Equity Security Analysis For Manufacuring Sectors

Business Analysis and Valuation Applications: Equity Security Analysis for
Manufacturing Sectors
Equity security analysis is the evaluation of a firm and its prospects from the
perspective of a current or potential investor in the firm’s stock. Security analysis is the
foundation for the second step, projecting future returns and assessing risk. Security analysis
is typically conducted with an eye towards identification of mispriced securities, in hopes of
generating returns that more than compensate the investor for risk.
Security analysis is undertaken by individual investors, by analysts at brokerage
houses (sell-side analysts), by analysts that work at the direction of funds managers for
various institutions (buy-side analysts), and others. The institutions employing buy-side
analysts include mutual funds, pension funds, insurance companies, universities, and others.
Security analysis is one component of a larger investment process that involves (1)
establishing the objectives of the investor or fund, (2) forming expectations about the future
returns and risks of individual securities, and then (3) combining individual securities into
portfolios to maximize progress toward the investment objectives.
Investor Objectives
The investment objectives of individual savers in the economy are highly
idiosyncratic. For any given saver they depend on such factors as income, age, wealth,
tolerance for risk, and tax status. Investors in high tax brackets are likely to prefer to have a
large share of their portfolio in stocks that generate tax-deferred capital gains rather than
stocks that pay dividends or interest-bearing securities.
Mutual funds (or unit trusts as they are termed in some countries) have become
popular investment vehicles for savers to achieve their investment objectives. Mutual funds
sell shares in professionally managed portfolios that invest in specific types of stocks and/or
fixed income securities. The major classes of mutual funds include
(1) Money market funds that invest in CDs and treasury bills,
(2) Bond funds that invest in debt instruments,
(3) Equity funds that invest in equity securities,
(4) Balanced funds that hold money market, bond, and equity securities, and
(5) Real estate funds that invest in commercial real estate.
Equity Security Analysis and Market Efficiency
How a security analyst should invest his or her time depends on how quickly and
efficiently information flows through markets and becomes reflected in security prices. In the
extreme, information would be reflected in security prices fully and immediately upon its
release. This is essentially the condition posited by the efficient markets’ hypothesis. This
hypothesis states that security prices reflect all available information, as if such information
could be costless digested and translated immediately into demands for buys or sells without
regard to frictions imposed by transactions costs. Under such conditions, it would be
impossible to identify mispriced securities on the basis of public information.
Approaches to Fund Management and Securities Analysis
Approaches used in practice to manage funds and analyze securities are quite varied.
One dimension of variation is the extent to which the investments are actively or passively
managed. Another variation is whether a quantitative or a traditional fundamental approach is
used. Security analysts also vary considerably in terms of whether they produce formal or
informal valuations of the firm.
The Process of a Comprehensive Security Analysis
The outline steps to be included in a comprehensive security analysis:
1) Selection of Candidates for Analysis
2) Inferring Market Expectations
3) Developing the Analyst’s Expectations
4) The Final Product of Security Analysis
Financial Statement Data and Security Prices
While security analysis clearly involves much information beyond the financial
statements, those statements play an important role. Much research over the past three
decades has helped describe the role of financial statement data in the setting of security
prices. An understanding of that role provides an appreciation for the importance of that data
in security analysis, as well as market agents’ ability to digest such data. The key findings of
the research are:
1) Earnings and book value are good indicators of stock prices.
2) Market agents can anticipate much of the information in earnings.
3) Financial statement details matter.

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