QUESTION TWO LEARNED SECURITY ANALYSIS Before a person decid

QUESTION TWO: LEARNED SECURITY ANALYSIS Before a person decides to invest in a particular security, he needs to understand and analyse the characteristics of the investments available. This will not only increase chances of success with regards to the required returns but also with regards to general management of financial risks. Required a) Describe and in the process contrast between the two major methods of security analysis (10 marks) b) In analysing the qualitative aspects of an industry under fundamental approach, highlight four factors that will help investors analyse a particular industry for purposes of assessing its future prospects. (5 marks) c) Despite the major benefits of security analysis, empirical evidence suggests that that is no guarantee to successful entrepreneurship or guarantee of success as an investor resulting from security analysis. State some of the reasons why security analysis does not always yield the anticipated results. (5 marks) Total 20 marks

Solution

(a) Two major methods of security analysis:

1. Discounted value of future income flows method and

2. Number of years of payback period (P.E ratio) or financial ratio method

1. Discounted value of future income flows method:

It includes two more methods, namely, compounding and discounting. Both methods are illustrated below:

Compounding:

If a person invests $1000 at 5% interest rate.

In one year, it becomes $1000(1+0.05) = 1050

In two years, it becomes $1000(1.05)²   =   1102.5

In three years, it becomes $1000(1.05)^{3 =} 1157.625

The above method is compounding method. The reversal of the above method is the discounting method.

Discounting:

If a person receives $1160 at the end of 3 years and if it is discounted to the present value at 5%, then it will be $1000 at present.

The present value of the principal of $1000 after 3 years at 5% rate is $1000/(1.05)⁵ = 783.5262

The above principle will apply to bonds and debentures valuation.

2.Number of years of payback period or financial ratios method:

The payback method is used in the form of P/E ratio for valuation of shares. For example, if earnings on the share is $ 20 and the price is $100, then P/E ratio is 5. Therefore, the payback period is 5 years. If the earnings on the share is higher, the payback period will be low.

The process contrast in the above two methods is focusing on the return on equity and value based in the discounted value of cash flow method and the payback period or financial ratio method focus within which time a person will get his investment back.

(b)

Fundamental approach highlights four elements that will help investors analyze a particular industry for purposes of assessing its future aspects. They are price to earnings (P/E) ratio, profits, earnings per share (EPS), as well as macroeconomic and industry specific factors. The person has to assess all the above elements for better decision making for investing his funds.

(c)

There are various benefits of security analysis. However, some limitations do exist. It does not guarantee the successful entrepreneurship or the success of an investor. The following are some of the reasons for why security analysis does not always yield the anticipated results: