Security analysis 2
Security analysis is the analysis of tradable financial
instruments called securities.
Security analysis is the process of deciding which securities are sound for true
investments.
True investments keep the principal safe and deliver an acceptable return.
We know that the first step in making an investment is determining your
required rate of return.
Once you have determined this rate, some investment alternatives, such as
savings accounts and T-bills, are fairly easy to evaluate because they provide
stated cash flows.
Security Analysis is broadly classified into two categories:
(1)Fundamental Analysis (2) Technical Analysis
Fundamental analysis (FA) is a method of measuring a security's intrinsic
value by examining related fundamental factors. Fundamental factors can be
defined as anything that can affect the security's value.
Fundamental factors can be varied from macroeconomic factors such as the
state of the economy and industry conditions to microeconomic factors like
the effectiveness of the company's management.
The end goal is to arrive at a number that an investor can compare with a
security's current price.
Thus, fundamental analysis is a method of assessing the intrinsic value of a
security by analyzing various macroeconomic and microeconomic factors.
The ultimate goal of fundamental analysis is to quantify the intrinsic value of
a security.
Its intrinsic value can then be compared to its current market price to help with
investment decisions.
Unlike technical analysis that concentrates on forecasting a security’s price
movements, fundamental analysis aims to determine the “correct price” (true
value) of a security.
By knowing the right price, an investor can make an informed investment
decision. A security can be overvalued, undervalued, or fairly valued.
Assumptions of FA
One of the primary assumptions of fundamental analysis is that the current
price from the stock market often does not fully reflect the value of the
company supported by the publicly available data.
A second assumption is that the value calculated from the company's
fundamental data is more likely to be closer to the true value of the stock.
Analysts often refer to this hypothetical true value as the intrinsic value.
There is not a single, generally accepted formula for arriving at the intrinsic
value of a stock.
For example, say that a company's stock was trading at $20, and after
extensive research on the company, an analyst determines that it ought to be
worth $24. Another analyst does equal research but determines that it ought to
be worth $26. Many investors will consider the average of such estimates and
assume that the intrinsic value of the stock may be near $25. Often investors
consider these estimates highly relevant information because they want to buy
stocks that are trading at prices significantly below these intrinsic values.
This leads to a third major assumption of fundamental analysis: In the long run,
the stock market will reflect the fundamentals. The problem is, nobody knows
how long "the long run" really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular
business, an investor can estimate the intrinsic value of a firm and find
opportunities to buy at a discount. The investment will pay off when the market
catches up to the fundamentals.
Advantages of FA
Fundamental analysis helps traders and investors to gather the right
information to make rational decisions about what position to take.
By basing these decisions on financial data, there is limited room for personal
biases.
Rather than establishing entry and exit points, fundamental analysis seeks to
understand the value of an asset, so that traders can take a much longer-term
view of the market. The aim is to then profit from the market correction.
Disadvantages of FA
Fundamental analysis can be time consuming, it requires multiple areas of
analysis which can make the process extremely complicated.
As fundamental analysis takes a much longer-term view of the market, the
results of the findings are not suitable for quick decisions. Traders looking to
create a methodology for entering and exiting trades in the short-term might be
better suited to technical analysis.
This method of stock analysis is considered to be in contrast to technical
analysis which forecasts the direction of prices through an analysis of historical
market data such as price and volume.
Fundamental Factors:
The various fundamental factors can be grouped into two categories:
Quantitative – "related to information that can be shown in numbers and
amounts."
Qualitative – "relating to the nature or standard of something, rather than to its
quantity."
In this context, quantitative fundamentals are hard numbers. They are used to
measure the characteristics of a business. The biggest source of quantitative
data is financial statements. Revenue, profit, assets, etc. can be used to
measure the potentiality of a business with great accuracy.
The qualitative fundamentals are less tangible. They might include the quality
of a company's key executives, its brand-name recognition, patents,
and proprietary technology.
Qualitative Fundamental Factors
There are four key fundamentals that analysts always consider when regarding
a company.
The business model: What exactly does the company do? This isn't as
straightforward as it seems. It's also important to consider a company's
customer base, market share among firms, growth, competition, business
cycles, etc. that will give an investor a deeper understanding of a company's
financial health.
