Security Analysis and Valuation
Security Analysis is the process of evaluating investment securities—such as stocks, bonds, and
other financial instruments—to determine their intrinsic value. The goal is to assess whether a
particular security is fairly priced, overvalued, or undervalued compared to its true worth.
In other words, it helps investors decide whether to buy, hold, or sell a security based on its potential
to generate future returns.
Its Importance:
Security analysis is a cornerstone of investment decision-making. It ensures that capital is allocated
efficiently by:
- Identifying profitable investment opportunities
- Avoiding overpriced or risky securities
- Supporting portfolio diversification and risk management
- Helping investors align their choices with financial goals
Major Approaches:
There are three main approaches to security analysis:
A. Fundamental Analysis
- Focus: The intrinsic value of a security.
- Method: Examine financial statements, industry conditions, management quality, and
macroeconomic trends.
- Goal: Find undervalued or overvalued securities by comparing market price to intrinsic value.
- Example: Studying a company’s balance sheet, income statement, and cash flows to decide
if its stock
is a good buy.
B. Technical Analysis
- Focus: Past price and volume data.
- Method: Use charts, patterns, and indicators to forecast future price movements.
- Goal: Identify short-term trading opportunities based on market trends.
- Example: Spotting a “head-and-shoulders” chart pattern that signals a price reversal.
C. Quantitative / Modern Portfolio Analysis
- Focus: Mathematical models and statistics.
- Method: Use quantitative techniques such as risk-return models, factor analysis, and
probability
distributions.
- Goal: Optimize portfolios and minimize risk while maximizing expected return.
- Example: Using the Capital Asset Pricing Model (CAPM) to determine the expected return of
a stock.
Key Steps in Security Analysis:
1. Economic Analysis – Study macroeconomic factors like GDP, inflation, interest rates.
2. Industry Analysis – Evaluate industry trends, competition, and growth prospects.
3. Company Analysis – Examine financial health, management, profitability, and future outlook.
4. Valuation – Use valuation models (DCF, P/E ratio, etc.) to estimate intrinsic value.
5. Decision-Making – Compare intrinsic value with market price to make investment choices.
Benefits:
- Improves investment decision quality
- Reduces the chance of losses due to poor judgment
- Provides a systematic approach to selecting securities
- Helps balance risk and return in a portfolio
Limitations:
- Relies on assumptions and forecasts, which may be wrong
- Market prices may not always reflect intrinsic value immediately
- Unexpected events (e.g., economic crises) can invalidate analysis
Example:
As a Financial Manager, you are evaluating ABC Corporation’s stock.
- You analyze its financial statements and see consistent revenue growth and strong cash flow.
- Using valuation models, you calculate its intrinsic value at ₱120 per share.
- The current market price is ₱90 per share.
Decision: Since the market price is below intrinsic value, you may decide to buy, expecting the price to
rise as the market recognizes its true worth.
Intrinsic Value – is the true, underlying, or real value of an asset or security, based on its fundamentals—not its
current market price.
It represents what a security is actually worth after considering factors like:
• Future earnings or cash flows
• Growth prospects
• Risk level
• Economic and industry conditions
"What is this investment really worth if I look past short-term market fluctuations?"
2. Key Concept
• If Market Price < Intrinsic Value → The security is undervalued → Good opportunity to buy.
• If Market Price > Intrinsic Value → The security is overvalued → Might consider selling.
• If Market Price ≈ Intrinsic Value → Fairly valued → Hold or look for other opportunities.
This is why intrinsic value is crucial for value investors, like Warren Buffett, who focus on buying quality assets
at a discount.
3. How It Is Determined
Intrinsic value is not directly observable—it must be estimated using analysis, such as:
• Discounted Cash Flow (DCF) analysis – Future cash flows are estimated and discounted back to
present value.
• Dividend Discount Model (DDM) – For dividend-paying stocks, value is based on the present value of
expected dividends.
• Earnings-based Models – Using earnings per share (EPS) and valuation multiples (P/E ratio).
4. Example
Imagine a company expected to generate ₱10 per share in annual free cash flow for the next 10 years. After
discounting those cash flows to today’s value, you calculate the intrinsic value as ₱120 per share.
• If the stock is currently trading at ₱90, it is undervalued (a potential buying opportunity).
• If it trades at ₱150, it is overvalued (price is higher than its real worth).
5. Key Insight
Intrinsic value is investor-specific because assumptions about future growth, risk, and discount rate may differ.
This is why different analysts can have different intrinsic value estimates for the same stock.
Sample Financial Statements
(For the Year Ended December 31, 2024)
Company: ABC Manufacturing, Inc.
1. Balance Sheet
Assets ₱ Liabilities & Equity ₱
Current Assets Current Liabilities
Cash & Cash Equivalents 1,000,000 Accounts Payable 500,000
Accounts Receivable 800,000 Short-Term Loans 300,000
Inventory 1,200,000 Total Current Liabilities 800,000
Total Current Assets 3,000,000 Long-Term Liabilities
Non-Current Assets Bonds Payable 1,200,000
Property, Plant & Equipment (net) 2,500,000 Total Liabilities 2,000,000
Intangible Assets 500,000 Equity
Total Non-Current Assets 3,000,000 Common Stock 2,500,000
TOTAL ASSETS 6,000,000 Retained Earnings 1,500,000
Total Equity 4,000,000
TOTAL LIABILITIES &
6,000,000
EQUITY
2. Income Statement
Particulars ₱
Revenue (Sales) 5,000,000
Less: Cost of Goods Sold (3,000,000)
Gross Profit 2,000,000
Operating Expenses (800,000)
Operating Income (EBIT) 1,200,000
Interest Expense (100,000)
Earnings Before Tax (EBT) 1,100,000
Tax Expense (30%) (330,000)
Net Income 770,000
3. Statement of Cash Flows
Cash Flows from Operating Activities
Net Income 770,000
Add: Depreciation 200,000
Changes in Working Capital (net) (50,000)
Net Cash from Operations (CFO) 920,000
Cash Flows from Investing Activities
Purchase of Equipment (300,000)
Net Cash from Investing (300,000)
Cash Flows from Financing Activities
Payment of Dividends (150,000)
Loan Proceeds (net) 200,000
Net Cash from Financing 50,000
Net Increase in Cash 670,000
Beginning Cash Balance 330,000
Ending Cash Balance 1,000,000
How These Help Find Intrinsic Value
1. Income Statement: Gives earnings and growth trends, used in models like Discounted Cash Flow (DCF)
or P/E ratio valuation.
2. Balance Sheet: Shows financial health (assets, liabilities, equity), used to assess leverage and book
value.
3. Cash Flow Statement: Focuses on actual cash generated (especially Free Cash Flow), crucial for
intrinsic value estimation.
Practice Exercise:
You can now compute Free Cash Flow (FCF):
Free Cash Flow (FCF) – is the amount of cash a company generates from its operations after paying
for capital expenditures (CapEx) needed to maintain or grow the business.
It represents the “free” cash available to:
• Pay dividends to shareholders
• Repurchase shares
• Pay down debt
• Reinvest in new projects
• Or simply build up cash reserves
In short, FCF = Cash left over after running and reinvesting in the business.
FCF = Cash from Operations − Capital Expenditures
Using the sample:
- CFO = ₱920,000
- CapEx (purchase of equipment) = ₱300,000
- FCF = ₱620,000
This FCF can then be projected into the future and discounted back to the present (DCF method) to estimate
intrinsic value.
Discounted Cash Flow (DCF) Calculation –
Example: ABC Manufacturing, Inc.
• Free Cash Flow (FCF) for 2024: ₱620,000
• We assume FCF will grow at 5% per year for the next 5 years (modest growth).
• Discount rate (r): 10% (reflects cost of capital / required return).
• Terminal growth rate (g): 3% (long-term steady growth after year 5).
• Number of shares: 100,000 shares (for per-share intrinsic value).
Step 1: Forecast Future Free Cash Flows (Years 1–5)
We grow FCF by 5% each year:
Year FCF (₱) Formula
1 651,000 620,000 × (1+0.05)
2 683,550 651,000 × 1.05
Year FCF (₱) Formula
3 717,728 683,550 × 1.05
4 753,614 717,728 × 1.05
5 791,295 753,614 × 1.05
Step 2: Discount Each Year’s FCF to Present Value
PV = FCF / (1+r)t
Year FCF (₱) PV Factor @10% Present Value (₱)
1 651,000 0.909 591,459
2 683,550 0.826 565,627
3 717,728 0.751 538,999
4 753,614 0.683 514,719
5 791,295 0.621 491,393
PV of 5-year FCFs = ₱2,702,197
Step 3: Calculate Terminal Value
Terminal Value = FCF in Year 5 × (1+g) / r−g
Terminal Value = 791,295 × 1.03 / 0.10 − 0.03
= 815,034 / 0.07
=11,643,343
Discount Terminal Value to Present:
PV of Terminal Value = 11,643,343 × 0.621 = 7,233,237
Step 4: Enterprise Value (Intrinsic Value)
Enterprise Value = PV of FCFs (Years 1–5) + PV of Terminal Value
Enterprise Value=2,702,197 + 7,233,237 = ₱9,935,434
Step 5: Per-Share Intrinsic Value
Intrinsic Value per Share = Enterprise Value / Number of Shares
Intrinsic Value per Share} = 9,935,434 / 100,000} = ₱99.35
Interpretation
• If the market price per share is below ₱99.35, the stock is undervalued → potential buy.
• If it is above ₱99.35, it may be overvalued → potential sell or avoid.
This is a simplified DCF model, but it captures the main idea:
Intrinsic value = present value of all future cash flows.
Another Comprehensive Example:
Company: XYZ Retail Corp.
Period: FY 2024
Number of Shares: 500,000
1. Financial Data
Income Statement (₱)
Particulars Amount
Revenue (Sales) 20,000,000
Cost of Goods Sold (12,000,000)
Gross Profit 8,000,000
Operating Expenses (3,000,000)
EBIT (Operating Profit) 5,000,000
Interest Expense (500,000)
EBT 4,500,000
Income Tax (30%) (1,350,000)
Net Income 3,150,000
Balance Sheet (₱)
Assets 2023 2024
Cash 500,000 600,000
Accounts Receivable 1,800,000 2,000,000
Inventory 2,500,000 2,700,000
PPE (Net) 5,000,000 6,200,000
Liabilities 2023 2024
Accounts Payable 1,200,000 1,300,000
Accrued Expenses 300,000 350,000
Additional Information
• Depreciation Expense: ₱800,000
• Capital Expenditures (CapEx): ₱2,000,000
• No major changes in other current assets or liabilities.
2. Step 1: Compute Free Cash Flow (FCF)
We start with EBIT, convert to after-tax operating profit, then adjust for non-cash items and working capital:
a) NOPAT (Net Operating Profit After Tax)
NOPAT = EBIT × (1 – Tax Rate)
NOPAT = 5,000,000 × (1 − 0.30) = 3,500,000
b) Add Back Non-Cash Charges
Adjusted NOPAT = 3,500,000 + 800,000 (Depreciation) = 4,300,000
c) Changes in Working Capital (ΔWC)
ΔWC = (ΔAR + ΔInventory) – ΔAP – Δaccrued
ΔAR = 200,000, ΔInventory = 200,000, ΔAP = 100,000, ΔAccrued = 50,000
ΔWC = (200,000 + 200,000) − (100,000 + 50,000)
= 400,000 − 150,000
=250,000
Subtract from cash flow:
Operating CF before CapEx = 4,300,000 − 250,000 = 4,050,000
d) Subtract CapEx
Free Cash Flow = 4,050,000 − 2,000,000 = 2,050,000
3. Step 2: Forecast Future FCFs
Assume FCF grows at 6% per year for 5 years, discount rate = 12%, terminal growth = 3%.
Year FCF (₱) PV Factor @12% Present Value (₱)
1 2,173,000 0.893 1,940,489
2 2,303,380 0.797 1,835,397
3 2,441,583 0.712 1,738,436
4 2,588,078 0.636 1,646,058
5 2,742,362 0.567 1,555,019
PV of FCFs (1–5): ₱8,715,399
4. Step 3: Terminal Value
Terminal Value = FCF in Year 5 × (1+g) / r – g
Terminal Value = 2,742,362 × 1.03 / 0.12 − 0.03
= 2,824,633 / 0.09
= 31,384,811
Discount to present:
PV of TV = 31,384,811×0.567 = 17,798,608
5. Step 4: Enterprise Value
EV = 8,715,399 + 17,798,608 = ₱26,514,007
6. Step 5: Intrinsic Value Per Share
Intrinsic Value per Share = 26,514,007 / 500,000 = ₱53.03
Interpretation
• If market price < ₱53.03 → stock is undervalued (buy signal).
• If market price > ₱53.03 → stock is overvalued (sell/avoid).
This example is more realistic because we computed FCF directly from EBIT, depreciation, working capital, and
CapEx before applying DCF.