CHAPTER FIVE

SECURITY ANALYSIS AND VALUATION

 5.1. Introduction
 The aim of the analysis is to determine what stock to buy and at what price
 An investment operation is one which, upon thorough analysis, promises safety of
principal and a satisfactory return.
 Investing involves a detailed analysis of cash flows, the riskiness of those cash
flows, and the discounting of those cash flows to arrive at a current valuation.
 Investing usually has a horizon that stretches out over several years.
 Investments derive profit from appreciation in the value of an enterprise; not from
appreciation of securities, which may or may not reflect a change in the
fundamentals of the enterprise to which they are attached.
 Cont…

 So, how does one go about valuing an enterprise, or generating a

probability-weighted future price of a security?
 There are two basic analysis methods;

 Fundamental analysis and

 Technical analysis.
 Cont…
 Fundamental analysis maintains that markets may misprice a security in the short
run but that the "correct" price will eventually be reached.
 Profits can be made by trading the mispriced security and then waiting for the
market to recognize its "mistake" and re-price the security.
 Technical analysis maintains that all information is reflected already in the stock
price.
 Investors' emotional responses to price movements lead to recognizable price chart
patterns.
 Technical analysis does not care what the 'value' of a stock is.
 Their price predictions are only extrapolations from historical price patterns.
 Cont…
 Investors can use any or all of these different but somewhat complementary
methods for stock picking.
 For example, many fundamental investors use technical for deciding entry
and exit points.
 Many technical investors use fundamentals to limit their universe of possible stock
to 'good' companies.
 The choice of stock analysis is determined by the investor's belief in the different
paradigms for "how the stock market works".
 5.2. Fundamental Analysis
 It involves analyzing its financial statements, its management, competitive
advantages, and its competitors and markets.
 When applied to futures and foreign exchange, it focuses on the overall state of the
economy, interest rates, production, earnings, and management.
 Fundamental analysis is performed on historical and present data, but with the goal
of making financial forecasts.
 There are several possible objectives of fundamental analysis.
 To conduct a company stock valuation and predict its probable price evolution,
 To make a projection on its business performance,
 To evaluate its management and make internal business decisions,
 To calculate its credit risk.
 Components of Fundamental Analysis
 Economic analysis;
 Industry analysis and
 Company analysis
 5.2.1. Economic analysis
 It is a study to determine if overall conditions are good for the stock market.
 The following are just some of the questions that the fundamental analyst
would ask to determine if economic conditions are right for the stock market.
 Is inflation a concern?
 Are interest rates likely to rise or fall?
 Are consumers spending?
 Is the trade balance favorable?
 Is the money supply expanding or contracting?
 Cont…
 The macro-economy is the overall economy environment in which all firms
operate.
 The key variables/factors commonly used to describe the state of the macro-
economy are:
 Growth rate of GDP
 Industrial growth rate
 Savings and investments
 Government budget and deficit
 Price level and inflation
 Interest rate
 Balance of payment, foreign exchange reserves, and exchange rate
 5.2.2. Industry analysis
 It is a market assessment tool designed to provide a business with an idea of the
complexity of a particular industry.
 It involves reviewing the economic, political and market factors that influence the
way the industry develops.
 Major factors can include:
 the power wielded by suppliers and buyers,
 the condition of competitors, and
 the likelihood of new market entrants.
 Industry analysis is a market strategy tool used by businesses to determine if they
want to enter a product or service market.
 Cont…
• Management decide whether to enter an industry or invest money elsewhere by
analyzing
A.economic factors: It include raw materials, expected profit margins and the
interference of substitute goods.
B. supply and demand: helps management understand if enough consumers
are willing to purchase more goods in an industry.
C. competitors,
D.future conditions: determine where the industry is in the business cycle.
E. government regulations: intensity of heavier regulations or taxes
 5.2.3. Company Analysis
• It is the final stage of fundamental analysis.
• A company may have made losses consecutively for two years or more and one may
not wish to touch its shares
• Yet it may be a good company and worth purchasing into.
• There are several factors one should look at this analysis:
• Which company has performed well in comparison with other similar
companies?
• Which company is performing well in comparison to earlier years?
• Which company is better by its management, policies, location and labor
relations?
• Which company is the market leader by its productions and segment?
 Objectives of Company Analysis
• Company analysis focuses on finding attractive firms by:
• Analyzing individual firms.
• Understanding each firm's strengths and risks.
• Identifying attractive firms with superior management and strong performance
(measured by sales and earnings growth).
• Stock selection focuses on finding attractive stocks by:
• Computing each stock’s intrinsic value.
• Comparing the intrinsic value to the stock’s market price.
• Identifying attractive stocks, which are substantially undervalued.
 Significant Factors to be Considered for Company Analysis

