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SECURITY ANALYSIS
Security analysis
An examination and evaluation of the various factors
affecting the value of a security.
Security analysis is about valuing the assets, debts and
equities of the companies from the perspective of outside
investors using publicly available information.
The security analyst must have a thorough understanding
of financial statements, which are an important source of this
information.
SECURITY ANALYSIS
Various approaches of Security analysis
Fundamental Analysis
Economic Analysis
Industry analysis
Company analysis
Technical Analysis
Fundamental Analysis
A method of evaluating a security that entails attempting
to measure its intrinsic value by examining related economic,
financial and other qualitative and quantitative factors.
FA is really a logical and systematic approach for
estimating the future dividends and share price.
FA assumes that share price is determined by a number of
fundamental factors regarding economic, industry, and company.
FA is the detailed analysis of the fundamental factors
affecting the performance of the company.
For example, an investor can perform fundamental analysis on a bond's value
by looking at economic factors, such as
interest rates and the overall state of the economy, and
information about the bond issuer, such as potential changes in credit
ratings.
For assessing stocks, this method uses revenues, earnings, future growth,
return on equity, profit margins and other data to determine a company's
underlying value and potential for future growth.
In terms of stocks, fundamental analysis focuses on the financial
statements of the company being evaluated.
One of the most famous and successful fundamental analysts is the
Oracle of Omaha,
Warren
Buffett,
who
is
well
known
for
successfully
employing fundamental analysis to pick securities. His abilities have
turned him into a billionaire.
Fundamental Analysis is a three stage process involving
first Economic analysis,
followed by Industry analysis and
Finally Company analysis.
FA is the scientific study of the basic factors, which determines
the share’s value.
Economic Analysis
The performance of the company depends much on the
performance of the economy.
Boon – Industries and companies is prosperous
Recession – performance of the company is poor
Economic Analysis
GNP
Savings and investments
Inflation: Higher rate of inflate – erode Purchasing power-low
demand for the products.
Low rate of inflation – industries & Co’s are prosperous
Agriculture
Rates of interest – low rate of interest- credit availability easy
Government revenues, expenditure and deficits
Infrastructure – SEZ
Monsoon
 Political stability
Industry Analysis
IA is one of the stages of FA is considered as an important
analysis.
It indicates to an investor whether the industry is growth
industry or not.
It gives an investor a choice of the industry in which the
investments should be made.
IA refers to an evaluation of the relative strengths and
weakness of particular industries divided in to three stages.
1. Life cycle of an industry
2. Characteristics of an industry
3. Profit potential of an industry
Life cycle of an industry
 Pioneering stage – technology and product are new. Weak
firms are eliminated and only a few firms survive the
stage.
 Expansion stage – companies in expansion stage are quite
attractive for investment.
 Stagnation stage
 Decay stage
Characteristics of an industry






Relationship between demand and supply
Period of life
State of labour
Government’s attitude
Availability of raw materials
Cost structure
Profit potential of an industry.
Company30-Jun-0030- Company30
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Bharat Heavy
Electricals Ltd.
66.73
2,046.55
2,967%
Axis Bank Ltd.
33.2
1,289.00
3,783%
Tata Power Co. Ltd.
82.05
1,303.60
1,489%
Sun Pharmaceutical
Inds. Ltd
26.84
496.80
1,751%
HDFC Bank Ltd.
50.86
500.52
884%
Company analysis
Marketing success
Sales
Growth in sales
Stability of sales
Accounting policies
Inventory pricing
Depreciation method
Cost or Market value method
FIFO
LIFO
Non-operating income
Tax carry over
Profitability
1.
2.
3.
4.
5.
6.
Gross profit margin
Net profit margin
Earnings power
Return on equity
EPS
Cash earning per share
Financial statement analysis –
1. Balance sheet,
2. P&L a/c
Ratio analysis
Balance sheet:
The balance sheet describes the assets, liabilities, and equity
of the firm at a point in time
Key variables to watch on the balance sheet are cash, accounts
receivable, inventories, and long-term debt.
