ber of items in the ļ¬nancials that could temper oneā™s view of the quality of earnings. As-
suming market agents are capable of conducting similar analyses, we would expect
stock prices to reļ¬‚ect ļ¬nancial statement details beyond just earnings.
A large number of studies have examined the relation between stock prices and ļ¬nan-
cial statement data beyond earnings. For example, one study focused on roughly a dozen
ļ¬nancial statement variables that could be useful in assessing the quality of earnings:
disproportionate inventory and receivables buildups, increases in gross margin percent-
age, and other factors.9 The results conļ¬rm that stock prices reļ¬‚ect such variables. In
other words, one can explain variation in stock prices better when armed not just with
earnings but also with the factors that help analysts interpret the quality of earnings.
Many studies have also examined the extent to which footnote disclosures are related
to stock price behavior. For example, one study examined the extent to which unrealized
gains in banksā™ investment portfolios are reļ¬‚ected in stock prices.10 The conclusion of
most studies in this area is that prices at least approximately reļ¬‚ect the details in foot-
notes. Thus, the evidence is consistent with the footnotes presenting important data and
Equity Security Analysis
13-15 Part 3 Business Analysis and Valuation Applications
with analysts ādoing their homework.ā Whether market agents do a complete job of di-
gesting footnote data is less clear.
Research on the relation of stock prices to ļ¬nancial statement details continues, and
many of the questions in the area remain unsettled.11 A few general comments on the
current state of understanding can be offered. First, many ļ¬nancial statement details are
important, in the sense that they reļ¬‚ect factors that drive stock prices. Second, whether
market agents learn about such details from the ļ¬nancial statements themselves or from
more timely sources is difļ¬cult to know. (Most studies are not sharp enough to answer
this question.) Third, whether stock prices reļ¬‚ect ļ¬nancial statement details completely
and immediately remains a subject of debate, with studies on both sides of the issue. One
implication of the research for security analysts is that to stay abreast of the market one
must be able to gather and interpret the kind of information reļ¬‚ected in the ļ¬nancial
statement detailsā”either by going directly to the statements or (preferably) to more
Equity security analysis is the evaluation of a ļ¬rm and its prospects from the perspective
of a current or potential investor in the ļ¬rmā™s stock. Security analysis is one component
of a larger investment process that involves (1) establishing the objectives of the investor
or fund, (2) forming expectations about the future returns and risks of individual securi-
ties, and then (3) combining individual securities into portfolios to maximize progress
toward the investment objectives.
Some security analysis is devoted primarily to assuring that a stock possesses the
proper risk proļ¬le and other desired characteristics prior to inclusion in an investorā™s
portfolio. However, especially for many professional buy-side and sell-side security an-
alysts, the analysis is also directed toward the identiļ¬cation of mispriced securities. In
equilibrium, such activity will be rewarding for those with the strongest comparative ad-
vantage. They will be the ones able to identify any mispricing at the lowest cost and exert
pressure on the price to correct the mispricing. What kinds of efforts are productive in
this domain depends on the degree of market efļ¬ciency. A large body of evidence exists
that is supportive of a high degree of efļ¬ciency in the U.S. market, but recent evidence
has reopened the debate on this issue.
In practice, a wide variety of approaches to fund management and security analysis
are employed. However, at the core of the analyses are the same steps outlined in Chap-
ters 2 through 12 of this book: business strategy analysis, accounting analysis, ļ¬nancial
analysis, and prospective analysis (forecasting and valuation). For the professional ana-
lyst, the ļ¬nal product of the work is, of course, a forecast of the ļ¬rmā™s future earnings
and cash ļ¬‚ows, and an estimate of the ļ¬rmā™s value. However, that ļ¬nal product is less
important than the understanding of the business and its industry, which the analysis pro-
vides. It is such understanding that positions the analyst to interpret new information as
it arrives and infer its implications.
518 Equity Security Analysis
Equity Security Analysis
While security analysis clearly involves much information beyond the ļ¬nancial state-
ments, those statements play an important role. Much research over the past three de-
cades has helped describe the role of ļ¬nancial statement data in the setting of security
prices. The research shows conclusively that ļ¬nancial statements reļ¬‚ect much of the in-
formation that drives prices. However, whether market agents acquire the information
directly from the ļ¬nancial statements themselves or from more timely sources is less
clear. Much of the information in ļ¬nancial statements appears to be anticipated before
its release. Finally, whether stock prices reļ¬‚ect ļ¬nancial statement details completely
and immediately remains a subject of debate. One implication of the research for secu-
rity analysts is that to stay abreast of the market, one must be able to gather and interpret
the kind of information reļ¬‚ected in the ļ¬nancial statement detailsā”either by going
directly to the statements or (preferably) to more timely sources.