• The different issues regarding a company that should be examined are:

1. The Management: It is upon the quality, competence and vision of the
management that the future of company rests.
• A good, competent management can make a company grow while a weak,
inefficient management can destroy a successful company.
2. The Annual Report: By law, this is prepared every year and distributed to the
shareholders.
• The Annual Report is broken down into the following specific parts:
• The director’s report
• The auditor’s report
• The financial statements
 Cont…
3. Ratios: analyze the firm financial statements and compared its performance in the
previous years, and with that of other companies.
• This can be difficult at times because:
(a) The size of the companies may be different.
(b) The composition of a company’s financial position may be significantly
different.
4. Cash flow Analysis: In cash flow analysis, investors must always checks;
• How much is the company's cash earnings?
• How is the company being financed and using it?
• The answers to these questions can be determined by preparing a statement of
sources and uses of funds.
 5.3. TECHNICAL ANALYSIS
• Fundamental analysis won't help you figure out when to buy, sell or hold.
• There will be times when the stock of a solid company falters and times when a
riskier company performs well.
• As a result, although fundamental analysis is important, it's not always sufficient to
make investment decisions.
 Cont…
• Technical analysis is the study of price movements and trends.
• It can help you figure out when to enter and exit the market.
• Investors' emotional responses to price movements lead to recognizable price chart
patterns.
• Technical analysis does not care what the 'value' of a stock is.
• Their price predictions are only extrapolations from historical price patterns.
• Many fundamental investors use technical for deciding entry and exit points.
• Many technical investors use fundamentals to limit their universe of possible stock
to 'good' companies.
 Cont…
• The foundation of technical analysis is chart.
• A chart is simply a graphical representation of a series of prices over a set time
frame.
• The goal of technical analysis is to
• spot market trends and
• manage risks associated with price movements.
BASIS FOR
COMPARISO FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS
N
Meaning Fundamental Analysis is a practice of analyzing Technical analysis is a method of determining
securities by determining the intrinsic value of the future price of the stock using charts to
the stock. identify the patterns and trends.
Relevant for Long term investments Short term investments
Function Investing Trading
Objective To identify the intrinsic value of the stock. To identify the right time to enter or exit the
market.
Decision Decisions are based on the information available Decisions are based on market trends and prices
making and statistic evaluated. of stock.
Focuses on Both Past and Present data. Past data only.
Form of data Economic reports, news events and industry Chart Analysis
statistics.
Future prices Predicted on the basis of past and present Predicted on the basis of charts and indicators.
performance and profitability of the company.
Type of trader Long term position trader. Swing trader and short term day trader.
 5.4. Valuation of securities
 In the previous chapter on risk and return relationship, we looked at securities at a
high level of abstraction.
 It is assumed that each security had been analyzed in detail and its risk and return
assessment had been done.
 We now turn our attention to the assessment of risk and return characteristics of
securities in some detail.
 A security is a financial instrument with a recognized financial worth.
 It has the potential to generate some future return above face value.
 Thus, the value of any given security is the present value of future returns associated
with it, adjusted for the time value of money.
 There are two major types of financial securities: Bonds and Stocks
 Cont…

 There are two major types of financial securities:

