Security Analysis Methodology
Background and Data Gathering
- Read as much as you can about the industry, from as many sources as you can find.
- Use the resources on the links page to investigate the industry and its major companies.
Your objective here is simply to learn as much about the industry and its companies
as you can.
Major Steps in the Analysis
- Read enough economic forecasts and economic commentary that you can make an informed
judgment as to where we are within the business cycle.Using the relationships covered in the course, determine the outlook for the rate of
inflation and future movement of interest rates over the next year.
- Given your scenario (or outlook) for economic growth, determine how your industry will
fare relative to others under this scenario.
- Read all that you can about the industry that you have been assigned.
- Try to thoroughly understand the industrys characteristics (i.e. what are the
major factors which determine or drive the industry's profits): the economic outlook
for the industrys customers, the degree of operating leverage, the degree of
financial leverage, presence of economies of scale, technological changes, net income's
sensitivity to interest rate changes, etc. Standard & Poor's Industry
Survey (in the library's Reference Room) is an excellent source for
- Identify the source of future sales for the industry (international expansion,
acquisitions, domestic growth, etc.).
- Analysis of the companys competitive position is very important - this competition
can place tremendous pressure on the profit margins of firms in the industry. Use
Michael Porters competitive strategy model (with its five factors) to analyze these
- Use the screening software found on the internet to find the companies in your
industry that have favorable characteristics (low P/E, high ROE, reasonable growth rate of
sales and earnings, market value, etc.). (See the links page of this
website for links to the screening programs.)
- Realize that a large amount of variation exists around
the average (or mean) characteristics for stocks. Characteristics often vary wildly
from industry to industry.
You will want to use both internet resources (see the links page) and library
materials to research each of your chosen companies in-depth. Consider the
- Identify which of the 3 generic strategies (if any) the company is following. How
is the firm trying to compete with others in the industry?
- What competitive advantages does the company enjoy?
- Look for indications of integrity, being owner-oriented, an emphasis on long-term
results, and an ability to manage change. The companys accounting policies
should be conservative, with an absence of gimmicks to push up earnings.
||Conduct a ratio analysis of each of the companies to (1)
weed out the companies with weak fundamentals, and (2) to identify the strengths of each
of the major firms. Remember that many of the ratios can be found in the company
profiles at various web sites (see the links page).
||Income Statement Analysis
- How consistent has the past sales growth been?
- Where will future growth come from - existing product lines, new products, acquisitions,
- Does the firm have a valid franchise - valuable proprietary products or services?
- How healthy are the firms customers?
||Operating Profit Margin
- What is the trend and stability of the firms operating profit margin
- Look at Michael Porters competitive strategy analysis again to see the impact on
- How consistent is the companys growth in earnings?
- What is the forecasted growth rate of earnings?
||Breakdown of Return on Equity
- How does the firms Return On Equity compare to other firms in the industry?
- Use the duPont model to break down ROE into the sources of profit for the firm.
How is the company achieving its profitability - from operating sources or financial
sources? Are there any favorable or unfavorable trends?
- What are the major sources of risk to the company (cyclical sales with an approaching
recession, high leverage, etc.) and stock (a high beta and/or a high P/E ratio in a weak
- What is the quality of the companys earnings - excellent, average, poor?
||Stock Analysis and Valuation
- Determine the fair price of the stock through use of a dividend discount model.
How much is the stock under-priced or over-priced?
- Determine the stocks expected rate of return (internal rate of return on the cash
- Place each stocks expected return (with proper labels) on a security market line
chart (use 2% as the risk-free rate and 8% for the expected market rate of return for the
- If the company is selling for less than its historical relative P/E ratio, what is the
- Based on your overall analysis, you are to recommend the most attractive stock (or
stocks) from the industry for investment in the portfolio. (However, it is
possible that none of the stocks will appear attractive. If so, then you have still
found something valuable - which stocks to avoid. Your grade will not be reduced if
you do not recommend any stocks for the portfolio.)
- As the expert analyst for the industry, you will present your recommendation to the
portfolio manager (your fellow students and instructor). This will be done both
verbally and written.
Here is the valuation spreadsheet.