CHAPTER 2

LITERATURE REVIEW OF STOCK MARKET

As the activities on a stock market tend to be specialized and not understood by common people, this chapter will give some basic definitions and review stock market history, participants, operations and importance, so as to serve as a basis for understanding how stock market can help promote investment and trade in a monetary zone. Besides, review of other studies will be done in this chapter to give various dimensions of stock market in an economy.

2.1 Definition

Although common,

the

term

stock

market

is

somehow abstract

for

the

mechanism that enables the trading of company stocks. It is also used to describe the totality of all stocks, especially within a country, for example in the phrase the stock market was up today, or in the term stock market bubble.

Stock market is

different from a

stock exchange, which is

an

entity

(a

corporation or mutual organization) in the business of bringing buyers and sellers of stock together. For example, the stock market in the United States includes the trading of stocks listed on the NYSE, NASDAQ and Amex and also on the OTCBB and pink sheets

2.2 History

In 12

th

century France, the courratier de change was concerned with managing

and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers.

In early 13

th

century Bruges commodity traders gathered inside the house of a man

called Van der Beurse, and in 1309 they institutionalized this, but Until then informal meeting and become the Brugse Beurse. The idea quickly spread around Flanders and neighboring counties and Beurzen and soon opened in Ghent and Amsterdam.

In the middle of the 13 securities.

th

century, Venetian bankers began to trade in government In 1351, the Venetian government outlawed

spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14 th century. This was only possible because these were independent city states not

ruled by a duke but a council of influential citizens.

The Dutch later started joint stock companies, which let shareholders invest in business ventures and get a share of their profits or losses. In 1602, the Dutch East India

Company issued the first shares on the Amsterdam stock exchange. It was the first company to issue stocks and bonds.

The first stock exchange to trade continuously was the Amsterdam Beurs, in the early 17 th century. The Dutch pioneered short selling, option trading,

debt-equity swaps, merchant banking, unit trusts and other speculative instruments, much as we know them.

Now, there are stock markets in virtually every developed country and most developing countries, with the worlds biggest markets in the United States, UK, Germany, France and Japan.

2.3 Stock Market Participants and Trading

1.

Many years ago, worldwide, buyers and sellers were individual investors such

as wealthy businessmen, with long family histories (and emotional ties) to particular corporations (think Ford). Over time, markets have become more institutionalized with buyers and sellers largely institutions e.g pension funds, insurance companies, mutual funds, hedge funds, investor groups and banks. The rise of institutional investor has brought with it some improvement sin stock market operations, but not necessarily in

the interest of the small investors or even of the nave institutions, of which there are many.

Now, participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order.

Most stocks are traded on exchanges e.g NYSE, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. The other type of exchange is a virtual kind e.g

Nasdaq, composed

of

network

of

computers

where

trades

are

made

electronically via traders at computer terminals.

Actual trades are based on an auction market paradigm where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for a stock. When the bid and ask prices match, a sale takes place on a first come first serve basis if there are multiple bidders and askers at a given price.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). Really, a stock exchange is nothing more than a super-sophisticated farmers market providing a meeting place for buyers and sellers.

2.4 Importance of stock markets

Just as it is important that networks of transportation, electricity and telecommunications function properly, so is it essential that payments can be transacted, capital can be saved and channeled to the most profitable investment projects and that both households and firms get help in handling financial uncertainty and risk as well as possibilities of

spreading consumption over time. Financial markets constitute an important part of the total infrastructure for every society that has passed the stage of largely domestic economies. Stock market which is part of the financial markets,

perform the following functions in an economy:

I.

Raising Capital for Businesses: The stock exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public

II.

Mobilizing Savings for Investment: When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed or kept in idle deposits with banks, are mobilized and redirected to promote business activity with the benefits for several economic sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and higher productivity levels.

III.

