CHAPTER 6

SECURITY ANALYSIS
 Security analysis
• Security analysis is an examination and
evaluation of the various factors affecting
the value of a security.
• Investors use security analysis to determine
how to invest in a particular market, how
much to invest, and when to invest
• Technical or Fundamental school of thought
may be used to analysis securities
Technical analysis:
• Technical analysis is the study of historical prices for the
purpose of predicting prices in the future
• Technical analysts frequently utilize charts of past prices
to identify historical price patterns
• These price patterns are then used to forecast prices in the
future
• It attempts to predict the supply and demand for a stock
by observing the past series of stock prices.
• Financial statements and market conditions are of
secondary importance to the technical analyst as they will
not be used to predict future benefits
• Fundamental analysis
– Fundamental analysis is a method of evaluating a
security by attempting to measure its intrinsic
value by examining related economic, financial
and other qualitative and quantitative factors.

– Fundamental analysts attempt to study everything

that can affect the security's value, including
macroeconomic factors (like the overall economy
and industry conditions) and individually specific
factors (like the financial condition and
management of companies).
• The end goal of performing fundamental
analysis is to produce a value that an
investor can compare with the security's current
price in hopes of figuring out what sort of
position to take with that security (underpriced
= buy, overpriced = sell or short).
• Thus, fundamental analyst considers:
– Financial statements
– Industry conditions
– Prospects for the economy
• The intrinsic value of an equity share depends on
a multitude of factors.
– The earnings of the company, the growth rate and the
risk exposure of the company have a direct bearing on
the price of the share.
– These factors in turn rely on the host of other factors like
economic environment, the industry and finally
companies’ own performance.
• The fundamental school of thought appraises the
intrinsic value of shares through
1. Macro economic Analysis
2. Industry Analysis
3. Company Analysis
1. Macroeconomic Analysis
• The level of economic activity has an impact
on investment in many ways.
• If the economy grows rapidly, the industry
can also expected to show rapid growth.
Macroeconomic Analysis involves
• Growth Rate of National Income (GDP
Growth Rate):
– Growth Rate in Industry
– Growth Rate in Service
– Growth Rate in Agriculture
• Inflation (consumer goods demand)
• Interest rates (cost of Financing)
• Budget (government revenue and spending)
• The tax structure (Concessions and incentives)
• The balance of payments (effect on exchange
rate, investment)
• Infrastructure facilities
• Demographical factors
• Business Cycles: the recurring pattern of recession and
recovery of the economy.
• Fiscal Policy: refers to government’s spending and tax
actions.
• Monetary Policy: refers to the manipulation of the money
supply to affect the macro economy.
• Monetary policy works largely through its impact on
interest rates.
– Money supply increase results to lower Interest rates,
enhance investment and demand (consumption) but with
inflationary pressures
– Reserve requirements (commercial banks)
– Margin requirements (brokerage accounts)
2. Industry Analysis
• Analyzing the industry in term of its elasticity
to economic activities
– Cyclical industry - performance is positively
related to economic activity
– Defensive industry - performance is insensitive to
economic activity.
– Growth industry - characterized by rapid growth in
sales, independent of the business cycle
• Industry Life Cycle Theory:
– Birth (heavy R&D, large losses - low revenues)
– Growth (building market share and economies
of scale)
– Mature growth (maximum profitability)
– Stabilization (increase in unit sales may be
achieved by decreasing prices)
– Decline (demand shifts lead to declining sales
and profitability - losses)
• Life Cycle of an Industry (Marketing view)
– Start-up stage: many new firms; grows rapidly
(example: genetic engineering)
– Consolidation stage: shakeout period; growth
slows (example: video games)
– Maturity stage: grows with economy (example:
automobile industry)
– Decline stage: grows slower than economy
(example: railroads)
• Qualitative Issues
– Competitive Structure
– Permanence (probability of product obsolescence)
– Vulnerability to external shocks (foreign
competition)
– Regulatory and tax conditions (adverse changes)
– Labor conditions (unionization)
3. Company Analysis:
• Sales Revenue (growth)
• Profitability (trend)
• Product line (turnover, age)
– Output rate of new products
– Product innovation strategies
– R&D budgets
• Pricing Strategy
• Patents and technology
• Organizational performance
– Effective application of company resources
– Efficient accomplishment of company goals
• Management functions
– Planning - setting goals/resources
– Organizing - assigning tasks/resources
– Leading - motivating achievement
– Controlling - monitoring performance
• Evaluating Management Quality
– Age and experience of management
– Strategic planning
• Understanding of the global environment
• Adaptability to external changes
– Marketing strategy
• Track record of the competitive position
• Sustainable growth
• Public image
– Finance Strategy - adequate and appropriate
– Employee/union relations
– Effectiveness of board of directors
 Company Analysis: Quantitative
Issues
• Operating efficiency
– Productivity
– Production function
• Understanding a company’s risks
• Financial, operating, and business risks
• Financial Ratio Analysis
– Past financial ratios
– With industry, competitors
• Regression analysis
– Forecast Revenues, Expenses, Net Income
– Forecast Assets, Liabilities, External Capital Requirements
 Company Analysis: Quantitative
Issues
• Balance Sheet
– Company’s Assets, Liabilities and Equity.
• Income statement
– Sales, expenses, and taxes incurred to
operate
– Earnings per share
• Cash flow statement
– Sources and Uses of funds
• Are financial statements reliable?
 Company Analysis: Quantitative
Issues
• Financial Ratio Analysis
– Liquidity
– Debt
– Profitability
– Efficiency
What does each ratio mean
from investors point of view
and which ratios are more
meaningful to investors?
 The Investment Valuation Process

