Theories of Investment Analysis | Company | Financial Economics

Read this article to learn about the top seven theories of investment analysis. The theories are: 1. Flow of Funds Theory 2. Market Efficiency and Random Walk Theory 3. Efficient Market Theory 4. Random Walk Theory 5. Trend Walk Theory 6. Capital Asset Pricing (CAP) Theory 7. Modern Portfolio Theory.

Theory # 1. Flow of Funds Theory:

To start with, the economy and the financial system are interlinked through the lubricating role of money. Money flows in the form of cash and credit and savings are the basis of investments, which take the form of claims on money. Trading in these claims constitute the financial markets such as stock and capital markets. At the macro level, investment leads to capital formation and is the basis of production of goods and services and income, which results in economic growth.

At the micro level, the savings flow into investment based on a scientific analysis of the forces operating on the markets — fundamental analysis — economic, industry and com­pany forces — financial and physical performance of companies analysed through financial ratios (financial management and management accounting) and technical analysis of the market trends based on past behaviour.

Theory # 2. Market Efficiency and Random Walk Theory:

The theory of Market Efficiency and Random Walk Theory explain the price formation through the absorption of information in a perfect manner and postulate that prices move in a random fashion independent of past trends. The market is said to be efficient, if price is determined by competitive forces of supply and demand based on the free flow of correct and full information. In the real world, information is not free and complete. There are trends in which prices move and technical analysis is the answer and the Dow Theory is applicable here.

If the market absorption and information flows are not perfect, market prices move around the intrinsic worth of the shares but may not reach them. The actual pricing of shares is to be evaluated in terms of its earnings potential (EPS), dividend distribution, P/E ratio and a host of other financial ratios and a forecast of the prices is to be made to assess whether the share is overpriced or underpriced. Then the principle of buying underpriced shares and selling overpriced shares is adopted by the investor. If the random walk theory is disproved, then the markets are not efficient.

Capital Assets Pricing Model:

According to the capital assets pricing model, there is an efficiency frontier for each investor and following the Markowitz model, the capital market line and efficiency frontier line can be drawn to arrive at an efficient portfolio for each investor. The efficient portfolio minimises the risk for a given level of return or maximizes the return for a given level of risk. The risk-return analysis under portfolio theory helps the construction of an efficient portfolio.

In modern portfolio theory, the risk is represented by the concept of Beta in substitution of the standard deviation of expected returns in CAPM. This Beta relates the specific risk of a company to market risk and is represented by the slope of the capital market line. The scrips with a high Beta are aggressive such as ACC and Reliance. They are more risky and give a higher return than the market average. The scrips with a low Beta are defensive and have lower returns but are less risky than the market average like ITC or Hindustan Lever.

If the specific risk of a company is the same as that of the market risk, the company’s risk premium (Beta = 1) is equal to the risk premium of the market. By using a proper Beta, consistent with the investor preferences, an efficient portfolio, can be constructed. Portfolio management is a dynamic process, based on portfolio theory, involving constant review of the pur­chases and sales of scrips and market operations, revision of the portfolio and reshuffle of investments, etc.

Thus the portfolio theory and portfolio management constitute the rational ground to base the purchases and sales of the investor. The fundamental factors, financial and physical performance of the company, provide the basis for the forecast of the prices of shares. The technical analysis of the market helps the determination of time for purchase or sale. All those together constitute the theoretical framework for investment analysis and market operations.

Risk and Portfolio:

The choice of a portfolio aims at reducing the risks which are broadly of two categories, namely, systematic risk and unsystematic risk. The elements of systematic risk are external to the firm and cannot be controlled by the firm. The examples are changes in economic conditions, interest rate changes, inflation, recession, changes in the market demand, etc. These risks are classified as interest rate risk, purchasing power risk (inflation) and market risk.

The unsystematic risk is the controllable variation in earnings due to the peculiar characteristics of the industry, management efficiency, consumer prefe­rences, labour problems, raw material problems, etc. These are classified as business risks, financial risks, etc. The total risk is defined as the total variability of returns, which is the summation of systematic and unsystematic risks referred to above.

For a scientific basis for investment, the analyst or investor has to make a rational analysis of the market and the scrips in which he would like to invest. For this purpose, he should be familiar with factors that influence the market prices and the rationale of price formation.

One should ask, what determines the prices? Why is the present price of a scrip of Telco at Rs. 230? Why is Tisco scrip quoted at Rs. 150 today? Is it overpriced or underpriced? Is it worth buying at this level or not? These and other questions should be analysed and understood by the investor and trader. The theoretical basis for this price formation is, therefore, important. These are briefly explained below in a simple non-technical language.