Analyzing Financial Ratios
• Financial ratios are the microscope that allows us to see
behind the raw numbers and find out what’s really going on
• Financial ratios fall into five categories:
–
–
–
–
–
Liquidity
Efficiency
Leverage
Coverage
Profitability
• When analyzing ratios always remember that no one ratio
provides the whole story, and that the standards for each
ratio are different for every industry
Liquidity Ratios
• The current ratio,
• quick ratio
• and cash ratio all fall into this category
• They help us to see if the company is able to
meet its short-term obligations
Efficiency Ratios
• The efficiency ratios tell us how effectively
management is using the firm’s assets to
generate sales
• Inventory turnover, accounts receivable turnover,
days sales outstanding, fixed asset turnover, and
total asset turnover all fall into this category
Leverage Ratios
• How much debt does the firm have? That’s the question
answered by the leverage ratios
• Examples are the debt ratio and debt to equity ratio
• Remember that lots of debt is great as long as sales are
increasing, but terrible if sales decline
• Some debt is, without a doubt, good, but too much can be
disastrous
• Especially be on the lookout for companies with a high
proportion of fixed costs (high operating leverage) and with
lots of debt. Airlines are a good example
Coverage Ratios
• Coverage ratios are most important to
creditors, but whatever is important to
creditors is important to shareholder’s too
• Examples of coverage ratios include the times
interest earned ratio and the fixed charge
coverage ratio
Profitability Ratios
• Investors tend to focus the most on
profitability ratios, but the others are
important as well
• Examples include the gross profit margin,
operating profit margin, net profit margin,
return on assets and return on equity
Using Financial Ratios
• There are two key uses of financial ratios:
– Trend Analysis – Looking for trends over time in
ratios. For example, we’d like to see that the
inventory turnover ratio is rising. Normally, at
least five years of data should be used.
– Comparison to Industry Averages – If we assume
that, on average, the firm’s competitors are doing
things right, then it makes sense to make these
comparisons. This can also help to identify areas
of relative strength and weakness
Growth Rates
• Growth rates of various variables are
important as well
• Key variables to calculate growth rates of are
revenues, operating profits, and free cash flow
Graham and Dodd Method of Investing
Definition
Fundamental investment tactics founded by Benjamin
Graham and David Dodd in the 1930s.
They wrote about their strategy in a book entitled “Security
Analysis."
In it, they advocate that investors should purchase
stocks in corporations with undervalued stocks because
they will eventually reach true market value and give
investors a positive return.
Criteria that investors should look for in a company are:
More current assets than current liabilities,
All long term debt, and
Selling at a low Price/Earning Ratio
The theory does not take into consideration the potential
for earnings growth.
Followers of this approach may also look
for STOCKS selling below their liquidating value.
Ratios Used in Value Investing Evaluation
EBIT
Earnings Per share = -----------------------------------------No. of Outstanding Equity Share
Sales
Sales Per share = -----------------------------------------No. of Outstanding Equity Share
Price Per share
Price – Earnings Ratio = -------------------------Earnings per share
Earnings per share
Earnings Yield = ------------------------Price Per share
Sales
Capital Turnover = -----------------------------------------Tangible Assets – Short term Accrued payables
Cash flow from operations after taxes
Cash flow Per share = -------------------------------------------------No. of Outstanding Equity Share
Net income + Minority + Tax adjusted interest
Return on Capital = -----------------------------------------------------Tangible assets – Short term Accrued payables
Net Income + Minority interest + Tax Adjusted Interest
Earnings Yield = ------------------------------------------------------------Sales
Growth Ratios
Growth in Sales =
Sales in Final Period
-----------------------------------------------------Sales in Base Period
Net Earned for Total capital in Final Period
Growth in Total Return = -----------------------------------------------------Net Earned for Total capital in Base Period
Earnings per share in Final Period
Growth in Earnings Per Share = -----------------------------------------------------Earnings per share in Base Period
Stability Ratios
Worst Year
Percent decline in return on capital = ------------------------------------------------Average of previous three years
Payout Ratios
Dividend paid on common
Payout Ratio = -----------------------------------------------------Net Income available for common
Dividend paid on common
Dividend to cash flow = -----------------------------------------------------Cash flow from operations after taxes