1. Despite many years of research, the evidence on market efficiency described in this
chapter appears to be inconclusive. Some argue that this is because researchers have
been unable to link company fundamentals to stock prices precisely. Comment.
2. Geoffrey Henley, a professor of finance, states: āThe capital market is efficient. I
donā™t know why anyone would bother devoting their time to following individual
stocks and doing fundamental analysis. The best approach is to buy and hold a well-
diversified portfolio of stocks.ā Do you agree? Why or why not?
3. What is the difference between fundamental and technical analysis? Can you think
of any trading strategies that use technical analysis? What are the underlying as-
sumptions made by these strategies?
4. Investment funds follow many different types of investment strategies. Income
funds focus on stocks with high dividend yields, growth funds invest in stocks that
are expected to have high capital appreciation, value funds follow stocks that are
considered to be undervalued, and short funds bet against stocks they consider to be
overvalued. What types of investors are likely to be attracted to each of these types
of funds? Why?
5. Three months ago, Intergalactic Software Company went public. You are a sophis-
ticated investor who devotes time to fundamental analysis as a way of identifying
mispriced stocks. Which of the following characteristics would you focus on in de-
ciding whether to follow this stock?
ā¢ The market capitalization
ā¢ The average number of shares traded per day
ā¢ The bidā“ask spread for the stock
ā¢ Whether the underwriter that brought the ļ¬rm public is a Top Five investment
ā¢ Whether its audit company is a Big Six ļ¬rm
ā¢ Whether there are analysts from major brokerage ļ¬rms following the company
ā¢ Whether the stock is held mostly by retail or institutional investors
Equity Security Analysis
13-17 Part 3 Business Analysis and Valuation Applications
6. There are two major types of financial analysts: buy-side and sell-side. Buy-side an-
alysts work for investment firms and make stock recommendations that are avail-
able only to the management of funds within that firm. Sell-side analysts work for
brokerage firms and make recommendations that are used to sell stock to the bro-
kerage firmsā™ clients, which include individual investors and managers of invest-
ment funds. What would be the differences in tasks and motivations of these two
types of analysts?
7. Many market participants believe that sell-side analysts are too optimistic in their
recommendations to buy stocks, and too slow to recommend sells. What factors
might explain this bias?
8. Joe Klein is an analyst for an investment banking firm that offers both underwriting
and brokerage services. Joe sends you a highly favorable report on a stock that his
firm recently helped go public and for which it currently makes the market. What
are the potential advantages and disadvantages in relying on Joeā™s report in deciding
whether to buy the stock?
9. Intergalactic Software Companyā™s stock has a market price of $20 per share and a
book value of $12 per share. If its cost of equity capital is 15 percent and its book
value is expected to grow at 5 percent per year indefinitely, what is the marketā™s as-
sessment of its steady state return on equity? If the stock price increases to $35 and
the market does not expect the firmā™s growth rate to change, what is the revised
steady state ROE? If instead the price increase was due to an increase in the marketā™s
assessments about long-term book value growth, rather than long-term ROE, what
would the price revision imply for the steady state growth rate?
10. Joe states: āI can see how ratio analysis and valuation help me do fundamental anal-
ysis, but I donā™t see the value of doing strategy analysis.ā Can you explain to him
how strategy analysis could be potentially useful?
1. See R. Bhushan, āFirm characteristics and analyst following,ā Journal of Accounting and
Economics 11, Nos. 2/5 (July 1989): 255ā“275, and P. Oā™Brien and R. Bhushan, āAnalyst follow-
ing and instititional ownership,ā Journal of Accounting Research 28, (1990): 55ā“xx.
2. For a recent review of evidence on market efficiency, see Eugene Fama, āEfficient Capital
Markets: II,ā Journal of Finance (December 1991): 1575ā“1618.
3. For example, see V. Bernard and J. Thomas, āEvidence that Stock Prices Do Not Fully Re-
flect the Implications of Current Earnings for Future Earnings,ā Journal of Accounting and Eco-
nomics (December 1990): 305ā“341.
4. A good example, in which a āvalue stockā strategy is examined, is in Josef Lakonishok, An-
dre Shleifer, and Robert Vishny, āContrarian Investment, Extrapolation, and Risk,ā Journal of Fi-
nance (December 1994): 1541ā“1578.
