Chapter 9 solutions 5th edition - Solution manual of Business Analysis & Valuation Using financial statement.

Chapter 9
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 do
not invest in following a few stocks very closely. However, it may not be the best advice for a
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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 do 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.
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Chapter 9  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

=

1 +

ROE – r e
-------------------------re – g

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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
7. 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.
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Chapter 9  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
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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 6. 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 do 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.
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in whole or in part.


Chapter 9  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 9

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