries depend upon agriculture for raw-material. Ø A good monsoon leads to higher demand for input and results in bumper crop. Ø This would lead to good spirit in the stock market. Ø When the monsoon is bad, agricultural and power production would suffer. They cast a shadow on the share market.

(9) Political Stability Ø A stable political environment is necessary for steady and balanced growth. Ø No industry or company can grow and prosper when the country is passing through political instability. Ø The long term economic policies are needed for industrial growth. Ø Stable policies can be framed only by stable political systems.

(10)Exchange rate • –The rate at which domestic currency can be converted into foreign currency. • –Affects the international competitiveness of the country. • –The depreciation of domestic currency makes the domestic products cheaper in foreign countries and increases the exports and hence the GDP growth.

2. INDUSTRY ANALYSIS Ø Industry analysis indicates to an investor whether the industry is a growth industry or not. Ø It gives an investor a choice of the industry in which the investments should be made. Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts, viz. , 1. Life cycle of an industry 2. Characteristics of an industry 3. Profit potential of an industry

1. Life cycle of an industry Ø Ø Ø Marketing experts believe that each product has a life cycle. In the same way industry is also said to have a life cycle. They are a. Pioneering Stage: Technology and product are newly introduced. There would be severe competition and only fittest companies survive this stage. The producers try to develop brand name, differentiate the product and create a product image. The severe competition often leads to the change of position to the firms in terms of market shares and profit. In this situation, it is difficult to select companies for investment because the survival rate is unknown.

Cont, , • Pioneering development. During this start-up stage, the industry experiences modest sales • growth and very small or negative profits. The market for the industry’s product or service • during this stage is small, and the firms incur major development costs.

Cont, , (b) Growth and Expansion stage: Ø This stage starts with the appearance of surviving firms from the pioneering stage. Ø Companies in this stage stabilize their prices, develop a market of their own and follow their own strategies. Ø Ultimately, by showing their competitive strength, the firms are able to maintain their position in the market. Ø This is the best time for the investor to make an investment in companies passing through the expansion stage. Ø The investors can get high returns because demand exceeds supply of the product.

(c) Stagnation Stage: Ø In this stage the growth of the industries Stabilizes. Ø Moreover, sales increases at slower rate. Ø The industry realizes that it cannot expand further. Ø To keep going, technological innovations in the production process and products should be introduced. Ø So, the companies who have taken note of the arrival of stagnation stage have to change their course of action. Ø Likewise, investors too should evaluate their investment in such industry on a continuous basis.

Cont, , (d) Decay stage: Ø In this stage, demand for the particular product and the earnings of the companies in the industry decline. Ø The specific future of the declining stage is that even in the boom period, the growth of the industry would be low and decline at a higher rate during the recession. Ø It is better to avoid investing in the shares of the low growth industry even in the boom period. Ø Investment in the shares of these companies leads to erosion of capital.

2. Characteristics of an industry In an Industry Analysis the analyst should consider a number of key characteristics: Ø Relationship between Demand & supply Ø Nature of the product Ø Nature of the competition Ø Growth of the industry Ø Labor Ø Government policy Ø Availability of Raw Material Ø Research and development

3. Profit potential of an industry • Specifically, a critical factor affecting the profit potential of an industry is the intensity of competition in the industry, as Porter has discussed in a series of books and articles. • (i) Threat new entrants: Ø New entrants inflate cost, push down the prices and reduce profitability. Ø An industry which is well protected from the entry of new firms would be ideal for investment. (ii) Competitions among existing firms: Ø The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. Ø If the competition between the firms in an industry is strong average profitability of the industry may be discouraged.

(iii) Pressure from substitute products: Ø Each firm in an industry face competition from other firms in the same industry producing substitute products. Ex: - Sony T. V, Samsung T. V etc. . Ø Substitute products may affect the profit potential of the industry badly. The pressure from the substitute products is found to be high under the following circumstances: (a) When the price of the products is attractive (b) When the cost for the prospective buyers to switch over to a substitute product is minimum. (c) When the substitute products are earning greater profits.

(iv) Bargaining power of buyers: Ø Buyers can bargain for price reduction asks for better quality and better service. Ø The bargaining power of a buyer group is said to be high under the following conditions: (a) If its capacity to buy is more than the capacity of the seller to sell. (b) If the cost of the switch over to a substitute product is low.

(V)Bargaining Power of Suppliers can suppress the profitability of the industries to which they sell by raising prices or reducing the quality of the components they provide. If a supplier reduces the quality of the components it supplies, the quality of the finished product will suffer, and the manufacturer will eventually have to lower its price. If the suppliers are powerful relative to the firms in the industry to which they sell, industry profitability can suffer. 5 -38

The Five Competitive Forces Model 5 -39

3. COMPANY ANALYSIS It involves a close investigative scrutiny of the companies financial and non financial aspects with a view to identifying its strength, weaknesses and future business prospects. The financial and non financial aspects are as follows: Ø Marketing success Ø Accounting Policies Ø Profitability Ø Capital Structure Ø Financial Analysis

Marketing success The success of the market of the firm depends on (a) The market share of annual sales (b) Growth of annual sales (c) The stability of annual sales. (d) Sales forecast

