SECURITY ANALYSIS

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.
 Technical analysis is the search for identifiable and recurring
stock price patterns.
 NOTE: Behavioral Finance Implications: Investors are aware
of market efficiency but sometimes overlook the issue of
psychology in financial markets- that is, the role that
emotions play. Particularly, in short turn, inventors’ emotions
affect stock prices, and markets
Framework for Fundamental Analysis:
 Bottom-up approach, where investors focus directly on a company’s
basic. Analysis of such information as the company’s products, its
competitive position and its financial status leads to an estimate of the
company's earnings potential and ultimately its value in the market. The
emphasis in this approach is on finding companies with good
growth prospect, and making accurate earnings estimates. Thus
bottom-up fundamental research is broken in two categories: growth
investing and value investing
 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 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

 For a stock, there are two cash flows:

 Future dividend payments
 The future selling price
Common Stock Valuation: An Example
 Assume that you are considering the purchase of a stock
which will pay dividends of $2 (D1) next year, and $2.16 (D2)
the following year. After receiving the second dividend,
you plan on selling the stock for $33.33. What is the
intrinsic value of this stock if your required return is 15%?
33.33
? 2.00 2.16

2.00 2.16  33.33

VCS    28.57
1.15 1
1.15 2
Some Notes About Common Stock
 In valuing the common stock, we have made two
assumptions:
 We know the dividends that will be paid in the future.
 We know how much you will be able to sell the stock for
in the future.
 Both of these assumptions are unrealistic, especially
knowledge of the future selling price.
 Furthermore, suppose that you intend on holding on
to the stock for twenty years, the calculations would be
very tedious!
Common Stock: Some Assumptions
 We cannot value common stock without making some
simplifying assumptions. These assumptions will define
the path of the future cash flows so that we can derive a
present value formula to value the cash flows.
 If we make the following assumptions, we can derive a
simple model for common stock valuation:
 Your holding period is infinite (i.e., you will never sell the stock so
you don’t have to worry about forecasting a future selling price).
 The dividends will grow at a constant rate forever.
 Note that the second assumption allows us to predict every
future dividend, as long as we know the most recent
dividend and the growth rate.
The Dividend Discount Model
(DDM)
 With these assumptions, we can derive a model that is
variously known as the Dividend Discount Model, the
Constant Growth Model, or the Gordon Model:
D 0 1  g D1
VCS  
k CS  g k CS  g

 This model gives us the present value of an infinite

stream of dividends that are growing at a constant rate.
Estimating the DDM Inputs
 The DDM requires us to estimate the dividend growth rate
and the required rate of return.
 The dividend growth rate can be estimated in three ways:
 Use the historical growth rate and assume it will continue
 Use the equation: g = ROE*(1-p) where p is dividend payout ratio
 Generate your own forecast with whatever method seems
appropriate
 The required return is often estimated by using the CAPM:
ki = krf + bi(km – krf ) or some other asset pricing model.
The DDM: An Example
 Recall our previous example in which the dividends
were growing at 8% per year, and your required return
was 15%.
 The value of the stock must be (D0 = 1.85):

. 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  gD 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:

2.161.08 2.33
V2    33.33
.15.08 . .08
015

 Remember, the value at period 2 is simply the present

value of D3, D4, D5, …, D∞
What if Growth Isn’t Constant?
 The DDM assumes that dividends will grow at a constant
rate forever, but what if they don’t?
 If we assume that growth will eventually be constant, then
we can modify the DDM.
 Recall that the intrinsic value of the stock is the present
value of its future cash flows. Further, we can use the DDM
to determine the value of the stock at some future period
when growth is constant. If we calculate the present value
of that price and the present value of the dividends up to
that point, we will have the present value of all of the future
cash flows.
What if Growth Isn’t Constant?
(cont.)
 Let’s take our previous example, but assume that the
dividend will grow at a rate of 15% per year for the next
three years before settling down to a constant 8% per
year. What’s the value of the stock now? (Recall that
D0 = 1.85)

2.1275 2.4466 2.8136 3.0387 …

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

PV of the first N dividends + PV of stock price at period N

 So, the model is just a mathematical formulation of the methodology that
was presented earlier. It is nothing more than an equation to calculate the
present value of a set of cash flows that are expected to follow a particular
growth pattern in the future.
Other Valuation Methods
 Some companies do not pay dividends, or the
dividends are unpredictable.
 In these cases we have several other possible valuation
models:
 Earnings Model
 Free Cash Flow Model
 P/E approach
 Price to Sales (P/S)
The Earnings Model
 The earnings model separates a company’s earnings (EPS) into
two components:
 Current earnings, which are assumed to be repeated forever with
no growth and 100% payout.
 Growth of earnings which derives from future investments.
 If the current earnings are a perpetuity with 100% payout, then
they are worth:
EPS1
VCE 
k
The Earnings Model (cont.)
 VCE is the value of the stock if the company does not
grow, but if it does grow in the future its value must be
higher than VCE so this represents the minimum value
(assuming profitable growth).
 If the company grows beyond their current EPS by
reinvesting a portion of their earnings, then the value
of these growth opportunities is the present value of
the additional earnings in future years.
 The growth in earnings will be equal to the ROE times
the retention ratio (1 – payout ratio):

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

 Which, since NPV is growing at a constant rate can

be rewritten as: r r 
RE1   RE1 RE1  1
PVGO 
NPV1
 k  k 
kg kg kg
The Earnings Model (cont.)
 The value of the company today must be the sum of
the value of the company if it doesn’t grow and the
value of the future growth:
r 
RE1   1
VCS 
EPS1 NPV1 EPS1
   k 
k kg k kg

