Page 139 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes (b) Determining the extent of change method: Different methods of forecasting earnings are
available. The two categories into which the methods fall are given below with a
brief list of some of the methods.

(i) Earlier methods
(1) Earnings methods
(2) Market share/profit margin approach (breakeven analysis)
(ii) Modern techniques

(1) Regression and correlation analysis
(2) Trend analysis (time series analysis)
(3) Decision trees
(4) Simulation
The methods are briefly explained in the following sections:

(i) Earnings model: The ROI method which has been earlier introduced as a
device for analyzing the effects of and interaction between the earnings and
assets can be used as a forecasting tool. If predicted data relating to assets,
operating income, interest, depreciation and forces are available the new values
can be substituted in the model and EAT can be forecasted.

(ii) Market share/profit margin approach: This is derivative of industry forecast
of market. Once the total market is known, the market share of the individual
company can be determined either using historical tract second or subjective
probabilities. The next step is estimating net income after taxes and dividends.
This can be done by cost analysis and estimates in relation to quantity of sales
or operating capacity. Breakeven analysis is the appropriate tool to carry out
such an analysis.
(iii) Projected financial statement: This method makes an item-wise analysis of
revenues and expenses and predicts them over a number of years, based on
the variations in the key determining variables. It is possible only when the
forecaster has through information about the inner working of the company.
A simplified approach involves consideration of branch/divisional total in
place of item-wise amounts.
The above three approaches are not mutually exclusive. They are not without
shortcomings. They are based on subjective evaluations made at various stages
of the analysis.
(iv) Regression and correlation analysis: These methods as applicable to industry
analysis can be used at company level. The methods permit analyzing the
relationships between several variables of company, industry and economy
to develop more accurate forecasts.
Because of the facility of considering many variables and analysing them, this
method is more advantageous.
(1) Analysts are forced to think through various problems of company and
the various interrelationships, internal and external variables and
company revenues and expenses.
(2) Analysts can clearly explain the causal variables of changes and improve
the confidence in forecasts.

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