Theory # 3. Efficient Market Theory:

This theory states that the market is capable of adjusting quickly and efficiently to the new information generated from the economy, industry and company. Under this theory, the prices are determined by market forces which are in turn influenced by perfect and free flow of correct, unbiased and costless information. These conditions are obtained under an ideal set up and not in the real world.

Theory # 4. Random Walk Theory:

This theory holds that no one can predict the prices of shares based on the past or historical trends. As the market is assumed to be efficient, all information is quickly absorbed in the prices, which move in a random manner and history does not repeat itself. The prices today do not depend upon the prices of yesterday. The prices have the equal capability of going up or down and it is, therefore, impossible for an average investor to earn more than the average profits except by chance. The prices move in a random manner depending upon the flow of information and any combination of shares is as good as any other combination to secure fair returns.

Theory # 5. Trend Walk Theory:

As opposed to the Random Walk Theory, the Trend Walk Theory postulates that the investor goes by the past trends and buys those which others are also buying. The trend is set by the so-called trend-setters and the investor follows the trends and is called the trend-walker. He goes by what he thinks is the trend set by the majority in the market. This behaviour is rational and justified by the logic that the market is determined by the past trends. The present is the offshoot of the past and the market absorbs the information imperfectly and as such random movements are not logical and consistent with reality.

The market pattern is set by the majority and the trend- walkers follow the market trends on a day-to-day basis. In contrast to the Random Walk Theory, this theory is more realistic as the information flows are often incorrect and biased and the market absorption is imperfect. The early risers or the trend­setters who are the first to realise the changes or are better informed would start the trends in the market and generally they are the gainers. The trend-walkers are the average investors who may sometimes get beaten up in the market when the trends change suddenly against them.

Theory # 6. Capital Asset Pricing (CAP) Theory:

Under this theory, the return on each security is related to the total risk inherent in that security. This risk is made up of systematic risk related to the market and unsystematic risk related to the company. If the risk is spread over a number of securities in the market, then the company-related risks are covered, reduced or eliminated. In a diversified portfolio, the unsystematic risk is eliminated but only the market-related systematic risk remains. In this model, the return is the same on different portfolios, if they are diversified in the sense that the risk is reduced. The earlier theory that the higher the risk, higher the return is not true under this theory. The reward is related to risk and high risk scrips provide high returns under normal conditions.

In the Capital Asset Pricing Theory, the company risk is eliminated and only the market risk remains. The market should be a free market with a large number of players who are influenced fairly and accurately by the demand and supply forces generated by the free flow of correct and perfect information. This information is digested by the market from time to time and the resultant prices are fair and competitive prices. Thus, the price of a share is determined as in an auction system and the market is the best performer and no individual can outperform the market.

This model postulates that the company risk premium and the market risk are related premium by a variable called “Beta.”

The following equation for security valuation presents the concept of “Beta”:

(Ri – Rf) = Bi (RM – Rf)

Where,

Ri is the rate of price appreciation on the scrip i (return on it).

Rf = Risk-free rate or return.

RM is the market risk or average market rate of return and Bi is the constant, which relates the premium of the market rate over the risk-free rate to the company’s risk premium (Ri – Rf). While (Ri – Rf) is the risk premium of the i scrip (RM – Rf) is the risk premium of the market and these concepts are related by the multiplier named “Beta”, which is thus a measure of the company’s risk relative to the market risk.

Theory # 7. Modern Portfolio Theory:

This theory is closely related to the above CAP Theory. Under this theory, the companies have different types of risks. These risks cannot be eliminated completely in any investment in shares on the stock market. But the investors are generally risk averse. They would like to choose a portfolio, which is least risky but with high returns. In the portfolio theory, the risk is reduced or eliminated by choosing companies in the portfolio whose covariance is negative, which means that they are not dependent upon the same economic variables.

Thus companies manufacturing autos should be combined with companies manufacturing its competitive products like scooters, cycles, etc. In this context, it is necessary that one should classify the companies into those with positive covariance (complementary) and negative cova­riance (competitive). Industries and companies, which move differently to the same economic variables, should be chosen in a portfolio in order to reduce the risk.

The risk is of two types, namely, systematic risk (market related) and specific risk (company related). Systematic risk reflects the behaviour of individual scrip to the market sequence. Some shares move along the market more closely than others. This relative measure of volatility by individual scrip to the market behaviour is given by “Beta.”

Concept of Beta:

This concept of Beta as a measure of systematic risk is useful in portfolio management. The Beta measures the movement of one scrip in relation to the market trend. Thus Beta can be positive or negative depending on whether the individual scrip moves in the same direction as the market or in the opposite direction and the extent of variance of one scrip vis-a-vis the market is being measured by Beta.