Facilitate

Company

Growth:

Companies

view acquisitions as

opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share or acquire other necessary business assets. A takeover bid or merger agreement through the stock market is the simplest and most common way to company growing by acquisition or fusion. IV. Redistribution of Wealth: By giving a wide spectrum of people a chance to buy shares and therefore become part owners

(shareholders) of profitable enterprises, the stock market helps to reduce large income inequalities. Both casual and professional stock investors through stock price rise and dividends get a chance to share in the profits of promising business that were set up by other people. V. Corporate Governance: By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations

by public stock exchange and the government. Consequently, it is believed that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privatively held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs or otherwise by a small group of investors). However, some well-documented cases are known where it is alleged that there has been considerable slippage in corporate governance on the part of some public companies (e.g famous Enron Corporation, MCI WorldCom, Pets.com, Webvan or Parmalat). VI. Creates Investment Opportunities for Small Investors: As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the stock exchange provides an extra source of income for small savers. VII. Government Raise Capital for Development Projects: The

Government and even local municipalities may decide to borrow money in order to finance huge infrastructure projects such as sewerage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the stock exchange whereby members of the public can buy them. When the government or municipal council gets this alternative source of funds, it no longer has the need to overtax the people in order to finance these development projects.

10

VIII. Barometer of the Economy: At the stock exchange, share prices rise and fall depending, largely on the market. Share prices tend to rise or remain stable when companies or the economy in general show signs of stability. Therefore the movement of share prices can be an indicator of the general trend in the economy.

2.5 Relation of Stock Market to Modern Financial System

The financial system in most western countries has undergone a remarkable transformation. One feature of this development is

disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via traditional lending and deposit banks

operations. The general publics heightened

interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process.

Statistics

show

that

in recent

decades

shares

have

made

up

an

increasingly large proportion of households financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households financial wealth, as against less than 20 percent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms

of saving with a higher risk has been accentuated by new rules for most

11

funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrial countries.

In all developed economic systems, such as the European Union, the United States, Japan and other developed world countries, the trend has been the same; saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another. But in developing countries, it is exactly the opposite that is happening with households savings.

2.6 The Behavior of the Stock Market

From past experience, it is known that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur so that excessive optimism (euphoria) may drive prices unduly high or excessive

pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient.

According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or dividends, ought to affect the share prices. But this largely theoretical academic viewpoint also predicts that little or no trading should take place contrary to fact since prices are already at or near equilibrium, having priced in all public knowledge. However, the efficient market hypothesis is sorely tested by such events as stock market crash in 1987, when the Dow Jones index

plummeted 22.6 percent the largest ever one day fall in the United States. This was

part of the world wide crash of stock markets which did not originate in

12

the United States. The event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a definite cause. A thorough search failed to detect any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one day share price movements in the United States in the post war period confirmed this (Source: Cutler, D. Poterba, J. & Summers, L. (1991), Speculative dynamics, Review of Economic Studies 58, pp. 520-546). Moreover, while the EMH predicts that all price movement, in the absence of change in the fundamental information, is random (e.g non-trending), many studies have shown a marked tendency for the stock market to trend over time for periods of weeks or longer.

Various explanations for large price movements have been promulgated. For instance, some research have shown that changes in estimated risk, and the use strategies, such as stop-loss limits and of VaR certain limits,

theoretically could cause financial markets to overreact.

Other

researchhas stock

shown price

that

psychological

factors

may

result

in has

exaggerated

movements.

Psychological

research

demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his

13

(psychological) risk threshold. (Source: Tversky, A. & Kahneman, D. (1974), Judgement under uncertainty: heuristics and biases, Science 185, pp. 1124-1131)

Another phenomenon also from psychology that works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which you may be familiar is the reluctance to enter a restaurant that is empty; people

generally prefer to have their opinion validated by those of others in the group.

In one paper the authors draw an analogy with gambling. (Source: Stephen Morris and Hyun Song Shin, Oxford Review of Economic Policy, vol. 15, no 3, 1999) In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically.

We are also liable to succumb to biased thinking. An example is when supporters of a national football team (or a favorite stock), for instance, are overconfident about the chances of winning (or the stock moving up).

The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the recent Nasdaq crash, less than 1 per cent of the analyst's recommendations had been to sell (and even during the 2000 - 2002 crash, the average did not rise above 5%). The media amplified the general

14

euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. This later magnified the gloom which descended during the 2000 2002 crash, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.

To end this section on the behavior of the stock markets, it will be worthwhile to share with the readers of this study a famous quote from the preface to a published biography about a well-known and long term value oriented stock investor, Warren Buffet. (1) Buffet began his career with only 100 U.S. dollars and has over the years built himself a multibillion-dollar fortune. The quote illustrates something of what has been going on in the stock market during the end of the 20th century and the beginning of the 21 st

With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all over talking each other to get investors' attention. At the same time, individual

investors, immersed in chat rooms and message questionable and often misleading tips. information, investors find Yet,

boards, are exchanging all this available

despite

it increasingly difficult to profit. Stock prices

skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the

15

market, only folly (Hagstrom, R.G. (2001), The Essential Buffet, John Wiley

& Sons, Inc. New York).

