Chapter Equity Security Analysis Discussion Questions 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 Evidence on market efficiency comes primarily from studies that show how stock prices change with the announcement of new public information In general, these studies show that stock prices change quickly with these announcements, implying a high level of efficiency However, more recent efficient markets research suggests that this conclusion may be premature This research finds, for example, that earnings information is not completely impounded into price for several quarters, a significant departure from the notion of a highly efficient market The primary difficulty in interpreting the evidence on market efficiency is that the empirical tests are joint tests of market efficiency with a particular asset pricing model The abnormal returns generated by trading strategies based on firm size and price-to-earnings ratios, for example, may therefore reflect the omission of important sources of risk from the pricing model used to generate the abnormal returns, rather than a market inefficiency 2.  Geoffrey Henley, a professor of finance, states: “The capital market is efficient I don’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.” Do you agree? Why or why not? Professor Henley’s strategy is consistent with much of the literature in modern finance If the stock market is efficient, diversification permits investors to generate a risk-return relation that strictly dominates that of investing in just a few stocks However, if the stock market is not completely efficient, it may be possible to use fundamental analysis to predict future stock prices In this sense, an informed investor can generate an even higher risk-return profile than holding a diversified portfolio by investing in stocks where he/she has an information advantage Of course, one could think of the superior returns from this strategy as a return on the investment of time and money required to acquire and evaluate information about the financial and strategic performance of a firm Thus, Professor Henley’s recommendation is probably very sound advice to most investors, who not invest in following a few stocks very closely However, it may not be the best advice for a © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 2  Instructor’s Manual professional investor who has invested in developing industry or firm-specific knowledge from detailed fundamental analysis 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 assumptions made by these strategies? Fundamental analysis uses information in a firm’s financial statements and other sources of public information to assess a firm’s expected future performance, and hence its likely value Firms with estimated values greater than their current prices are then recommended as buys and those with values lower than the current price as sells In contrast, technical analysis uses patterns of past stock price changes, trading volume, or levels of short-sale interest in the stock for making recommendations on whether to buy or sell a stock The key assumption underlying technical trading strategies is that the stock market is inefficient Technical descriptors of stock price movement, past prices, volume, etc., are common knowledge and, in an efficient market, should fully reflected in prices 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? Income Funds The main investors in income funds tend to be investors who need a relatively steady stream of income, or those with relatively low tax rates on ordinary income Retirees and parents financing the educational costs of their children are two common groups that invest in income funds since the companies in the fund pay dividends that provide a relatively predictable stream of income Investors with low ordinary income tax rates may also own income funds since they can earn higher after-tax returns from these funds relative to other investors Firms with high dividend to stock price ratios tend to be lower risk firms in mature industries Excess cash from their operations is returned to stockholders via dividends rather than reinvested in the firm However, dividend income is not guaranteed which causes income funds to vary in their payouts to investors Despite the fact that firms try to avoid lowering dividends, firms can and change their dividend policy depending on their financial condition Growth Funds Investors in growth funds are typically medium to long-term investors who are willing to assume additional risk in hopes of earning higher long-run returns In addition, investors with high current tax rates may be attracted to growth funds because they typically generate capital gains, which can be deferred, rather than dividends Firms in growth funds tend to be in new and rapidly expanding industries Consequently, these firms tend to be riskier than average Value Funds Investors in value funds are often medium to long-term investors who believe that it is possible to find undervalued firms using publicly available information and that any mispricing for undervalued firms is not corrected quickly Furthermore, they expect the return on value funds to increase as the market begins to reprice undervalued stocks © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter  Equity Security Analysis  3 Short Funds The typical investor in a short fund is willing to assume the considerable additional risk and expense related to short sales for the possibility of a higher return The investment time horizon is typically shorter than those of either growth or value funds Short fund investors believe it is possible to use publicly available information to find overvalued firms 5.  Intergalactic Software Company went public three months ago You are a sophisticated investor who devotes time to fundamental analysis as a way of identifying mispriced stocks Which of the following characteristics would you focus on in deciding whether to follow this stock?  