Chapter-5
Security Analysis
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5.1. Introduction
• Investment (in financial assets or securities) covers two
major steps or decisions. These are:
– Security Analysis: Involves estimating/identifying
the merits of individual investments/securities.
– Portfolio Management: Deals with the construction
and maintenance of a collection of investments
(Portfolio is simply collection of investment assets).
• Also, investment decision involves:
– Asset allocation: the choice among broad asset
classes such as stocks, bonds, real estate,
commodities, and so on.
– Security selection: the choice of which particular
securities to hold within each broad asset class. 2
Cont…
What is a security?
• Security is an instrument or a method of borrowing or lending, or a source of
contributing to the funds needed by the corporate body or non-corporate body.
• Superior returns are possible by proper security analysis, through better
forecasting abilities and superior expertise in security analysis.
• What is security analysis?
• Security Analysis is one of the functions of investment decisions necessary to
understand security characteristics in the valuation of individual securities.
• Security analysis is the detail examination of risk and return characteristics of
particular security in the light of different fundamental factors.
• Conducting security analysis involves examining securities to identify those
which are mispriced- (to sell and to buy , under- or over- valued securities).
It helps to pick up the right security that suit investors’ requirement.
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cont…
• Formally, we can define “Security Analysis” as “the process of
gathering and organizing information and then using it to determine
the intrinsic value of a security.
• Intrinsic Value:
– The underlying or inherent value of a stock, as determined through
fundamental analysis.
– A prudent/rational investor will only buy a stock if its market price
does not exceed what the investor thinks the stock is worth
(required).
– Intrinsic value depends upon several factors:
• Estimates of future cash flows (CF)
• Discount rate (DR=r)
• Amount of risk that reflects and determines the DR (r).
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Cont…
• Investment decision is based on availability of money and information
on the economy, industry and company.
• Two basic approaches of security analysis are fundamental analysis
and technical analysis.
a. Fundamental Analysis – estimating true value of a security based on
future expected returns. A fundamental analyst tries to discern the
logical worth of a security based on its anticipated earnings stream.
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Con’t…
• The fundament analysis is the study of stocks value using basic
financial variables in order to determine company’s intrinsic value. It
considers the variables such as 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. Also the industry and economy are important in
the analysis.
b. Technical analysis – the examination of past prices for trends. A
technical analyst attempts to predict the supply and demand for a stock
by observing the past series of stock prices. Financial statements and
market (industry and economic) conditions are of secondary importance
to the technical analyst. Technical analysis is , thus, the search for
identifiable and recurring stock price patterns.
Behavioral Finance Implications: 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. In addition to the above two
the behavioral finance implications need to be taken in to account.
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1. Fundamental Security Analysis
• Fundamental analysis is used to determine the intrinsic value of
the share by examining the underlying forces that affect the
well being of the economy, Industry groups and companies.
• Fundamental analysis is to first analyze the economy, then the
Industry and finally individual companies. This is called as top
down approach.
• The actual value of a security, as opposed to its market
price or book value is called intrinsic value.
• The intrinsic value includes other variables such as brand
name, trademarks, and copyrights that are often difficult to
calculate and sometimes not accurately reflected in the
market price
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Con’t…
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A. Economics analysis
• Economic analysis occupies the first place in the financial analysis
top down approach. When the economy is having sustainable growth,
then the industry group (Sectors) and companies will get benefit and
grow faster.
• The analysis of macroeconomic environment is essential to
understand the behavior of the stock prices. The commonly analyzed
macro economic factors are as follows.
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Thus, the common economic factors:
1. Gross domestic product (GDP)
2. Savings and investment
3. Inflation
4. Interest rates
5. Budget
6. The tax structure
7. The balance of payment
8. Infrastructure
9. Demographic factors
10. Political stability
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B. Industry Analysis
• The second step in the fundamental analysis of securities is Industry
analysis. An industry or sector is a group of firms that have similar
technological structure of production and produce similar products.
These industries are classified according to their reactions to the
different phases of the business cycle. They are classified into growth,
cyclical, defensive and cyclical growth industry. A market assessment
tool designed to provide a business with an idea of the complexity of a
particular industry. Industry analysis involves reviewing the economic,
political and market factors that influence the way the industry
develops
• Thus, factors to be considered while analyzing industry includes:
1. Characteristics of the industry
2. Demand and market
3. Government policy
4. Labor and other industrial problems
5. Management 11
C. Company Analysis
• Company analysis is a study of variables that influence the future of a
firm both qualitatively and quantitatively. It is a method of assessing
the competitive position of a firm, its earning and profitability, the
efficiency with which it operates its financial position and its future
with respect to earning of its shareholders.
• The fundamental nature of the analysis is that each share of a
company has an intrinsic value which is dependent on the company's
financial performance. If the market value of a share is lower than
intrinsic value as evaluated by fundamental analysis, then the share is
supposed to be undervalued. The basic approach is analyzed through
the financial statements of an organization. 12
Framework for Fundamental Analysis: Bottom-Up Vs. Top-Down
• 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.
• Bottom-Up fundamental research is broken in two categories: growth
investing and value investing.
– Growth Stock:
It carries investor expectation of above average future growth in
earnings and above average valuations as a result of high
price/earnings (P/E) ratios. Investors expect these stocks to perform
well in future and they are willing to pay high multiples for this
expected growth.
– 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. 13
“Top- Down” Approach involves the following steps:
• Step 1: Economic Analysis
– State of overall economy
– Investors begin with economy/market considering interest rates,
inflation and other factors to find out favorable time to invest in
common stock.
• Step 2: Industry Analysis
– Outlook for specific industry
– Level of competition in industry
– Then consider future industry/sector prospect to determine which
industry/sector to invest in.
• Step 3: Company Analysis
– Financial condition of specific company
– Historical behavior of specific company’s stock
– Promising individual companies of interest in the prospective
sectors are analyzed for investment decisions. 14
Fundamental Analysis at Company Level
• There are two basic approaches for valuation of common stocks at
company level using fundamental analysis, which are:
a. 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.
b. Relative Valuation Model, uses P/E ratio, P/B ratio and P/S ratio.
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a. Intrinsic Valuation, DDM (Dividend Discount Model):
• 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. 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+…..
=D1/(k – g) …… (after simplification) is
the intrinsic value of stock (Vo). Here, g is annual constant growth rate of the
dividend.
where, D1, D2, D3..are future 1st, 2nd , 3rd years dividends, k is required rate of return
Now, compare Vo and Po(actual market price of the stock).
If Vo > Po, the stock is undervalued and should be purchased
If Vo < Po, the stock is overvalued and should be not be purchased and if held, sell it
If Vo = Po, the stock is at correctly priced.
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
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b. Relative Valuation
• Relative valuation technique uses comparisons to determine a stock’s
value. By calculating measures such as P/E ratio and making
comparisons to some benchmark(s) such as the market, an industry or
other stocks history over time, analyst can avoid having to estimate g
and k parameters of DDM.
• In relative valuation, investors use several different ratios such as P/E,
P/B, P/S etc. in an attempt to assess value of a stock through
comparison with benchmark.
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i. Earning Multiplier or P/E Ratio Model:
• This model is the best-known and most widely used model for stock
valuation.
• Analysts are more comfortable taking about earning per share (EPS)
and P/E ratios, and this is how their reports are worded.
• P/E ratio simply means the multiples of earnings at which the stock
is selling. For example, if a stock’s most recent 12 months earning is
Br. 5 and it is selling now at Br. 150, then it is said that the stock is
selling for a multiple of 30 (P/E ratio is 30). The price of the stock per
share is 30 times earnings (EPS).
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Determinants of P/E Ratio:
• For a constant growth model of DDM,
Price of a stock, P=D1/(k - g)
Or, P/E=(D1/E)/(k - g)
This indicates that P/E depends on:
[Link] dividend payout ratio, D1/E
[Link] rate of return, k, which is to be estimated
[Link] growth rate, g, of dividends
Thus, the following relationships should hold, being other things equal:
4. The higher the expected payout ratio, the higher the P/E ratio
5. The higher the expected growth rate, the higher the P/E ratio
6. The higher the required rate of return, the lower the P/E ratio
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Valuation Using P/E Ratio:
• To use the earnings multiplier model for valuation of a stock,
investors must look ahead because valuation is always forward
looking. They can do this by making a forecast of next year’s earnings
per share E1, assuming a constant growth model, as
Next years earning per share, E1=Eo(1+g)
where, g=ROE X (1 - Payout ratio) and
Eo is current year’s earnings per share, ROE (return on
equity)= NI/Equity, and 1- payout ratio means the retention
ratio.
• Then calculate the forward P/E ratio as
Forward P/E ratio= Po/E1, where E1 is expected earning per share for
next year and Po is price of stock per share.
• In practice, analysts often recommend stocks on the basis of this
forward P/E ratio or multiplier by making a relative judgment with
some benchmark.
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Other Relative Valuation Ratios:
• Price to Book Value(P/B): This is the ratio of stock price to per
share stockholders’ equity.
Analysts recommend lower P/B stock compared to its own ratio
over time, its industry ratio, and the market ratio as a whole.
• Price to Sales Ratio(P/S): A company’s stock price divided by
its sales per share.
A PSR 1.0 is average for all companies but it is important to
interpret the ratio within industry bounds and its own historical
average.
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2. Technical Analysis
• It is techniques to study past patterns and predict future
price using different statistical and mathematical methods
and tools.
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Thank you!!!
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