An Introduction to Security Analysis

1
An Introduction to Security Analysis
Where We Are Going

• We will discuss the jobs of various financial
  reporting professionals, sources of information
  and the financial reporting environment

Chapter 1
2

Who Does Security Analysis?

Buy-side analysts
Sell-side analysts
Investment bankers
Corporate finance specialists
Merger acquisition analysts
Individual investors
Venture capitalists
Employees
Potential investors
3
Where Do Analysts Get Information?

• Financial statements
• Related disclosures of firm under analysis
• Stock analyst reports
• Newspaper magazine articles

4
Other Sources of Information
Industry experts
Economic data
Purchased data
Competitors customers
Competitors' annual quarterly reports
5
Financial Reporting Environment

• Managers need a way to convince investors of the
  fairness of financial reports
• To do this

6
Financial Reporting Environment
Continued

• Reporting rules and mandated audits of publicly
  held companies have been established

7
Analysts Rely on

• Generally Accepted Accounting Principles
  (GAAP)

8
GAAP

• Ensures that information in financial statements
  is useful to investors
• Analysts understand information is not perfect

9
The Content of a Financial Report is Determined
by
Managers
Regulators
Auditors
10
The Securities and Exchange Commission (SEC) Has
Power to

• Prescribe accounting methods
• Specify disclosure requirements

11
The FASB is Responsible for

• Establishing accounting standards in the U.S.
• Issuing pronouncements
• Giving interpretations

12
The FASB Does Not Have

• Authority or responsibility to enforce compliance
  with these standards

13
Influence of Management

• Why do management want to distort F/S?
• Conflict of interest between management and
  stockholders
• Stock option
• Bonus tied to performance
• Debt covenants that require the maintenance of
  certain financial ratios

14
Influence of Management

• Management has significant influence over
  financial statements through
• Accounting method choice
• Depreciation, inventory valuation, profit
  realization
• Accounting estimates
• Bad debt expense, depreciable life
• Accounting disclosures
• GAAP only prescribes the minimum disclosure
  requirement

15
The Auditor

• Determines that financial statement methods are
  consistent with GAAP
• Verifies financial statement assertions
• Limits distortions to financial reporting
• Tests firm's internal control systems

16
Limitations of GAAP

• GAAP are not perfect for the valuation purpose
• Necessary Information not Available Under GAAP
• Most historical numbers by GAAP
• Nonfinancial or qualitative data are usually not
  available
• Information not in Appropriate Format
• Earnings, cash flows figures may need to be
  modified for valuation purposes

17
Security Analysis in 4 Phases
1. Business Analysis
2. Financial Statement Analysis
3. Forecasting
4. Valuation
18
Security Analysis Process
Business Analysis
GAAP Financial Statements
Financial Statement Analysis
Forecast Assumptions
Valuation
Time
Historical Periods
Valuation Date
Forecast Periods
19
In Business Analysis, the Analyst . . .

• Tries to understand
  the key business drivers of firm

20
In Financial Statement Analysis, the Analyst . .
.
Uses historical financial statements to learn
about a firms

• Profitability
• Growth
• Resource needs

21
In Forecasting, the Analyst . . .

• Uses previous phases information to predict
  future financial results

22
In Valuation, the Analyst . . .

• Uses forecasting and a valuation model to
  determine value for firm's equity

23
Summary

• Many people do security analysis
• Analysts rely on a variety of sources
• Analysts rely on GAAP financial reports
• Analysts use four phases in their security
  analysis