Security Analysis and Business Valuation on Wall Street: A Comprehensive Guide to Today's Valuation Methods, + Companion Web Site, 2nd Edition

Preface xiii

What Is Security Analysis? xiv

Recent Trends xv

Why Study Security Analysis and Business Valuation? xvii

Overview of the Contents xviii

What’s New in the Second Edition xviii

PART ONE The Investing Environment 1

CHAPTER 1 Why Analyze a Security? 3

The Origins of Security Analysis 3

No Profit Guarantee 5

Day-to-Day Trading and Security Analysis 6

Herd Psychology and Security Analysis 6

Momentum Investors 7

Game Theory and Security Analysis 8

The Premise of Security Analysis 9

Scientific Method 10

Security Analysis Techniques 12

Basic Valuation Approaches 12

Other Valuation Approaches 14

Summary 16

CHAPTER 2 Who’s Practicing Security Analysis and Business Valuation? 17

Securities Firms and Their Analysts 18

Major Institutional Investors 20

A Dying Art? 21

Index Funds and Exchange-Traded Funds 24

Small Money Management Firms 25

Rating Agencies 26

Individual Investors: A Special Category 26

Business Valuation 28

Summary 28

CHAPTER 3 Seeking a Level Playing Field 29

Brief History of Securities Regulation 30

The Chief Regulator: The Securities and Exchange Commission 32

Sales and Trading Practices 34

Margin Regulation 37

The Life Cycle of a New Security Issue 37

Summary 49

CHAPTER 4 Other Sources of Information 51

The Business Media 51

The Free Internet 53

The Fee-for-Service Internet 53

Trade Associations, Consulting Firms, Government Publications, and Financial Organizations 54

