Security Analysis and Valuation
Two lenses, two different underlying beliefs
Fundamental analysis and technical analysis are not merely two different techniques — they rest on genuinely different beliefs about what drives security prices, and a Final-level question testing this distinction rewards a candidate who can articulate that underlying disagreement, not merely list each approach's tools.
Fundamental analysis
Fundamental analysis rests on the belief that a security has an intrinsic value, determined by the underlying economic, industry and company-specific factors that drive its future cash flows, and that market price will, over time, converge toward this intrinsic value, making the analytical task one of estimating intrinsic value correctly and identifying where market price currently diverges from it.
The top-down (EIC) framework. Fundamental analysis is conventionally structured as a three-level cascade: Economic analysis assesses the macroeconomic environment — GDP growth, inflation, interest rates, fiscal and monetary policy — since a company's prospects are shaped by the broader economy it operates within, regardless of how well-run the company itself is. Industry analysis assesses the specific industry's structure and outlook — using tools such as Porter's five forces from the strategic management syllabus, industry life cycle stage, and regulatory environment — since even in a favourable macroeconomic environment, individual industries face very different competitive dynamics and growth prospects. Company analysis assesses the specific firm's own financial statements, competitive position, management quality and growth prospects — the level at which most of the specific valuation techniques below are actually applied.
Company-level analysis and valuation. This is where fundamental analysis produces a specific intrinsic value estimate, typically through discounted cash flow techniques (dividend discount models, free cash flow models) or relative valuation using multiples — the specific techniques this chapter and the business valuation chapter develop in full.
Technical analysis
Technical analysis rests on a fundamentally different belief: that price and volume data itself, reflecting the aggregate of all market participants' actions and sentiment, contains sufficient information to forecast future price movements, without needing to separately estimate a company's intrinsic value from its underlying economic fundamentals at all.
Core assumptions. Technical analysis assumes market price reflects everything relevant (a claim distinct from, and in tension with, the efficient market hypothesis's stronger claim that price reflects everything relevant instantly and correctly); that prices move in identifiable trends that persist for meaningful periods rather than moving as pure random noise; and that history tends to repeat, meaning identifiable price patterns that have preceded certain movements in the past carry some predictive value for the future.
Charting techniques. Technical analysts use tools including trend lines and support/resistance levels (price levels at which buying or selling pressure has historically been strong enough to reverse or pause a price movement), moving averages (smoothing out short-term price noise to reveal an underlying trend, with a shorter-period average crossing above a longer-period average often read as a bullish signal, and vice versa), and specific chart patterns (head-and-shoulders, double tops and bottoms, triangles) believed to signal an impending continuation or reversal of the prevailing trend.
The Efficient Market Hypothesis (EMH) and its three forms. The EMH holds that security prices fully reflect all available information, and its three forms differ in what "available information" is assumed to include. Weak form efficiency holds that prices reflect all past price and volume information, implying technical analysis cannot generate abnormal returns, since any pattern in historical price data is already priced in. Semi-strong form efficiency holds that prices reflect all publicly available information, including financial statements and public announcements, implying that neither technical analysis nor fundamental analysis based on public information can generate abnormal returns. Strong form efficiency holds that prices reflect all information, public and private (insider) alike, implying that even those with access to material non-public information cannot generate abnormal returns — a form widely regarded as empirically unrealistic, given the well-documented profitability of insider trading where it occurs, which is precisely why insider trading is illegal rather than merely unprofitable. The EMH's forms are directly, and deliberately, in tension with the premises of technical analysis (weak form) and, to a lesser extent, fundamental analysis based on public information (semi-strong form), and a Final-level question can ask you to evaluate a specific analytical claim against this EMH framework.
Theory of valuation and return concepts
The general valuation principle. Any security's value is the present value of the future cash flows it is expected to generate, discounted at a rate reflecting the risk of those cash flows — the same discounting logic from the capital budgeting chapter, now applied to a traded security rather than a physical investment project.
Required return and the equity risk premium. An investor's required return on any risky security comprises the risk-free rate plus a risk premium compensating for the security's specific risk; for equity specifically, the equity risk premium is the additional return equity investors require over the risk-free rate for bearing the general risk of equity investment, and CAPM, already familiar from Intermediate FM, is the standard tool for translating this general premium into a specific required return for an individual security via its beta.
Approaches to valuation of equity shares
Dividend discount models. The Gordon growth model, already met at Intermediate level for cost of equity, is used here in reverse — given a required return and an assumed constant growth rate, it estimates a share's intrinsic value: P₀ = D₁ ÷ (Ke − g). Where growth is expected to proceed at different rates across distinct phases (a high-growth phase followed by a stable, mature growth phase), a multi-stage (two-stage or three-stage) dividend discount model is used: cash flows in the explicit high-growth phase are discounted individually, and a terminal value, computed using the Gordon growth formula applied to the final explicit year's dividend and the assumed stable long-run growth rate thereafter, is added and itself discounted back to the present.
Free cash flow models, used where dividends are an unreliable proxy for a company's genuine cash-generating capacity (a growing company retaining most or all of its cash flow, paying little or no dividend), value equity as the present value of free cash flow to equity (FCFE) — cash flow available to equity shareholders after meeting all operating expenses, interest, taxes, and reinvestment needs — discounted at the cost of equity, or value the entire firm as the present value of free cash flow to firm (FCFF) — cash flow available to all providers of capital, debt and equity alike, before financing costs — discounted at the WACC, with the value of debt then subtracted to arrive at the value attributable to equity.
Valuation of preference shares and debentures
Preference shares, carrying a fixed dividend and, if redeemable, a fixed redemption amount at a specific future date, are valued as the present value of the expected future dividend stream (perpetuity, if irredeemable) plus the present value of the redemption amount (if redeemable), discounted at the required return appropriate to preference shares specifically — a lower rate than equity's required return, reflecting preference shares' preferential, lower-risk claim, but a higher rate than debt's, reflecting that preference dividend, unlike interest, is not a guaranteed legal obligation.
Debentures/bonds are valued as the present value of the periodic coupon interest payments (an annuity) plus the present value of the face value repaid at maturity, discounted at the market's currently required yield for a bond of this specific risk and maturity — this required yield, if it differs from the bond's own coupon rate, is precisely what determines whether the bond trades at a premium (yield below coupon) or a discount (yield above coupon) to its face value, an inverse relationship between bond price and yield that recurs throughout the fixed income material in this paper's later chapters on portfolio management and interest rate risk.
Why this chapter is placed early in the AFM valuation sequence
Every later valuation-heavy chapter — portfolio management's treatment of individual securities as portfolio building blocks, business valuation's discounted cash flow and relative valuation techniques applied at the whole-firm level, and mergers and acquisitions' valuation of a target — draws directly on the equity, preference share and debenture valuation formulas this chapter establishes, and on the fundamental-versus-technical, EMH-grounded framework for thinking about what a security's price actually represents in the first place. Treat this chapter as supplying the vocabulary and formulas the rest of the valuation-heavy portion of this paper assumes as already fluent.
