1. Bassem 041714253044 Bimo 041714253004 Irwan 041714253011 Analysis Financial Report And Business Assessment EQUITY SECURITY ANALYSIS CHAPTER 9 Presented by Group # 1

2. 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 Security analysis is the foundation for the second step of investment process, projecting future returns and assessing risk.

3. Equity Security Analysis and Market Efficiency 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 Efficient market hypothesis cannot represent an equilibrium in a strict sense

4. Market Efficiency and the Role of Financial Statement Analysis 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 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 arrives Create trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process

5. Approaches to Fund Management and Security Analysis Active versus Passive Management Active: 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 performance

6. Approaches to Fund Management and Security Analysis Quantitative versus Traditional Fundamental Analysis: Technical 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. Supplemented traditional fundamental analysis with more quantitative approaches

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

8. The Process of Comprehensive Security Analysis A generalized security analysis framework is useful which involves the following steps: 1.Selection of candidates to analyze Specialization by industry sector or potential mispricing basis allows more depth of analysis. Funds typically specialize in investing in stocks with certain risk profiles or characteristics e.g. growth stocks, technology stocks or energy stocks. Managers of these types of funds seek to focus on identifying stocks that fits their fund objectives. Slide 15

9. The Process of Comprehensive Security Analysis A generalized security analysis framework is useful which involves the following steps: Selection of candidates to analyze (continue) An alternative approach to stock selection is to screen firms on the basis of some potential mispricing followed by a detailed analysis of only those stocks that met the specified criteria. Slide 16

10. The Process of Comprehensive Security Analysis Screening stocks that appear to be mispriced, the following questions are useful: What is the risk profile of a firm? Are the risks diversifiable or they are systematic? How volatile is its earning stream and stock prices? What are the most likely bad outcomes in the future? What is the upside potential? How closely linked are the firm’s risks to the health of the overall economy? Does the firm posses the characteristics of a growth stock? Slide 17

11. The Process of Comprehensive Security Analysis A generalized security analysis framework is useful which involves the following steps: (continue) 2.Inferring market expectations Identifying potentially mispriced securities requires a comparison of the analysts expectations with those of the market. The analyst view the stock price as the reflection of market expectations and to compare the analyst’s own estimate of value with that market price. Slide 18

12. The Comprehensive Security Analysis Process To illustrate, buy using the discounted abnormal earnings valuation model, analyst can find out the intrinsic value per share of the company and compare that to the market price to determine whether the market price is over-valued, fairly priced or under-valued. Based on the finding, the security analyst can then make the respective buy, hold or sell recommendation to investors. Slide 20

13. Discounted Abnormal Earnings Valuation (Residual Income) Model Value of a firm (V t ) Book value of the firm (BV t ) Residual Income, RI t = (NI t – k * BV t-1 ) k = Cost of equity capital or require rate of return of equity Abnormal earnings (residual income) is the net income of a firm less a charge that measures stockholders’ opportunity cost of capital. charge = k * BVt-1 = expected income The residual income valuation model breaks the intrinsic value of a stock into 2 elements (1)Current book value of equity and (2)Present value of expected future residual income Slide 21

14. Intrinsic Value and Investment Strategy Intrinsic value > Market value Buy Intrinsic value < Market value Sell Intrinsic value = Market value Hold Intrinsic value of stock compare to market price of stock comparison  finding  investment strategy Slide 22

15. Discounted Abnormal Earnings Valuation (Residual Income) Model Given Information: 1. Net income at year 1 =$1,000 2. Net Income expected to growth at 10% for next 3 years 3. Dividend pay-out ratio remain at 40% 4. Book value of equity at end of year 1 = $3,000 5. Cost of equity capital (k) = 15% 6. Total outstanding shares =1,000 Example Slide 23

16. Discounted Abnormal Earnings Valuation (Residual Income) Model Workings:Year 01Year 02Year 03Year 04 1.Projected Net income1000110012101331 2.Dividend payout ratio40%40%40%40% 3.Dividend 400440484532 4.Projected net earnings600660726799 5.End of year BV of equity3000366043865185 6.Cost of equity K15%15%15%15% 7.Expected earnings (k x beg equity) 450549658 8.Residual income - 650661673 9.Discount factor - 0.8670.7560.658 10.PV of residual income - 564500 443 11.Sum of PV of RI = 564+500+443=$1,507 12.Add beginning BV of equity =$3,000 13.Total intrinsic value of equity= $4,507 14.No. of share O/S = 1,000 15.Value per share =$4.507 Slide 24

17. Discounted Abnormal Earnings Valuation (Residual Income) Model Recommendation: when intrinsic value = $4.507 per share Compare to market price: 1.If market price = $4.5 = fairly price => hold 2.If market price = $2.5 = under price => buy 3.If market price = $5.5 = over price => sell The residual income model directly shows the importance of future profitability in estimating company value and accurate estimates can be made only after consideration of the quality and persistence of a company’s earnings. Example Slide 25

18. Performance of Security Analysts and Fund Managers Analyst and fund manager performance has been the topic of extensive research. Performance of sell-side analysts (research analyst in brokerage firm / investment bank) Sell-side analysts have incentives to be overly optimistic with their forecasts and recommendations However, recent research indicates that these analysts’ recommendations outperform market index. Research indicates that analysts generally add value in the capital market. Slide 38

19. Performance of Security Analysts and Fund Managers Analyst and fund manager performance has been the topic of extensive research. Performance of fund managers There is no consistent evidence that actively managed mutual funds produce superior returns for investors. Slide 39

20. Performance of Security Analysts and Fund Managers Analyst and fund manager performance has been the topic of extensive research. Recent research indicates that analysts’ recommendations outperform market index. There is no consistent evidence that actively managed mutual funds produce superior returns for investors. Slide 37