Market capitalization  The average number of shares traded per day  The bid-ask spread for the stock  Whether the underwriter that brought the firm public is a top tier investment banking firm  Whether the firm’s audit company is a Big Four firm  Whether there are analysts from major brokerage firms following the company  Whether the stock is held mostly by retail or by institutional investors Many of the characteristics mentioned in the question can be correlated with potential mispricing The size of the market capitalization will influence the extent of interest of institutional interests Below a certain threshold size level, it may not be economical for institutional investors to own the stock because it will be difficult for them to make a significant investment in it without owning a significant portion of the firm The average number of trades per day and the bid-ask spread influence trading costs The reputation of the underwriter, the quality of the firm’s auditor, and the number of analysts following the stock all influence the information environment of the firm The information environment, in turn, can influence the liquidity of the stock and the ease with which the stock can be traded Finally, if mainly retail investors hold a stock, its potential for mispricing is greater than if it is held mostly by sophisticated institutional investors 6.  Intergalactic Software Company’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% and its book value is expected to grow at 5% per year indefinitely, what is the market’s assessment of its steady state return on equity? Determine the market’s assessment of its steady state return on equity using the discounted abnormal earnings model V ­­­ B = + ROE – r e -re – g © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 4  Instructor’s Manual where V B g re = 20 = 12 = 05 =.15 Solving for ROE yields ROE = 217 Hence, the market estimate of Intergalactic Software Company’s steady state return on equity is roughly 21.7 % per year If the stock price increases to $35 and the market does not expect the firm’s growth rate to change, what is the revised steady state ROE? Again using the discounted abnormal earnings model, the new V = 35 and all other variable remain the same Solving the model we get a revised steady state return on equity of 34.2 percent per year If instead the price increase was due to an increase in the market’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? Let ROE equal 217 from the first part and solve for g instead With a ROE of 21.7 percent, a price of $35 suggests a steady state growth rate of 11.5 percent There are two major types of financial analysts: buy-side and sell-side Buy-side analysts work for investment firms and make stock recommendations that are available 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 brokerage firms’ clients, which include individual investors and managers of investment funds What would be the differences in tasks and motivations of these two types of analysts? Sell-side analysts work for brokerage houses and provide brokers with information to provide to their clients on the attractiveness of different firms as investment vehicles The sell-side analyst’s main task, therefore, is to analyze companies, usually using fundamental analysis, where there are opportunities to interest customers to either buy or sell the stock Sell-side analysts produce a report presenting their analysis, making forecasts of future financial information, and recommending clients to buy, sell, or hold a stock Because brokerage houses generate income from commissions earned on stock trades carried out for these clients, they provide direct and indirect incentives for sell-side analysts to write reports that generate commission business The analyst is viewed as valuable because he/she has developed an intimate knowledge of recommended firms In the short run, a persuasive analyst’s report can convince customers to buy or sell shares of a company immediately Of course, if the analyst’s recommendations later turn out to be consistently unprofitable, investors will be unlikely to continue using their recommendations for making buy/sell decisions The most effective sell-side analysts often play a role in selling new issues to institutional investors, by accompanying investment bankers from their firm on road shows to promote new offers © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter  Equity Security Analysis  5 Buy-side analysts work for investment funds and make recommendations about investment opportunities that are consistent with the fund’s operating guidelines In preparing a recommendation, an analyst can either put together his/her own reports for individual companies or evaluate the reports of several sell-side analysts The buy-side analyst must be able to evaluate competing buy and sell recommendations made by various sell-side analysts The buy-side analyst’s motivation is to earn the highest returns for the investment fund The buyside analyst is often compensated based on the success of her recommendations Investment funds typically charge fees based on the amount of capital managed by the fund Moreover, a successful fund attracts additional capital from investors, generating more revenue for the investment fund’s managers Hence, the buy-side analyst’s compensation is closely tied to the quality of her recommendations 8.  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? Need for access to firms Sell-side analysts often depend on information from the firm to answer questions about firm performance and strategy not contained in other public information about the firm This information can make an analyst’s reports more thorough and persuasive to potential investors Furthermore, higher quality reports can increase revenues for the firm and compensation for the analyst After a sell recommendation, firms are less likely to be as open and forthcoming with analysts who have recommended a sale Conversely, a strong recommendation to buy a firm’s stock may result in greater access to the firm in the future Hence, the sell-side analyst could provide optimistic recommendations to help guarantee access to the firms they cover Potential for investment banking services by the analyst’s firm Investment banking services can be a significant source of income for brokerage/investment banking firms Moreover, firms are more likely to use the investment banking services of brokerage/investment banking firms that issue favorable recommendations A negative recommendation may cause the brokerage/investment banking firm the loss of significant additional revenues from underwriting or investment banking services in the future As a result, sell-side analysts may be more likely to be optimistic in recommendations about a specific firm Difficulty of taking advantage of a sell recommendation It may be more difficult for a brokerage firm’s client to take advantage of a sell recommendation A much narrower group of clients can take advantage of a sell recommendation If a client owns the stock, he can sell it outright If the client does not own the stock, he must find another stockholder to borrow it from in order to short it and take advantage of the recommendation Furthermore, short sales are typically more expensive than regular stock purchases, last only a finite amount of time before expiring, and carry a higher risk for the investor Hence, a sell recommendation for a stock is less likely to generate the same revenues for the firm as a buy recommendation 9.  