Security Analysis

Introduction

I created this page to introduce students to securities analysis. The information provided on this page is not intended to be comprehensive but is intended to provide students with enough information to start learning on their own. There are many perspectives on investment analysis but this page will be limited to fundamental analysis which is best suited to long time horizons. This approach can also be used to evaluate projects in corporate finance.

An investment recommendation needs a minimum of three components: a specific security, the price of that security, and a specific time. The first two are self explanatory but the third is a proxy for a particular information set. This means that buying a particular security at a particular price may or may not be a good idea depending on what we know about the state of the world at any given time. (I will discuss this more under the Process section.)

There are two basic approaches to valuation: relative value and intrinsic value. Relative value utilizes market multiples as a common basis of comparison between two firms. The most common market multiples are: price to earnings, price to book, price to sales, and price to cash flow. Certain market multiples may be useful in some industries and not others. Remember to account for differences in fiscal year end when comparing multiples. Four of the most commonly used time frames for the market multiple denominators are: last fiscal year, trailing twelve months (TTM), next twelve months (NTM), and next fiscal year. Each of these time frames has positives and negatives that vary from industry to industry. Intrinsic valuation is most commonly done using discounted cash flows methodologies such as the dividend discount model, free cash flow to the firm, or free cash flow to equity.

Process

Securities analysis is as much art as science. In addition to making reasonable assumptions about financial data, the analyst must consider many qualitative aspects of the company and the market.

Identify the information set that will determine asset prices in the future.
What factors matter to the firm’s business model? Which of these factors will matter to the firm years from now?
Is this different from the information set that is currently determining prices?
Are other investors basing their valuations off of short term factors such as next quarter’s results, an investment theme, technical analysis, etc…
Is the relevant information set accurate?
Are the assumptions being used to value the firm reasonable? If they differ from your assumptions, is it because you are missing information or is there a disagreement on the interpretation of available information?

Research Questions

These are some of the questions you should ask yourself as you learn about a company. Again, this list is not intended to be comprehensive; only thought provoking.

Who are the firm’s main competitors?
How do market multiples compare with the firm’s competitors?
What are the performance limits to the firm’s business model? What are peak margins and why?
How flexible is the business model? Do high fixed costs prevent it from quickly reacting to changes in demand?
What portion of the firm’s valuation is composed of physical assets and what portion is composed of intangible assets?
Is the market’s valuation of intangible assets reasonable?
What types of investors are invested in the firm and what types of investors are trading the security?

Risks: operational execution, financial execution, macroeconomic, legal, regulatory, headline risk
Management: quality, reliability, accounting standards, strategy, public relations, ethics

Getting Information

Financial websites have a good presentation of the superficial information about a company. A small sample would include Bloomberg, Google, MarketWatch, Reuters, Seeking Alpha, and Yahoo. Transcripts of earnings calls may be obtained from the company investor relations website or from other investor websites. There may be some well written blog posts that are useful for background but for a bottom up fundamental analysis of a company, you need to use primary sources.

The Securities and Exchange Commission (SEC) maintains a database of company filings called the EDGAR database. The most relevant form is the annual 10-K statement which includes the three financial statements (income statement, balance sheet, and statement of cash flows) as well as all the background information needed to understand the business. The 10-Q statement is the shorter version released on a quarterly basis. International firms file 6-K forms with similar information. On the top of the search results for a particular company’s filings is a link to the RSS feed. Copy this link and paste it into an RSS reader. Email applications like Outlook and Mac Mail also have RSS reader capabilities. When a company releases new information, the filing will appear similar to an email in your RSS reader. Press releases can be obtained from business news aggregator sites like Business Wire.

For economic information, the Federal Reserve maintains the FRED database. This is a good source for interest rates, GDP, inflation data, international trade, and other macroeconomic variables. The one year constant maturity treasury bill series DGS1 is a good series to use as the risk free rate.

Final Notes

I suggest using a forecast period of five years (current year plus four) for discounted cash flow models. The terminal value should use very conservative assumptions such as a growth rate in line with long term GDP growth rather than historic firm growth. In addition to learning Excel, I recommend a getting a financial calculator such as the BA II Plus from Texas Instruments or the HP-12C. Check the library for additional books, blogs, magazines, and movie recommendations.