CHAPTER FIVE

SECURITY ANALYSIS
 Securities Analysis

• Security analysis is the first part of investment

decision process involving the valuation and
analysis of individual securities.
Market Theories
 Cont’d
• The efficient market hypothesis, the random walk
theory and the rational expectations hypothesis
all suggest that stock markets are efficient.
• This means that at any time, a stock’s price is the
best available estimate of its true value.
 Behavioral Finance Implication
• Investors are aware of market efficiency but
sometimes overlook the issue of psychology in
financial markets – that is, the role that emotions
play.
• Particularly, in short turn, inventors’ emotions
affect stock prices, and markets.
 Reasons for Inefficient Market
• It seems unlikely that:
New information is available to everyone at the same
time
All investors react immediately to all information in
the same way
All investors make accurate forecasts and correct
decisions
• If all investors reacted to new information in the
same way and at the same time, no investor
should be able to outperform others.
 Cont…
• However, there have been times when investors
have been able to consistently outperform index
averages like the S&P/TSX Composite Index.
• This evidence suggests that capital markets are
not entirely efficiently priced.
• For example, investors do not react in the same
way to the same information.
• One investor may buy a security at a certain price
hoping to receive income or make a capital gain.
 Cont…
• Another investor may sell the same security at
the same price because that investor believes the
security is overvalued.
• Also, not everyone can make accurate forecasts
and correct valuation decisions.
• Finally, mass investor psychology and greed may
also cause investors to act irrationally.
• Even when investors do act rationally, thorough
stock valuation can be a complex task.
 Methods of Investment Analysis
 Two basic approaches of security analysis are:
1) Fundamental analysis
2) Technical analysis
 Fundamental Analysis
• Fundament analysis is the study of stocks value
using basic financial variables in order to
determine company’s intrinsic value.
• The variables are sales, profit margin,
depreciation, tax rate, sources of financing, asset
utilization and other factors.
• Additional analysis could involve the company’s
competitive position in the industry, labor
relations, technological changes, management,
foreign competition, and so on.
 Bottom-up Approach
• Bottom-up approach, where investors focus
directly on a company’s basic.
• 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.
 Cont…
• Bottom-up fundamental research is broken in two
categories: growth investing and value investing.
1) Growth Stock: It carry investor expectation of above
average future growth in earnings and above average
valuations as a result of high price/earnings ratios.
Investors expect these stocks to perform well in future
and they are willing to pay high multiples for this
expected growth.
2) Value Stock: Features cheap assets and strong balance
sheets.
• In many cases, bottom-up investing does not attempt to
make a clear distinction between growth and value stocks.
• Top-down approach is better approach.
Top-down Approach
 Cont…
• In top-down approach, also called the three-step
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.
 Fundamental Market/Macroeconomic Analysis