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 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 6  Instructor’s Manual which it currently makes the market What are the potential advantages and disadvantages in relying on Joe’s report in deciding whether to buy the stock? The combination of brokerage and underwriting activities adds several advantages and disadvantages that should be considered separately from those discussed in Question These additional advantages and disadvantages come from the information gathered by and the revenues generated by the underwriting part of the firm Advantage Better knowledge of the firm If Mr Klein has better knowledge of the firm than other analysts, then his recommendation should be better as well As part of the public offering process, underwriters will conduct due diligence on the firm, gaining considerable knowledge and insight about its current operations and future prospects The firm’s management may also have a better relationship with Mr Klein than other analysts from other brokerages because of an overall level of comfort developed between management and Mr Klein’s firm during the public offering process As a result of this relationship, management may be responsive to Mr Klein’s questions about the firm In addition, to the extent that knowledge moves from the underwriting side to the brokerage side, Mr Klein may have access to additional information about the firm It is important to note two mitigating factors in the United States First, firms like Mr Klein’s are required to maintain a “Chinese Wall” between their brokerage and underwriting businesses to eliminate the transfer of any private information from the latter to the former Second, firms are supposed to provide the same access to information to all of their analysts, eliminating selective disclosure to specific analysts Disadvantages Need for consistency between investment banking and brokerage operations Since underwriters are selling the stock, it is unlikely that they will provide negative reports on their clients The investment banking side of the business may therefore pressure Mr Klein to make recommendations that are generally supportive of the firm’s underwriting decisions Desire for future investment banking business with the firm Investment banking is likely a significant source of revenue for Mr Klein’s firm Firms whose brokerage operations issue negative recommendations about a particular company are less likely to provide investment banking services for that company than those that issue positive recommendations Thus, Mr Klein’s positive recommendation may be related either to his firm’s desire to keep the company’s future investment banking business or to the fact that its historical optimism made it initially an attractive underwriter for the client 10.  Joe states, “I can see how ratio analysis and valuation help me fundamental analysis, but I don’t see the value of doing strategy analysis.” Can you explain to him how strategy analysis could be potentially useful? Strategy analysis could aid fundamental analysis in two primary ways—by providing better insight into a firm’s future performance and by offering a more complete picture of a strategy’s risks © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter  Equity Security Analysis  7 Strategy analysis helps an analyst evaluate the impact of strategy on a firm’s future performance, measured by sales, earnings, and other measures As these performance measures change, the fundamental value of the company will also change Consider a computer company that decides to switch from a differentiated product strategy to a low-cost product strategy Such a change in strategy would have a significant impact on firm revenues, cost structure, and potential sales growth An analyst following the company will have to understand how each of these implications of the change in strategy will affect the firm’s fundamental value Thus, understanding the impact of strategy on future performance can be an integral part of an analyst’s fundamental analysis Strategy analysis can also help highlight potential risks associated with a change in strategy As the firm’s risks change, the firm’s fundamental values will also change First, there is the risk that the firm will not be able to implement the strategy as promised Consider again the change in strategy from product differentiation to low-cost production If the firm cannot reduce its cost structure, it faces the unenviable task of selling undifferentiated products at higher prices than its competitors Hence, the fundamental value of the firm will depend on the likelihood of its strategy being successfully implemented Second, there may be changes in firm risk caused by the successful implementation of the strategy change If the strategy change involves entry into a new market or industry, the firm may be changing the risk of its operations Being either the low-cost producer of an undifferentiated product or the producer of a differentiated product both entail risks to the firm The likelihood that competitors will be able to produce at a lower cost or develop differentiated products superior to the firm’s, suggests the risk involved with following a particular strategy Finally, the analyst must evaluate the firm’s chances for success given the current industry structure and profitability as well as the strategies of other firms in the industry In each of these cases, strategy analysis can be used to identify and evaluate the risks the firm faces which, in turn, will affect the fundamental value of the firm Chapter © 2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part  ... analysts: buy-side and sell-side Buy-side analysts work for investment firms and make stock recommendations that are available only to the management of funds within that firm Sell-side analysts... the reports of several sell-side analysts The buy-side analyst must be able to evaluate competing buy and sell recommendations made by various sell-side analysts The buy-side analyst’s motivation... Investors in growth funds are typically medium to long-term investors who are willing to assume additional risk in hopes of earning higher long-run returns In addition, investors with high current