CHAPTER 4: SECURITY ANALYSIS
4.2 INTRODUCTION
Investment decisions depend on whether securities are to be bought, held, or sold. Buying a security is
based on achieving the highest return per unit of risk or the lowest risk per unit of return. Selling a
security does not necessarily depend on such requirements. A security considered attractive today may
not be so tomorrow due to management policy changes or economic policy changes by the government,
and vice versa. Therefore, continuous analysis of securities is essential.
Security Analysis involves systematic examination of risk-return profiles of various securities to help a
rational investor estimate the intrinsic value of a company from all price-sensitive information/data,
enabling purchase when the market underprices securities to earn reasonable returns.
Two primary approaches are:
• Fundamental Analysis
• Technical Analysis
Fundamental analysis examines factors affecting risk-return characteristics, while technical analysis
studies demand/supply positions and share price trends.
1. FUNDAMENTAL ANALYSIS
Fundamental Analysis is based on the assumption that share prices depend on the future dividends
expected by shareholders. The present value of future dividends discounted at an appropriate rate gives
the intrinsic value of the share.
• The intrinsic value represents the true value of a share.
• If the market price < intrinsic value → buy the share.
• If market price > intrinsic value → sell the share.
Shareholders pay a price based on expected dividends and the price at which they plan to sell in the
future.
1.1 Dividend Valuation Model
Assuming uniform dividends:
𝐷(1) = 𝐷(2) = 𝐷(3) = ⋯ = 𝐷
The price at time 0 is:
𝐷 𝐷 𝐷
𝑃(0) = + 2 + +⋯
(1+𝑘) (1+𝑘) (1+𝑘)3
This infinite series simplifies to:
𝐷
𝑃(0) = (Equation 3)
𝑘
where
• 𝑃(0) = price of the share today
• 𝐷 = dividend per share (constant)
• 𝑘 = required rate of return
1.2 Dividend Growth Model
Dividends generally grow at a compounded rate 𝑔 due to earnings growth:
𝐷(1), 𝐷(1)(1 + 𝑔), 𝐷(1)(1 + 𝑔)2 , …
So,
𝐷(1) 𝐷(1)(1 + 𝑔) 𝐷(1)(1 + 𝑔)2
𝑃(0) = + + +⋯
(1+𝑘) (1+𝑘)2 (1+𝑘)3
If 𝑔 < 𝑘, this is a perpetual geometric series with sum:
𝐷(1)
𝑃(0) = (Equation 5)
𝑘−𝑔
or equivalently,
𝐷(0)(1 + 𝑔)
𝑃(0) = (Equation 6)
𝑘−𝑔
where
• 𝐷(0) = dividend at current period
• 𝑔 = growth rate in dividends
• 𝑘 = required rate of return
If 𝑔 ≥ 𝑘, the model fails as price tends to infinity, which is unrealistic.
This is known as Gordon’s Dividend Growth Model.
1.3 Dividend Growth Model with PE Multiple
If a company pays out a fraction 𝑏 of earnings as dividends (Dividend Payout Ratio), then:
𝐷(1) = 𝑏 × 𝐸(1)
Using this,
𝑏𝐸(1)
𝑃(0) = (Equation 7)
𝑘−𝑔
or
𝑏𝐸(0)(1 + 𝑔)
𝑃(0) = (Equation 8)
𝑘−𝑔
where
• 𝐸(1) = earnings per share (EPS) at end of first period
• 𝐸(0) = current EPS
This model helps estimate the intrinsic price and fundamental P/E multiple of a security.
1.4 Components of Fundamental Analysis
Fundamental analysis includes three concentric circles:
• Economic Analysis
• Industry Analysis
• Company Analysis
These stages are vital in the investment decision-making process.
1.2 Economic Analysis
Focus: Macro-economic factors affecting overall economy and sectors.
1.2.1 Factors Affecting Economic Analysis
• (a) Growth Rates of National Income: Real GDP growth after adjusting for inflation is crucial for
industrial prospects.
• (b) Growth Rates of Industrial Sector: Industry-wise growth based on product demand.
• (c) Inflation: Measured by Wholesale Price Index (WPI) or Consumer Price Index (CPI); influences
demand and corporate pricing policies.
