What is Security Analysis?
Security analysis is the analysis of tradeable financial instruments called securities. These can be classified into debt securities, equities, or some hybrid of the two. More broadly, futures contracts and tradeable credit derivatives are sometimes included.
Table of Contents
- 1 What is Security Analysis?
- 2 Fundamental Analysis
Security analysis is typically divided into fundamental analysis, which relies upon the examination of fundamental business factors such as financial statements, and technical analysis, which focuses upon price trends and momentum.
Another form of security analysis is the technical analysis which uses graphs and diagrams for price prediction securities. Simply the process of analysing returns and risks of financial securities may be termed as security analysis.
Fundamental analysis is really a logical and systematic approach to estimating the future dividends and share price it is based on the basic premise that share price is determined by a number of fundamental factors relating to the economy, industry and company.
In other words, fundamental analysis means a detailed analysis of the fundamental factors affecting the performance of companies.
Each share is assumed to have an economic worth based on its present and future earning capacity .this is called its intrinsic value or fundamental value. the purpose of fundamental analysis is to evaluate the present and future earning capacity of a share based on the economy, industry and company fundamentals and thereby assess the intrinsic value of the share.
The investor can compare the intrinsic value of the share with the prevailing market price to arrive at an investment decision. if the market price of the share is lower than its intrinsic value, the investor would decide to buy the share as it is underpriced. The price of such a share is expected to move up in the future to match its intrinsic value.
On the contrary, when the market price of a share is higher than its intrinsic value, it is perceived to be overpriced. The market price of such a share is expected to come down in future and hence, the investor should decide to sell such a share.
The fundamental analysis thus provides an analytical framework for rational investment decision making. This analytical framework is known as the EIC framework, or economy –industry –company analysis.
The fundamental analysis thus involves three steps:
The performance of a company depends on the performance of the economy. Let us look at some of the key economic variables that an investor must monitor as part of his fundamental analysis.
The growth rate of national income: The rate of growth of the national economy is an important variable to be considered by an investor. GNP (gross national product), NNP (net national product), GDP (gross domestic product) are the different measures of the total income or total economic output as a whole.
The estimated growth rate of the economy would be a pointer towards the prosperity of the economy. An economy typically passes through different stages of prosperity known as the economic or business cycles.
The four stages of an economic cycle are:
- Depression: is the worst of the four stages. During a depression, demand is low and declining. Inflation is often high and so are interestrates.
- Recovery stage: The economy begins to receive After a depression. Demand picks up leading to more investments in the economy. Production, employment and profits are on the increase.
- Boom: The phase of the economic cycle is characterized by high demand. Investments and production are maintained at a high level to satisfy the high demand. Companies generally post higher profits.
- Recession: The boom phase gradually slow down .the economy slowly begin to experience a downturn in demand, production employment etc, the profits of companies are also start to decline. This is the recession stage of the economy
An industry ultimately invests its money in the securities of one or more specific companies, each company can be characterized as belonging to an industry. the performance of companies would, therefore, be influenced by the fortunes of the industry to which it belongs. an industry “as a group of firms producing reasonably similar products which serve the same needs of a common set of buyers.”
Industry Life Cycle
The industry life cycle theory is generally attributed to Julius grodinsky. According to the industry life cycle theory, the life of an industry can be segregated into the pioneering stage the expansion stage, the stagnation stage, and the decay stage.
This kind of segregation is extremely useful to an investor because the profitability of an industry depends upon its stage of growth:
This is the first stage in the industrial life cycle of a new industry where the technology as well as the product are relatively new and have not reached a state of perfection. The pioneering stage is characterized by rapid growth in demand for the output of the industry.
As a result, there is a greater opportunity for profit. Many firms compete with each other vigorously. Weak firms are eliminated and a lesser number of firms survive the pioneering stage. ex; leasing industry.
Once an industry has established itself it enters the second stage of expansion or growth. These companies continue to become stronger. Each company finds a market for itself and develops its own strategies to sell and maintain its position in the market.
The competition among the surviving companies brings about improved products at lower prices. Companies in the expansion stage of industry are quite attractive for investment purposes.
In this stage, the growth of the industry stabilizes. The ability of the industry to grow appears to have been lost. Sales may be increasing but at a slower rate than that experienced by competitive industries or by the overall economy.
The transition of the industry from the expansion stages to the stagnation stages is very slow. An important reason for this transition is a change in social habits and the development of improved technology. Ex: the black and white television industry in India provides s a good example of an industry that passed from the expansion stages to the stagnation stage.
The decay stage occurs when the products of the industry are no longer in demand. New products and new technologies have come to the market. Customers have changed their habits, style and liking. as a result, the industry becomes obsolete and gradually ceases to decay of an industry.
Company analysis is the final stage of fundamental analysis. The economic analysis provides the investor with a broad outline of the prospects of growth in the economy, the industry analysis helps the investor to select the industry in which investment would be rewarding.
Now he has to decide the company in which he should invest his money. Company analysis provides the answer to this question. In company analysis, the analyst tries to forecast the future earnings of the company because there is strong evidence that the earnings have a direct and powerful effect on share prices.
The level, trend and stability of earnings of a company, however, depend upon a number of factors concerning the operations of the company.
The financial statements of a company help to assess the profitability and financial health of the company. The two basic financial statements provided by a company are the balance sheet and the profit and loss account.
The balance sheet indicates the financial position of the company on a particular date, namely the last day of the accounting year. The profit and loss account also called the income statement, reveals the revenue earned, the cost incurred and the resulting profit and loss of the company for one accounting year.
Analysis of Financial Statements
Financial ratios are most extensively used to evaluate the financial performance of the company, it also helps to assess whether the financial performance and financial strengths are improving or deteriorating, ratios can be used for comparative analysis either with other firms in the industry through a cross-sectional analysis or a time series analysis.
Four groups of ratios may be used for analyzing the performance of the company Liquidity ratios. These ratios measure the company’s ability to fulfil its short term obligations and reflect its short term financial strength or liquidity. The commonly used liquidity ratios are:
Current ratio = Current Assets / Current liabilities
Quick ratio (acid test) ratio =current assets –inventory-prepaid expenses / Current liabilities
Technical analysis believes that the share price is determined by the demand and supply forces operating in the market. the technical analysis concentrates on the movement of share prices . he claims that by examining past share price movements future share price can be accurately predicted.
The basic premise of technical analysis is that prices move in trends or waves which may be upward or downward A rationale behind the technical analysis is that share price behaviour repeats itself over time and analysts attempt to drive methods to predict this repetition.
Principles of Technical Analysis
- The market value of a security is related to the demand and supply factors operating in the market.
- There are both rational and irrational factors which surround the supply and demand factors of a security.
- Security prices behave in a manner that their movement is continuous in a particular direction for some length of time.
- Trends in stock prices have been seen to change when there is a shift in the demand and supply factors.
- The shift in demand and supply can be detected through charts prepared specially to show the market action.
- Patterns which are projected by charts record price movements and these recorded patterns are used price movements and these recorded patterns are used by analysts to make forecasts about the movement of prices infuture.
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