2.7 Empirical Evidences about Stock Market

Different studies have been carried out by financial economists on the implications of stock market development for various components of an economy. Relationships have been found to exist between stock market development and those aspects of an economy, even though some have been controversial, while other relationships have shown clear and significant correlation.

In this section, review and summary empirical findings are made of three studies, which development investigated the relationships of firms between stock market

andfinancing

choices

by Demirguc-Kunt and

Maksimovic (1996); stock market development and financial intermediaries: stylized facts by Demirguc-Kunt and Levine (1996) and stock market development and long run growth by Levine and Zervos (1996).

2.7.1 Stock Market Development and Financing Choices of Firms

In many developing countries with emerging stock markets, banks are fearful of stock market development because they think that stock markets will volume of their business. This reduce the

article under review empirically analyzed the

effects of stock market development on firms financing choices using data from thirty developing and industrial countries from 1980 to 1991.

16

Finance literature suggests that stock markets serve important functions even in those economies in which a well developed banking sector already exists, the reason being that equity and debt financing are in general not prefect substitutes. Equity financing has a key role in the management of conflicts of interest that may arise between different stakeholders in the firm. Stock markets also provide entrepreneurs with liquidity and with opportunities to diversify their portfolios. Stock trading transmits information about the firms prospects to potential investors and creditors.

The article empirically explored the effect of financial market development, particularly stock market development, on the financing choices of firms. It compared relationship between the choice of capital structure the

and financial market

development in the sample. It investigated the extent to which the variation in the aggregate debt-equity ratios within these countries can be explained by (a) the level of development of the countrys financial markets, (b) macroeconomic factors (c) the differences between the tax treatment of debt and equity securities and (d) the firm specific factors that have been identified in the corporate finance literature as determining financial structure.

The study found that in general there is a significant positive relationship between bank development and leverage and a negative but insignificant relationship between stock market development and leverage. However, when the study broke down the full sample into sub samples and control for other variables of firm financing, an

interesting relationship between leverage and stock market development emerges. For stock markets that are

already developed, further development leads to a substitution of equity for

17

debt financing. By contrast, in developing stock markets, large firms become more levered as the stock market develops, whereas small firms do not appear to be significantly affected by stock market development.

The results have important implications. In many developing countries with emerging stock markets, banks are fearful of stock market development because they think that stock markets will reduce the volume of their business. Instead, the results imply that initial improvements in the functioning of a developing stock market produce a higher debt-equity ratio for firms and thus more business for banks. These results also suggest that in countries with developing financial systems, stock markets and banks play different yet complementary roles. Thus policies undertaken to develop stock market need not affect existing banking systems adversely. The results are consistent with the conclusion of Demirguc-Kunt and Levine (1996) that stock market and simultaneously. financial intermediary development precede

2.7.2 Stock Market Development and Financial Intermediaries: Stylized

Facts

World stock markets are booming and emerging stock markets account for a disproportionate share of this growth. Yet economists lack a common concept or measure of stock market development.

The above named article under review gave empirical content to the phrase stock market development by collecting and comparing a broader array of empirical indicators of stock market development than any study before it. Using data on forty-four developing and industrial countries from 1986 to

18

1993, they examine different measures of stock market size, market liquidity, market concentration, integration with market volatility, markets. institutional Since each development and indicator suffers

world capital

statistical and conceptual shortcomings, they use a variety of indicators, which provide a more accurate depiction of stock markets than any single measure. Furthermore, stock market development like the level of economic development is a complex and multifaceted concept. No single measure will capture all aspects of stock market development. Thus, the goal was to produce a set of stylized facts about various indicators of stock market development that facilitates and stimulates research into the links among stock markets, economic development and corporate financing decisions.

After describing each of the stock market development indicators, the article examined relationship among them. An enormous cross-country variation was found in the stock market indicators. For example, five countries had market capitalization to gross

domestic product (GDP) ratios greater than 1, and five countries had market capitalization to GDP ratios less than 0.10. It found attractive correlation among indicators. For example, large stock markets are more liquid, less volatile and more internationally integrated than smaller markets; countries with strong information disclosure laws, internationally accepted accounting standards and unrestricted international capital flows tend to have larger and more liquid markets; countries with markets concentrated in a few stocks tend to have smaller, less liquid and less internationally integrated markets and internationally integrated markets are less volatile.

