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501
Prospective Analysis: Valuation Implementation




12-41 Part 2 Business Analysis and Valuation Tools




SPECIALTY RETAILERS INDUSTRY COMPOSITE
(including Gap, Limited, Melville, Petrie, and Nordstrom)

COMMON SIZE INCOME STATEMENT
Jan. 1992 Jan. 1991 Jan. 1990 Jan. 1989 Jan. 1988
..................................................................................................................................................

Sales 1.000 1.000 1.000 1.000 1.000
CGS 0.638 0.635 0.630 0.632 0.637
Gross Pro¬t 0.362 0.365 0.370 0.368 0.363
SGA 0.252 0.253 0.251 0.253 0.250
Operating Income Before Depreciation 0.110 0.112 0.119 0.115 0.113
Depreciation and Amortization 0.026 0.025 0.024 0.024 0.023
Operating Pro¬t 0.084 0.087 0.094 0.091 0.090
Interest Expense 0.007 0.008 0.008 0.008 0.009
The Gap




Non-op and Special Items 0.005 0.005 0.004 0.004 0.009
Pretax Income 0.082 0.085 0.091 0.087 0.091
Income Taxes 0.032 0.030 0.033 0.031 0.035
Minority Interest 0.002 0.002 0.002 0.003 0.003
Income Before Extra Items 0.049 0.052 0.056 0.053 0.053
Extra Items and Discontinued Operations 0.000 0.000 0.000 0.004 0.000
Net Income 0.049 0.052 0.056 0.057 0.053
EBI/Sales 0.053 0.057 0.060 0.061
Asset Turnover 2.141 2.153 2.175 2.190
Leverage = Assets/equity (average) 1.874 1.889 1.869 1.860
Net income/EBI 0.919 0.919 0.923 0.921
ROE = Product of above 0.196 0.211 0.226 0.230
ROA = EBI/Assets 0.114 0.122 0.131 0.134
Sustainable Growth 0.058 0.062 0.058 0.054
..................................................................................................................................................
EBI = earnings before interest, net of assumed 40% tax effect.
Sustainable growth = ROE — earnings retention rate.




SELECTED FINANCIAL STATEMENT DATA
Jan. 1992 Jan. 1991 Jan. 1990 Jan. 1989 Jan. 1988
(millions of $)
..................................................................................................................................................

Net Receivables 1,604 1,430 1,290 1,156 631
Inventory 3,578 3,067 2,558 2,316 1,986
Net Property and Equipment 4,456 3,874 3,200 2,878 2,476
Total Assets 11,588 10,104 8,635 7,749 6,622
Total Equity 6,230 5,344 4,576 4,192 3,534
Sales 23,220 20,172 17,819 15,734 13,771
Cost of Goods Sold 14,804 12,817 11,226 9,946 8,769
Selling, General, & Administrative Expense 5,855 5,096 4,480 3,984 3,442
Operating Income Before Depreciation 2,561 2,259 2,113 1,805 1,560
Net Income 1,132 1,047 990 889 730
..................................................................................................................................................
13
13 E q u it y S e c u rit y An al ys is
chapter




E quity security analysis is the evaluation of a ¬rm and its prospects
from the perspective of a current or potential investor in the ¬rm™s stock. Security anal-
ysis is one step in a larger investment process that involves (1) establishing the objectives
Business
3


