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MBF 2263 Portfolio Management
& Security Analysis
Lecture 8
Fundamental Analysis &
Security Selection
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INTRODUCTION
• Before we look into any investment process, we
must first examine the economic environment,
then the industrial sector we want to invest, and
finally the company of which the stock we want
to invest into. the sequence of looking at the
economy first, then industrial sector and finally
company is known as top-down approach.
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Fundamental analysis
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• In a snapshot, we can see that a company
operates inside an industry, and the industry
operates in an economy. Hence, if the economy
is in its upswing in business cycle, then there is
likelihood that company will have growth in sales
volume, translating into higher profit figure.
Hence, it is important for any investor to monitor
the macroeconomic environment.
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Key Economic Variables and
Economic Indicators
• One of the important macroeconomic variables is
growth domestic product (GDP). Gross domestic
product (GDP) measures the value of output
produced within the domestic boundaries of the
Malaysia over a given time period. An important
point is that our GDP includes the output of
foreign owned businesses that are located in
Malaysia following foreign direct investment in
the Malaysian economy.
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• Another key economic variable is consumer
price index (CPI). The Consumer price index
(CPI) is a weighted price index which
measures the monthly change in the prices of
goods and services. The spending patterns on
which the index is weighted are revised each
year, mainly using information from the Family
• Expenditure Survey.
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• The expenditure of some of the higher income
households, and of pensioner households mainly
dependent on state pensions, is excluded. As
spending patterns change over time, the
weightings used in calculating the CPI are
altered.
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• From the concept of CPI, we can measure the
inflation. The definition of inflation is as follows:
„⁄.Inflation is best defined as a sustained
increase in the general price level leading to a
fall in the value of money⁄‰ Inflation is a key
• variable for macroeconomics management of the
Central Bank. By looking at the inflation rate,
Central Bank will decide whether to increase or
decrease the overnight policy rate (OPR) that will
alter the level of economic activities.
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INDUSTRY ANALYSIS
• Industry analysis is the study of industry groupings,
which is conducted by examining the competitive
position of a particular industry in relation to others,
and by identifying firms within an industry that hold
particular promise. For instance, during the period
of the „hi-tech bubble from the early part of 1999 to
mid-2000, hi-tech industry stocks were considered
the best investments, and yielded very high returns.
However, after the „hi-tech bubble‰ burst in mid2000, hi-tech industry stocks were considered to be
the worst investments.
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• Generally speaking, investors can obtain valuable
insights about an industry by looking for the
answers to the following questions:
(a) What economic factors are particularly essential
to the industry? Is demand for the industry’s goods
and services related to key economic variables and,
if so, what are the prospects for these variables?
How important is foreign competition to the health
of the industry?
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(b)
How
important
are
technological
advancements? Are there any taking place, and
what is the likely impact of a potential
breakthrough?
(c) What is the nature of the industry? Is it
characterised by monopolistic competition or are
there many competitors in the industry?
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(d) What are the important financial and operating
considerations? Is there an adequate supply of
labour, capital, and raw materials? And what are
the capital spending plans and the needs of the
industry?
(e) What are the government’s policies towards the
industry? To what extent is the industry regulated?
Is it regulated like public utilities are and, if so, how
friendly are the regulating bodies?
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COMPANY ANALYSIS
• Company analysis is mainly concerned with a firm’s
financial position and potential earning power. Many
empirical studies have shown that a company’s
share price is highly related to the changes in that
company’s financial position and earnings. To
understand what financial statements have to say
about a company’s financial condition and operating
results, it is often necessary to turn to financial
ratios. Financial ratio analysis is the study of the
relationships among and between various financial
statement accounts. Each measure relates to one
item on the balance sheet or income statement.
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VALUATION OF COMMON STOCKS
USING DIVIDEND DISCOUNT MODELS
• In this form of valuation process, the intrinsic value
of any investment is equal to the present value of
the expected cash flow benefits. In the case of
common stock, this converts to the cash dividends
each year, plus the future sale price of the stock.
Another way to view the cash flow benefits from
common stock is to assume that the dividends will
be received over an infinite time horizon – an
assumption that is appropriate so long as the firm
is considered a “going concern”.
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• The basic idea is that the value of common stock
is simply the discounted value of all the cash
flows associated with the common stock. In
general, the following formula seems reasonable
for making this calculation:
Vo=ΣDt /(1 + k)t
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• where:
• V0 is the value of a common stock at time
t=0
• Dt is the estimated dividend to be paid by the
common stock at time t
• k is the “appropriate” disscount rate; k is also
known as the required rate of return from the
CAPM.
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The Zero Growth Model
• In this case, dividends are assumed to remain
unchanged forever. Thus, the cash flows paid
by the common stock constitute a perpetuity,
and we have the following formula:
V0 = D1 / k
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The Constant Growth Model
• The constant growth model assumes that
dividends grow at a fixed rate, which is
• denoted by g, forever. In this case, the formula
for the value of a common stock is
• the following:
V0 = D1 /(k – g) and k > g
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