Page 99 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Introduction

Security analysis comprises of an examination and evaluation of the various factors affecting the
value of a security. 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 through understanding of financing 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.

3.1 Equity Value and Enterprise Value

The equity value of a firm is simply its market capitalization, that is, 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 cast-equivalents would
be used to offset the liabilities and therefore are not included in the enterprise value.

Example: Imagine purchasing a house with a market value of 10, 00,000, for which the
owner has 5,00,000 assumable mortgage. To purchase the house, the new owner would pay
5,00,000 in cash and assume the 5,00,000 mortgage, for a total capital structure of 10, 00,000.
If 2,00,000 of that market value were due to 2,00,000 in cash locked in a safe the basement, and
the owner pledged to leave the money in the house, the cash could be used to pay down the
5,00,000 mortgage and the net assets would become 8,00,000 and the liabilities would become
3,00,000. The “enterprise value” of the house therefore would be 8,00,000.

3.2 Valuation Methods

Two types of approaches to valuation are discounted cash flow methods and financial ratio
methods.
Two discounted cash flow approaches to valuation are:
1. Value the flow to equity, and
2. Value the cash flow to the enterprise.

The “cash flow to equity” approach to valuation directly discounts the firm’s cash flow to the
equity owners. This cash flow takes the form of dividends or share buybacks. While intuitively
straightforward, this technique suffers from numerous drawbacks. First, it is not very useful in
identifying areas of value creation. Second, changes in the dividend payout ratio result in a
change in the calculated value of the company even though the operating performance might
not change. This effect must be compensated by adjusting the discount rate to be consistent with
the new payout ratio. Despite its drawbacks, the equity approach often is more appropriate
when valuing financial institutions because it treats the firm’s liabilities as a part of operations.

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