The Beta is negative, if the share price moves contrary to the general trend and positive if it moves in the same direction. The scrips which are having a high Beta of more than 1 are called aggressive, and those with a low Beta of less than 1 are called defensive. The portfolios with aggressive scrips will outperform the market.

It is, therefore, necessary to calculate Betas for all scrips and choose those with high Betas for a portfolio of high returns. But aggressive scrips are also risky as they outperform the market in uptrend as well as downtrend and fluctuations are wide. If the B is 1.5, this security is more risky by 50% than the market portfolio. If B is 1, the risk of the security is the same as that of the market.

The calculation of “Beta” is explained below:

The concept of B is defined commonly as that part of the variability of the return of a scrip which is relative to the overall variability of the market return.

The formula is Rj = a + Bj RM + u

Where Rj is the return on security j, RM is the return on market index, Bj is a measure of the risk, a is the intercept term and u is the error term introduced to estimate this regression equation. This model is commonly known as market model and Beta can be derived from the equation.

For example, if the risk-free rate is 10%, the expected market return is 15% and B is 1.5, the expected return on the security should be worked out as follows:

Risk free rate + B [expected return on market Portfolio – Risk free rate] = 10 + 1.5 (15 – 10) = 10 + 7.5 = 17.5%.

While the market rate is 15%, the rate on the security considered gives a larger return of 17.5%, as it is more risky than the market average.

Fundamental School:

The fundamental school believes in the behaviour of shares on the basis of the companies’ performance and indirectly through the forces operating from industry and the economy. This approach depends on an assessment of the past behaviour of the company for projecting its future price behaviour. Besides, this school believes that the share price generally converges towards its intrinsic value. Any company will have its shares valued by its intrinsic worth, which in turn depends upon the estimate of its future earning potential and future growth of the company.

The school proceeds to assess the value of a share in terms of its intrinsic worth which depends on the operation of the market forces and other fundamental factors influencing the company. These factors may emanate from the economy, industry and company. If the information flows are perfect and correct, the market price veers around the intrinsic value of the share. But if there are imperfections in the market and information flows are false, biased and inadequate, then there will be divergence between the market price and the intrinsic value of the share.

At any time, the intrinsic value is the individual investor’s perception of the price of the scrip depending upon his forecast of the company’s earning potential. The intrinsic value of a scrip, which was explained earlier, is the discounted value to the present of future earnings of the company, which will be distributed as dividends to the shareholders. In reality, the market price diverges from the intrinsic worth very frequently. The factors of emotional nature cannot be captured by the approach of fundamental school. Hence there is need for technical analysis also.

Intrinsic Value and Market Value of Securities:

In any fundamental analysis, the objective of the analyst would be to find out the securities which are undervalued or low-priced in the market in comparison with the intrinsic value. Graham & Dodd (Securities Analysis) have defined the intrinsic value “as that value which is justified by the facts of assets, earnings, dividends.” These facts are reflected in the earning potential of the company. The analyst has to project the future earnings per share and value them for the present time by summing up the discounted future dividends or earnings.

This means that all future earnings are discounted to the present value, which gives its intrinsic value at present. Another method is to take the earnings rate and multiply it by the industry average P/E ratio. For example, if the earnings per share is Rs. 5, as in the case of ABS Plastics, and its capitalisation rate is assumed to be 11, which is the industry average P/E ratio, then the market price should be around Rs. 55 (11 x 5). The present market price at about Rs. 80 is, therefore, an indication of overvaluation, which may partly reflect the investors’ perception of capital appreciation and the premium they place on the share of the company for psychological and behavioral reasons.

Evaluation of Shares:

At any time, the investor likes to choose the scrips which are undervalued with a view to buy them and make a profit later when the value is high. Therefore, an evaluation of securities is very important for an investor to choose the portfolio. The scrips which are undervalued may be growth-oriented chips or blue chips or income stock or cyclical or defensive stocks.

Generally, people prefer growth stocks or blue chip stocks, which have expansion plans and have unbroken records of earnings and dividend payments and issue of bonus. Some of the blue chip stocks may also be growth stocks, which are expanding and diversifying and their growth rates are higher than the market averages.

Many investors, who are particularly averse to risk, prefer income stocks. These stocks are expected to give consistent dividends and with a good record of income distribution. Such companies which earn good dividends are mutual funds, unit trusts, public limited companies with a good record. A careful evaluation is, however, necessary to decide what undervalued scrips are to be bought.

Crudely expressed a share is undervalued, if its risk is lower than the market risk, but the return is higher than the market reward. The market price can also be compared to book value of the share or its P/E ratio can be compared to similar ratios of companies in the same industry or the industry average, to know whether the share price is undervalued.