Page 142 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 7: Fundamental Analysis 1: Economic Analysis

decision-making is both an art as well as a science. This is indeed an on-going process in which Notes
a decision-maker attempts to update himself regarding the characteristics of returns of securities.
These characteristics keep on changing and investors go on attempting to understand their
impact on their decisions. The investment decision-maker takes them into account in order to
decide which securities should be bought or held or sold by him. A very simple decision rule is
applicable here: buy a security that has highest bought, held or sold security volume and the
above required per unit of risk or lowest risk per unit or return. And, sell the security, which
does not satisfy the above required.
The above decision rule to buy/sell securities is highly simple, but it is very difficult to apply
both risk and return fashion in actual practice. This is because there are a large number of factors,
which affect both risk and return in the real world. Thus, a security that had the highest return
per unit of risk at one point of time and was considered to be a good buy might turn into a less
attractive proposition and could be considered later on as a possible candidate for disinvestments.
Such a situation might arise due to change in the management concerned company or changes in
government policy concerning the economy, making it less attractive.

Investment decision-making being continuous in nature should be attempted systematically.
Broadly approaches are suggested in the literature. These are: fundamental analysis and technical
analysis. In this approach, the investor attempts to look at fundamental factors that affect risk
return characteristic of the security. While in the second approach, the investor tries to identify
the price trends that reflect these characteristics. Technical analysis concentrates on demand and
supply of securities and prevalent trend in share prices mean by various market indices in the
stock market.

7.1 Fundamental Analysis

An attempt is made to analyze various fundamental or basic factors that affect the risk-return of
the securities. The effort here is to identify those securities that one perceives as mispriced in the
stock market. The assumption in this case is that the ‘market price’ of security and the price as
justified by its fundamental factors called ‘intrinsic value’ is different and the marketplace
provides an opportunity for a discerning investor to detect such discrepancy. The moment such
a description is identified, a decision to invest or disinvest is made. The decision rule under this
approach is like this:
If the price of a security at the market place is higher than the one, which is justified by the
security fundamentals, sell that security. This is because, it is expected that the market will
sooner or later realize its mistake and price the security properly. A deal to sell this security
should be based on its fundamentals; it should be both before the market correct its mistake by
increasing the price of security in question. The price prevailing in market is called ‘Market
Price’ (MP) and the one justified by its fundamentals is called ‘Intrinsic Value’ (IV) trading rules/
recommendations.

1. If IV > MP, buy the security
2. If IV < MP, sell the security
3. If IV = MP, no action
The fundamental factors mentioned above may relate to the economy or industry or company
or all some of this. Thus, economy fundamentals, industry fundamentals and company
fundamentals are considered while prizing the securities for taking investment decision. In fact,
the economy-industry-company framework forms integral part of this approach. This framework
can be properly utilized by making suitable adjustments in a regular context.

LOVELY PROFESSIONAL UNIVERSITY 137