Security analysis is a complex term that encompasses a process of evaluating security. Knowing the true value of a stock, bond or other asset is crucial for making investment decisions. As a part of the security analysis, the analysts are trying to include the effect of market fluctuation on the value of securities.
As investing is becoming ever more popular the need to understand its basic principles rises. From the current trends, we can see that passive investing in ETF funds has gained popularity over traditional active investing principles. Several questions became frequently asked, and security analysis is always appearing as one of the top searched terms.
Key Takeaways
- Security analysis is a process of determining the true value of the security
- Key tools for the evaluation of security are fundamental and technical analysis
- Proper security analysis lowers the investment risk, uncovers undervalued gems, and helps in setting realistic goals
Without a proper security analysis investing would resemble walking through thick fog with eyes closed. In this article, we will go through the entire process of security analysis, its importance, and its methods. Also, we will point out risks connected with security analysis and how to handle them with minimum impact.
What Is The Importance of Security Analysis
In a highly turbulent world of investing, security analysis plays the role of a roadmap. If done properly it can help an investor to make properly timed and evaluated investment choices. Since bad investing picks can result in substantial capital losses, conducting a thorough security analysis is essential.
Objectives of Security Analysis
Security analysis consists of several objectives that are all focused on assessing potential investments and making good decisions.
One of the crucial goals is to identify undervalued securities. That includes identifying investments that are trading below their intrinsic value. Good examples include companies with strong fundamentals or bonds with strong creditworthiness.
Then the investor determines its real value and follows it. When the value drops, then it is logical to make a move and acquire it. The company fundamentals must remain unchanged, because only then it can be again recognized by the market, resulting in a price rise.
The second goal of the security analysis is to assess the risk connected with the investment. This is done by checking the company's fundamentals, trends in the industry, and potential outlook.
From this data, an investor can get a grasp on the risks accompanying the investment and make a judgment call. This includes a risk/benefit analysis which aims to determine if is it worth taking a risk and does the investment has a chance to pay off.
Another element of risk management is creating a suitable portfolio. Security analysis also helps in this department by choosing investments that complement each other. Security analysis with its view of both the company and the market can offer insights on how to create a well-balanced portfolio.
By analyzing the potential of the investment, security analysis can set achievable return goals. This factor plays a crucial role in investing, offering an investor an insight into the potential of the investment.
Methods of Security Analysis
Fundamental Analysis
The key element of the fundamental analysis is to dig deep into company fundamentals. It is primarily used to assess and determine the intrinsic value of the company. To define it analysts assess these parameters:
Overall financial health of the company
Key elements that are analyzed when evaluating financial health are financial statements like income statements, balance sheets, and cash flow statements. From that data, an analyst can take a wide look at the performance, profitability, and stability of the company and its debt levels.
Management quality and competence
A key aspect of the operational functioning of the company is its management team. It is of utmost importance to check its track record and what are their plans for the future of the company. Managers with a clean record, and with a vision can be a driving force in any company. In case the management is the reason behind the company's recent bad streak, that can be a turn-off from an investment.
Competitive advantage
As a part of company assessment, the analysis includes identifying potential competitive advantages that the company already has or has the potential to develop. Investing in a first mover can be a good move if you can track it down before the competition identifies. Also, choosing companies that are focused on innovation has a higher chance of developing competitive advantage.
Industry trends
When analyzing a company one should not forget to analyze the sector in which it operates. Analysts should keep track of current market trends, and the potential for growth of the specific sector. Companies from thriving industries have a better potential for higher earnings and an increase in demand.
Growth potential
If you are looking for a long-term investment you should understand the importance of future growth potential. Short-term market fluctuations do not carry much weight in this category, but attempting to predict the next 3 to 5 years period is highly beneficial. When assessing future potential an analyst should take into account market conditions and price trends. With it, he should assess potential threats and vulnerabilities that can cause a problem in the long term.
Technical Analysis
Unlike fundamental analysis, its technical counterpart is focused on the analysis of price and trading volume data of the company from the past. Based on it, analysts attempt to predict future price movements.
It has conflicting benefits and downsides. It has found use in short-term trading where investors are looking to capitalize on quick price fluctuations. Also, it can determine potential entry and exit points from the investment. And, it can also be used alongside fundamental analysis to identify investment targets.