of the investor or fund, (2) forming expectations about the future returns and risks of in-
Analysis dividual securities, and then (3) combining individual securities into portfolios to max-
imize progress toward the investment objectives.
and Security analysis is the foundation for the second step, projecting future returns and
assessing risk. Security analysis is typically conducted with an eye towards identi¬ca-
Valuation
tion of mispriced securities, in hopes of generating returns that more than compensate
Application the investor for risk. However, that need not be the case. For analysts who do not have a
comparative advantage in identifying mispriced securities, the focus should be on gain-
s ing an appreciation for how a security would affect the risk of a given portfolio, and
whether it ¬ts the pro¬le that the portfolio is designed to maintain.
Security analysis is undertaken by individual investors, by analysts at brokerage
houses (sell-side analysts), by analysts that work at the direction of funds managers for
various institutions (buy-side analysts), and others. The institutions employing buy-side
analysts include mutual funds, pension funds, insurance companies, universities, and
others.
A variety of questions are dealt with in security analysis:
• A sell-side analyst asks: How do my forecasts compare to those of the analysts™
consensus? Is the observed market price consistent with that consensus? Given my
expectations for the firm, does this stock appear to be mispriced? Should I recom-
mend this stock as a buy, a sell, or a hold?
• A buy-side analyst for a “value stock fund” offered to mutual fund investors asks:
Does this stock possess the characteristics we seek in our fund? That is, does it have
a relatively low ratio of price to earnings, book value, and other fundamental indi-
cators? Do its prospects for earnings improvement suggest good potential for high
future returns on the stock?
• An individual investor asks: Does this stock offer the risk profile that suits my in-
vestment objectives? Does it enhance my ability to diversify the risk of my portfo-
lio? Is the firm™s dividend payout rate low enough to help shield me from taxes
while I continue to hold the stock?
As the above questions underscore, there is more to security analysis than estimating

13-1




503
504 Equity Security Analysis




13-2
Equity Security Analysis




the value of stocks. Nevertheless, for most sell-side and buy-side analysts, the key goal
remains the identi¬cation of mispriced stocks.


INVESTOR OBJECTIVES
The investment objectives of individual savers in the economy are highly idiosyncratic.
For any given saver they depend on such factors as income, age, wealth, tolerance for
risk, and tax status. For example, savers with many years until retirement are likely to
prefer to have a relatively large share of their portfolio invested in equities, which offer
a higher expected return but high short-term variability. Investors in high tax brackets
are likely to prefer to have a large share of their portfolio in stocks that generate tax-de-
ferred capital gains rather than stocks that pay dividends or interest-bearing securities.
Mutual funds (or unit trusts as they are termed in some countries) have become pop-
ular investment vehicles for savers to achieve their investment objectives. Mutual funds
sell shares in professionally managed portfolios that invest in speci¬c types of stocks
and/or ¬xed income securities. They therefore provide a low-cost way for savers to in-
vest in a portfolio of securities that re¬‚ects their particular appetite for risk.
The major classes of mutual funds include (1) money market funds that invest in CDs
and treasury bills, (2) bond funds that invest in debt instruments, (3) equity funds that
invest in equity securities, (4) balanced funds that hold money market, bond, and equity
securities, and (5) real estate funds that invest in commercial real estate. Within the bond
and equities classes of funds, however, there are wide ranges of fund types. For example,
bond funds include:
• Corporate bond funds that invest in investment-grade rated corporate debt instru-
ments
• High yield funds that invest in non-investment-grade rated corporate debt
• Mortgage funds that invest in mortgage-backed securities
• Municipal funds that invest in municipal debt instruments and which generate in-
come that can be nontaxable
Equity funds include:
• Income funds that invest in stocks that are expected to generate dividend income
• Growth funds that invest in stocks expected to generate long-term capital gains
• Income and growth funds that invest in stocks that provide a balance of dividend
and capital gains
• Value funds that invest in equities that are considered to be undervalued
• Short funds that sell equity securities short that are considered to be overvalued
• Index funds that invest in stocks that track a particular market index, such as the
S&P 500
• Sector funds that invest in stocks in a particular industry segment, such as the tech-
nology or health sciences sectors
• Regional funds that invest in equities from a particular country or geographic
region, such as Japan, Europe, or the Asia-Pacific region
505
Equity Security Analysis




13-3 Part 3 Business Analysis and Valuation Applications




The focus of this chapter is on analysis for equity securities.