• Sudden unpredictable events can affect – favorably

or unfavorably – the country’s economy and the
prices of its securities.
• Such events include international crises such as
war, unexpected election results, regulatory
changes, technological innovation, debt defaults,
and dramatic changes in the prices of important
agricultural, metal and energy commodities.
 Cont…
• These factors can be grouped under the following
categories:
1) Fiscal policy: levels of government expenditures,
taxation and government debt
2) Monetary policy: Changes in monetary policy affect
interest rates and corporate profits.
3) Flow of funds: When the relative valuation of stocks
and bonds or stocks and T-bills changes, capital flows
from one asset class to the other.
4) Inflation: It results in higher interest rates, lower
corporate profits, and lower price-earnings multiples.
 Fundamental Industry Analysis
• It has often been suggested that industry and
company profitability has more to do with industry
structure than with the product that an industry sells.
• Industry structure results from the strategies that
companies pursue relative to their competition.
• Companies pursue strategies that they feel will give
them a sustainable competitive advantage and lead
to long-term growth.
• Pricing strategies and company cost structures affect
not just long-term growth, but the volatility of sales
and earnings.
 Classifying Industries by Stage of Growth
a) Emerging Growth Industries፡ a new company or
industry may be unprofitable at first, although future
prospects may appear promising.
b) Growth Industries፡ A growth industry is one in which
sales and earnings are consistently expanding at a
faster rate than most other industries.
c) Mature Industries፡ Industry maturity is characterized
by a dramatic slowing of growth to a rate that more
closely matches the overall rate of economic growth.
d) Declining Industries፡ As industries move from the
mature/stable to the declining stage, they tend to stop
growing and begin to decline.
 Fundamental Company Analysis
• The analysis of a company requires looking closely at
the company’s financial history and recent events,
with a goal of assessing the future prospects of the
company.
• There are two basic approaches for valuation of
common stocks using fundamental analysis, which are:
1) Intrinsic Valuation: Discounted cash flow(DCF)
technique. One form of DCF is Dividend Discount
Model(DDM), that uses present value method by
discounting back all future dividends
2) Relative Valuation Model, uses P/E ratio, P/B ratio
and P/S ratio
 Intrinsic Valuation
• In this method, an investor or analyst carefully
studies the future prospects for a company and
estimates the likely dividends to be paid, which
are the only payments an investor receives
directly from a company.
• In addition, the analyst estimates an appropriate
required rate of return on the risk foreseen in the
dividends.
 Cont…

• Then calculate the estimated discounted present value of

all future dividends as below:
• PV of stock, Vo= D1/(1+k) +D2/(1+k)2+ D3/(1+k)3+…..
• Vo =D1/(k – g) …… (after simplification)
• where, D1, D2, D3..are future 1st, 2nd , 3rd years
dividends, k is required rate of return
• Now,
• If Vo > Po, the stock is undervalued and should be
purchased
• If Vo < Po, the stock is overvalued and should be not be
purchased
• If Vo = Po, the stock is at correctly priced
 DDM
• Alternatively, in practice, investors can use DDM
to select stocks.
• The expected rate of return, k, for constant
growth stock can be written as
• k= D1/Po + g, where D1/Po is dividend yield
and the 2nd part g is price change component
 Cont…
• The types of information that an analyst must gather
include:
Financial statement data and related disclosures;
Major news items in recent years;
Position and market share in industry;
International investment;
Where the company is in its life cycle (i.e. high
growth/developmental, maturing, declining);
Contributions of major product, divisions, or subsidiaries to
the company’s performance;
Research and development efforts;
Sensitivity of company to commodity prices (e.g., oil); and
Major litigation.
 Cont’d
• One of the key ingredients in a company analysis
is the analysis of the financial disclosures.
• Financial statements in the most countries are
based on Generally Accepted Accounting
Principles (GAAP).
• GAAP are a set of principles that promulgated
from a number of sources, including the Financial
Accounting Standards Board (FASB), the
Accounting Principles Board (APB), and the
American Institute of Certified Public Accountants
Research Bulletins (among others).
 Analyzing a Company’s profitability
• Profitability can generally be described as how
well a company can get a return on the
investments they make.
• If a company is bringing in more revenue than
it costs to create those revenues, then a
company can be called profitable.
 Profitability Ratios
1) Profitability related to 3) Profitability related to
sales equity shares (EPS)
 Gross profit margin  Earnings per share
 Operating margin  Earnings yield
 Net profit margin  Dividend yield
2) Profitability Related to  Dividend payout ratio
Investment  Price earnings ratio(P/E
 Return on assets ratio)
 Return on capital 4) Overall profitability (or
employed earning power)
 Return on equity  Return on investment
 Technical Analysis
• Technical analysts view the range of data studied by
fundamental analysts as too massive and unmanageable
to pinpoint price movements with any real precision.
• Instead, they focus on the market itself, whether it is the
commodity, equity, interest rate or foreign exchange
market.
• They study, and plot on charts, the past and present
movements of prices, the volume of trading, statistical
indicators and, for example in the case of equity
markets, the number of stocks advancing and declining.
• They try to identify recurrent and predictable patterns
that can be used to predict future price moves.
 End of Chapter Five
• Questions?