However, it comes with its share of disadvantages. The most obvious is that analyzing the past is not a very accurate way to predict the future. Since the analysis is using several different indicators it can be difficult to combine them all and get meaningful results.
The key aspects of technical analysis are:
Technical charts and indicators
To adequately examine data analysts employ charts that visually present the price movement of the security through time. Also, they derive indicators from price and trade volume data to attempt to identify a trend.
Identifying support and resistance levels
With the help of technical analysis, it is possible to identify price levels where the price of the security found support or resistance. Support is known as buying pressure, while resistance is characterized as selling pressure. With that data, it is easier to predict future price movements.
Assessing trends
When conducting technical analysis one of the crucial aims is to identify trends in price movements. Analysts with the help of various tools can identify upward, downward, or sideway price trends.
Impact of market psychology
Security analysts besides a focus on technical terms, also pay attention to market sentiment. The idea that market psychology can have an impact on price movements is not new. By studying trading activity and volume analysts try to measure investor confidence. This confidence can have a major impact on buying or selling pressure.
Quantitative Analysis
Quantitative analysis takes a more mathematical and data-driven approach to making informed investment decisions. Like technical analysis, it uses historical data and combines it with statistical models to assess potential returns and risk levels.
When compared to a more traditional approach to analysis quantitative analysis can process more data in a shorter period. This way the investor can assess larger numbers of investment opportunities.
On the other hand, since it is heavily dependent on quality and amount of data, it can be inaccurate or incomplete. And due to its use of historical data, it can lose sight of unforeseen events or sudden market shifts.
The core principle of every quantitative analysis is the use of statistical models. These models and algorithms are used to process large amounts of data to get a grasp on security performance and risks.
Managers and analysts frequently use it to determine, measure, and manage investment risk. By selecting securities that can deliver higher returns with a specific amount of risk it has found wide use in portfolio optimisation.
Tools & Techniques Used in Security Analysis
Every element of the security analysis has its set of tools. With it, each element of the analysis evaluates the potential profitability and risks of a specific investment.
Fundamental analysis tools include:
- Financial statements. These encompass financial data that show the financial health of the company. In this group are balance sheets, income statements, and cash flow statements.
- Ratios. With analyzing ratios the company in question is compared with its competitors. Ratios that are most looked at are Price/Earnings (P/E), Debt/Equity (D/E), and Return on Equity (ROE).
- Economic indicators. These encompass macro and micro economic factors which can give a wider perspective on the company. Those include unemployment rates, GDP growth, and inflation rates, amongst others.
Technical analysis depends on these tools:
- Chart patterns. Several patterns like double top, head, and shoulders, can help in predicting future price movements.
- Technical indicators. These are used to predict potential buy or sell points and include moving averages, relative strength index (RSI), and Bollinger bands.
- Volume and momentum. With these tools, analysts are attempting to measure the strength of the price move. It can indicate whether the trend will continue or reverse.
Types of Securities
Stocks
When evaluating stocks, security analysis is used from the companies and the market perspective.
When looking from the company's perspective analysts are using fundamental analysis. Here comes in handy using financial instruments to determine a stock’s intrinsic value. This is done by checking the financial health of the company, its management, competitive advantage, and industry outlook.
For checking the market perspective the use of technical analysis plays a crucial role. By investigating price trends it can create an insight into investor sentiment. Also, it can help define entry and exit points. Other technical indicators like the moving average, or RSI can provide additional insight into the buying or selling pressure of the security.
Bonds
Conducting a security analysis on bonds encompasses addressing these key factors:
- Creditworthiness. An analysis should determine if the issuer of the bond can repay the loan. To get a grasp on those elements the analysts should investigate issuers financial health, debt levels, and overall risk of the investment. The safest bonds are those issued by the government. On the other spectrum of safety are high-yield bonds, also called junk bonds
- Interest rate. A fixed interest rate that is paid out semi-annually. Bonds that are highly rated and with lower risk will bring lower interest rates
- Bond maturity date. It shows when you will get your principal investment back. Bonds with a longer maturity date are prone to interest rate changes
Risks Involved in Security Analysis
Market Risk
Market risk is a chance that the investor will experience losses due to factors that impact the overall performance of the market. It affects the performance of the entire market at the same time. This risk cannot be eliminated through diversification of the portfolio. It can come as a result of changes in interest rates, larger geopolitical events, or from recession impact.
