What factors should be kept in mind while evaluating the cost of securities in todays economic environment?

What factors should be kept in mind while evaluating the cost of securities in todays  economic environment?

Security analysis is the basis for rational investment decisions. If a security’s estimated value is above its market price, the security analyst will recommend buying the stock. If the estimated value is below the market price, the security should be sold before its price drops. However, the values of the securities are continuously changing as news about the securities becomes known. The search for the security pricing involves the use of fundamental analysis. Under fundamental analysis, the security analysts studies the fundamental facts affecting a stock’s values, such as company’s earnings, their management, the economic outlook, the firm’s competition, market conditions etc. Fundamental analysis is primarily concerned with determining the intrinsic value or the true value of a security. For determining the security’s intrinsic value the details of all major factors (GNP, industry sales, firm sales and expense etc) is collected or an estimates of earnings per share may be multiplied by a justified or normal prices earnings ratio. After making this determination, the intrinsic value is compared with the security’s current market price. If the market price is substantially greater than the intrinsic value the security is said to be overpriced. If the market price is substantially less than the intrinsic value, the security is said to be under priced. However, fundamental analysis comprises: 1. Economic Analysis 2. Industry Analysis 3. Company Analysis.

ECONOMIC ANALYSIS

For the security analyst or investor, the anticipated economic environment, and therefore the economic forecast, is important for making decisions concerning both the timings of an investment and the relative investment desirability among the various industries in the economy. The key for the analyst is that overall economic activities manifest itself in the behaviour of the stocks in general. That is, the success of the economy will ultimately include the success of the overall market.

MACRO ECONOMIC FACTORS - The macro economy is the study of all the firms operates in economic environment. The key variables to describe the state of economy are explained as below:

1. Growth rate of Gross Domestic Product (GDP): GDP is a measure of the total production of final goods and services in the economy during a year. It is indicator of economic growth. It consists of personal consumption expenditure, gross private domestic investment, government expenditure on goods and services and net export of goods and services. The firm estimates of GDP growth rate are available with a time lag of one or two years. The expected rate of growth of GDP will be 7.5 percent in year 2005-06. Generally, GDP growth rate ranges from 6-8 percent. The growth rate of economy points out the prospects for the industrial sector and the returns investors can expect from investment in shares. The higher the growth rate of GDP, other things being equal, the more favorable it is for stock market.

 2. Savings and investment: Growth of an economy requires proper amount of investments which in turn is dependent upon amount of domestic savings. The amount of savings is favorably related to investment in a country. The level of investment in the economy and the proportion of investment in capital market is major area of concern for investment analysts. The level of  investment in the economy is equal to: Domestic savings + inflow of foreign capital - investment made abroad. Stock market is an important channel to mobilize savings, from the individuals who have excess of it, to the individual or corporate, who have deficit of it. Savings are distributed over various assets like equity shares, bonds, small savings schemes, bank deposits, mutual fund units, real estates, bullion etc. The demand for corporate securities has an important bearing on stock prices movements. Greater the allocation of equity in investment, favorable impact it have on stock prices.

3. Industry Growth rate: The GDP growth rate represents the average of the growth rate of agricultural sector, industrial sector and the service sector. The current contribution of industry sector in GDP in the year 2004-05 is 6.75 percent approximately. Publicly listed company play a major role in the industrial sector. The stock market analysts focus on the overall growth of different industries contributing in economic development. The higher the growth rate of the industrial sector, other things being equal, the more favourable it is for the stock market.

4. Price level and Inflation: If the inflation rate increases, then the growth rate would be very little. The increasingly inflation rate significantly affect the demand of consumer product industry. The inflation rate in the Indian economy has been around 7 percent till 1990s. In recent years, the inflation rate has fallen significantly. At present it ranges from 4-5 percent (2005). The industry which have a weak market and come under the purview of price control policy of the government may lose the market, like sugar industry. On the other hand the industry which enjoy a strong market for their product and which do not come under purview of price control may benefit from inflation. If there is a mild level of inflation, it is good to the stock market but high rate of inflation is harmful to the stock market.

