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

Economic 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.

Industry Analysis

• Read all that you can about the industry that you have been assigned.
• Try to thoroughly understand the industry’s characteristics (i.e. what are the major factors which determine or drive the industry's profits):  the economic outlook for the industry’s 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 this.
• Identify the source of future sales for the industry (international expansion, acquisitions, domestic growth, etc.).
• Analysis of the company’s competitive position is very important - this competition can place tremendous pressure on the profit margins of firms in the industry.  Use Michael Porter’s competitive strategy model (with its five factors) to analyze these competitive pressures.
• 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.

 

Company Analysis

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 following:

Strategy

• 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?

Management

• Look for indications of integrity, being owner-oriented, an emphasis on long-term results, and an ability to manage change.  The company’s accounting policies should be conservative, with an absence of gimmicks to push up earnings.

Ratio Analysis

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

Sales

• How consistent has the past sales growth been?
• Where will future growth come from - existing product lines, new products, acquisitions, international expansion?
• Does the firm have a valid franchise - valuable proprietary products or services?
• How healthy are the firm’s customers?

Operating Profit Margin

• What is the trend and stability of the firm’s operating profit margin (OPM)?

• Look at Michael Porter’s competitive strategy analysis again to see the impact on each firm.

Earnings

• How consistent is the company’s growth in earnings?

• What is the forecasted growth rate of earnings?

Breakdown of Return on Equity

• How does the firm’s 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?

Risks

• 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 market period)?
• What is the quality of the company’s 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 stock’s expected rate of return (internal rate of return on the cash flows)?
• Place each stock’s 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 CAPM)
• If the company is selling for less than its historical relative P/E ratio, what is the reason?

Conclusion

• 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.

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