 Where RE1 is the retained earnings in period 1, r is the

return on equity, k is the required return, and g is the
growth rate
The Free Cash Flow Model

 Free cash flow is the cash flow that’s left over after making
all required investments in operating assets:

FCF  NOPAT  Op Cap

 Where NOPAT is net operating profit after tax

 Note that the total value of the firm equals the value of its
debt plus preferred plus common:
V  VD  VP  VCS
The Free Cash Flow Model (cont.)
 We can find the total value of the firm’s operations
(not including non-operating assets), by
calculating the present value of its future free cash
flows:
FCF0 1  g 
VOps 
kg

 Now, add in the value of its non-operating assets

to get the total value of the firm:
FCF0 1  g 
V  VOps  VNonOps   VNonOps
kg
The Free Cash Flow Model (cont.)
 Now, to calculate the value of its equity, we subtract
the value of the firm’s debt and the value of its
preferred stock:
FCF0 1  g 
VCS   VNonOps  VD  VP
kg
 Since this is the total value of its equity, we divide by
the number of shares outstanding to get the per share
value of the stock.
Relative Value Models
 Professional analysts often value stocks relative to one another.
 For example, an analyst might say that XYZ is undervalued relative to
ABC (which is in the same industry) because it has a lower P/E ratio,
but a higher earnings growth rate.
 These models are popular, but they do have problems:
 Even within an industry, companies are rarely perfectly comparable.
 There is no way to know for sure what the “correct” price multiple is.
 There is no easy, linear relationship between earnings growth and price
multiples (i.e., we can’t say that because XYZ is growing 2% faster that it’s
P/E should be 3 points higher than ABC’s – there are just too many
additional factors).
 A company’s (or industry’s) historical multiples may not be relevant today
due to changes in earnings growth over time.
The P/E Approach
 As a rule of thumb, or simplified model, analysts often
assume that a stock is worth some “justified” P/E ratio
times the firm’s expected earnings.
 This justified P/E may be based on the industry average
P/E, the company’s own historical P/E, or some other P/E
that the analyst feels is justified.
 To calculate the value of the stock, we merely multiply its
next years’ earnings by this justified P/E:

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
 Privileged Subscription
Privileged Subscription – The sale of new securities in which existing
shareholders are given a preference in purchasing these securities up to the
proportion of common shares that they already own; also known as a rights
offering.

Preemptive Right – The privilege of shareholders to maintain their

proportional company ownership by purchasing a proportionate share of any
new issue of common stock, or securities convertible into common stock.
 Terms of Offering
Right – A short-term option to buy a certain number
(or fraction) of securities from the issuing corporation;
also called a subscription right.
Terms specify:
• the number of rights required to subscribe for
an additional share of stock
• the subscription price per share
• the expiration date of the offering
 Subscription Rights

Options available to the holder of rights:

• Exercise the rights and subscribe for
additional shares
• Sell the rights (they are transferable)
• Do nothing and let the rights expire
Generally, the subscription period is
three weeks or less.
 Subscription Rights
A shareholder who owns 77 shares and just
received 77 rights would like to purchase 8
new shares. It takes 10 rights for each new
share. What action should the shareholder
take?
The shareholder can then purchase 7 shares (use 70
rights) and still retain the 7 remaining rights. Thus,
the shareholder needs to purchase an
additional 3 rights.
 Value of Rights
What gives a right its value?
A right allows you to buy new stock at a discount that
typically ranges between 10 to 20 percent from the
current market price.
The market value of a right is a function of :
• the market price of the stock
• the subscription price
• the number of rights required to purchase an
additional share of stock
 How is the Value of a
Right Determined?

P0 – R0 = [ (R0)(N) + S ], therefore
R0 = P0 – [ (R0)(N) + S ]
R0 = the market price of one right when the stock is selling
“rights-on”
P0 = the market price of a share of stock selling
“rights-on”
S = the subscription price per share
N = the number of rights required to purchase one share
of stock
 How is the Value of a
Right Determined?
P0 – S
Solving for R0. R0 =
N+1

PX = P0 – R0 = [ (R0)(N) + S ]
By substitution for R0, we can solve the
“ex-rights” value of one share of stock, PX.

(P0 )(N) + S
PX =
N+1
 Example of the Valuation of
a Right
What is the value of a right when the stock is
selling “rights-on”? What is the value of one share
of stock when it goes “ex-rights”?
• Assume the following information:
• The current market price of a
stock “rights-on” is $50.
• The subscription price is $40.
• It takes nine rights to buy an additional
share of stock.
 How is the Value of a
Right Determined?
$50 – $40
Solving for R0. R0 =
9+1

R0 = $1

Solving for PX. ($50 )(9) + $40

PX =
9+1

PX = $49
 Theoretical Versus Actual
Value of Rights
Why might the actual value of a right differ
from its theoretical value?
• Transaction costs
• Speculation
• Irregular exercise and sale of rights over
the subscription period
Arbitrage acts to limit the deviation of the
actual right value from the theoretical
value.
ILLUSTRATION
 XYZ Ltd has an issued share capital of 10 million ordinary
shares with a par value of Sh.10, on which it pays a constant
dividend of Sh.4 per share. The market value per share was
Sh.20 ex-dividend. The company then proposed a 1 for 4 rights
issue with an issue price of Sh.15. The money raised would be
used to finance a major new project, which was expected to
increase annual cash flows after taxation by Sh.9,500,000.
This information is released together with the announcement
of rights issue.
 Required:
 Compute the cum-right price at the eve-of the rights issue
 Compute the theoretical ex-rights price
 Calculate the market price per share at the time of the rights
issue if the money raised was to be used to redeem Sh.
37,500,000 of 8% debentures. The tax rate is 30%.