 Bonds and Stocks
 5.4.1. Bond valuation
• The cash flows from a specific bond depend on its contractual features.
• For a standard coupon-bearing bond, the cash flows consist of interest payments plus
the amount borrowed when the bond matures.
• In the case of a floating rate bond, the interest payments vary over time.
• In the case of a zero coupon bond, there are no interest payments, only the face
amount when the bond matures.
• For a “regular” bond with a fixed coupon rate, here is the situation:
• General valuation method −𝑛
𝑅 (1− ( 1+𝑖 ) ) Parvalue
Value of Bond = + (1  r ) t
𝑖
 Illustration:
• H-Corporation sold a $1,000,000 bond issue at the beginning of 2020 in order to
obtain funds for expansion. The bonds were issued at face values of $1,000,000 with
an original maturity of 10 years and a coupon rate of 10%. If an investor requires a
12% rate of return on these securities, what would be the value of these bonds to the
investor in 2020? Assume the bond is to be purchased at the beginning of 2020 and
interest compounded annually.
 Cont…
• Impact of Required rate of return (RRR) on bond values- when the RRR on a bond
differs from its coupon rate, the value of a bond would differ from its par/face value.

• RRR > coupon rate : the bond value would be less than its par value that is the bond
would sell at discount.

• RRR < coupon rate : the bond value would be more than the par value that is the
bond would sell at a premium.
 5.4.2. Stock Valuation
• There are different methods of equity valuation. The majors are:
• Balance Sheet Valuation
• Dividend discount model
• Free cash flow model
• Earning Multiplier Approach
 Balance Sheet Valuation
• There are four measures derived from it.
 book value,
 liquidation,
 replacement cost, and
 Tobin’s Q ratio.
Book Value Method: is based on the books of a business, where:
Owners' equity = Total assets - Total liabilities
• It is Net worth of a company divided by total number of outstanding equity shares.
• The basic limitation of this value is that the book value doesn’t reflect the true
current economic value of the share.
• It also doesn’t consider the future earnings potential of the company.
 Cont…
Liquidation Value Method: similar to the book valuation method, except that the
liquidation values of assets are used instead of the book value of the assets.
• The liquidation value of a company is equal to what remains after all assets have
been sold and all liabilities have been paid.

Replacement Cost Method: one of the interest in valuing a firm is the replacement
cost of its assets less its liabilities.
• Some analysts believe the market value of the firm cannot get too far above its
replacement cost because
• if it did, competitors would try to replicate the firm.
 Cont…
Tobin’s Q: This idea is popular among economists, Replacement value is being the
current cost of replacing the firm’s assets.
• The ratio of all the combined stock market valuations to the combined replacement
costs should be around one.
 Dividend discount model
• The most theoretically sound stock valuation method
• Can be called income valuation or the discounted cash flow (DCF) method
• It involves discounting of the profits (dividends, earnings, or cash flows) the stock
will bring to the stockholder in the foreseeable future, and a final value on disposal.
Inputs into the DDM: Dividends expected to be received in one year (D1)
Growth rate in dividends (g)
Required rate of return (K)
K = Risk-free rate + (market risk premium x beta)
 Stable model/ Constant growth DDM
• It is best suited for firms experiencing long-term stable growth.
• Stable firms are assumed to grow at the rate equal to the long-term nominal growth rate of
the economy (inflation plus real growth in GDP).

Value of stock = D1 / K-g (Gordon model)

Where K > g
• DDM understates the intrinsic value of the firm.
• Important considerations such as the value of patents, brand name, and other intangible
assets should be used in conjunction with the DDM to assess the value of a firm's equity.
• These intangibles should be added to the result of a DDM calculation to arrive at a more
appropriate valuation.
 Cont…
If g = 0.05, and the most recently paid dividend was D 0 = 3.81, the market
capitalization rate for Steady State is 12%
i. What is expected future dividends?
ii. What is the intrinsic value?
iii. What will be the price of the stock initially and the next year expected
price?
End of the chapter!