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Chapter 5:
Starting the Analysis
 The Security Analysis Process
 Model Research Report
 The Analyst’s Responsibility
 The Cascade of Projections
 Selecting Stocks for Study: Top-Down versus
Bottom-Up
 Limited Time and Resources
 The Margin of Safety

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THE SECURITY ANALYSIS PROCESS

 A competent business evaluation follows a tried-

and-true methodology that has changed little over
the past 20 years. Each step of the evaluation
imposes a discipline on the practitioner, and the
structured format prohibits the cutting of corners
that might lead to faulty conclusions.
 The finished product, referred to as a research
report, business evaluation report, or investment
memorandum‫ز‬
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 EXHIBIT 5.1
With most of Kraft Foods’ earnings originating
in the United States, the analyst inquires about
the future health of the U.S. economy
Macroecnmic prospect

Will the U.S. stock market increase

in price over the long term? Even given strong
Capital markets individual corporate performance, Kraft
Foods’ stock price is heavily dependent on
general market conditions.

Demand and pricing trends in the U.S.

packaged food industry affect Kraft Foods’
Packaged food industry operations. Are more competitors entering
the business? Are more people opting to use
restaurants, instead of cooking at home?

A thorough analysis of Kraft Foods’ business,

Kraft Foods management, and financial condition is
Business analysis required to predict earnings and value
sensibly.
Financial analysis
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 The report use by not only the author but also to the
professionals and for in house consumption (i.e., portfolio
managers, private equity managers, and corporate
development executives)
 The report must be concise and easy to read
 There is two challenges the analyst face
a. he must investigate the specific investment situation
covering all the request intellectual basis to reach an
investment decision that is convincing to himself and
others
b. The tone and the style of his report must be appealing to
fellow professionals .otherwise no one will care to listen
to his ideas , The successful evaluator is usually one with
a cogent writing ability, enabling him to interest readers
while getting his point across, since most members of his
audience lack his industry expertise, the thoughtful
analyst explains and simplifies the technicalities and
jargon endemic to operating businesses.
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The model research report for a publicly traded equity
begins with a short description of the company that has
issued the common stock under evaluation and it closes
with a summary recommendation. Included in the
introductory paragraph are the firm’s product lines, its
areas of operation, and its annual sales and profits.

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MODEL RESEARCH REPORT
 Following a brief introduction and the
analyst’s recommendation, the report closely
follows the top-down model.
 The report begins with an economic analysis,
assessing the state of the economy and its
likely impact on the future stock prices and
relevant industry earnings growth Economic
prospects

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 A healthy economy often translates into higher
stock values and is usually positive for most
industries
 Once the report concludes that the economy
supports equity investment, it moves on to a study
of the appropriate capital market

 the influence of general market movements on

individual stock prices is considerable, Even when
the earnings per share of a given stock are
advancing quickly its share price can still decline
if broad market indexes perform badly. Likewise,
even companies with lousy earnings prospects
may see their values rise during bull markets.
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 A thorough research report addresses the important questions: Is the general
market going up? down? How does this affect the price of the company under
study

 Note : Making an accurate prediction of the short- to intermediate-term direction of

an equity market is a difficult business, and few people have proven themselves to
be adept market timers. 

 Nevertheless, a complete research report presents a view on where the general

market appears to be heading.
 There is little to be gained in absolute terms by buying a good stock in a down
market .Inevitably, the stock’s price will be dragged down with those of other
stocks

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 Most institutional managers, however, measure
themselves in relative terms against a relevant index.

 Thus, if the Internet stock index falls 20 percent, and

the manager’s Internet mutual fund falls only 15
percent, the manager has beaten the index even
though fund holders lose money. Analysts who
select stocks that perform well on a relative basis are
thus valuable commodities on Wall Street.

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THE ANALYST’S RESPONSIBILITY
 Few investment firms expect the security analyst to be
economic forecaster, market timer, industry expert, and
company analyst at the same time.
 the sections of the model research report are divided
among three separate executives: the economist, the
market strategist, and the security analyst .
EXHIBIT 5.3 Dividing Responsibility for Top-Down Analysis

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A full-time in-house economist or an outside consulting firm
supplies the macroeconomic overlay for the analyst’s
research report. Key variables such as future GNP growth,
interest rates, and foreign exchange rates are left out of the
analyst’s hands. Thus, if the economist predicts sharply
higher interest rates, the analyst may have a hard time
recommending housing stocks, which have lower earnings in
times of high interest rates.

