Learning objectives
The syllabus for this examination is broken down into a series of learning objectives and is included in the Syllabus Learning Map at the back of this workbook. Each time a learning objective is
INTRODUCTION
This chapter focuses on security valuation techniques as applied to equity investments. It uses fundamental analysis and draws on the knowledge introduced earlier in this study guide on financial statement analysis and time value of money techniques to value stocks and preferred shares. A brief introduction to technical analysis is also included.
9.1 APPROACHES TO SECURITY VALUATION
9.1.1 INTRODUCTION
Learning Objective 9.1.1 – Understand the basic principles of industry and sector analysis
The valuation of securities generally follows a top down approach. To begin with, the analyst assesses the state of the macro economy in terms of inflation, unemployment rates, exchange rates, balance of payments, and other macro parameters that will have an impact on the value of the security. Moving down, the characteristics of industry to which the firm belongs will have to be examined.
To help in firm analysis it is useful to classify the business into a particular sector or industry. A sector is a classification that is broader than an industry. For example, the utilities sector encompasses various industries such as Electric, Gas, Telephone and Water. It should be intuitively obvious that the performance of a firm is likely to be tied to the fortunes of the industry to which it belongs. Firms in declining industries will find it more difficult to generate profits than a firm that is in a growing industry.
The goal of industry analysis is to determine the relative attractiveness of the different industries. Specifically, an analyst wants to determine the risk-return trade-offs and the important factors that affect future performance. Once these factors have been identified, the analyst will seek to forecast future trends in each industry. Industry analysis is an important element in successful investing. Although the overall market may be going up, a particular industry may be in decline. In studying an industry it may be useful to distinguish demand related factors from supply side factors. On the demand side, analysts try to identify who the end-users of products are and how they may change their behavior in the future. On the supply side, analysts try to identify the degree of concentration ratio. This measures how much of the industry is dominated by the largest firms. Then the analyst will seek to answer questions like how do these firms compete? Is the competition based on price, quality or warranties? From this the analyst should be able to assess whether particular industries are attractive or unattractive for investment.
9.1.2 INDUSTRY LIFE CYCLE
Learning Objective 9.1.2 – Know the stages in an industry life cycle:
Start-up
Growth
Consolidation
Decline
Looking across the economy, it is easy to see that some industries are growing at very rapid rates while others appear to be standing still in terms of new investments and innovations. Furthermore some industries that were in rapid growth in the past, appear to slow down and then to go into decline. These observations have led economists to define an industry life cycle hypothesis, which states that industries go through a discernible pattern. A typical cycle involves four stages: startup followed by a period of rapid growth, reaching a period of consolidation and maturity and then the final stage of decline. It is important for analysts to understand the stage or phase of an industry, since the future prospects and risks of the firm depend on the remaining life of the industry. Biotechnology for example appears to be in its rapidly developing stage while natural gas could be thought to be a mature industry. External forces such as political and regulatory changes and social and demographic changes can greatly influence a particular industry's progression through its life cycle.
9.1.3 CYCLICAL AND DEFENSIVE INDUSTRIES
Learning Objective 9.1.3 – Know the differences between Cyclical and Defensive Industries
The economy goes through recurrent periods of expansion and contraction. Economists have spent considerable effort in understanding these cycles. In this section, we look at how different stocks behave at different stages of the business cycle. Analysts may want to classify a firm as either being defensive or cyclical. Defensive stocks and cyclical stocks can be expected to respond differently as the economy goes from an expansion to a contraction and vice versa. Cyclical industries are industries that are particularly sensitive to the business cycle. Such industries tend to outperform other industries when the economy is coming out of a recession, but do worse than other industries when the economy goes into a recession. Durable goods, luxury items and automobiles tend to fall into this category. Stocks of companies in cyclical industries will show attractive gains just before and during an upturn in the economy.
Defensive industries on the other hand find that their sales and profits are relatively immune to the business cycle. For example, a grocery store will continue to sell a similar amount of basic groceries regardless of whether the economy is expanding or contracting. Firms in such industries will tend to have a superior performance relative to other firms when the economy enters a recession.
From an investment timing perspective it makes sense to invest in cyclical stocks just before an upturn and switch to defensive stocks just before a downturn. However this is easier said than done, before it is clear where the economy is in the business cycle the economy may have moved into or out of a recession.
9.1.4 VALUING USING DIVIDENDS
Learning Objective 9.1.4 – Know how the main types of investments are valued: