Security Analysis

Learning Goals Analyzing shares based on Economic, Industry and Fundamental of the company Analyzing shares to determine WHAT shares is worth buying and WHEN is the right time to buy. Understand ratio analysis and how it helps in determining the performance of the company.

Introduction Security analysis is the process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock. Intrinsic value provides a measure of the underlying worth of a share of stock - undervalued, fairly priced, or overvalued. Intrinsic value depends on several factors: Estimates of stock’s cash flows The discount rate used to translate future cash flows into a present value. The amount of risk embedded in achieving the forecasted level of performance.

Security analysis addresses the question of what to buy by determining what a stock ought to be worth Traditional security analysis usually takes a “top-down” approach; It begins with economic analysis and then moves to industry analysis and finally to fundamental analysis.

Economic Analysis assesses the general state of the economy and its potential effects on security returns. Stock prices tend to move up when the economy is strong, and they retreat when the economy starts soften. the overall performance of the economy has a significant bearing on the performance of the companies that issue common stock. But not all stocks are affected by the economy. Sectors like food and retailing, may be only mildly affected by the economy but the construction and auto industries are often hard hit when times get rough.

The behavior of the economy is captured in the business cycle, which reflects changes in total economic activity over time. Measures of economics in the business cycle are: Gross Domestic Product (GDP) Gross National Product (GNP) Government Fiscal Policy Monetary Policy Other Factors

Industry Analysis Stock price are influenced by industry conditions Key Issues: The first step in industry analysis is to establish the competitive position of a particular industry in relation to others. The next step is to identify companies within the industry that hold particular promise.

Normally investor can gain valuable insight about an industry by seeking answers to the following questions: Nature of the industry: monopolistic, competitors, Industry regulation; how friendly are regulatory bodies? What role does labor play in the industry? Labor union Technological developments? Which economic forces are important to the industry? Financial and operating consideration; adequate supply of labor, material and capital

Industry life cycle Sales Start upConsolidationMaturityRelative decline Rapid and increasing growth Stable growthSlowing growthMinimal or negative growth The industry life cycle

Fundamental Analysis Looks in depth at the financial condition and operating results of a specific company and the underlying behavior of its common stock. It’s include the company’s investment decisions, the liquidity of its assets, its use of debt, its profit margins and earnings growth, and ultimately the future prospects of the company and its stock. more traditional approach to security analysis. Used to evaluate both growth and value oriented stocks, a well as income shares, turn-around, and other situations

Concept - stock is influenced by the performance of the company that issued the stock. If the company’s prospectus look strong, the market price of its stock is likely to reflect that and be bid up.

Valuing the Company and Its Future Forecasted Sales and Profits Example: Lets say in the year 2002, a company reported sales of RM 100 million, we estimate that revenues will grow at an 8% annual rate, and the net profit margin should be about 6%. Thus estimated sales next year will equal RM 108 million (100 million X 1.08). And, with a 6% profit, we should expect to see earnings next year of Future after-tax = RM 108 millionx 0.06 = RM6.5 million Earnings in year t Future after-tax= estimated sales x Net profit margin Earnings in year t for year t expected in year t

Forecasted Dividends and Prices P/E ratio has considerable bearing on the stock’s future price behavior. Higher P/E ratios can be expected with higher rates of growth in earnings, an optimistic market outlook, and lower debt levels As inflation rates rise, bond interest rise. This causes required returns on stocks to rise. Higher required returns on stocks mean lower stock prices and lower P/E multiples Lower inflation rate translate to high P/E ratios and stock prices. High P/E ratio have low dividend payouts. The reason: Earnings growth tends to be more valuable than dividends, especially in companies with high rates of return on equity.

Estimated EPS= Future after tax earning in year t_______ In year tNumber of common stock outstanding in year =ROExBook value per share Estimated Dividend = estimated EPS x Estimated payout ratio Per share in year t in year t Estimated share price = Estimate EPS x Estimated P/E ratio At end of year t in year t

Key Financial Ratio Compare : Historical standards, - where the company’s ratios are compared and studied from one year to the next or Industry standards, - which involve comparison of a particular company’s ratios to those of other companies in the same line of business. Financial ratios can be divided into five groups: Liquidity Activity Leverage Profitability Common Stock or Market Ratio

Liquidity Ratio Current ratio = Total Current Assets Total Current Liabilities NWC = Total Current Assets - Total Current Liabilities

Activity Ratio ARTO = Annual Sales Account Receivables ITO = Annual Sales Inventory TATO = Annual sales Total Assets

Leverage Ratio DER = Long Term Debt Stockholders’ Equity TIE = Earnings Before Interest and Taxes Interest Expenses

Profitability Ratio NPM = Net Profit after Taxes Total Revenues (sales) ROA = Net Profit after Taxes Total Assets ROE = Net Profit after Taxes Stockholder’s Equity

Breaking down ROA and ROE ROA =Net Profit Margin x Total Asset Turnover ROE = ROA x equity multiplier Equity Multiplier = ( total assets ______) Total stockholders’ equity

Market Ratio P/E=Market price of common stock Earning per share (EPS) EPS=Net profit after taxes – Preferred dividend Number of common stock outstanding PEG ratio =Stock‘s P/E ratio______ 2 to 5 year growth rate in earnings

Dividend per share = Annual dividends paid to common stock Number of share outstanding Dividend Payout Ratio=Dividends Per Share Earnings Per Share BV per share = Common Stockholders’ Equity Number of C/shares Outstanding = Total equity – Preferred stock Number of share outstanding

Price-to-book-value = Market Price of Common Stock Book Value Per Share