Security analysis
SECURITY ANALYSIS
Security: A security is a legal document that
represent contractual or ownership claim.
Analysis: The examination and evaluation of the
relevant information to select the profitable securities
from various alternatives.
Security analysis involves the analysis and valuation
of particular securities that might be included in the
portfolio
Analysis that answer:
Which security should I buy?
which industry and company's security should I
buy?
At What price?
Security analysis
DEFINITION-SECURITY
ANALYSIS
Security analysis is one vital part of
investment decision process involving the
analysis and valuation of individual
securities.
It is the detail examination of risk and
return characteristics of individual
security in the light of different
fundamental factors.
“The process of gathering and organizing information
and then using it to determine the intrinsic value or
future price of a security
APPROACH TO SECURITY
ANALYSIS
Security
Analysis
Fundamental Technical
Analysis Analysis
Economic Industry Company Past price
analysis Analysis analysis movement
FUNDAMENTAL ANALYSIS
Fundamental Analysis involves examining the economic, financial
and other qualitative and quantitative factors related to a security in
order to determine its intrinsic value.
Intrinsic Value – is estimated value of security
The present value of the expected future cash flows discounted at
the decision maker’s required rate of return.
To determine the intrinsic value:
Future Cash flows from security are forecasted
Determine required rate of return
Calculate present value
Intrinsic value is then compared with the security’s current
market price.
FUNDAMENTAL ANALYSIS
Identifying underpriced and overpriced security, in other
word ‘mispriced’ security.
Security is said to be Mispriced when market price of such
security deviate from its intrinsic value .
It can be defined as a systematic approach to
estimate future cash flow and determine intrinsic
value of securities through analyzing of
fundamental factors and then compares this
intrinsic value with current market value and make
investment decision.
FUNDAMENTAL ANALYSIS CONT…
It is based on the assumption that the security price
is determined by the fundamental factors like
economy, industry and company factors
(Competition, Market share, EPS of the company,
Management quality, Technological changes,
Foreign exchange, Inflation, Row material, etc)
APPROACH OF FUNDAMENTAL ANALYSIS
top down approach
The analyst first considers
conditions in the overall economy
then determines which industries
are the most attractive in light of
the economic conditions
and finally identifies the most
attractive companies within the
attractive industries.
CONT…..
Top to down approach of
Fundamental analysis
Economy Industry Company
Supply of raw
material Financial and non
GDP
Industry life financial data
Inflation rate
cycle stage income statement
Exchange rate
Competitive balance sheet
Interest rate condition in the
Infrastructure industry Ratio analysis
facility Government Management quality
Employment rate policy
Technological
change
Valuation of
Securities
SECURITY VALUATION
Valuation is the process of determining the
fair value of a financial asset.
The process is also referred to as “valuing”
or “pricing” a financial asset.
Valuations of financial assets involve the
following three steps:
Step 1.Estimate the expected cash flows;
Step 2. Determine the required rate of
return
Step 3.Calculate the present value of the
expected cash flows using the interest rate
or interest rates.
INTRINSIC VALUE
Fundamental analyst make investment decision
based on market price of share and its intrinsic value
Economic
Conditions Compare
intrinsic market
value price
Industry
Condition Estimate Calculat
s Future e the
Cash I.V of
Flow Securit
y If the irinsic
If Intrinsic Value > Value <Market
Market price price
Firm
Specific Buy underpriced Sell overpriced
Informatio security security and get
n Investor Decision to profit
buy/sell
Estimating intrinsic value
of common stock
There are two basic approaches for valuation of common
stock using fundamental analysis
A. Discounted Cash Flow Techniques
1. Single or multiple years holding model
Finite holding period
Cash flow: dividend and sells proceed
2. Dividend Discount Model
Infinite holding period-since as legal entity, corporations have un limited life
Cash flow is Dividend
B. Relative valuation techniques
1. Price earnings ratio (P/E)=Share price/earning per share
2. Price book value ratios (P/BV)= share price/book value
per share
ESTIMATING INTRINSIC VALUE OF COMMON STOCK
A. Discounted Cash Flow Techniques
One year holding period or Single Holding Period
If the stock is not held for an infinite period, it is
expected be sold at the end of first year
D1 S1
S0 1
1
(1 k ) (1 k )
S0 = Intrinsic value of common stock
D1 = the amount of dividend expected to be
received at the end of first year
S1 =Expected selling price at the end of one
year
k = Rate of return required by investor
EXAMPLE 1
Consider a situation in which we are valuing a share of
common stock that we plan to hold for only one year.
What will be the value of the stock today if it pays a
dividend of ETB 5, is expected to have a price of ETB
75 and the investor’s required rate of return is 10%?
Value of Common stock
= Present Value of future cash flows
= Present Value of (dividend + expected
selling price)
5 75
S0 4.54 68.2 72.7
1.1 (1.1)
MULTIPLE -YEAR HOLDING MODEL
The value of a stock today is in theory
equal to the present value of all future
dividends plus that of the selling price.
D D2 D3 D4 Dn Sn
S0 1 .......... .
1 k (1 k ) 2 (1 k ) 3 (1 k ) 4 (1 k ) n (1 k ) n
n
Dt Sn
t 1 (1 k ) t (1 k ) n
S0 = Intrinsic value of common stock
D1=The amount of dividend expected to be
received at the end of one year
Sn =Expected selling price at n period
k = Rate of return required by investor
EXAMPLE 2
If an investor expects to get birr 3, birr 4 and birr 4.50
as dividend from a share during the next three years
and hopes to sell it off at birr 75 at the end of the third
year, and if his required rate is 10 %, what is the
intrinsic value? And what is your decision if the
current market price of the share is birr 55?