19

The article also documented the relationship between the various stock market indicators and measures of financial intermediary development. Since debt and equity are frequently viewed as alternative sources of corporate finance, stock markets and banks are sometimes viewed as alternative vehicles of financing

corporate investments (Demirguc-Kunt and Maksimovic 1996). Consequently, the article documented cross country ties between stock market development and financial intermediary development. It used the measures of the size of the banking system, the amount of credit going to private firms, the size of the nonblank financial corporation and the size of private insurance and pension companies. It found that most stock market indicators are highly correlated with the development and efficient functioning of banks, nonblank financial corporations and private insurance and pension companies. Countries with well developed stock markets tend to have well developed financial intermediaries.

2.7.3 Stock Market Development and Long-Run Growth

Is financial system important for economic growth? One line of research argues that it is not and another line stresses the importance of financial system in mobilizing savings, allocating capital, exerting corporate control and easing risk management. Moreover, some theories provide a conceptual basis for the belief that larger, more efficient stock markets boost economic growth. The article under review examined whether there is a strong empirical link between stock market development and longrun growth.

The article documented theoretical disagreement which exists about the importance of stock markets for economic growth. Mayer (1988) argues that even large stock markets are unimportant sources of corporate finance.

20

Stiglitz (1985, 1994) says stock market liquidity will not enhance incentives for acquiring information about firms or exerting corporate governance. Moreover,

Devereux and Smith (1994) emphasis that greater risk sharing through internationally integrated stock markets can actually reduce saving rates and slow economic growth. Finally, the analyses of Shleifer and Summers (1988) and Morck, Shleifer, and Vishny (1990a, 1990b) suggest that stock market development can hurt economic growth by easing counterproductive corporate takeovers.

The article used cross country regressions to examine the link between stock market development and economic growth. To conduct this investigation, it needed measures of stock market development. Theory does not provide a unique concept or measure of stock market development, but it does suggest that stock market size, liquidity and integration with world capital markets may affect economic growth. Consequently, the study used a conglomerate index of overall stock market development constructed by Demirgus-Kunt and Levine (1996).

The article further built on Atje and Jovanovics (1993) study of stock market trading and economic growth in two ways. First, it used indexes of stock market development that combine information on stock market size, trading and integration. Second, it controlled for initial conditions and other factors that may affect economic growth in light of the evidence that many cross county regression results are fragile to changes in the conditioning information set (Levine and Renelt 1992). Thus it gauged the robustness of the relationship between overall stock market development and economic

growth to changes in the conditioning information set. It found a strong

21

correlation

between

overall

stock

market

development

and

long-

run economic growth. After controlling for the initial level of GDP per capita, initial investment in human capital, political instability and measures of monetary, fiscal and exchange rate policy, stock market development remains positively and significantly correlated with long-run economic growth. The results are consistent with theories that and imply a positive relationship between stock market

development

long-run

economic growth. The results are inconsistent with

theories that predict no correlation or a negative link between stock market development and economic performance.

SECURITY ANALYSIS

Investment success is pretty much a matter of careful selection and timing of stock purchases coupled with perfect matching to an individuals risk tolerance. In order to carry out selection, timing and matching actions an investor must conduct deep security analysis.

Investors purchase equity shares with two basic objectives;

1. To make capital profits by selling shares at higher prices. 2. To earn dividend income.

These two factors are affected by a host of factors. An investor has to carefully understand and analyze all these factors. There are basically two approaches to study security prices and valuation i.e. fundamental analysis and technical analysis

The value of common stock is determined in large measure by the performance of the firm that issued the stock. If the company is healthy and can demonstrate strength and growth, the value of the stock will increase. When values increase then prices follow and returns on an investment will increase. However, just to keep the savvy investor on their toes, the mix is complicated by the risk factors involved. Fundamental analysis examines all the dimensions of risk exposure and the probabilities of return, and merges them with broader economic analysis and greater industry analysis to formulate the valuation of a stock.

FUNDAMENTAL ANALYSIS

Fundamental analysis is a method of forecasting the future price movements of a financial instrument based on economic, political, environmental and other relevant factors and statistics that will affect the basic supply and demand of whatever underlies the financial instrument. It is the study of economic, industry and company conditions in an effort to determine the value of a companys stock. Fundamental analysis typically focuses on key statistics in companys financial statements to determine if the stock price is correctly valued. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.

