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
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
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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
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
Growth Funds. Investors in growth funds are typically medium to long-term investors who are
Value Funds. Investors in value funds are often medium to long-term investors who believe that it
Chapter 9 Equity Security Analysis 3
Short Funds. The typical investor in a short fund is willing to assume the considerable additional
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
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.
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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?
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?
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
Buy-side analysts work for investment funds and make recommendations about investment
Chapter 9 Equity Security Analysis 5
The buy-side analyst’s motivation is to earn the highest returns for the investment fund. The buy-
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
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
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
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
generated by the underwriting part of the firm.
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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
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
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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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
Chapter 9