• Two approaches
1. Top-down approach
2. Bottom-up approach
• The difference between the two approaches is
the perceived importance of economic and
industry influence on individual firms and
stocks
Top-down approach
• Relies heavily on the analysis and forecasting
of trends in the economy and industry
• Evaluates the expected impact of changes in
the world economy on the macro economy of
the country.
• Evaluates the expected influence of these
changes on the domestic industry.
• Identifies the stocks which are expected to
outperform the market.
• In this approach
– investors begin with economy/market
considering interest rates and inflation to find
out favorable time to invest in common stock
– then consider future industry/sector prospect
to determine which industry/sector to invest in
– Finally promising individual companies of
interest in the prospective sectors are analyzed
for investment decision.
Top-Down approach is a three-Step Approach:
1. General economic influences
– Decide how to allocate investment funds among
countries, and within countries to bonds, stocks, and cash
2. Industry influences
– Determine which industries will prosper and which
industries will suffer on a global basis and within
countries
3. Company analysis
– Determine which companies in the selected industries
will prosper and which stocks are undervalued
Bottom-up approach
• Bottom-up approach, is an approach where
investors focus directly on a company’s basic
performance.
• Analysis of such information as the company’s
products, its competitive position and its financial
status leads to an estimate of the company's
earnings potential and ultimately its value in the
market.
• The emphasis in this approach is on finding
companies with good growth prospect, and making
accurate earnings estimates.
Valuation of Alternative Investments
• You may recall from your studies in corporate finance
that the value of an asset is the present value of its
expected returns.
• Specifically, you expect an asset to provide a stream of
returns during the period of time you own it.
• To convert this estimated stream of returns to a value
for the security, you must discount this stream at your
required rate of return.
• This process of valuation requires estimates of (1) the
stream of expected returns and (2) the required rate of
return on the investment.
• An estimate of the expected returns from an
investment encompasses not only the size but also the
form, time pattern, and the uncertainty of returns,
which affect the required rate of return.
• Form of Returns: The returns from an investment can
take many forms, including earnings, cash flows,
dividends, interest payments, or capital gains
(increases in value) during a period.
• Returns or cash flows can come in many forms, and
you must consider all of them to evaluate an
investment accurately.
Time Pattern and Growth Rate of Returns
• You cannot calculate an accurate value for a
security unless you can estimate when you will
receive the returns or cash flows.
• Because money has a time value, you must know
the time pattern and growth rate of returns from an
investment.
• This knowledge will make it possible to properly
value the stream of returns relative to alternative
investments with a different time pattern and
growth rate of returns or cash flows.
 Valuation of Alternative Investments
• Valuation of Bonds
• Valuation of Preferred Stock
• Valuation of Common Stock
 Valuation of Bonds

• Calculating the value of bonds is relatively

easy because the size and time pattern of
cash flows from the bond over its life are
known.
• A bond typically promises Interest
payments as per their contractual
agreement and principal and on the bond’s
maturity date.
 Valuation of Bonds
Characteristics of Bonds
• Bonds are debt securities that pay a rate of interest
based upon face amount or par value of the bond.

• The Price changes as market interest changes

• Interest payments are commonly semiannual

• Bond investors receive full face amount when

bonds mature
 Valuation of Bonds
Value of Bond = Present value of interest payments + Present
Value of Principal
that is PV of Annuity (pmt, I, N) + PV (FV, I, N

N
PMT FV
PV  t
 N
t 1 (1  k) (1  k)

