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Security analysis is the first step undertaken in theprocess of investment decisions.
The task involves determining prospective benefitsfrom investment in a security, the conditions subject
to which they may be received, and the likelihood ofsuch conditions. The task involves arriving at what ought to be the
price . Security valuation is the end objective of security
analysis in this sense. Its objective is to identify under priced and overpriced
securities.
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Active Approach
- Fundamental Analysis
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Technical Analysis
Passive approach
- Buy and Hold Approach- Index Fund Approach
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Introduction
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To determine a proper price for a firmsstock, the security analyst mustforecast the dividend and earnings thatcan be expected from the firm.
This is the heart of fundamentalanalysis - that is, the analysis of thedeterminants of value such as earning
prospects.
Fundamental Analysis is based on thepremise that a security has an intrinsicvalue at any given time.
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TOP-DOWN V. BOTTOM UPTOP-DOWN APPROACH
attempts to forecast in the following order
1. economic activity
2. industry performance
3. firms performance
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TOP-DOWN V. BOTTOM UPBOTTOM-UP APPROACH:
attempts to estimate prospects in the following
order:
1. The firm
2. The Industry3. The economy
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1. To analyze overall economy andsecurities markets.
2. Analyze the industry in which thecompany operates
3.Finally, the analysis of the companyshould be considered.
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A study of economic trends as indicated bythe rate of growth in GDP, employment,aggregate corporate profits, personaldisposable income, balance of paymentposition, inflation, money supply etc
A study of economic policies of theGovernment
An analysis of the relationship betweeneconomic trends and economic policies andthe stability of such relationships.
A study of world economic trends and their
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GDP - Rapidly growing GDP indicates an expandingeconomy with ample opportunity for a firm to increasesales.
Employment Unemployment rate - of total laborforce yet to find work. indicates whether theeconomy is operating at full capacity.
Inflation Increase in prices low purchasing power. Interest rates demand for sectors like housing and
high priced consumer durables such as automobiles ishighly sensitive to interest rates. High interest ratehigh cost of funding for companies.
Budget deficit difference between governmentspending and revenues.
Industrial production Growth of Infrastructure
Agricultural output.
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The economy recurrently experiences periods ofexpansion and contraction although the length andbreadth of the cycles can be irregular.
The recurring pattern of recession and recovery iscalled the business cycle.
The transition points are called peaks and troughs.
As the economy passes through different stages ofbusiness cycle, the relative performance of variousindustry groups might be expected to vary.
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You want to identify the industries thatwill be most helped or hurt in anymacro economic scenario you envision.
Suppose the forecast is a tightening ofthe money supply, you might want to
avoid industries such as automobileproducers that might be hurt by thelikely increase in interest rates.
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The leading indicators are those time seriesof data that historically reach their highpoints (peaks) or their low points (troughs) in
advance of total economic activity.The roughly coincidental indicators reach
their peaks or troughs at approximately thesame time as the economy.
Finally, the lagging indicators reach theirturning points after the economy has alreadyits own.
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peak Trough
(Measure of
GNP)
Level of
economicactivity
T I m e
leading
lagging
coincidental
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Short-term forecasters of the nationaleconomy have constructed a vastmultitude of models and indices,
designed mainly to help identify andpredict turning points in thebusiness cycle.
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Since the early signs of a recessionor recovery are of keen interest tobusinessmen, policymakers,
investors, and workers, monthlyindicator models have the addedbenefit of generating more
frequent data revisions andreports
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While this approach is most valuable insuggesting the direction of change ineconomic activity.
it does not convey any information on themagnitude of change.
Signals provided by different lead indicatorscan be mixed. i.e Some might signal a turnwhile the others might not, resulting in a
serious problem of interpretation.
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Econometric models
Trend analysis
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Once the analyst forecasts the state ofthe macro economy, it is necessary todetermine the implication of that
forecast to specific industries.Not all industries are equally sensitive
to the business cycle.
Let us look at the plot of commercialvehicles and tea production in India .
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Surprisingly beer industry seems to bedoing well whenever the stock marketis up and vice versa.
People seem to be drinking more whenthey are happy than when they are not.
Conclusion The industriesrespond differently
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Past performance of the Industry
Permanence of the product andtechnology of the Industry
Role of govt. in the Industry
Labor conditions
COMPETETION
Overall SWOT Analysis to
determine the above factors
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Pioneering stage
Expansion stage
Stagnation stage
Decay stage
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Although the relevant environment for anyfirm is very broad, encompassing social aswell as economic forces; the key aspect ofthe firms environment is the industry
or the industries in which it competes.
Industry structure has a strong influencein determining the competitive rules of thegame as well as strategies potentiallyavailable to the firm.
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1. Threat of New Entrant New entrants bring new capacity, the desire to gain
market share, and often substantial resources. Pricescan be bid down or incumbents costs inflated as a
result of reducing profitability.
2. Intensity of rivalry among existing competitors
Rivalry occurs because one or more competitors
either feels the pressure or sees the opportunity toimprove the position.
Using tactics like price competition, advertisingbattles, product introductions, and increased
customer services or warranties.
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All firms in an industry are competing, in abroad sense, with industries producingsubstitute products.
Substitutes limit the potential returns in anindustry by placing a ceiling on the pricesfirms in the industry can profitably charge.
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Buyers compete with the industry by forcing downprices, bargaining for higher quality or more services,and playing competitors against each other all atthe expense of industry profitability.
A buyer group is powerful if the followingcircumstances hold true.
If it is concentrated or purchases large volumesrelative to seller sales.
If the products purchased are undifferentiated andstandard and always other suppliers can be found.
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Buyers pose a credible threat of backwardintegration. They use threat of selfmanufacture as a bargaining lever.
The buyer has full information
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Suppliers can exert bargaining powerover participants in an industry bythreatening to raise prices or reduce
the quality of purchased goods andservices.
A supplier group is powerful if thefollowing apply.
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It is dominated by a few companies and ismore concentrated than the industry it sellsto.
The industry is not an important customer ofthe supplier group.
The suppliers product is an important input
to the buyers business.
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The supplier groups products aredifferentiated or it has built upswitching costs.
The supplier group poses a crediblethreat of forward integration.
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Financial Statements
- Balance sheet
- Income Statement
FINANCIAL STATMENT ANALYSIS
it helps the analyst understand a firms currentcondition
where it is headed
what factors affect it
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FINANCIAL STATMENT ANALYSISRATIO ANALYSIS
Common-size financial statementsComparative financial statements
Trend analysis
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liquidity ratios: indicate the ability of the firm to meet
future short-term financial obligations
some liquidity ratios:current ratio
quick ratio
cash ratio
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operating performance ratios: indicate how well the management is
operating the business
some examples:total asset turnover
net fixed asset turnover
equity turnover
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risk analysis/ leverage ratios: indicates the uncertainty of income flows
for the total firm and for the individual
sources of capital (debt and stock)some examples:
debt to equity ratio
long-term debt/total capital ratio
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Profitability ratios: indicate the profitability
it involves analysis using several other
ratiosnet profit margin
ROI
ROA
ROCE