Economic analysis systematic approach to determining the optimum use of scarce resources, involving comparison of two or more alternatives in achieving a specific objective under the given assumptions and constraints.
Economic analysis deals with the analysis of forces operating in the overall economy. In the security analysis, the expected course of the economy must be enquired into because overall economic conditions and economic activities affect corporate profits and investors' expectations and thereby affect the security prices in the capital market. Economic analysis has an important role in the investment decisions. If the economic analysis shows strong and vibrant economic conditions, investors will buy the shares in expectation of earning capital profits at a later stage. An expectation of sagging economic conditions can lead to lower corporate profits and the security price will fall resulting from the selling pressure.
The economic analysis helps to identify whether the economic climate is conducive or not for the growth of the business in general. It is imperative to note that when economy grows, all industries are expected to benefit. In case of weak economies, industries struggle to survive.
An investor is interested in forecasting the expected performance of the economy in general and its effect on the performance of a particular industry or on a particular company.
Thus , economic forecasting gains a place of prime relevance in the economy analysis.
The outlook for the industries and companies depends on the outlook for the economy. A security analyst may start with the forecast of Gross Domestic Product (GDP) which is a measure of national income and is defined as the value of total goods and services produced in the economy in one year. An analysis of the components of GDP and how these components are related to the performance of industries and companies is also required. Economic analysis has an important role in the investment decisions. If the economic analysis shows strong and vibrant economic conditions, investors will buy the shares in expectation of earning capital profits at a later stage. An expectation of sagging economic conditions can lead to lower corporate profits and the security price will fall resulting from the selling pressure.
GROSS DOMESTIC PRODUCT (GDP)
By definition, the total of the final expenditures must equal the total of the receipts in the economy. This total quantity is known as the gross national product, or GNP for short. Thus, to give it a formal definition, GNP is the total value of the final output of goods and services produced in the economy. GDP is defined as the market value of goods and services produced in an economy during a period (generally one year). It may be calculated by adding the market values of all the final goods and services produced over the period. GDP is an important measure of economic activity. GDP is considered measure of economic growth in a country. Change in GDP results on account of:
Change in availability of resources.
Change in usage of these resources, and
Change in efficiency with which factors of production are used.
GDP indicates the performance of the economy during the period. An increasing trend in GDP tells about an expanding economy which provides a lot of opportunities to the firms to increase the level of activities and to increase the earnings. There are two other measures, Gross National Product and Net National Product which are also indicators of economic activity.
BUSINESS CYCLES
Business cycles refer to cyclical movement in the economic activity in a country as a whole. An economy marching towards prosperity passes through different phases, each known as a component of a business cycle. These phases are generally designated as depression, recovery, boom and recession. Depression is the lowest level of economic activities. The demand level in the economy is very low. Intrest rates and inflation rates are high. These affect the probability of corporate sector in general. Individual companies face different degrees of economic crises. There is a heavy pressure on their profitability resulting in lesser and lesser dividend pay out and reinvestment activities. Companies even might be forced to shut down some of the plants.
Some industries may show above-average response and would tend to outperform the economy. These include capital goods industries such as consumer durables. The demand for these goods is generally deferred during recession period. But during the recovery, the demand pattern outperforms the general demand level. However, during the same period, industries dealing with essential commodities such as food are less responsive. On the other hand, these industries would tend to outperform the general level during the recession period.
An understanding of business cycles will be great help to an investor. If the indications for recession are there, one should go for investment in the essential goods industries while in case of indications for recovery; the investment in capital goods industry may be preferred.
There are several indicators of interest rates. These are interest rates in the call money market or the bank rate or the prime lending rate of the lending institutions.
MONETARY POLICY, MONEY SUPPLY AND LIQUIDITY
The liquidity in the economy depends upon the money supply which is regulated by monetary policy of the government. Reserve Bank of India has been adopting several measures to regulate the money supply and liquidity in the economy. Business firms require funds for expansion projects. The capacity to raise funds from the market is affected by the liquidity position in the economy. The monetary policy is designed with an objective to maintain a balance in liquidity position. Neither the excess liquidity nor the shortages are desirable. The shortage of liquidity will tend to increase the interest rates while the excess will result in inflation.
INFLATION
Inflation refers to general increasing trend in prices. Inflationary pressure in the economy affects (decreases) the purchasing power of the consumers and thus has a considerable impact on the performance and profitability of companies. High inflation rate can be considered as an indication for slower growth rate and low inflation rate can be taken as a positive sign for an expansionary phase. Inflation has a relationship with capital market as well. During inflation, the nominal required rate of return of investors goes up resulting in the decrease in bond and equity prices. Inflation can be measured in terms of wholesale index or consumer price index. An analysis of these indices will indicate the economic conditions expected to prevail.
INTREST RATES
Interest rates directly affect the cost of funds to the industry. Higher inters rates increase the cost of funds and thus squeezes the income of companies. On the other hand, a lower interest rate reduces the cost of funds resulting in higher profit. There are several reasons for change in interest rates such as monetary policy, fiscal policy, inflation rate, etc. Irrespective of the reasons for change in interest rates, the investment pattern in the economy is affected by the change in interest rates; the interest rates affect the opportunity cost of the investors also, thus affecting the bond and equity prices. So, the changes in interest rates have repercussion on the profit of the companies as well as on the market prices of securities.
Monetary supply and monetary environment affect share prices through affecting the discounting rate. An easy monetary policy is expected to result in decreasing discount rate. Money supply also affects the real economy through
Change in growth in demand level,
Change in growth of supply position.
A shift in money supply may be a leading indicator of the beginning of a new phase in the economic and business environment.
VARIABLES FOR ECONOMIC ANALYSIS
Central to all forecasting techniques is an understanding of the national income and products accounts, which summarize both the receipts and the expenditures of all segments of the economy, whether government, business, or personal. These macroeconomic accounts taken together measure the total of economic activity in the Unites States over some specified period of time.
OTHER FACTORS
Besides the factors mentioned, there are certain other factors which should also be incorporated in the road economic analysis. Some of these factors are:-
Industrial Growth Rate- sect oral and Total
Agricultural output and rainfall pattern.
Fiscal policy of the government.
Foreign Exchange Reserves
Growth of Infrastructural Facilities.
Global Industrial Linkages
Global Economic scenario and confidence
General Economic Sentiments and confidence in the Economy.
Economic and Political Stability
