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Tuesday, December 4, 2007

Chapter 2: The Scope & Limitations of Security Analysis

'Analysis' connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. Individual skill (art) and chance are important factors in determining success or failure. Nevertheless, analysis is not only useful but indispensable in the field of investment and possible in that of speculation.

Three functions of security analysis:

Descriptive function- Make adjustments in the financial figures to bring out the true operating results in the period covered, and particularly in order to place the data of a number of companies on a fairly comparable plane. Evaluation of favorable and unfavorable factors in the position of the issue compared with others in the same field, also projections of earning power on various assumptions as to future conditions.

Selective function- Pass judgment on the merits of securities.

1) Bonds and preferred stocks- Make sure that interest payments will be met in the future without difficulty or doubt through an ample margin of safety in the past to protect against possible adverse developments that lie ahead.

2) Common stock- Selecting those that will pay a good return or increase in price or both. There are 2 approaches. The older approach places its chief emphasis on anticipation of an increase in price of the stock in the longer term, whereby, the present market is by and large an appropriate reflection of the present situation of the stock. The newer approach attempts to value a common stock independently of its market price. If the 'intrinsic value' found is substantially above or below the current price, the analyst concludes that the issue should be bought or sold.

A general definition of intrinsic value would be 'that value which is justified by assets, earnings, dividends, definite prospects'. The most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate 'capitalisation factor' or multiplier.

"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised." --Warren Buffett

Critical function- Security analysis may be competent to express critical judgments, looking to the avoidance of mistakes, to the correction of abuses, and to the better protection of those owning bonds or stocks. Questions largely dependent upon the act of management include capitalisation setup, dividend and expansion policies, managerial competence and compensation, and even continuing or liquidating an unprofitable business.

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