5. Agriculture and monsoons: Agriculture is directly and indirectly linked with the industries. Hence increase or decrease in agricultural production has a significant impact on the industrial production and corporate performance. Companies using agricultural raw materials as inputs or supplying inputs to agriculture are directly affected by change in agriculture production. For example- Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw material. Fertilizer and insecticides industries are supplying inputs to agriculture. A good monsoon leads to higher demand for inputs and results in bumper crops. This would lead to buoyancy in stock market. If the monsoon is bad, agriculture production suffers and cast a shadow on the share market.

6. Interest Rate: Interest rates vary with maturity, default risk, inflation rate, productivity of capital etc. The interest rate on money market instruments like Treasury Bills are low, long dated government securities carry slightly higher interest rate and interest rate on corporate debenture is still higher. With the deregulation interest rates are softened, which were quite high in regulated environment. Interest rate affects the cost of financing to the firms. A decrease in interest rate implies lower cost of finance for firms and more profitability and it finally leads to decline in discount rate applied by the equity investors, both of which have a favourable impact on stock prices. At lower interest rates, more money at cheap cost is available to the persons who do business with borrowed money, this leads to speculation and rise in price of share.

7. Government budget and deficit: Government plays an important role in the growth of any economy. The government prepares a central budget which provides complete information on revenue, expenditure and deficit of the government for a given period. Government revenue come from various direct and indirect taxes and government made expenditure on various developmental activities. The excess of expenditure over revenue leads to budget deficit. For financing the deficit the government goes for external and internal borrowings. Thus, the deficit budget may lead to high rate of inflation and adversely affects the cost of production and surplus budget may results in deflation. Hence, balanced budget is highly favourable to the stock market.

8. The tax structure: The business community eagerly awaits the government announcements regarding the tax policy in March every year. The type of tax exemption has impact on the profitability of the industries. Concession and incentives given to certain industry encourages investment in that industry and have favourable impact on stock market.

9. Balance of payment, forex reserves and exchange rate: Balance of payment is the record of all the receipts and payment of a country with the rest of the world. This difference in receipt and payment may be surplus or deficit. Balance of payment is a measure of strength of rupee on external account. The surplus balance of payment augments forex reserves of the country and has a favourable impact on the exchange rates; on the other hand if deficit increases, the forex reserve depletes and has an adverse impact on the exchange rates. The industries involved in export and import are considerably affected by changes in foreign exchange rates. The volatility in foreign exchange rates affects the investment of foreign institutional investors in Indian Stock Market. Thus, favourable balance of payment renders favourable impact on stock market.

10. Infrastructural facilities and arrangements: Infrastructure facilities and arrangements play an important role in growth of industry and agriculture sector. A wide network of communication system, regular supply or power, a well developed transportation system (railways, transportation, road network, inland waterways, port facilities, air links and telecommunication system) boost the industrial production and improves the growth of the economy. Banking and financial sector should be sound enough to provide adequate support to industry and agriculture. The government has liberalized its policy regarding the communication, transport and power sector for foreign investment. Thus, good infrastructure facilities affect the stock market favourable.

 11. Demographic factors: The demographic data details about the population by age, occupation, literacy and geographic location. These factors are studied to forecast the demand for the consumer goods. The data related to population indicates the availability of work force. The cheap labour force in India has encouraged many multinationals to start their ventures. Population, by providing labour and demand for products, affects the industry and stock market.

12. Sentiments: The sentiments of consumers and business can have an important bearing on economic performance. Higher consumer confidence leads to higher expenditure and higher business confidence leads to greater business investments. All this ultimately leads to economic growth. Thus, sentiments influence consumption and investment decisions and have a bearing on the aggregate demand for goods and services.