Marketing success n n n Sales Revenue (growth) Profitability (trend) Product line (turnover, age) q q q n n Output rate of new products Product innovation strategies R&D budgets Pricing Strategy Patents and technology

Accounting Policies While analyzing a company, the investor should carefully consider the accounting policies followed by the company. A. Inventory Pricing Generally, the prices of inventory change over a period of time. Due to changes in the prices of the inventory, the value of inventory changes during an accounting year. Ex: - FIFO and LIFO B. Depreciation methods The amount of depreciation varies depending upon the method employed. Higher amount of depreciation reduces profit while the lower amount of depreciation increases profit. • Straight line method • Diminishing balance method C. Non operating income Non-operating incomes are those items of incomes which are not earned in the routine business of the company. • Dividend • Interest D. Tax Carry over Ø A company must take adequate provisions for payment of tax on its earnings. Further, excess tax paid in the previous year may be refunded in the current year and such refund may be adjusted against the tax due in the current year. Ø The incidence of corporate tax and tax carryover are the factors which the investor should carefully take into consideration.

Organizational performance and Management functions n Organizational performance q q n Effective application of company resources Efficient accomplishment of company goals Management functions q q Planning - setting goals/resources Organizing - assigning tasks/resources Leading - motivating achievement Controlling - monitoring performance

Evaluating Management Quality n Evaluating Management Quality q q Age and experience of management Strategic planning n n q Marketing strategy n n n q q q Understanding of the global environment Adaptability to external changes Track record of the competitive position Sustainable growth Public image Finance Strategy - adequate and appropriate Employee/union relations Effectiveness of board of directors

Capital Structure • Generally, companies raise long term funds through the issue of shares and other securities like bonds, debentures etc. • The capital structure affects return on the equity shareholder’s investment. • Equity holders return can be increased by using more debts than equity capital. So the investor should study the company’s capital structure before take decision.

Financial Analysis Ø The financial statement of the a company provide the best possible information about the profitability and financial soundness of the company. Ø This is the primary source of information for evaluating the prospects of the investment in company’s stock. Ø The statement gives the historical and current information about the company’s operations. Ø Balance Sheet Analysis

Financial Analysis n Balance Sheet q n Income statement q q n Sales, expenses, and taxes incurred to operate Earnings per share Cash flow statement q n Snapshot of company’s Assets, Liabilities and Equity. Sources and Uses of funds Are financial statements reliable? q G. A. A. P.

Financial Ratio Analysis n Financial Ratio Analysis q q n Liquidity (ability to pay bills) Debt (financial leverage) Profitability (cost controls) Efficiency (asset management) Du. Pont Analysis q q Top-down analysis of company operations Objective: increase ROE

Liquidity Ratios n n Measure ability to pay maturing obligations Current ratio q n Current assets / current liabilities Quick ratio q (Current assets less inventories) / current liabilities

Debt Ratios n n Measure extent to which firm uses debt to finance asset investment (risk attribute) Debt-equity ratio q n Total debt - total assets ratio q n (Current liabilities + long-term debt) / total assets Times interest earned q n Total long-term debt / total equity EBIT / interest charges Fixed charge coverage ratio q (EBIT + Lease Exp. ) / (Int. Exp. + Lease Exp. )

Profitability Ratios When an investor buys a security, he is buying the right to the future earnings of the company. Ø A prudent investor is always interested in stability and growth of the earnings from security. n Measure profits relative to sales n Gross profit margin ( % ) = Gross profit / sales n Operating Profit Margin = Operating profits / sales n Net profit margin = Net profit after taxes / sales n ROA = Net Profit / Total Assets n ROE = Net Profit / Stockholder Equity* n Earning per share Ø

Efficiency Ratios n n Measure effectiveness of asset management Average collection period (in days) q n Inventory turnover (times per year) q n Cost of Goods Sold / average inventory Total asset turnover q n Average receivables / Sales per day Sales / average total assets Fixed asset turnover q Sales / average net fixed assets

Technical Analysis n n Technical analysis is a security analysis discipline forecasting the future direction of prices through the study of past market data, primarily price and volume. Technical analysis is the attempt to forecast stock prices on the basis of market-derived data. Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time. They are looking for trends and patterns in the data that indicate future price movements.

Assumptions of Technical Analysis ü ü ü The market value of any good or service is determined solely by the interaction of supply and demand. Supply and demand are governed by numerous factors. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time.

ü Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

Advantages of Technical Analysis n Not heavily dependent on financial accounting statements Problems with accounting statements: 1. Lack information needed by security analysts 2. Accounting policies allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Non quantifiable factors do not show up in financial statements q

Advantages of Technical Analysis n n Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly

2. Challenges to Technical Trading Rules: ü An obvious challenge to technical analysis is that the past price patterns or relationships between specific market variables and stock prices may not be repeated. • As a result, a technique that previously worked might miss subsequent market turns.

ü Another problem with technical analysis is that the success of a particular trading rule will encourage many investors to adopt it. • It is contended that this popularity and the resulting competition technique. will eventually neutralize the

ü when we examine specific trading rules, they all require a great deal of subjective judgment. • The same price pattern may arrive at widely different interpretations of what has happened and, therefore, will come to different investment decisions. ü In connection with several trading rules, the standard values that signal investment decisions can change over time

Cont’d