Principles of Security Analysis

Principles of Security Analysis
Sheila Mae A. Malesido
INVESTMENT SECURITIES
◦ Companies invest assets in investment securities (also called marketable securities).
◦ Investment securities vary widely in terms of the type of securities that a company
invests in and the purpose of such investment. Some investments are temporary
repositories of excess cash held as marketable securities.
◦ Investment securities can be in the form of either debt or equity.
◦ Debt securities are securities representing a creditor relationship with another
entity—examples are corporate bonds, government bonds, notes, and municipal
securities.
◦ Equity securities are securities representing ownership interest in another entity
—examples are common stock and nonredeemable preferred stock.
Debt Securities
◦ Debt securities represent creditor relationships with other entities. Examples are
government and municipal bonds, company bonds and notes, and convertible debt.
◦ Debt securities are classified as trading, held to maturity, or available for sale.
◦ Accounting guidelines for debt securities differ depending on the type of security.
Held-to-Maturity Securities.
◦ These are debt securities that management has both the ability and intent to hold to
maturity.
◦ They could be either short term (in which case they are classified as current assets) or
long term (in which case they.
Trading Securities.
◦ Trading securities are debt (or no influential equity) securities purchased with the intent
of actively managing them and selling them for profit in the near future.
◦ Trading securities are current assets. Companies report them at aggregate fair value at
each balance sheet date. Unrealized gains or losses (changes in fair value of the
securities held) and realized gains or losses (gains or losses on sales) are included in
net income.
Available-for-Sale Securities.
◦ These are debt (or no influential equity) securities not classified as either trading or held-
to-maturity securities.
◦ These securities are included among current or noncurrent assets, depending on their
maturity and/or management’s intent regarding their sale. These securities are reported
at fair value on the balance sheet.
Fair Value
◦ Fair value of an asset is the amount the asset can be exchanged for in a current normal
transaction between willing parties. When an asset is regularly traded, its fair value is
readily determinable from its published market price. If no published market price exists
for an asset, fair value is determined using historical cost.
Equity Securities
◦ Equity securities represent ownership interests in another entity. Examples are common
and preferred stock and rights to acquire or dispose of ownership interests such as
warrants, stock rights, and call and put options.
◦ Redeemable preferred stock and convertible debt securities are not considered equity
securities (they are classified as debt securities).
◦ The two main motivations for a company to purchase equity securities are
◦ to exert influence over the directors and management of another entity (such as
suppliers, customers, subsidiaries) or
◦ to receive dividend and stock price appreciation income.
No Influence - Less than 20% Holding.

◦ When equity securities are nonvoting preferred or when the investor owns less than 20%
of an investee’s voting stock, the ownership is considered non influential.
◦ In these cases, investors are assumed to possess minimal influence over the investee’s
activities.
Significant Influence - Between 20% and 50% Holding.

◦ Security holdings, even when below 50% of the voting stock, can provide an investor the
ability to exercise significant influence over an investee’s business activities.
◦ Evidence of an investor’s ability to exert significant influence over an investee’s business
activities is revealed in several ways, including management representation and
participation or influence conferred as a result of contractual relationships.
Controlling Interest - Holdings of More than 50%.
◦ Holdings of more than 50% are referred to as controlling interests - where the investor is
known as the holding company and the investee as the subsidiary. Consolidated
financial statements are prepared for holdings of more than 50%.
The Fair Value Option

◦ A recent standard (SFAS 159) allows companies to selectively report held-to-maturity
and available-for-sale securities at fair value.
◦ If a company chooses this option, then the accounting for all available-for-sale and held-
to-maturity securities will be similar to that accorded to trading securities under SFAS
115.
◦ Specifically, for all investment securities (trading, available for sale, and held to
maturity),
◦ WHAT IS SECURITY ANALYSIS?
• Security Analysis refers to the analysis of trading securities.
• It analyses the share price return and the risk involved in the investment.
• The process of estimating return and risk for individual securities
• It is the essence of valuation of financial instruments
Analyzing Investment Securities