Intrinsic Value = Present Value of (dividends + expected
selling price)
3 4 4.50 75
S0
1. 1 (1.1) 2 (1.1) 3 (1.1) 3
2.7 3.3 3.38 56.35 65.7
intrinsic value (65.7) > market value(55)---buy
since the current market price (birr 55) is lower than the
intrinsic value (65.7), the share is underpriced at the market
and can be bought
B. Dividend Discount Model
Dividend is the only cash flow
The value of a share of common stock is the present value of all
future dividends
Common stock has no maturity period – they may be expected to bring a
dividend stream of infinite duration.
D1 D2 D3 D4 D
S0 .......... .
(1 k ) (1 k ) 2 (1 k ) 3 (1 k ) 4 (1 k )
Dt
t
t 1 (1 k )
Commonly used assumptions
To value common stock, you must make assumptions about the growth of
future dividends: constant dividend, constant growth
1. The dividend per share remains constant forever, implying that the
growth rate is nil (THE ZERO GROWTH MODEL)
2. The dividend per share grows at a constant rate per year forever (THE
CONSTANT GROWTH MODEL)
ZERO GROWTH MODEL
Investor anticipates to receive the same amount of
dividend per year forever.
Zero growth model assumes a constant dividend, non-
growing dividend stream:
D1 = D 2 = ...
= D
D D D D D
S0 .......... .
1 k (1 k ) 2 (1 k ) 3 (1 k ) 4 (1 k )
D D
t
t 1 (1 k ) k
Plugging constant value D into the common stock valuation
formula reduces to simple equation for a perpetuity: D/K
EXAMPLE 3
Suppose investor want to buy common stock of ABC Company. He
expects to get constant dividend of birr 5 each year without expecting to
grow forever. If investors require a 10% rate of return, what is the
intrinsic value of the stock?
S0 = D / K
5
S0 ETB50.00
10%
To find K
Just adjust the above valuation
model:
D
k = So
CONSTANT DIVIDEND GROWTH
MODEL
Assumes that the dividend per share grows at a constant
rate (g) 2 3 n
D0 (1 g ) D0 (1 g ) D0 (1 g ) D0 (1 g )
S0 2
3
.......... . n
.......
1 k (1 k ) (1 k ) (1 k )
If dividends grow at a constant rate forever, you can value
stock as a growing perpetuity, denoting next year’s
dividend as D1:
D1 = D0 x (1+g)
D2 = D1 x (1+g) = D0 x (1+g)2
:
: Where
; D0 = Current Dividend (time period 0) (paid
Dt = D0 x (1+g)t already)
D1 =Dividend received after one year
or next year dividend.
D1= D0 (1+g)
D2 =Dividend received after two years
K=Estimate the required rate of return (k)
g=Estimated dividend growth rate (g)
S0 = the present value of the infinite series of
CONSTANT DIVEDEND
GROWTH
With a little algebra, this reduces to:
D 0 (1 g) D1
S0
k -g k -g
Commonly called the Gordon
Growth Model.
Assumptions
1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite
period
3. The required rate of return (k) is greater than the infinite
growth rate (g)
EXAMPLE 4
Consider the valuation of a share of common
stock that paid a ETB5 dividend at the end of
last year and is expected to pay a cash
dividend every year from now to infinity.
Each year, the dividends are expected to grow
at a rate of 2%. Based on an assessment of the
riskiness of the common stock, the investor’s
required rate of return is 10%.
What is the intrinsic value of this common
stock? And what is your investment decision if
the current market price of the share is birr 45?
EXAMPLE 4
D 0(1 g )
S0 Or S0 = D1 / (K-g)
(K g )
5(1 0.02) 5.10
S0 birr 63.75
0.1 - 0.02 0.08
Since the share is under priced, I
will buy it
TECHNICAL ANALYSIS
There is two method of analyzing securities
Fundamental analyses-
Estimate share prices on the basis of economic, industry and
company statistics.
Technical analysis is an alternative method of security
analysis
The technical analyst mainly studies the stock price
movement of the security market.
If there is an up trend in the price
movement ,investor may purchase security.
With down price trend, investor may sell it
Technical analysis involves the examination of past market
data such as prices and the volume of trading, which leads
to an estimate of future price trends and then make
investment decision.
TREND LINES
Trend is the direction of price movement.
Y Trend Line
Rising trend line
There are three basic kinds of
trends:
The share prices can either P
increase or fall or remain flat. R
I
An Up trend where prices C Flat trend line
are generally increasing. E
A Down trend where prices
are generally decreasing.
Falling trend line
Flat trend
X
A Trading Range. Days
COMPARISON BETWEEN FUNDAMENTAL
AND TECHNICAL ANALYSIS
FUNDAMENTAL ANALYSIS TECHNICAL ANALYSIS
The study of Fundamental factors : Study of past price movement.
economic, industry and company
factors
Fundamental analyst attempts to Technical traders believe there is
measure a company's intrinsic value no reason to analyze a company's
fundamentals because these are
all accounted in the stock's price.
Fundamental analysis is used to make Technical analysis is used for a
an investment trade
long-term approach -Commonly used comparatively short-term
by long term investors approach
THANK YOU FOR YOUR
ATTENTION!!!
Q&A