Where N = time to maturity

K= market interest rate (required rate of return)
PMT = semiannual interest payment
FV = face value
Valuation of Preferred Stock
• The owner of a preferred stock receives a promise to
pay a stated dividend for an infinite period.
• Preferred stock is a perpetuity because it has no
maturity.
• As was true with a bond, stated payments are made on
specified dates although the issuer of this stock does
not have the same legal obligation to pay investors as
do issuers of bonds.
• Payments are made only after the firm meets its bond
interest payments. Because this reduced legal
obligation increases the uncertainty of returns,
investors should require a higher rate of return on a
firm’s preferred stock than on its bonds.
 Valuation of Preferred Stock
• Because preferred stock is a perpetuity, its
value is simply the stated annual dividend
divided by the required rate of return on
preferred stock (kp) as follows:
V= dividend/ Kp
• Given a market price, you can derive its
promised yield
Dividend
kp 
Price
Valuation of Common Stock

• Do you think common Stock Valuation

is relatively difficult than bonds and
preferred stocks? Why?
 Valuation of Common Stock
Common Stock Valuation is relatively
difficult due to
Uncertain cash flows : Equity is the residual
claim on the firm’s cash flows (dependent on
ability and decision to pay)
Life of the firm is forever and stocks are
irredeemable.
Rate of return (the appropriate discount rate) is
not easily observed.
 Discounted cash-flow valuation
There are two approaches to value common stocks. These are:
1. Discounted cash-flow valuation
2. Relative valuation technique
1. Discounted cash-flow valuation techniques
asserts that the value of an asset is the present
value of its expected future cash flows as
t n
CFt
follows: V  j  (1  k )
t 1
t
where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the investors’ required rate of return for
asset j,
Discounted cash-flow valuation
Well-known discounted cash-flow valuation model is called
Dividend Discount Model (DDM):
Dividend Discount Model (DDM): The dividend discount
model assumes that the value of a share of common stock is the
present value of all future dividends as follows.
n
Dt
Vj  t
t 1 (1  k )

D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2 (1  k ) 3 (1  k ) 
where:
Vj = value of common stock j
Dt = dividend at time t
k = required rate of return on stock j
Discounted cash-flow valuation
If the stock is not held for an infinite period and
sold at the end of time “n”, then the value of the
stock would be determined as follows

D1 D2 Dn SPj
Vj   2
 ...  n

(1  k ) (1  k ) (1  k ) (1  k ) n
2. Relative valuation techniques
• In contrast to the discounted cash flow techniques that
attempt to estimate a specific value for a stock based on
its estimated growth rates and its discount rate, the
relative valuation techniques implicitly contend that it
is possible to determine the value of an economic entity
(i.e., the market, an industry, or a company) by
comparing it to similar entities on the basis of several
relative ratios that compare its stock price to relevant
variables that affect a stock’s value, such as earnings,
cash flow, book value, and sales.
• The following relative valuation ratios are commonly used:
(1) price/earnings (P/E)
(2) price/cash flow (P/CF),
(3) price/book value (P/BV)
 Relative valuation techniques

1. The price earnings (P/E) ratio

• Also called Earnings Multiplier Model
• This values the stock based on expected annual
earnings
• It can be calculated as:

Current Market Price


Annual Earnings
 Relative valuation techniques
The infinite-period dividend discount model
indicates the variables that should determine the
value of the P/E ratio
D1
Pi 
k  g
Relative valuation techniques

Dividing both sides by expected earnings

during the next 12 months (E1)
Pi D1 / E1

E1 k  g

Thus, the P/E ratio is determined by

1. Expected dividend payout ratio (E1)
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)
 Relative valuation techniques
Example: Assume a stock has an expected dividend payout
of 50 percent, a required rate of return of 12 percent, and an
expected growth rate for dividends of 8 percent.
• This shows that D/E = .50; k = .12; g=.08

D1
Pi 
k  g
.50
P/E 
.12 - .08
.50/.04
12.5
 Relative valuation techniques
• A small change in either or both k or g will
have a large impact on the multiplier
• If D/E = .50; k=.13; g=.08, then P/E = 10
• If D/E = .50; k=.12; g=.09, then P/E = 16.7
• If D/E = .50; k=.11; g=.09, then P/E = 25
 Relative valuation techniques
(2) price/cash flow (P/CF)
• The growth in popularity of this relative valuation
ratio can be traced to concern over the propensity
of some firms to manipulate earnings per share,
whereas cash flow values are generally less
prone to manipulation.
• Also, as noted, cash flow values are important in
fundamental valuation (when computing the
present value of cash flow), and they are critical
when doing credit analysis .
 Relative valuation techniques
The price to cash flow ratio is computed
as follows:

Pt
P / CFi 
CFt 1
Where:
P/CFj = the price/cash flow ratio for firm j
Pt = the price of the stock in period t
CFt+1 = expected cash flow per share for firm j
 Relative valuation techniques
3-The Price/Book Value Ratio
• The price/book value (P/BV) ratio has been
widely used for many years by analysts in the
banking industry as a measure of relative
value. P
P / BV j  t
BVt 1
Where:
P/BVj = the price/book value for firm j
Pt = the end of year stock price for firm j
BVt+1 = the estimated end of year book value per share
for firm j