5. For example, see J. Ou and S. Penman, āFinancial Statement Analysis and the Prediction of
Stock Returns,ā Journal of Accounting and Economics (November 1989a): 295ā“330; R. Holth-
ausen and D. Larcker, āThe Prediction of Stock Returns Using Financial Statement Information,ā
520 Equity Security Analysis
Equity Security Analysis
Journal of Accounting and Economics (June/September 1992): 373ā“412; and Richard Sloan, āDo
Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?ā The
Accounting Review 71, No. 3: 298ā“325.
6. On average across time, 66 percent of the variance in price per share is explained by book
value per share and the rank of earnings per share. See Victor Bernard, āAccounting-Based Val-
uation, the Determinants of Market-to-Book Ratios, and Implications for Financial Statements
Analysis,ā working paper, University of Michigan (January 1994).
7. For two of several discussions of research in this area, see Baruch Lev, āOn the Usefulness
of Earnings and Earning Research: Lessons and Directions from Two Decades of Empirical Re-
search,ā Journal of Accounting Research, supplement 1989: 153ā“197; and Peter Easton, Trevor
Harris, and James Ohlson, āAggregate Accounting Earnings Can Explain Most of Security Re-
turns,ā Journal of Accounting and Economics (June/September 1992): 119ā“142.
8. V. Bernard and J. Thomas, āPost-Earnings-Announcement Drift: Delayed Price Response
or Risk Premium?ā Journal of Accounting Research (Supplement 1989): 1ā“36. For seminal work
on the timeliness of earnings information, see R. Ball and P. Brown, āAn Empirical Evaluation of
Accounting Income Numbers,ā Journal of Accounting Research (Autumn 1968): 159ā“178; and
William H. Beaver, āThe Information Content of Annual Earnings Announcements,ā Journal of
Accounting Research (Supplement, 1968), 67ā“92.
9. Baruch Lev and Ramu Thiagarajan, āFundamental Information Analysis,ā Journal of Ac-
counting Research (Autumn 1993): 190ā“215.
10. M. Barth, āFair value accounting: Evidence from investment securities and the market val-
uation of banks,ā The Accounting Review (January 1994), 1ā“25.
11. For some incomplete reviews of work in this area, see Victor Bernard, āCapital Markets
Research in Accounting During the 1980ā™s: A Critical Review,ā in The State of Accounting Re-
search As We Enter the 1990ā™s, Thomas J. Frecka, editor. (Urbana: University of Illinois Press,
1989): 72ā“120; and Victor Bernard and Katherine Schipper, āRecognition and Disclosure in Fi-
nancial Reporting,ā working paper, University of Michigan (November 1994).
Arch Communications Group Inc.
T here are some great bargains to be had in paging stocks, analysts say. The
sector, bruised repeatedly since the start of the year, got kicked again when tech-
nology stocks plummeted recently, and for no good reason. . . . One stockā”Arch
Business Analysis and
Communicationsā”is an absolute bargain. āOne of the most beaten up stocks Valuation Tools
is Arch, and there is no reason for it,ā said Christopher Larsen of NatWest
The paging industry has been deluged with bad news in the last six months,
from management turmoil and broken bank covenants to broad worries of a rise
in interest rates and of paging being eclipsed by a new generation of mobile
phones. . . . Arch stock has fallen from a trading range of $22ā“$26 early in the
year to as low as $12 in recent sessions . . . but analysts are adamant the sector
has a bright future. 13
Reuters Financial Service, July 29, 19961 Equity Security Analysis
Founded in 1986, Arch Communications Group Inc. was the third largest paging com-
pany in the U.S. serving nearly three million subscribers. Arch offered paging services
and equipment on local, regional, and nationwide (40 states) bases, and in 180 of the 200
largest U.S. cities.
Arch followed a strategy that consisted of three primary elements: low prices, stan-
dard and reliable technologies, and prompt and efļ¬cient service delivery. Arch offered
competitively priced messaging services and was able to do so because of its own low
cost structure. Archā™s low costs were drawn from economies of scale in its operations
and the size of its subscriber base. Second, for the majority of its paging services, Arch
avoided using experimental paging technologies. Rather, Arch endorsed paging technol-
ogies that might not be the latest or most advanced but were consistently predictable and
dependable. When it came to pioneering new technologies, Arch prefered to let other
Research Associate Sarayu Srinivasan prepared this case under the supervision of Professor Krishna G. Palepu as
the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative
situation. This case beneļ¬ted signiļ¬cantly from the insights of analyst John Adams. Copyright Ā© 1996 by the President
and Fellows of Harvard College. Harvard Business School case 9-197-047.
1. Nick Louth, āTalking Pointā”Bargains Shine in Paging Stocks,ā Reuters Financial Service , July 29, 1996.
522 Equity Security Analysis