Security analysis is about valuing the assets, debt, warrants, and equity of companies from the perspective of outside investors using publicly available information. The security analyst must have a thorough understanding of financial statements, which are an important source of this information. As such, the ability to value equity securities requires cross-disciplinary knowledge in both finance and financial accounting. While there is much overlap between the analytical tools used in security analysis and those used in corporate finance, security analysis tends to take the perspective of potential investors, whereas corporate finance tends to take an inside perspective such as that of a corporate financial manager.   Equity Value and Enterprise Value The equity value of a firm is simply its market capitalization; that is, the market price per share multiplied by the number of outstanding shares. The enterprise value, also referred to as the firm value, is the equity value plus the net liabilities. The enterprise value is the value of the productive assets of the firm, not just its equity value, based on the accounting identity: Assets  =  Net Liabilities  +  Equity Note that net values of the assets and liabilities are used. Any cash and cash-equivalents would…

A firm’s performance can be evaluated using financial ratios. Referencing these ratios to those of other firms allows a comparison to be made. The following is a listing of some useful ratios. Leverage :   Assets / Shareholder’s Equity Gross Margin   =   Gross Profit / Sales. Gross margin measures the profitability considering only variable costs and is a measure of the percentage of revenue that goes to fixed costs and profit. Net Profit Margin   =   Net Income / Sales Total Asset Turnover   =   defined as Sales / Total Assets Return on Assets (ROA)   =   Net Income / Assets ROA is a measure of the return on money provided by both owners and creditors, and is a measure of how efficiently all resources are managed. Return on Equity (ROE)   =   defined as Net Income / Equity where the equity value is the shareholder’s equity at the end of the period in which the income was earned. ROE is a measure of the return on money provided by the firm’s owners. ROE can be calculated indirectly as: ROE  =  ( Net Income / Total Assets ) ( Total Assets / Equity ) ROE also can be calculated using DuPont analysis : ROE  = …

When valuing the operations of a firm using a discounted cash flow model, the operating cash flow is needed. This operating cash flow also is called the unlevered free cash flow (UFCF). The term “free cash flow” is used because this cash is free to be paid back to the suppliers of capital. Calculating Free Cash Flow For a particular year, the unlevered free cash flow is calculated as follows: 1. Start with the annual sales and subtract cash costs and depreciation to calculate the earnings before interest and taxes (EBIT). The EBIT also is referred to as the operating income and represents the pre-tax earnings without regard to how the business is financed. 2. Calculate the earnings before interest and after tax (EBIAT) by multiplying the EBIT by one minus the tax rate. Note that the EBIAT represents the after-tax earnings of the firm as if it were financed entirely with equity capital. 3. To arrive at the UFCF, add the depreciation expense back to the EBIAT, and subtract capital expenditures (CAPEX) that were not charged against earnings and subtract any investments in net working capital (NWC). The free cash flow calculation in equation form: Operating Income (EBIT) =…

  In a discounted cash flow valuation, the cash flow is projected for each year into the future for a certain number of years, after which unique annual cash flows cannot be forecasted with reasonable accuracy. At that point, rather than attempting to forecast the varying cash flow for each individual year, one uses a single value representing the discounted value of all subsequent cash flows. This single value is referred to as the terminal value. The terminal value can represent a large portion of the valuation. The terminal value of a piece of manufacturing equipment at the end of its useful life is its salvage value, typically less than 10% of the present value. In contrast, the terminal value associated with a business often is more than 50% of the total present value. For this reason, the terminal value calculation often is critical in performing a valuation. The terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern. Terminal Value if Liquidated If the firm is to be liquidated, the liquidation value can be based on book value, salvage value, or break-up value, but liquidation…

  In the enterprise model of valuation, the firm’s equity value is calculated by subtracting the value of the firm’s debt from the enterprise value. Debt valuation then becomes an important component of a valuation of the firm’s equity. A company’s debt is valued by calculating the payoffs that debt holders can expect to receive, taking into account the risk of default. The default risk is addressed by considering the probability of default and the amount that could be recovered in that event. For modeling purposes, one may assume that the cash flow from the recovered amount is realized at the end of the year of default. Debt valuation may take one of the following two approaches: Discount the expected cash flow at the expected bond return; or Discount the scheduled bond payments at the rating-adjusted yield-to-maturity.   Debt Valuation – Method 1 Discount the expected cash flow at the expected bond return Under this method, the value of the bond is the sum of the expected annual cash flows discounted at the expected bond return: Value  =  the sum for each year  t  of E(cash flow)t / ( 1 + rdebt )t where  E(cash flow)t  =  expected cash flow…

(pre-merger value of both firms  +  synergies)    =   pre-merger stock price post-merger number of shares The above equation then can be solved for the value of the minimum required synergies. The success of a merger is measured by whether the value of the acquiring firm is enhanced by it. The practical aspects of mergers often prevent the forecasted benefits from being fully realized and the expected synergy may fall short of expectations.

In their 1973 paper, The Pricing of Options and Corporate Liabilities, Fischer Black and Myron Scholes published an option valuation formula that today is known as the Black-Scholes model. It has become the standard method of pricing options. The Black-Scholes formula calculates the price of a call option to be: C  =  S N(d1)  –  X e-rT N(d2) where   C  =  price of the call option   S  =  price of the underlying stock   X  =  option exercise price   r  =  risk-free interest rate   T  =  current time until expiration   N()  =  area under the normal curve   d1  =  [ ln(S/X) + (r + σ2/2) T ] / σ T1/2   d2  =  d1 – σ T1/2   Put-call parity requires that: P  =  C  –  S + Xe-rT Then the price of a put option is: P  =  Xe-rT N(-d2)  –  S N(-d1) Assumptions The Black-Scholes model assumes that the option can be exercised only at expiration. It requires that both the risk-free rate and the volatility of the underlying stock price remain constant over the period of analysis. The model also assumes that the underlying stock does not pay dividends; adjustments can…

Stock indexes are useful for benchmarking portfolios, for generalizing the experience of all investors, and for determining the market return used in the Capital Asset Pricing Model (CAPM). A hypothetical portfolio encompassing all possible securities would be too broad to measure, so proxies such as stock indexes have been developed to serve as indicators of the overall market’s performance. In addition, specialized indexes have been developed to measure the performance of more specific parts of the market, such as small companies. It is important to realize that a stock price index by itself does not represent an average return to shareholders. By definition, a stock price index considers only the prices of the underlying stocks and not the dividends paid. Dividends can account for a large percentage of the total investment return. Weighting One characteristic that varies among stock indexes is how the stocks comprising the index are weighted in the average. Even if no explicit weighting is applied when calculating an average, there may be an implicit one. While a one dollar price change in one stock in a simple stock price index will have the same effect as a one dollar change in any other stock, a given…

Some investment managers and individual investors attempt to improve their performance by timing the market and adjusting their portfolio according to predictions about the market or specific sectors. Examples of market timing include switching among sectors, switching among different countries’ securities, switching between stocks and bonds, or switching between stocks and risk-free treasury bills. The effect of correctly timing the market would be to increase the portfolio beta in up markets and decrease it in down markets. For the purpose of this discussion, an up market is one in which the market return exceeds the risk-free rate, and a down market is one in which the market return is less than the risk-free rate. Proponents of market timing may argue that the market timer does not have to be correct 100% of the time in order to benefit from timing. Some even may argue that for market timing to be worthwhile, the timer simply must be right more often than wrong. Opponents to market timing may argue that the financial markets are fairly efficient, and therefore there is little to be gained from attempting to time them. Furthermore, there are transaction costs and tax implications associated with buying and selling…