• (d) Monsoon: Due to strong linkages with agriculture and allied sectors, monsoon impacts
economic and stock market performance.
1.2.2 Techniques Used in Economic Analysis
• (a) Anticipatory Surveys: Expert opinions on construction, machinery investment, inventories,
consumer spending; limitations include non-guarantee of intentions and consensus bias.
• (b) Barometer/Indicator Approach: Utilizes leading, coincidental, and lagging indicators to
forecast economic direction; composite/diffusion indices combine indicators for better signals.
• (c) Economic Model Building: Hypothesizes total economic demand, forecasts components of
GNP (consumption, investment, government spending, net exports), and ensures consistency
with independent forecasts.
1.3 Industry Analysis
Growth rates differ across industries; thus, industry-specific factors must be examined.
1.3.1 Factors Affecting Industry Analysis
• (a) Product Life-Cycle: Profitability varies from high in growth stage to decline in maturity/decline
stage.
• (b) Demand-Supply Gap: Excess supply reduces prices and profits; shortage increases them.
• (c) Barriers to Entry: Includes innate product/technology barriers and those created by
incumbents.
• (d) Government Attitude: Crucial for industry prospects.
• (e) Competition: Leadership, product homogeneity/differentiation, demand pattern, industry type
(growth, cyclical, defensive, decline).
• (f) Cost Conditions and Profitability: Cost allocation, labor productivity, product pricing,
capacity utilisation, capital expenditure.
• (g) Technology and Research: Vital for growth and survival; includes nature of technology, R&D
expenditure, expected innovation.
1.3.2 Techniques Used in Industry Analysis
• (a) Regression Analysis: Diagnoses demand determinants using GNP, disposable income, price
elasticity.
• (b) Input-Output Analysis: Detects production flow and changing patterns in the economy.
1.4 Company Analysis
Examines company-specific quantitative and qualitative fundamentals.
(a) Net Worth and Book Value: Net worth = Equity + Preference Capital + Free Reserves – Intangible
Assets – Losses. Book value = Net worth / Number of shares. Market price reflects future earnings, not
just asset value.
(b) Sources and Uses of Funds: Funds flow analysis detects mismatches between short-term financing
and long-term investments.
(c) Cross-Sectional and Time Series Analysis: Uses common-sized statements and financial ratios for
comparison across firms and over time.
(d) Size and Ranking: Net capital employed, profits, ROI, sales compared to industry peers.
(e) Growth Record: Growth in sales, net income, capital employed, EPS; important ratios include
Price/Earnings (P/E), EPS growth rate, net block growth. Example: Company A (P/E 6) vs. Company B (P/E
10) with same EPS; lower P/E preferred if other factors equal.
(f) Financial Analysis: Profitability, efficiency, leverage, solvency ratios; includes EPS, P/E, yield, book
and intrinsic value, return on investment, liquidity ratios.
(g) Competitive Advantage: Long-term success depends on maintaining competitive advantages such
as brand or market dominance.
(h) Quality of Management: Intangible but vital; judged by experience, integrity, investor relations,
dividend policy, conference calls, management discussion & analysis reports, insider shareholding
trends, past executive performance.
(i) Corporate Governance: Compliance with SEBI (LODR) Regulations 2015, stakeholder service,
disclosure quality, independent directors.
(j) Regulation: Compliance with Companies Act, SEBI Act, FEMA for foreign dealings, monitored by RBI
and SEBI.
(k) Location and Labour-Management Relations: Economic viability depends on input availability,
market proximity, and industrial relations.
(l) Pattern of Existing Stock Holding: Shareholding concentration and institutional holdings impact
control and stability.
(m) Marketability of Shares: Trading volume, listing status, public holding dispersion, speculative
interest, and stock exchange activity affect liquidity.
Techniques Used in Company Analysis
• (a) Correlation & Regression Analysis: Determines relationships among economy, industry, and
company variables; forecasts with reliability testing.
• (b) Trend Analysis: Regression over time to understand historical behavior.
• (c) Decision Tree Analysis: Uses probabilities of sequential decisions to assess outcomes;
reduces uncertainty in decision-making.
