Security Analysis: An Introduction

Doing security analysis is to value individual

firms, makes buy/sell recommendations, or
searches to find portfolios that will outperform
the market.
Who are involved:
Brokerage research analysts
Investments bankers
Corporate finance specialists
Mergers and acquisitions analysts
Venture capitalists
Individual investors
The Goal in Valuation:

is to estimate the value of the firm in a

way that is not influenced by accounting
distortions.
Who Does Security Analysis:
Buy-side analysts:
are professionals who analyse securities
and make buy or sell recommendations for
their firms funds.
Sell-side analysts:
work for brokerage firms, which execute
trades on behalf of individuals and
institutional investors.
Where do analysts get information:
1. Financial statements and related disclosures of
the firm under analysis
2. Stock analyst reports
3. Newspaper and magazine articles
4. The firms competitors and customers
5. Competitors annual and quarterly reports
6. Economic data and purchased data services
that provide information on sales, distribution,
pricing, and so on.
7. Industry experts
Gap in information access

Asymmetric information:
The managers know more about the firm
than the investors do, and the investors
may have no way of knowing whether the
reports they receive fairly present the
underlying economics of the business.
Therefore,
Managers need a way to convince
investors of the fairness of the financial
reports.
 Financial Reporting Environment
Factors influencing financial reporting

Management Auditors

1. Accounting
method choice GAAP
Financial
2. Accounting
Reports
estimates
3. Accounting
disclosures
4. Unravelling
management Regulators
distortions (SEC, FASB)
The Limitations of GAAP for Security Analysis

Necessary Information Not Available Under

GAAP:
1. Historical Costs Basis vs. Future Orientation Value
2. Financial Data vs. Non-financial data such as
qualitative data, industry information, other
iformation must be found outside the financial
reports.
Information Not in Appropiate Format:
Prescribed format under GAAP vs. free cash flow
model
GAAP balance sheet vs. economic balance sheet.
 A Look at Security Analysis in Phases

Business Analysis

GAAP Financial Statements Forecast

Financial Statements Analysis Assumptions

Valuation
Business Analysis

The analyst tries to understand the key business

drivers affecting the firms:
Internal environment of the firm such as:
the firms mission,
products and services,
pricing,
marketing strategies,
manufacturing,
research and developments,
distribution process,
financial health,
and the human resources issues
 External environment affects the firm:
Does the firm operate in an industry with many small
players, or a few very large players, such as the
computer software industry?
What are the barriers to entering this industry?
Will there be new competitors entering in the future?
What are the growth prospects for the industry?
Who are the firms competitors and what are their
products and strategies?
Who are the key customers and how do they affect
the firms prospect?
Are there regulations that affect the business
operations?