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Common Stock
Security Analysis Concept & Types
Security analysis is a part of investment decision process
involving the valuation and analysis of individual securities.
Two basic approaches of security analysis are fundamental
analysis and technical analysis.
Fundament analysis is the study of stocks value using basic
financial variables in order to determine company’s intrinsic
value.
The variables are sales, profit margin, depreciation, tax rate,
sources of financing, asset utilization and other factors.
Additional analysis could involve the company’s competitive
position in the industry, labor relations, technological
changes, management, foreign competition, and so on.
Security Analysis cont…
Technical analysis is the search for identifiable and
recurring stock price patterns.
Growth Stock:
It carry investor expectation of above average future growth
in earnings and above average valuations as a result of high
price/earnings ratios.
Investors expect these stocks to perform well in future and
they are willing to pay high multiples for this expected
growth.
Value Stock: Features cheap assets and strong balance sheets.
In many cases, bottom-up investing does not attempt to make a clear
distinction between growth and value stocks. Top-down approach is a
better approach
Top-down Approach
In this approach
Investors begin with economy/market considering interest
rates and inflation to find out favorable time to invest in
common stock.
Then consider future industry/sector prospect to
determine which industry/sector to invest in
Finally promising individual companies of interest in the
prospective sectors are analyzed for investment decision.
What is Value?
In general, the value of an asset is the price that a
willing and able buyer pays to a willing and able seller
Note that if either the buyer or seller is not both
willing and able, then an offer does not establish the
value of the asset
Several Kinds of “Value”
There are several types of value, of which we are concerned
with four:
Book Value – The carrying value on the balance sheet of the firm’s
equity (Total Assets less Total Liabilities)
Tangible Book Value – Book value minus intangible assets
(goodwill, patents, etc)
Market Value - The price of an asset as determined in a competitive
marketplace
Intrinsic Value - The present value of the expected future cash flows
discounted at the decision maker’s required rate of return
Determinants of Intrinsic Value
There are two primary determinants of the intrinsic value
of an asset to an individual:
The size and timing of the expected future cash flows.
The individual’s required rate of return (this is determined by a
number of other factors such as risk/return preferences, returns on
competing investments, expected inflation, etc.).
Note that the intrinsic value of an asset can be, and often is,
different for each individual (that’s what makes markets
work).
Common Stock
A share of common stock represents an ownership position
in the firm. Typically, the owners are entitled to vote on
important matters regarding the firm, to vote on the
membership of the board of directors, and (often) to
receive dividends.
In the event of liquidation of the firm, the common
shareholders will receive a pro-rata share of the assets
remaining after the creditors (including employees) and
preferred stockholders have been paid off. If the
liquidation is bankruptcy related, the common
shareholders typically receive nothing, though it is possible
that they may receive some small amount.
Common Stock Valuation
As with any other security, the first step in valuing
common stocks is to determine the expected future
cash flows.
Finding the present values of these cash flows and
adding them together will give us the value:
CFt
VCS
t 1 1 k t
. 1.08
185 2.00
VCS 28.57
.15.08 . .08
015
Note that this is exactly the same value that we got
earlier, but we didn’t have to use an assumed future
selling price.
The DDM Extended
There is no reason that we can’t use the DDM at any
point in time.
For example, we might want to calculate the price that
a stock should sell for in two years.
To do this, we can simply generalize the DDM:
D N 1 gD N 1
VN
k CS g k CS g
For example, to value a stock at year 2, we simply use
the dividend for year 3 (D3).
The DDM Example (cont.)
In the earlier example, how did we know that the stock
would be selling for $33.33 in two years?
Note that the period 3 dividend must be 8% larger
than the period 2 dividend, so:
2.161.08 2.33
V2 33.33
.15.08 . .08
015
0 1 2 3 4
g = 15% g = 8%
What if Growth Isn’t Constant?
(cont.)
First, note that we can calculate the value of the stock at
the end of period 3 (using D4):
3.0387
V3 43.41
.15 .08
Now, find the present values of the future selling price and
D1, D2, and D3:
2.1275 2.4466 2.8136 43.41
V0 2
3
34.09
1.15 1.15 1.15
So, the value of the stock is $34.09 and we didn’t even have
to assume a constant growth rate. Note also that the value
is higher than the original value because the average
growth rate is higher.
Two-Stage DDM Valuation Model
The previous example showed one way to value a stock
with two (or more) growth rates. Typically, such a
company can be expected to have a period of supra-
normal growth followed by a slower growth rate that
we can expect to last for a long time.
In these cases we can use the two-stage DDM:
D0 1 g1 1 g 2
n
D0 1 g1 1 g1
n
kCS g 2
VCS 1
kCS g1 1 kCS
1 k CS n
Two-Stage DDM Valuation Model (cont.)
The two-stage growth model is not a complex as it seems:
The first term is simply the present value of the first N dividends (those
before the constant growth period)
The second term is the present value of the future stock price.
D0 1 g1 1 g 2
n
D0 1 g1 1 g1
n
kCS g 2
VCS 1
kCS g1 1 kCS
1 k CS n
g br
Where b = retention ratio and r = ROE (return on
equity).
The Earnings Model (cont.)
If the company can maintain this growth rate
forever, then the present value of their growth
opportunities is:
NPVt
PVGO
t 1 1 k t
VCS P EPS1
E
The P/S Approach
In some cases, companies aren’t currently earning any
money and this makes the P/E approach impossible to use
(because there are no earnings).
In these cases, analysts often estimate the value of the stock
as some multiple of sales (Price/Sales ratio).
The justified P/S ratio may be based on historical P/S for
the company, P/S for the industry, or some other estimate:
VCS P Sales1
S