Security analysis comes in handy by understanding how a company could react to market risks. If the company has strong fundamentals, like a balance sheet, and cash flow, it may better handle risks that are out of its reach. Also, companies with higher debts are prone to higher, not just market, but overall risk.
With the help of security analysis, an investor can create a portfolio that is less susceptible to market risk. However, even the best security analysis is not all-powerful. Major geopolitical events are hard to predict and their impact is usually hard to sustain.
Credit Risk
Credit risk is defined as the risk of a financial loss due to inability to repay a loan. For measuring credit risk analysts are checking credit history, capacity to repay, the loan’s condition, and associated collateral.
Consumers who have a higher credit risk are charged with higher interest rates on borrowed capital.
Through analyzing company fundamentals, the analysts are checking its debt levels and overall financial health. If a company has a strong balance sheet and a clear income statement, it has a better credit rating.
Security analysis can be used to identify opportunities from the credit risk scope. Those include investing in high-yield and investment-grade bonds.
Through analysis of high-yield bonds, the investor can potentially identify undervalued bonds. Those can offer higher returns when compared to investment risks.
Investment-grade bonds offer a good balance between credit quality and potential returns. Security analysis can help in tracking bonds from this category. The best bonds from this group include those with high coupon rates and those with a near-maturity date.
Liquidity Risk
Liquidity risk refers to potential issues for selling the security quickly and at a fair price. If the investment strategy is focused on quick access to capital, then managing liquidity risk is essential.
Analysts through security analysis combat the risk by going over the relevant factors. Those factors include:
- Trading volume. Securities that have a high trading volume will likely be more liquid. This comes as a result of a potentially higher number of buyers and sellers of the security. When the trading volume is high, investors often have to go with lower prices. In some extreme cases, they can have trouble finding a trader at all
- Size and impact of the market. The larger the market the securities tend to be more liquid. Highly influential markets like NASDAQ and NYSE are focused on trading liquid assets
- Bid-ask-spread. The difference between the highest price offered for security and the lowest price the seller is willing to accept. The narrower the range, the liquidity is higher
Strategies You Can Use For An Effective Security Analysis
To effectively implement security analysis you need to utilize a multipronged approach. It starts by defining your investment goals and risk tolerance levels. Without those input parameters, you cannot conduct a proper security analysis, or make sensible investment decisions.
Moving from the goals and risks the next step is to use all the elements of the analysis, with a strong focus on fundamental and technical elements.
Start with gathering information and conducting fundamental research. A properly organized fundamental analysis includes an assessment of company filings so the analyst can determine potential profitability, debt levels, and growth potential. Evaluate any competitive advantages that the company has, because they can create a moat.
When the company checks out on financial parameters, move to a wider perspective. Inspect the industry of the target company. Investigate the current trends, its growth and innovation potential, and the main competitors.
Look for any reports compiled by established financial institutions. These are often filled with relevant data that is often difficult to get to. However, be aware of potential biases that the analysts could have toward a company or an industry.
Conduct a technical analysis, as a part of the entire analysis process. Helpful elements of the technical analysis can include identifying market trends. Indicators that can point in the right direction are moving averages and relative strength index.
However, we advise you to always use technical analysis in combination with the fundamental analysis. Analyzing the past performance of the security or industry sector is not always the measure of its future potential.
Do not get overwhelmed by past or present performance of the company. If the company has outperformed in the past or currently has good performance, that is not a certain sign of future potential. You should look for companies with good fundamentals and a potential positive outlook. Other crucial indicators are position in the market, competitive advantage, and industry outlook.
Final Thoughts
Security analysis plays a crucial role in portfolio management when dealing with major decisions in the financial market. Avoiding conducting a security analysis, or doing it badly can result in bad investment choices and eventually losses.
When thinking about security analysis, imagine it as a tool that helps you in making sensible choices, rather than those based on emotions. And that tool is crucial if you decide to make a long and fruitful investment career.