2. TECHNICAL ANALYSIS
2.1 Meaning
Technical Analysis studies share price movements through price graphs or charts with the assumption
that price trends are repetitive due to investor psychology. It focuses on:
• (i) Whether a trend exists in prices
• (ii) Indications of trend reversal
Methods include visual (chart patterns) and statistical analysis of price and returns.
2.2 Assumptions
• Market value depends on supply and demand.
• Supply and demand are governed by rational and irrational factors.
• Stock prices move in trends that last substantial periods.
• Technical analysis relies on past price trends rather than financial statements.
2.3 Principles of Technical Analysis
a. The Market Discounts Everything: Share price reflects all information, including fundamentals
(aligned with EMH).
b. Price Moves in Trends: Prices tend to continue past trends rather than reverse abruptly.
c. History Tends to Repeat Itself: Price movement patterns recur, observable via charting.
2.4 Theories of Technical Analysis
2.4.1 Dow Theory
• Developed by Charles Dow using DJIA and DJTA indices.
• Market movements divided into:
• Primary (main trend, 1-3 years)
• Secondary (counter-trend, 2 weeks to months)
• Daily fluctuations (noise)
• Market trend is bullish if successive highs and lows rise; bearish if they fall.
• Primary uptrend has three upward moves (accumulation, earnings reports, speculation) followed
by three downward moves (distribution, confirmation of decline, distress selling).
2.4.2 Elliot Wave Theory
• Developed by Ralph Elliot in 1934, analyzing 75 years of price movements.
• Price movements occur in waves:
• Impulsive Waves: 3 or 5 waves in the direction of trend (up or down).
• Corrective Waves: 3 waves counter-trend correcting the impulsive waves.
• Complete cycle = 5-wave impulse + 3-wave correction (total 8 waves), alternating bullish and
bearish phases.
2.4.3 Random Walk Theory
• Stock prices behave randomly; no predictable pattern.
• Price changes are independent, like outcomes of a roulette wheel.
• Implies prices cannot be predicted, and past trends have no bearing on future prices.
2.5 Charting Techniques
• (i) Line Chart: Connects closing prices over time.
• (ii) Bar Chart: Vertical line from low to high price with horizontal ticks for open and close prices.
• (iii) Japanese Candlestick Chart: Similar to bar chart but color-coded (black = close < open,
white = close > open, Doji = close ≈ open) for visual trend indication.
• (iv) Point and Figure Chart: Plots X’s and O’s to detect trend reversals, using box size and reversal
criteria.
2.6 Market Indicators
• (i) Breadth Index: Ratio of net advances/declines to total issues; supports or contradicts Dow
averages.
• (ii) Volume of Transactions: Volume confirms trend strength; rising prices with increasing volume
= bullish, falling prices with increasing volume = bearish.
• (iii) Confidence Index: Ratio of high-grade to low-grade bond yields; leading indicator of market
turning points.
• (iv) Relative Strength Analysis: Measures securities outperforming or underperforming others;
high relative strength stocks tend to outperform.
• (v) Odd-Lot Theory: Contrarian indicator assuming small investors (odd-lotters) are usually
wrong.
2.7 Support and Resistance Levels
• Support Level: Price floor where buying pressure exists.
• Resistance Level: Price ceiling where selling pressure exists.
• Price expected to move between these levels; breaches indicate trend changes.
2.8 Interpreting Price Patterns
• (a) Channel: Parallel trend lines indicating rising or falling price bands.
• (b) Wedge: Resistance and support lines converging; signals trend reversal.
• (c) Head and Shoulders: Reversal pattern with three peaks; top (bearish), inverse (bullish).
• (d) Triangle or Coil: Price consolidation; breakout direction uncertain.
• (e) Flags and Pennants: Short consolidation before continuation of prior trend.
• (f) Double Top: Bearish reversal pattern.
• (g) Double Bottom: Bullish reversal pattern.
• (h) Gap: Price jump between closing and next opening price; signals strong buying/selling
pressure.
2.9 Decision Using Data Analysis
• (a) Arithmetic Moving Average (AMA):
𝑛−1
1
𝐴𝑀𝐴𝑛,𝑡 = ∑ 𝑃𝑡−𝑖
𝑛
𝑖=0
Used for short-term (10-day), intermediate (60-day), and long-term (200-day) trends.