Credit Rating Agencies 54

Securities Firm Research 55

Newswires 56

Independent Expert Services 56

Summary 57

PART TWO Performing the Analysis and Writing the Research Report 59

CHAPTER 5 Starting the Analysis 61

The Security Analysis Process 62

Model Research Report 63

The Analyst’s Responsibility 64

The Cascade of Projections 66

Selecting Stocks for Study: Top-Down versus Bottom-Up 67

Limited Time and Resources 68

The Margin of Safety 69

Summary 70

CHAPTER 6 Industry Analysis 73

Background 73

Organizing an Industry Analysis 75

Industry Classification 75

External Factors 81

Demand Analysis 86

Supply Analysis in the Industry Study 92

Profitability, Pricing, and the Industry Study 94

International Competition and Markets 95

Summary 98

CHAPTER 7 Company-Specific Analysis 99

Systematic Approach of a Business Analysis 101

Overview and Business Description 106

Products and Markets Section 106

Production and Distribution 110

Competition 111

Other Topics Included in the Business Review114

Summary 117

CHAPTER 8 Financial Statement Analysis of an Established Business 119

Beginning the Investigation 120

The Raw Materials of an Analysis 121

Evolution of the Approach to Financial Statements 122

Illustration of the Basic Approach 123

Review of Neiman Marcus Financial Analysis 135

Summary 137

CHAPTER 9 The Limitations of Accounting Data 139

Basic Accounting Issues 141

Global Issues 141

Company-Specific Accounting Issues 145

The Fundamental Objective of Public Companies 149

Case Study: Stability Corporation 150

Summary 163

CHAPTER 10 Financial Analysis and Company Classification 165

Company Classifications 166

The Mature Company 166

The Growth Company 167

The Cyclical Company 169

The Declining Company 175

The Turnaround 175

The Pioneer 175

Financial Games 176

Extra Shares Outstanding? 180

Summary 180

CHAPTER 11 Financial Projection Pointers 181

The Cascade of Projections 182

The Typical Financial Projection 182

Alternate Means of Forecasting 183

Critiquing the Huntsman Chemical Projection 185

Preparing Projections 186

Cyclical Company Forecast 189

Hockey Stick Phenomenon 190

Summary 192

PART THREE Valuation and the Investment Decision 193

CHAPTER 12 Valuation Methodologies 195

Assessing Each Methodology 196

Applying Multiple Methodologies 197

Summary 198

CHAPTER 13 Intrinsic Value and Discounted Cash Flow 199

Issues in Applying Discounted Cash Flow 200

Discounted Cash Flow versus Relative Value 203

Discounted Cash Flow and the P/E Ratio 203

The Discounted Cash Flow Valuation Process 205

Summary 208

CHAPTER 14 Discounted Cash Flow: Choosing the Right Discount Rate 209

Beta 211

The Buildup Method for the Equity Rate of Return 212

Special Cases 213

Summary 215

CHAPTER 15 The Relative Value Approach 217

Real Estate Analogy 218

What’s the Right P/E Ratio? 218

Case Study: Temporary Staffing Services 219

Valuing an Initial Public Offering 222

Balance Sheet Items and Relative Value 223

How High Is Up? 223

Summary 223

CHAPTER 16 Marginal Performers 225

Defining the Problem Company 226

Small Companies and Relative Value 232

Summary 232

CHAPTER 17 The Mergers and Acquisitions Market, Security Analysis, and Valuation 233

Understanding Leveraged Buyouts 235

LBO Mechanics 236

Case Study: Keane, Inc. 237

How Much Can the PE Firm Pay? 237

LBO Valuation and the Security Analysis of a Publicly Traded Company 239

Strategic Takeover Values 240

Summary 241

CHAPTER 18 Sum-of-the-Parts Analysis 243

Background 243

Taxes Favor Spin-Offs versus Cash Sales 244

Sample Sum-of-the-Parts Analysis 245

Business Division Valuation 245

Nonoperating Corporate Assets and Liabilities 250

Unlocking Sum-of-the-Parts Values 250

Summary 251

CHAPTER 19 The Investment Recommendation 253

Summary Top-Down Analysis 255

Discounted Cash Flow Valuation 257

Relative Value/Sum-of-the-Parts Valuation Approach 259

Acquisition Value 261

Leveraged Buyout Method 262

Investment Recommendation 265

Summary 266

PART FOUR Special Cases 267

CHAPTER 20 Private Equity 269

Industry Segmentation and Size 269

Fee Structure 270

Private Equity Does Not Beat the S&P 500 271

Private Equity Funds and Information Collection 271

Private Equity Changes to the Public Company

Valuation Methodology 272

Liquidity and Control Adjustments 273

Summary 277

CHAPTER 21 Natural Resource Companies 279

General Methodology 279

The Financial Reporting of Natural Resource Companies 281

Case Study: Encore Acquisition Company 284

Mining Companies 290

Summary 292

CHAPTER 22 Financial Industry Stocks 293

Product Lines 295

The Nature of Financial Assets 296

Two Sets of Skills 298

Lending 298

Large Commercial Banks 304

Summary 307

CHAPTER 23 Insurance Companies 309

General Background 309

Principal Functions of an Insurance Company 311

Insurance Company Regulation 312

Financial Statement Analysis: Property and Casualty Company 313

Financial Statement Ratios 317

Life Insurance Companies 317

Summary 319

CHAPTER 24 Highly Speculative Stocks 321

Background 321

Discounted Cash Flow 323

Case Study: Ballard Power Systems 324

Venture Capital Markups and IPOs 328

Historical Perspective 329

Security Analysis, Technology Stocks, and Portfolio 329

Summary 330

CHAPTER 25 Distressed Securities and Turnarounds 331

Investment Opportunities 332

Screening Technique 333

Recognize the Options of an Unsuccessful Turnaround 334

Financial Analysis of a Company with Leverage Problems 335

The Investment Decision 338

Evaluating Turnarounds 339

Liquidations 340

Summary 342

CHAPTER 26 International Stocks 343

The Role of Security Analysis 343

American Depositary Receipts 345

Developed Country Markets 346

Relative Value Multiples 349

Summary 350

CHAPTER 27 The Emerging Markets 351

Emerging Markets and Security Analysis 353

Stock Pricing Guidelines 357

Financial Projections 360

Emerging Market Equity Discount Rate 361

Relative Value in the Emerging Markets 364

Summary 366

PART FIVE In Conclusion 367

CHAPTER 28 Asset Booms and Busts 369

The 2008 Crash: Contributing Causes 369

Collapse of the U.S. Housing Bubble 370

Failure of the Referees 371

The Certainty of Another Crash 375

How Might Security Analysis and Business Valuation Change? 377

Summary 378

CHAPTER 29 Closing Thoughts 379

Notes 383

About the Author 385

Index 387