CH.9 EQUITY SECURITY ANALYSIS

Equity Security Analysis Equity security analysis is the evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm’s stock Equity security analysis is the evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm’s stock Security analysis is the foundation for the second step of investment process, projecting future returns and assessing risk. Security analysis is the foundation for the second step of investment process, projecting future returns and assessing risk.

Equity Security Analysis and Market Efficiency Efficient market hypothesis: information would be reflected in security prices fully and immediately upon its release. Efficient market hypothesis: information would be reflected in security prices fully and immediately upon its release. Under this condition it would be impossible to identify mispriced securities on the basis of public information Under this condition it would be impossible to identify mispriced securities on the basis of public information Efficient market hypothesis cannot represent an equilibrium in a strict sense Efficient market hypothesis cannot represent an equilibrium in a strict sense

Market Efficiency and the Role of Financial Statement Analysis Market agents could profit from digesting financial statement information: Market agents could profit from digesting financial statement information: The information would be useful to the select few who receive newly announced financial data, interpret it quickly, and trade on it within minutesThe information would be useful to the select few who receive newly announced financial data, interpret it quickly, and trade on it within minutes The information would be useful for gaining understanding of the firm, so as to place analyst in a better position to interpret other news as it arrivesThe information would be useful for gaining understanding of the firm, so as to place analyst in a better position to interpret other news as it arrives Create trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting processCreate trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process

Approaches to Fund Management and Security Analysis Active versus Passive Management Active versus Passive Management Active: relies heavily on security analysis to identify mispriced securitiesActive: relies heavily on security analysis to identify mispriced securities Passive: serves as a price taker, avoiding the costs of security analysis and turnover while seeking to hold a portfolio designed to match some overall market index or sector performancePassive: serves as a price taker, avoiding the costs of security analysis and turnover while seeking to hold a portfolio designed to match some overall market index or sector performance

Approaches to Fund Management and Security Analysis Quantitative versus Traditional Fundamental Analysis: Quantitative versus Traditional Fundamental Analysis: Technical analysis: attempts to predict stock price movements on the basis of market indicatorsTechnical analysis: attempts to predict stock price movements on the basis of market indicators Fundamental analysis: attempts to evaluate the current market prices relative to projections of the firm’s future earnings and cash-flow generating potential.Fundamental analysis: attempts to evaluate the current market prices relative to projections of the firm’s future earnings and cash-flow generating potential. Supplemented traditional fundamental analysis with more quantitative approaches Supplemented traditional fundamental analysis with more quantitative approaches

Approaches to Fund Management and Security Analysis Formal versus Informal Valuation Formal versus Informal Valuation Formal method: described in ch.7Formal method: described in ch.7 Informal method:Informal method: compare earnings projection with consensus forecast compare earnings projection with consensus forecast Recommend a stock because his or her earnings forecast appears relatively high in comparison to the current price Recommend a stock because his or her earnings forecast appears relatively high in comparison to the current price “Marginalist” “Marginalist”

Performance of Security Analysts and Fund Managers Performance of Security Analysts Performance of Security Analysts Analyst earnings forecasts are more accurate than those produced by time series models that use past earnings to predict future earningsAnalyst earnings forecasts are more accurate than those produced by time series models that use past earnings to predict future earnings Stock prices tend to respond positively to upward revisions in analysts earnings forecasts and recommendations, and negatively to downward revisionsStock prices tend to respond positively to upward revisions in analysts earnings forecasts and recommendations, and negatively to downward revisions Analysts play a valuable role in improving market efficiencyAnalysts play a valuable role in improving market efficiency

Performance of Security Analysts and Fund Managers Performance of Fund Manager Performance of Fund Manager No consistent evidence that actively managed mutual funds generate superior returns for investorsNo consistent evidence that actively managed mutual funds generate superior returns for investors