Fundamental analysis is the cornerstone of investing. The basic philosophy underlying the fundamental analysis is that if an investor invests re.1 in buying a share of a company, how much expected returns from this investment he has.

The fundamental analysis is to appraise the intrinsic value of a security. It insists that no one should purchase or sell a share on the basis of tips and rumors. The fundamental approach calls upon the investors to make his buy or sell decision on the basis of a detailed analysis of the information about the company, about the industry, and the economy. It is also known as top-down approach. This approach attempts to study the economic scenario, industry position and the company expectations and is also known as economicindustry-company approach (EIC approach).

Thus the EIC approach involves three steps: 1. Economic analysis 2. Industry analysis 3. Company analysis

1. ECONOMIC ANALYSIS

The level of economic activity has an impact on investment in many ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and vice versa. When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms. The analysis of macro economic environment is essential to understand the behavior of the stock prices.

The commonly analyzed macro economic factors are as follows:

Gross Domestic Product (GDP): GDP indicates the rate of growth of the economy. It represents the aggregate value of the goods and services produced in the economy. It consists of personal consumption expenditure, gross private domestic investment and government expenditure on goods and services and net exports of goods and services. The growth rate of economy points out the prospects for the industrial sector and the return investors can expect from investment in shares. The higher growth rate is more favorable to the stock market.

Savings and investment: It is obvious that growth requires investment which in turn requires substantial amount of domestic savings. Stock market is a channel through which the savings are made available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual

funds, real estate and bullion. The savings and investment patterns of the public affect the stock to a great extent.

Inflation: Along with the growth of GDP, if the inflation rate also increases, then the real growth would be very little. The effects of inflation on capital markets are numerous. An increase in the expected rate of inflation is expected to cause a nominal rise in interest rates. Also, it increases uncertainty of future business and investment decisions. As inflation increases, it results in extra costs to businesses, thereby squeezing their profit margins and leading to real declines in profitability.

Interest rates: The 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. More money is available at a lower interest rate for the brokers who are doing business with borrowed money. Availability of cheap funds encourages speculation and rise in the price of shares.

Tax structure: Every year in March, the business community eagerly awaits the Governments announcement regarding the tax policy. Concessions and incentives given to a certain industry encourage investment in that particular industry. Tax reliefs given to savings encourage savings. The type of tax exemption has impact on the profitability of the industries.

Infrastructure facilities: Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide network of communication system

is a must for the growth of the economy. Regular supply of power without any power cut would

boost the production. Banking and financial sectors also should be sound enough to provide adequate support to the industry. Good infrastructure facilities affect the stock market favorably.

2.

INDUSTRY ANALYSIS

An industry is a group of firms that have similar technological structure of production and produce similar products and Industry analysis is a type of business research that focuses on the status of an industry or an industrial sector (a broad industry classification, like "manufacturing"). Irrespective of

specific economic situations, some industries might be expected to perform better, and share prices in these industries may not decline as much as in other industries. This identification of economic and industry specific factors influencing share prices will help investors to identify the shares that fit individual expectations

Industry Life Cycle: The industry life cycle theory is generally attributed to Julius Grodensky. The life cycle of the industry is separated into four well defined stages. Pioneering stage: The prospective demand for the product is promising in this stage and the technology of the product is low. The demand for the product attracts many producers to produce the particular product. There would be severe competition and only fittest companies survive this stage. The

producers try to develop brand name, differentiate the product and create a product image. In this situation, it is difficult to select companies for investment because the survival rate is unknown. Rapid growth stage: This stage starts with the appearance of surviving firms from the pioneering stage. The companies that have withstood the competition grow strongly in market share and financial performance. The technology of the production would have improved resulting in low cost of production and good quality products. The companies have stable growth rate in this stage and they declare dividend to the shareholders. It is advisable to invest in the shares of these companies. Maturity and stabilization stage: the growth rate tends to moderate and the rate of growth would be more or less equal to the industrial growth rate or the gross domestic product growth rate. Symptoms of obsolescence may appear in the technology. To keep going, technological innovations in the production process and products should be introduced. The investors have to closely monitor the events that take place in the maturity stage of the industry. Decline stage: demand for the particular product and the earnings of the companies in the industry decline. It is better to avoid investing in the shares of the low growth industry even in the boom period. Investment in the shares of these types of companies leads to erosion of capital.