Competitive advantage: A company's long-term success is driven largely by
its ability to maintain a competitive advantage—and keep it. Powerful
competitive advantages, such as Coca-Cola's brand name and Microsoft's
domination of the personal computer operating system, create
a channel around a business allowing it to enjoy growth and profits. When a
company can achieve a competitive advantage, its shareholders can be well
rewarded for decades.
Management: Some investors believe that management is the most important
criterion for investing in a company. It makes sense: Even the best business
model is doomed if the leaders of the company fail to properly execute the plan.
While it's hard for retail investors to meet and truly evaluate managers, you can
look at the corporate website and check the resumes of the top brass and the
board members. How well did they perform in prior jobs? Have they been
unloading a lot of their stock shares lately?
For fundamental research of stocks, analysts need to study the management
decisions of that company to understand the strength and weaknesses of
management. It will help you gauge their capabilities.
The questions that you need to get answered by observing the management
are –
Whether management is efficient or not?
Whether it can work as a team or not?
It is comprised of experienced and talented people?
Whether they have a track record or not?
If yes, then how is their track record?
Whether they deliver to their promises or not?
Corporate Governance: Corporate governance describes the policies in place
within an organization denoting the relationships and responsibilities between
management, directors, and stakeholders. These policies are defined and
determined in the company charter and its bylaws, along with corporate laws
and regulations. You want to do business with a company that is run ethically,
fairly, transparently, and efficiently. Particularly note whether management
respects shareholder rights and shareholder interests. Make sure their
communications to shareholders are transparent, clear, and understandable.
If you don't get it, it's probably because they don't want you to.
Qualitative factors
Focus on durable return on equity,
• Calculate owner earnings. (Owner earnings are basically equal to free cash
flow after capital expenditures.)
• Look for a company with relatively high sustainable profit margins for its
industry.
• Make sure the company has created sufficient market value for every dollar
retained
• Make sure about high Topline (sales)and bottom line (net profit) growth,
• Satisfactory Dividend history during the last ten years
• Look for high directors Shareholding proportions
• Look for no or little debt.
The investment decision process
After you have completed the qualitative and quantities analysis you will
estimate a security’s value and compare this estimated value to the prevailing
market price to decide whether or not you want to buy the security.
This investment decision process is similar to the process you follow when
deciding on a corporate investment or when shopping for clothes, or a car. In
each case, you examine the item and decide how much it is worth to you (its
value).
If the price equals its estimated value or is less, you would buy it. The same
technique applies to securities, except that the determination of a security’s
value is more formal.
Three parts of Fundamental Analysis
Fundamental analysis consists of three main parts:
1. Economic analysis
2. Industry analysis
3. Company analysis
In security selection process, a traditional approach of Economic, Industry
Company analysis is employed.
EIC analysis is the abbreviation of economic, industry and company.
The person conducting EIC analysis examines the conditions in the entire
economy and then ascertains the most attractive industries in the light of the
economic conditions. At last the most attractive companies within the
attractive industries are pointed out by the analyst.
By analyzing various macroeconomic factors such as interest rates, foreign
reserve, exchange rates, inflation, and GDP levels, an investor tries to
determine the overall direction of the economy.
Afterward, the investor assesses specific prospects and potential
opportunities within the economy and identifies the industries and sectors of
the economy offering the best investment opportunities.
Finally, they analyze and select individual company witnen the most promising
industries.
There are two general approaches to the valuation process:
(1) the top down, three-step approach, or
(2) the bottom-up, stock picking approach.
Both of these approaches can be implemented by either fundamentalists or
technicians.
The difference between the two approaches is the perceived importance of the
economy and a firm’s industry on the valuation of a firm and its stock.
The top down approach
Economy analysis: Analysis of Alternative
Economies and Security Markets
Industry analysis: Determine which
industries will prosper and which
industries will suffer within the
selected economies
Analysis of Individual
Companies
within the
industry
What is top-down approach?
The top-down approach, as its name indicates, is an analytical process that
goes from top to bottom and generally consists of three steps.
The investor starts by examining the economic situation at the national or
international level to see if the outlook appears favorable for equity markets.
Followers of top-down approach need to accurately forecast macroeconomic
conditions, then to find and interpret the impact of the economic conditions on
various sectors, on particular industries, and finally on specific companies.