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 The investment firm’s market strategist takes
responsibility for defining the market’s direction.
 His view is usually synthesized in a recommended
portfolio allocation

 in case predict stock market is going up recommends a

heavy portfolio weighting to common stocks, such as 65
percent stocks, 25 percent bonds, and 10 percent cash

In case predict going down market

the suggested stock allocation is smaller, such as 35
percent stocks, 50 percent bonds, and 15 percent cash.

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few strategists recommend 100 percent stock weightings
(or 100 percent bonds); their record of success is too
erratic to justify full commitments

• after two top-down evaluations are provided, the analyst

has considerable work ahead (industry outlook)

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If the economic study and capital markets forecast
are taken out of the analyst’s hands, what’s left?
 A lot….
the analyst has considerable work ahead
 he must present a studied outlook on the industry
in which the particular company operates. Not
only must the report explain the fundamental
factors driving the demand for the industry’s
products, but it must also keep the reader abreast
of significant developments. What new product
lines are being introduced? Is the price/cost
structure changing? Which competitors are
profiting at the expense of others?
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 By assembling an economic review, a capital
markets forecast, and an industry study, the
analyst lays the foundation for his business
evaluation. These three items are the building
blocks for the company analysis, which provides
an understanding of the subject business and looks
in-depth at the issuer’s financial condition and
operating results. Of critical importance is
determining the sustainability of the issuer’s
earnings stream as well as reaching a conclusion
on the likelihood of future growth
.Accomplishing this objective requires the analyst
to synthesize his knowledge of the company and
his industry into an earnings projection. In
deriving this forecast,

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THE CASCADE OF
PROJECTIONS
 macroeconomic, capital market, an industry
elements affect company’s performance.
( corporate earnings forecast)

 The job of the analyst is to identify the most

influential variables out of the hundreds available
to him

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 Note : Developing a chain of forecasts with real
predictive ability is quite difficult
 Any projection of economic or business
indicators is inherently uncertain, so each
forecast has a margin of error, which
becomes magnified as you move from the
top (economy) level to the bottom
(company) section.. The accuracy of
analysts’ forecasts drops dramatically as the
period expands

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SELECTING STOCKS FOR STUDY:
TOP-DOWN VERSUS BOTTOM-UP
EXHIBIT 5.7 Top-Down versus Bottom-Up
Top-Down Bottom-Up
Macroeconomy Screens for relative value on

financial ratios
Capital markets Macroeconomy
Industry → Industry
Company-business→ analysis Company-business
analysis
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Financial analysis → Financial analysis
 LIMITED TIME AND RESOURCES

 Obtaining certain information is time consuming and

expensive. Similarly, establishing quantitative
formulas linking economic indicators, industry
variables, and company-specific results can be a long,
laborious, and costly task. Many times, such
regressions have negligible predictive value, so the
time and money go for naught. Professionals
recognize this situation and learn to live with
imprecise valuations. Top reserve the validity of this
work in a world of unscientific estimates, analysts
rely heavily on the notion of the margin of safety
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THE MARGIN OF SAFETY

 The margin of safety principle is a linchpin of

security analysis, for Graham and Dodd
recognized early on that economic and financial
forecasts of any kind were inherently uncertain.
As a defensive measure, they encouraged analysts
to refrain from a purchase recommendation unless
the related research report provided a protective
cushion between the market’s price and the
analyst’s indicated value. A reasonable cushion in
today’s market is 15 percent.

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 Thus, if your research report concludes that John Deere’s
shares are worth $200 each, and the market price is $160,
then Deere is a buy because the estimated value is at least
15 percent higher than the market price (i.e., $200/$160 =
125 percent). The logic works similarly for sale decisions
and short-sale recommendations. If your research report
shows a Wells Fargo share value of $25 when the stock is
trading at $30, you should recommend that the WellsFargo
shares be sold


 The margin of safety principle is applicable to all valuation approaches
covered in this book: intrinsic value, relative value, acquisition value,
leveraged buyout value, and liquidation value. Since these methods are
less than exact, a 15 percent difference provides a reasonable degree of
assurance that an investment recommendation is correct. Nonetheless,
applying a margin of safety is no guarantee against losses .It just
reduces the probability of loss in favor of increasing the chances of
profit .Consider it to be the equivalent of an insurance policy
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Thank you all ….

Done by : ahmed nofal & ahmed abu assi .

Supervise by : Dr. emad abu shaaban .

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