Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Introduction to Security Valuation

OverviewSecurity Analysis •Is the analysis of tradeable financial instruments called securities.

•Determining the correct value of a security in the market place.

Security AnalysisSecurity Analysis is divided in to two: 1.Fundamental Analysis – involves analyzing fundamental business factors such as financial statement, competitors and the market.

2.Technical Analysis – discipline for forecasting the future direction of prices through the study of past market data primarily price and volume behavior of the market

What is a Security?

• Originally used to describe financial instruments secured by physical asset.

• Now it evolved to indicate all instrument irrespective of whether they offer a security or not.

SEC. 1. This title may be cited as the ‘‘Securities Act of 1933’’. (May 27, 1933, ch. 38, title I, Sec. 1, 48 Stat. 74.)

• SEC. 2. (a) DEFINITIONS.—When used in this title, unless the context otherwise requires—

• (1) The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

Securities are broadly categorized into:

Debt securitiesEquity securities Derivative contractsHybrid securities

Debt Securities• may be called debenture, bonds, deposits,

notes or commercial paper depending on their maturity and certain characteristics.

• Holder of a debt security is typically entitled to the payment of principal and interest together with other contractual rights.

Equity Securities• Is a share of equity interest in an entity such as the capital

stock of a company, trust or partnership.

• Most common form of equity interest is common stock although preferred equity is also a form of capital stock.

• Unlike debt securities which typically require regular payment (interest) to the holder, equity securities are not entitled to any payment.

• In bankruptcy, they share only in the residual interest of the issuer after all obligations have been paid to the creditors.

Hybrid Securities• Combine some of the characteristics of both

debt and equity securities.

• Example : Preferred shares, convertibles, equity warrants.

Derivative Contracts• A financial security such as an option or future

whose characteristics and value depend on the characteristics and value of an underlying security.

• Examples: forwards, futures, options and swaps.

Derivative Contracts• Spot - currency transaction in the interbank market is the purchase

of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day, i.e., the T+2 rule (immediate delivery)

• Forward - The exchange rate is established at the time of the agreement, i.e., today (the agreed exchange rate is called the forward exchange rate), but payment and delivery are not required until maturity.

• Swap transaction - in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates with the same counterparty.

• Foreign currency option - is a contract giving the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date).(i.e. buying a ticket at a benefit concert, you have a right to attend but does not have to do so.

Defining an InvestmentA current commitment of funds for a period of time in to derive a rate of return that would compensate the investor for:–the time the funds are committed–the expected rate of inflation–uncertainty of future flow of funds.

Defining an Investment From this definition, we know that the first step in making an

investment is determining your required rate of return. Once you have determined this rate, some investment alternatives, such

as savings accounts and T-bills, are fairly easy to evaluate because they provide stated cash flows.

Most investments have expected cash flows and a stated market price (for example, common stock), and you must estimate a value for the investment to determine if its current market price is consistent with your required return.

To do this, you must estimate the value of the security based on its expected cash flows and your required rate of return. This is the process of estimating the value of an asset.

After you have completed estimating a security’s intrinsic value, you compare this estimated intrinsic value to the prevailing market price to decide whether you want to buy the security or not.

The Investment Decision Process• This investment decision process is similar to the

process you follow when deciding on a corporate investment or when shopping for clothes, a stereo, or a car.

• In each case, you examine the item and decide how much it is worth to you (its value). If the price equals its estimated value or is less, you would buy it.

• The same technique applies to securities except that the determination of a security’s value is more formal.

The Investment Decision Process

• Determine the required rate of return (required rate of return – rate of return that investors expect to earn given its risk.)

• Evaluate the investment to determine if its market price is consistent with your required rate of return– Estimate the value of the security based on its

expected cash flows and your required rate of return– Compare this intrinsic value to the market price to

decide if you want to buy it

Valuation Process

• Two approaches– 1. Top-down, three-step approach– 2. Bottom-up, stock valuation, stock picking

approach

• The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks.

• Both of these approaches can be implemented by either fundamentalist or technicians.

Valuation Process

• Advocates of the top-down, three-step approach believe that both the economy/market and the industry effect have a significant impact on the total returns for individual stocks.

• In contrast, those who employ the bottom-up, stockpicking approach contend that it is possible to find stocks that are undervalued relative to their market price, and these stocks will provide superior returns regardless of the market and industry outlook.

Overview of the valuation process• First examine the influence of the general economy

on all firms and the security markets

• Then analyze the prospects for various global industries with the best outlooks in this economic environment

• Finally turn to the analysis of individual firms in the preferred industries and to the common stock of these firms.

Why is a Three-Step Valuation Approach

1. General economic influences– Decide how to allocate investment funds among countries,

and within countries to bonds, stocks, and cash

2. Industry influences– Determine which industries will prosper and which

industries will suffer on a global basis and within countries

3. Company analysis– Determine which companies in the selected industries will

prosper and which stocks are undervalued

Does the Three-Step Process Work?

• Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry

Theory of Valuation

• The value of an asset is the present value of its expected returns.

• You expect an asset to provide a stream of returns (cash flow) while you own it.

Theory of Valuation

• To convert this stream of returns (cash flow) to a value for the security, you must discount this stream at your required rate of return.

• Discount factor = 1/(1+r)t

Theory of Valuation

• To convert this stream of returns (cash flow) to a value for the security, you must discount this stream at your required rate of return

• This requires estimates of:– The stream of expected returns, (cash flows) The

required rate of return on the investment (r )

Stream of Expected Returns (Cash Flows)

1. Form of returns– Earnings– Cash flows– Dividends– Interest payments– Capital gains (increases in value)

2. Time pattern and growth rate of returns - you cannot calculate an accurate value for a security unless you can estimate when you will receive the returns or cash flows.

Required Rate of Return

• Uncertainty of Return (cash flow)• Determined by

– 1. Economy’s risk-free rate of return, plus– 2. Expected rate of inflation during the holding

period, plus– 3. Risk premium determined by the uncertainty of

returns• Business risk; financial risk; liquidity risk; exchanger

rate risk and country

Required Rate of Return• We can identify the sources of the uncertainty of

returns by the internal characteristics of assets or by market-determined factors.

• Earlier, we subdivided the internal characteristics for a firm into business risk (BR), financial risk (FR), liquidity risk (LR), exchange rate risk (ERR), and country risk (CR). The market-determined risk measures are the systematic risk of the asset, its beta, or its multiple APT factors.

Investment Decision Process: A Comparison of Estimated Values and Market Prices

You have to estimate the intrinsic value of the investment at your required rate of return and then compare this estimated intrinsic value to the prevailing market price.

If Estimated Value > Market Price, BuyIf Estimated Value < Market Price, Don’t Buy

Valuation of Alternative Investments

• Valuation of Bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known1. Interest payments are made usually every six months equal to one-half the coupon rate times the face value of the bond2. The principal is repaid on the bond’s maturity date