Followers of the top-down approach believe the general economic situation
and the strength of a particular industrial sector have a considerable impact on
share yields.
The economic environment influences company profits, investors' attitudes
and expectations, and this necessarily affects the market prices of shares.
What is bottom up approach?
Instead of starting the analysis from the larger scale, the bottom-up approach
immediately starts analyzing individual stocks.
The rationale of investors who follow the bottom-up approach is that individual
stocks may perform much better than the overall industry.
The bottom-up approach is primarily concentrated on various microeconomic
factors such as a company’s earnings and financial metrics.
Analysts who use such an approach develop a thorough assessment of each
company to gain a better understanding of its operations.
To sum up, the bottom-up approach suggests buying shares in companies that
are relatively self-contained, with considerable independence from their
economic environment and an ability to ensure development on their own.
The key here is to find the potentially strong company which may outperform
the industry and market in future.
If the fundamental factors are good, then regardless of what the industry is
doing, the bottom up investors will pick such companies to invest.
Bottom up approach helps in picking quality stocks.
Top-down vs bottom-up
Advocates of the top-down, three-step approach believe that both the
economy and the industry effect have a significant impact on the total returns
for individual stocks.
In contrast, those who employ the bottom-up, stock picking approach contend
that it is possible to find stocks that are undervalued relative to their market
price, and these stocks will provide superior returns regardless of the market
and industry outlook.
Both of these approaches have numerous supporters, and advocates of both
approaches have been quite successful.
Logic and empirical support of top-down, three-step approach
In this book, we advocate and present the top-down, three-step approach
because of its logic and empirical support.
Although we believe that a portfolio manager or an investor can be successful
using the bottom-up approach, we believe that it is more difficult to be
successful because these stock-pickers are ignoring substantial information
from an analysis of the outlook for the market and the firm’s industry.
Psychologists suggest that the success or failure of an individual can be caused
as much by his or her social, economic, and family environment as by genetic
gifts.
Extending this idea to the valuation of securities means we should consider a
firm’s economic and industry environment during the valuation process.
Regardless of the qualities or capabilities of a firm and its management, the
economic and industry environment will have a major influence on the success
of a firm and the realized rate of return on its stock.
As an example, assume you own shares of the strongest and most successful
firm producing home furnishings. If you own the shares during a strong
economic expansion, the sales and earnings of the firm will increase and your
rate of return on the stock should be quite high.
In contrast, if you own the same stock during a major economic recession, the
sales, earnings, and cash flows of this firm (and probably most or all of the firms
in the industry) would likely experience a decline, and the price of its stock
would be stable or decline.
Therefore, when assessing the future value of a security, it is necessary to
analyze the outlook for the aggregate economy and the firm’s specific industry.
The valuation process is like the chicken-and-egg dilemma.
Do you start by analyzing the macro-economy and various industries before
individual stocks, or do you begin with individual securities and gradually
combine these firms into industries and the industries into the entire
economy?
For reasons discussed in the next section, we contend that the discussion
should begin with an analysis of aggregate economies and overall securities
markets and progress to different industries with a global perspective.
Monetary and fiscal policy measures enacted by various agencies of national
governments influence the aggregate economies of those countries.
The resulting economic conditions influence all industries and companies
within the economies.
Monetary policy produces similar economic changes.
A restrictive monetary policy that reduces the growth rate of the money supply
reduces the supply of funds for working capital and expansion for all
businesses.
Alternatively, a restrictive monetary policy that targets interest rates would
raise market interest rates and therefore firms’ costs and make it more
expensive for individuals to finance home mortgages and to purchase other
durable goods, such as autos and appliances. Monetary policy therefore
affects all segments of an economy and that economy’s relationship with other
economies.
Any economic analysis requires the consideration of inflation. As discussed,
inflation causes differences between real and nominal interest rates and
changes the spending, saving, and investment behaviors of consumers and
corporations.
Interest Rates and Bond Prices
The relationship between interest rates and bond prices is clearly negative
because the only variable that changes in the valuation model is the discount
factor.
Specifically, the expected cash flows from a straight noncallable bond would
not change, so an increase in interest rates will cause a decline in bond prices
and a decline in interest rates will boost bond prices.