• Buy signals and sell signals depend on price crossing moving averages combined with moving
average slope.
• (b) Exponential Moving Average (EMA):
𝐸𝑀𝐴𝑡 = 𝛼𝑃𝑡 + (1 − 𝛼)𝐸𝑀𝐴𝑡−1
where
2
𝛼=
𝑛+1
EMA gives more weight to recent prices, making it more sensitive to price changes.
2.10 Evaluation of Technical Analysis
Supporters argue:
• Crowd psychology sustains trends that technical tools help identify.
• Demand-supply shifts are gradual; technical analysis detects early signals.
• Price reflects fundamental information gradually assimilated.
Critics argue:
• Tools often lack convincing theoretical basis.
• Empirical support for random walk casts doubt.
• Signals may lag actual trends.
• Widespread use reduces effectiveness (self-defeating).
Conclusion:
Technical analysis may not work well in efficient markets but can be useful in imperfect, inefficient
markets, especially combined with fundamental analysis.
3. DIFFERENCES BETWEEN FUNDAMENTAL AND TECHNICAL ANALYSIS
[Link] Basis Fundamental Analysis Technical Analysis
Analyzes macro factors (GDP, Uses historical market data
Inflation, Interest Rate, Growth) and (Price Movement, Volume,
1 Method
company micro factors (Sales, Open Interest) to predict
Profitability, Solvency, Assets) future prices.
Prices of a share discount
Prices move in trends;
2 Rule everything; price captures all
history tends to repeat.
information including fundamentals.
Suitable for short-term
3 Usefulness Suitable for long-term investing.
investing.
4. EFFICIENT MARKET THEORY (EFFICIENT MARKET HYPOTHESIS - EMH)
4.1 Search for Theory
Developed by Eugene Fama in 1960s, EMH states that at any time, all available price-sensitive
information is fully reflected in securities prices. Hence:
• No investor can consistently outperform the market.
• Stocks are fairly priced based on available information.
• Only way to achieve higher returns is by taking higher risks.
4.2 Misconceptions
• Market prices fluctuate due to surprises, which cause price volatility.
• Institutional managers failing to outperform does not imply incompetence but market efficiency.
• Random stock price movements indicate unpredictability, not irrationality.
4.3 Levels of Market Efficiency
• (i) Weak Form Efficiency: Prices reflect all past price and volume information.
• (ii) Semi-Strong Form Efficiency: Prices reflect all publicly available information.
• (iii) Strong Form Efficiency: Prices reflect all public and private information.
4.4 Empirical Evidence on Weak Form
Tests used:
• Serial Correlation Test: No significant correlation found in price changes.
• Run Test: Number of runs consistent with randomness.
• Filter Rule Test: No consistent outperformance over buy-and-hold after costs.
4.5 Empirical Evidence on Semi-Strong Form
• Prices adjust rapidly to public announcements (earnings, splits).
• Some anomalies exist: delayed price adjustments, small firms outperforming large firms, P/E
effects, day-of-week effects.
4.6 Empirical Evidence on Strong Form
• Insiders and specialists may earn superior returns.
• Mutual fund managers generally do not outperform randomly selected portfolios.
4.7 Challenges to EMH
• Information inadequacy and misinformation.
• Human cognitive limitations in processing information.
• Investor irrationality affecting prices.
• Market power of large institutions undermining competitiveness.
5. EQUITY RESEARCH AND TOOLS AVAILABLE
Equity Research involves analyzing a company's financials and other factors to decide whether to buy,
hold, or sell equity shares. It is also used in M&A for swap ratios.
Equity Research Analysts perform this analysis.
Popular Equity Research Tools (mostly online):
S.N Founde
Name Website
o d
Bloomberg [Link]
1 1981
Terminal g-terminal/
Benzinga
2 2010 [Link]
Pro
Refinitiv
3 2010 [Link]
EIKON
4 MarketXLS 2015 [Link]
Stockopedi
5 2010 [Link]
a
6 Koyfin 2016 [Link]
7 [Link] 2014 [Link]
8 GuruFocus 2004 [Link]
Business
9 2014 [Link]
Quant
10 Ycharts 2009 [Link]
Students advised to familiarize themselves with these tools through websites without paid subscriptions.