Summary Chapter 9 Business Analysis and Valuation IFRS edition 5th Edition By Krishna PDF

Preview

Summary

Chapter 9 – Equity security analysisEquity security analysis – evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm’s shares – Projecting future returns and assessing risk identification of mispriced securities in hopes of generating returns that...

Description

Chapter 9 – Equity security analysis Equity security analysis – evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm’s shares – Projecting future returns and assessing risk – identification of mispriced securities in hopes of generating returns that more than compensate the investor for risk – focus on gaining an appreciation for how a security would affect the risk of a given portfolio - involves the following steps: 1. Establishing the objectives of the investor 2. Forming expectations about the future returns and risks of individual securities 3. Combining individual securities into portfolios that maximise progress towards the investment objectives Security analysis is undertaken by individual investors/sell side analysts/buy-side analysts (pension funds, insurance companies, investment funds). Investor objectives and investment vehicles The investment objectives of individual savers are highly idiosyncratic – depend on factors such as income, age, wealth, tolerance for risk, tax status -

Savers with many years until retirement = equity – higher expected return and short term volatility

-

Investors in high tax brackets = tax deferred capital gains rather than shares that pay dividends or interest bearing securities.

Collective investment funds – select shares in professionally managed portfolios that invest in specific types of equity and/or fixed income securities – low cost – reflect individuals’ risk profile (e.g. bond funds, real estate funds, etc.) Bond and equities fans -

corporate bond funds

-

government bond funds

Equity funds -

income funds (generate dividend income)

-

value funds (undervalued equities)

-

income and growth funds (dividend income and capital gains)

-

…

Hedge funds are becoming an increasingly important force in the market using the following investment strategies: -

market neutral funds – Equal amounts of money in purchasing undervalued securities and shorting overvalued ones

-

short selling funds

-

special situation funds - purchase of undervalued securities waiting for a special event in the market

Equity security analysis and market efficiency Efficient market hypothesis – information should be reflected in security prices fully and immediately upon release – security prices reflect all information without cost and translated into demands for buys or sells without regard to transaction costs. Expected return in efficient markets is just enough to compensate for unavoidable risk (not diversifiable). investors must arrive at a balance between risky securities and risk free shortterm government bonds depending on how much risk she/he is willing to bear. Misspricing of securities suggests that securities analysis is subject to the same laws of supply and demand faced in all other competitive industries. Market efficiency and the role of financial statement analysis In extremely efficient market , investors could profit from digesting financial statement information in two ways: -

interpret newly announced financial data quickly and trade on it within minutes

-

create trading strategies designed to exploit systematic ways in which the publicly available data are ignored or discounted in the price setting process.

Market efficiency depends on managements credibility but also on the degree of understanding present in the investment community. There is evidence pointing to very efficient securities market: -

when information is announced publicly, the markets react very quickly

-

it is difficult to identify specific funds or analysts who have consistently generated abnormally high returns

-

share prices reflect a rather sophisticated level of fundamental analysis.

The degree of mispricing is relatively small for large firms. it is currently difficult to align with the efficient markets hypothesis both it remains a useful benchmark for thinking about the behaviour of security prices. Approaches to fund management and securities analysis 

Active vs passive management -

active portfolio management = identification of mispriced securities

-

passive portfolio management = combined approach between matching of overall market index and sector performance



Quantitative vs traditional fundamental analysis -

technical analysis = attempt to predict share price movements on the basis of market indicators (priority share price movements, volume, etc) – subjective judgement with more quantitative approaches (earning revisions, ratios revisions)

-

fundamental analysis = attempt to evaluate the current market price relative to projections of the firms future profits and cash flow generating potential – involve business strategy analysis, accounting analysis, financial analysis and prospective analysis (forecasting and valuation) – human judgement based



Formal vs informal valuation -

formal valuation = (chapter 7) estimation both firm values for evaluating merger or buyout proposal, for issuing a fairness opinion, for periodic managerial review.

The process of a comprehensive security analysis 

Selection of candidates for analysis – must fit fund objective (nature of firm’s risk and risk profile) -

organised by industry or sector

-

investing in shares with certain risk profiles or characteristics (e.g. growth shares, value shares)

-

based on mispricing = earnings momentum – positive signal of future price movements/recent short term share price movements



Inferring market expectations – judging whether the share is correctly valued -

comparison of the analyst’s expectations with those of the market (current share price)

-

summarising analysts’ forecasts of revenue and earnings – not representing a complete description of expectations about future performance

-

understanding the types of long term forecasts reflected in share prices



express price as a function of future cash flows or earnings

Developing the analyst’s expectations – understanding that enables the analyst to interpret new information -

forecasts are less important than the understanding of the business and its industry as provided by the analyst



Final product of security analysis – recommendation to buy, sell or hold the share -

supported by a set of forecasts and report summarising the foundation for the recommendation (assessment of the firm’s business, income statement, balance sheet, cash flow forecasts)

-

considering the investment type horizon required to capitalize on the recommendation (longer horizon = greater risk of changes in economic conditions not anticipated – analysis requires being able to recognise whether a share is misvalued as well as to anticipate when a price correction is likely to take place

-

focus on recommendations that are likely to pay off in the short term.

Performance of security analysts and fund managers Performance of security analysts Analysts generally add value in the capital market. Analysts earnings forecasts are more accurate than those produced by time series models that used past earnings to predict future earnings. In addition, while analysts incorporate new firm and economy information in the market, share prices tend to respond positively to upward revisions and recommendations and negatively to downward revisions. Although analysts perform valuable analysis, they tend to be biased by their optimism. Not surprisingly, forecasts of near term earnings are much more accurate than those of long term performance. With the sharp rise in trading by hedge funds, which actively seek shares to short sell, there has been but general decline in sell side analysts’ optimistic recommendations in the last few years . In contrast, traditional money management firms are typically restricted from short selling. Performance of fund managers Measuring whether collective investment and pension fund managers earn superior return is a difficult task for several reasons: -

no agreement about how to estimate benchmark performance for a fund

-

many of the traditional measures of fund performance abstract from market-wide performance – understate fund abnormal performance if fund managers can time the market by reducing portfolio risk prior to market declines and increasing risk before a market run up.

Funds earning positive abnormal returns in one period continue to outperform in subsequent periods as caused by general momentum in stock returns and the fund expenses rather than superior fund manager ability....