EQUITY SECURITY ANALYSIS AND
MARKET EFFICIENCY
How a security analyst should invest his or her time depends on how quickly and ef¬-
ciently information ¬‚ows through markets and becomes re¬‚ected in security prices. In
the extreme, information would be re¬‚ected in security prices fully and immediately
upon its release. This is essentially the condition posited by the ef¬cient markets hypoth-
esis. This hypothesis states that security prices re¬‚ect all available information, as if such
information could be costlessly digested and translated immmediately into demands for
buys or sells without regard to frictions imposed by transactions costs. Under such con-
ditions, it would be impossible to identify mispriced securities on the basis of public in-
formation.
In a world of ef¬cient markets, the expected return on any equity security is just
enough to compensate investors for the unavoidable risk the security involves. Unavoid-
able risk is that which cannot be “diversi¬ed away” simply by holding a portfolio of
many securities. Given ef¬cient markets, the investor™s strategy shifts away from the
search for mispriced securities and focuses instead on maintaining a well diversi¬ed
portfolio. Aside from this, the investor must arrive at the desired balance between risky
securities and short-term government bonds. The desired balance depends on how much
risk the investor is willing to bear for a given increase in expected returns.
The above discussion implies that investors who accept that stock prices already re-
¬‚ect available information have no need for analysis involving a search for mispriced se-
curities. Of course, if all investors adopted this attitude, no such analysis would be
conducted, mispricing would go uncorrected, and markets would no longer be ef¬cient!
This is why the ef¬cient markets hypothesis cannot represent an equilibrium in a strict
sense. In equilibrium, there must be just enough mispricing to provide incentives for the
investment of resources in security analysis.
The existence of some mispricing, even in equilibrium, does not imply that it is sen-
sible for just anyone to engage in security analysis. Instead, it suggests that securities
analysis is subject to the same laws of supply and demand faced in all other competitive
industries: it will be rewarding only for those with the strongest comparative advantage.
How many analysts are in that category depends on a number of factors, including the
liquidity of a ¬rm™s stock and investor interest in the company.1 For example, there are
about 40 sell-side professional analysts who follow IBM, a company with a highly liquid
stock and considerable investor interest. There are many other buy-side analysts who
track the ¬rm on their own account without issuing any formal reports to outsiders. For
the smallest publicly traded ¬rms in the U.S., there is typically no formal following by
analysts, and would-be investors and their advisors are left to themselves to conduct
securities analysis.
506 Equity Security Analysis




13-4
Equity Security Analysis




Market Efficiency and the Role of Financial Statement Analysis
The degree of market ef¬ciency that arises from competition among analysts and other
market agents is an empirical issue addressed by a large body of research spanning the
last three decades. Such research has important implications for the role of ¬nancial
statements in security analysis. Consider, for example, the implications of an extremely
ef¬cient market, where information is fully impounded in prices within minutes of its
revelation. In such a market, agents could pro¬t from digesting ¬nancial statement in-
formation in two ways. First, the information would be useful to the select few who re-
ceive newly-announced ¬nancial data, interpret it quickly, and trade on it within
minutes. Second, and probably more important, the information would be useful for
gaining an understanding of the ¬rm, so as to place the analyst in a better position to in-
terpret other news (from ¬nancial statements as well as other sources) as it arrives.
On the other hand, if securities prices fail to re¬‚ect ¬nancial statement data fully, even
days or months after its public revelation, there is a third way in which market agents
could pro¬t from such data. That is to create trading strategies designed to exploit any
systematic ways in which the publicly available data are ignored or discounted in the
price-setting process.


Market Efficiency and Managers™ Financial Reporting Strategies
The degree to which markets are ef¬cient also has implications for managers™ approach-
es to communicating with their investment communities. The issue becomes most im-
portant when the ¬rm pursues an unusual strategy, or when the usual interpretation of
¬nancial statements would be misleading in the ¬rm™s context. In such a case, the com-
munication avenues managers can successfully pursue depend not only on manage-
ment™s credibility, but also on the degree of understanding present in the investment
community. We will return to the issue of management communications in more detail
in Chapter 17.


Evidence of Market Efficiency
There is an abundance of evidence consistent with a high degree of ef¬ciency in the pri-
mary U.S. securities markets.2 In fact, during the 1960s and 1970s, the evidence was so

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