◦ Analysis of investment securities has at least two main objectives:
◦ To separate operating performance from investing (and financing) performance
◦ To analyze accounting distortions due to accounting rules and/or earnings
management involving investment securities. We limit our analysis to debt
securities and non influential (and marketable) equity securities. Analysis of the
remaining equity securities is discussed later in this chapter.
Objectives of Security Analysis
◦ To estimate the risk and return related to a particular security
◦ To find out the intrinsic value of the security with a view to make a buy/sell decision
◦ To identify the under valued securities to buy or over value securities to sell
◦ To analyze the stock market trends to understand the stock market pattern and behavior
◦ To forecast the future earning and dividends along with the price of the securities
◦ To find out the key determinants of the intrinsic value
◦ To analyze and point out the position of economy industry and the company with a view
to select the possible company for investment
Transfers between Categories.
◦ When management’s intent or ability to carry out the purpose of investment securities
significantly changes, securities usually must be reclassified (transferred to another
class).
◦ Normally, debt securities classified as held-to-maturity cannot be transferred to another
class except under exceptional circumstances
Approaches of Security Analysis

◦ Fundamental analysis
◦ Technical analysis
◦ Efficient market hypothesis
1. FUNDAMENTAL ANALYSIS
◦ A time-honored value-based approach depending upon a careful assessment of the
fundamental economy, industry and the company.
◦ It studies the general economic situation makes an evaluation of an industry and finally
does an in-depth analysis of both financial and the non financials of the company of
choice
◦ It is aimed at analyzing the various fundamentals or basic factors that affect the risk and
return of the securities
◦ The Fundamental Analysis involves the following:
◦ ECONOMIC ANALYSIS
◦ INDUSTRY ANALYSIS
◦ THE COMPANY ANALYSIS
◦ ECONOMIC ANALYSIS
◦ The investor has to analyze the economic factor to forecast of the economy in order to
identify the growth of the economy and its trend.
◦ Further based on the economic analysis the investor will identify the industry groups
which are promising in the coming years in order to choose the best company in such
industry group.
◦ It provides the investor to develop a sound economic understand and be able to interpret
the impact of important economic indicators on the markets.
INDUSTRY ANALYSIS
◦ The object of the industry analysis is to assess the prospects of various industrial
groupings
◦ The industry analysis helps to identify the industries with a potential for future growth
and to select companies from such industry to invest in its securities
◦ The industry analysis involves industry life cycle analysis, investment implication,
structure and characteristics of an industry
COMPANY ANALYSIS
◦ Is a study of variable that influence the future of a firm both qualitatively and quantitively
◦ The purpose if to know the intrinsic value of a share of a company
2. TECHNICAL ANALYSIS
◦ Frequently used as a supplement to fundamental analysis is concerned with a critical
study of the daily or weekly price volume data of index comprising several shares
◦ The buying and selling pressure, which govern the price trend helps the investors to buy
cheap and sell high, regardless of the type of company the investor choose
◦ The technical analysis complies a study of the market itself and not of the various
external factors which affect the market.
◦ According to technical analysis, all relevant factors gets reflected in the volume of the
stock exchange transaction and the level of the share prices
EFFICIENT MARKET HYPOTHESIS
◦ Also called Random Walk Theory
◦ It is the extension of fundamental and technical analysis to equity investment decisions
◦ Efficient market for the simple reason that there are numerous knowledgeable analysts
and investors who would not allow the market price to deviate from the intrinsic value
due to their active buying and selling
◦ The current market price incorporates all fundamental information
◦ The prices of securities observed at any time are based on correct evaluation of all
information available at that time
◦ In an efficient market, prices fully reflect all available information
FORMS OF EFFICIENCY OF EFFICIENT MARKET THEORY

◦ Weak form of efficiency
◦ Prices reflect in all information found in the record of past prices and volumes
◦ Semi-storage form of efficiency
◦ Prices reflect not only all information found in the records of past and volumes but also
other publicity available information
◦ Strong form of efficiency
◦ Prices reflect all available information, public as well as private

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Principles of Security Analysis

Sheila Mae A. Malesido

No Influence - Less than 20% Holding.

Significant Influence - Between 20% and 50% Holding.

The Fair Value Option

Analyzing Investment Securities

Approaches of Security Analysis

FORMS OF EFFICIENCY OF EFFICIENT MARKET THEORY

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