For example, if you own a 10-year bond with a coupon of 10 per cent, when
interest rates increase from 10 percent to 12 percent, the price of this bond will
decline from $1,000 (par) to $885. In contrast, if rates decline from 10 percent
to 8 percent, the price of the bond will increase from $1,000 to $1,136.
The size of the price change will depend on the characteristics of the bond. As
will be discussed in a longer-term bond will experience a larger price change for
a change in interest rates.
Therefore, we can anticipate a negative relationship between inflation and the
rates of return on bonds because inflation generally has a direct effect on
interest rates; in turn, interest rates have an inverse effect on bond prices and
rates of return.
Inflation, Interest Rates, and Stock Prices
The relationship among inflation, interest rates, and stock prices is not direct
and consistent.
The reason is that the expected cash flows from stocks can change along with
inflation and interest rates, and we cannot be certain whether this change in
cash flows will enhance or offset the change in interest rates.
To demonstrate this, consider the following potential scenarios following an
increase in the rate of inflation and the effect of this on stock prices based on
the DDM:
The positive scenario.
Interest rates rise due to an increase in the rate of inflation, and corporate
earnings likewise experience an increase in growth because firms are able to
increase prices in line with cost increases.
In this case, stock prices might be fairly stable because the negative effect of
an increase in the required rate of return (k) is partially or wholly offset by the
increase in the growth rate of earnings and dividends (g), which causes an
increase in the value of stocks. As a result, the returns on stock increase in line
with the rate of inflation—that is, stocks would be a good inflation hedge.
Mildly negative scenario.
Interest rates and the required return k increase due to inflation, but expected
cash flows continue to grow at the prior rate assuming small increases in prices
at rates below the increase in the inflation rate and cost increases. This would
cause a decline in stock prices similar to what happens with a bond. The
required rate of return (k) would increase, but the growth rate of dividends (g)
would be constant. As a result, the k–g spread discussed would widen and
stock prices would decline.
Very negative scenario.
Interest rates and the required return k increase due to inflation, while the
growth rate of cash flows declines because during the period of inflation the
costs of production increase, but many firms are not able to increase prices at
all, which causes a major decline in profit margins. Given this scenario, stock
prices will experience a significant decline because k will increase and g will
decline, causing a large increase in the k–g spread.
The relationship among inflation, interest rates, and stock prices is not as direct
or consistent as the relationship between interest rates and bond prices. The
point is, the effect of interest rate changes on stock prices will depend on what
caused the change in interest rates and the effect of this event on the expected
cash flows for alternative common stocks.
Fiscal policy initiatives, such as tax cuts, can encourage spending, whereas
additional taxes on income can discourage spending.
Increases or decreases in government spending on defense, on unemployment
insurance, retraining programs, or on highways also influence the general
economy.
These fiscal policies influence the business environment for firms that rely
directly on such government expenditures. In addition, we know that
government spending has a strong multiplier effect.
For example, increases in road building increase the demand for earth-moving
equipment and concrete materials. As a result, in addition to construction
workers, the employees of industries that supply the equipment and materials
have more to spend on consumer goods, which raises the demand for
consumer goods, which, in turn, affects another set of suppliers.
In addition to monetary and fiscal policy actions, such events as war, political
disorders in foreign countries, or international monetary devaluations produce
changes in the business environment that add to the uncertainty of sales and
earnings expectations and therefore the risk premium required by investors.
For example, the geo- political relationship between China and Russia with
other countries increases the uncertainty of investors in china and Russia
during the current period caused a significant increase in the risk premium for
investors and a reduction in investment in those reasons.
In short, it is difficult to avoid the impact of macroeconomic developments that
affect the total economy. Because aggregate economic events have a deep
effect on all industries and companies within these industries, these
macroeconomic factors should be considered before industries are analyzed.
If a recession is imminent in a country, you would expect a negative impact on
its security prices. Because of these economic expectations, investors would
be worried about investing in most industries in the country and the country will
be underweighted by most investors.
In contrast, optimistic economic and stock market outlooks for a given country
should lead an investor to increase the overall allocation and you would expect
a positive impact on its security prices.
Thus, we recommend a three-step, top-down valuation process in which you
first examine the influence of the general economy on all firms and the security
markets,
then analyze the prospects for alternative industries in this economic
environment,
and finally turn to the analysis of individual firms in the alternative industries
and to the common stock of these firms.