Growth of the industry: The historical performance of the industry in terms of growth and profitability should be analyzed. The past variability in return and growth in reaction to macro economic factors provide an insight into the future.

Nature of competition: Nature of competition is an essential factor that determines the demand for the particular product, its profitability and the price of the concerned company scrips. The companies' ability to withstand the local as well as the multinational competition counts much. If too many firms are present in the organized sector, the competition would be severe. The competition would lead to a decline in the price of the product. The investor before investing in the scrip of a company should analyze the market share of the particular company's product and should compare it with the top five companies.

SWOT

analysis:

SWOT

analysis

represents

the

strength,

weakness,

opportunity and threat for an industry. Every investor should carry out a SWOT analysis for the chosen industry. Take for instance, increase in demand for the industrys product becomes its strength, presence of numerous players in the market, i.e. competition becomes the threat to a particular company. The progress in R & D in that industry is an opportunity and entry of multinationals in the industry is a threat. In this way the factors are to be arranged and analyzed.

3. COMPANY ANALYSIS
In the company analysis the investor assimilates the several bits of information related to the company and evaluates the present and future values of the stock. The risk and return associated with the purchase of the stock is analyzed to take better investment decisions. The present and future values are affected by a number of factors.

Competitive edge of the company: Major industries in India are composed of hundreds of individual companies. Though the number of companies is large, only few companies control the major market share. The competitiveness of the company can be studied with the help of the following; Market share: The market share of the annual sales helps to determine a companys relative competitive position within the industry. If the market share is high, the company would be able to meet the competition successfully. The companies in the market should be compared with like product groups otherwise, the results will be misleading. Growth of sales: The rapid growth in sales would keep the shareholder in a better position than one with stagnant growth rate. Investors generally prefer size and growth in sales because the larger size companies may be able to withstand the business cycle rather than the company of smaller size. Stability of sales: If a firm has stable sales revenue, it will have more stable earnings. The fall in the market share indicates the declining trend of company, even if the sales are stable. Hence the stability of sales

should be compared with its market share and the competitors market share.

Earnings of the company: Sales alone do not increase the earnings but the costs and expenses of the company also influence the earnings. Further, earnings do not always increase with increase in sales. The companys sales might have increased but its earnings per share may decline due to rise in costs. Hence, the investor should not only depend on the sales, but should analyze the earnings of the company.

Financial analysis: The best source of financial information about a company is its own financial statements. This is a primary source of information for evaluating the investment prospects in the particular companys stock. Financial statement analysis is the study of a companys financial statement from various viewpoints. The statement gives the historical and current information about the companys operations. Historical financial statement helps to predict the future and the current information aids to analyze the present status of the company. The two main statements used in the analysis are Balance sheet and Profit and Loss Account.

The balance sheet is one of the financial statements that companies prepare every year for their shareholders. It is like a financial snapshot, the company's financial situation at a moment in time. It is prepared at the year end, listing the company's current assets and liabilities. It helps to study the capital structure of the company. It is better for the investor to avoid a company with excessive debt component in its capital structure. From the balance sheet,

liquidity position of the company can also be assessed with the information on current assets and current liabilities.

Ratio analysis: Ratio is a relationship between two figures expressed mathematically. Financial ratios provide numerical relationship between two relevant financial data. Financial ratios are calculated from the balance sheet and profit and loss account. The relationship can be either expressed as a percent or as a quotient. Ratios summarize the data for easy understanding, comparison and interpretations.

Ratios for investment purposes can be classified into profitability ratios, turnover ratios, and leverage ratios. Profitability ratios are the most popular ratios since investors prefer to measure the present profit performance and use this information to forecast the future strength of the company. The most often used profitability ratios are return on assets, price earnings multiplier, price to book value, price to cash flow, and price to sales, dividend yield, return on equity, present value of cash flows, and profit margins.

a) Return on Assets (ROA) ROA is computed as the product of the net profit margin and the total asset turnover ratios. ROA = (Net Profit/Total income) x (Total income/Total Assets)

This ratio indicates the firm's strategic success. Companies can have one of two strategies: cost leadership, or product differentiation. ROA should be rising or keeping pace with the company's competitors if the company is successfully pursuing either of these strategies, but how ROA rises will depend on the company's strategy. ROA should rise with a successful cost leadership strategy because the companys increasing operating efficiency. An example is an increasing, total asset, turnover ratio as the company expands into new markets, increasing its market share. The company may achieve leadership by using its assets more efficiently. With a successful product differentiation strategy, ROA will rise because of a rising profit margin.

b) Return on Investment (ROI) ROI is the return on capital invested in business, i.e., if an investment Rs 1 crore in men, machines, land and material is made to generate Rs. 25 lakhs of net profit, then the ROI is 25%. The computation of return on investment is as follows:

Return on Investment (ROI) = (Net profit/Equity investments) x 100

As this ratio reveals how well the resources of a firm are being used, higher the ratio, better are the results. The return on shareholders investment should be compared with the return of other similar firms in the same industry. The inertfirm comparison of this ratio determines whether the investments in the firm are attractive or not as the investors would like to invest only where the return is higher.

c) Return on Equity Return on equity measures how much an equity shareholder's investment is actually earning. The return on equity tells the investor how much the invested rupee is earning from the company. The higher the number, the better is the performance of the company and suggests the usefulness of the projects the company has invested in. The computation of return on equity is as follows:

Return on equity = (Net profit to owners/value of the specific owner's Contribution to the business) x 100

The ratio is more meaningful to the equity shareholders who are invested to know profits earned by the company and those profits which can be made available to pay dividend to them.

d) Earnings per Share (EPS) This ratio determines what the company is earning for every share. For many investors, earnings are the most important tool. EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. The computation of EPS is as follows:

Earnings per share = Net profit/Number of shares outstanding

The EPS is a good measure of profitability and when compared with EPS of similar other companies, it gives a view of the comparative earnings or earnings power of a firm. EPS calculated for a number of years indicates whether or not earning power of the company has increased.

e) Dividend per Share (DPS) The extent of payment of dividend to the shareholders is measured in the form of dividend per share. The dividend per share gives the amount of cash flow from the company to the owners and is calculated as follows:

Dividend per share = Total dividend payment / Number of shares outstanding

The payment of dividend can have several interpretations to the shareholder. The distribution of dividend could be thought of as the distribution of excess profits/abnormal profits by the company. On the other hand, it could also be negatively interpreted as lack of investment opportunities. In all, dividend payout gives the extent of inflows to the shareholders from the company.

f) Dividend Payout Ratio

From the profits of each company a cash flow called dividend is distributed among its shareholders. This is the continuous stream of cash flow to the owners of shares, apart from the price differentials (capital gains) in the market. The return to the shareholders, in the form of dividend, out of the company's profit is measured through the payout ratio. The payout ratio is computed as follows:

Payout Ratio = (Dividend per share / Earnings per share) * 100 The percentage of payout ratio can also be used to compute the percentage of retained earnings. The profits available for distribution are either paid as dividends or retained internally for business growth opportunities. Hence, when dividends are not declared, the entire profit is ploughed back into the business for its future investments.

g) Dividend Yield Dividend yield is computed by relating the dividend per share to the market price of the share. The market place provides opportunities for the investor to buy the company's share at any point of time. The price at which the share has been bought from the market is the actual cost of the investment to the shareholder. The market price is to be taken as the cum-dividend price. Dividend yield relates the actual cost to the cash flows received from the company. The computation of dividend yield is as follows

Dividend yield = (Dividend per share / Market price per share) * 100

High dividend yield ratios are usually interpreted as undervalued companies in the market. The market price is a measure of future discounted values, while the dividend per share is the present return from the investment. Hence, a high dividend yield implies that the share has been under priced in the market. On the other hand a low dividend yield need not be interpreted as overvaluation of shares. A company that does not pay out dividends will not have a dividend yield and the real measure of the market price will be in terms of earnings per share and not through the dividend payments.

h) Price/Earnings Ratio (P/E) The P/E multiplier or the price earnings ratio relates the current market price of the share to the earnings per share. This is computed as follows:

Price/earnings ratio = Current market price / Earnings per share

This ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares in a particular company. Many investors prefer to buy the company's shares at a low P/E ratio since the general interpretation is that the

market is undervaluing the share and there will be a correction in the market price sooner or later. A very high P/E ratio on the other hand implies that the company's shares are overvalued and the investor can benefit by selling the shares at this high market price.

i) Debt-to-Equity Ratio Debt-Equity ratio is used to measure the claims of outsiders and the owners against the firms assets. Debt-to-equity ratio = Outsiders Funds / Shareholders Funds

The debt-equity ratio is calculated to measure the extent to which debt financing has been used in a business. It indicates the proportionate claims of owners and the outsiders against the firms assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm.

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