London School of Economics and Political Science (LSE)

Modules

1

143 Valuation and securities analysis

Prerequisite

If taken as part of a BSc degree, 25 Principles of accounting and 24 Principles ofbanking and finance

Aims and objectives

This unit is aimed at students interested in equity research, corporate finance, and fund management. It is designed to provide the tools, drawn from accounting,finance, economics, and strategy, required to:
? Analyse the performance of securities;
? Value securities;
? Assess returns on active investment strategies.
Furthermore, it provides empirical evidence on returns to fundamental and technical analysis.

Learning outcomes

On completion of this unit, students should:

• ?Be able to analyse the performance of securities and understand the equity research published by financial analysts;?
• Have gained the knowledge in valuation technologies required in corporate finance;
• Be able to read and critically assess valuation reports;
• Have gained insights in fund management;

Appreciate the difficulties associated with assessing abnormal returns to fundamental and technical analysis.

Syllabus

This unit covers three broad topics: financial analysis, securities valuation, and returns to fundamental and technical analysis.

Introduction

Introduction to the analysis framework using financial statements: The setting: investors, firms, securities, and financial markets. The framework for analysis.

Business strategy analysis. Accounting analysis. Financial analysis. Prospective analysis.
Introduction to stylised financial statements: Stylised profit and loss, balance sheet, and cash flow statements. Accounting relations governing the stylised financial statements.

The Framework for Analysis: Industry analysis. Competitive strategy analysis.
Sources of competitive advantage. Achieving and sustaining competitive advantage.
Financial analysis: performance evaluation:Concept of comprehensive earnings.
Earnings and stock returns. Bottom line profitability. Cost of equity capital.
Concept of residual earnings. Business profitability. Economic value added. Link
between business and bottom line profitability. Accounting rates of return and
stock rates of return. Determinants of business profitability. Business profitability
and free cash flows.
Accounting analysis: Overview of the institutional framework governing financial
reporting. Factors influencing accounting quality. Assessing the quality of
accounting.
Prospective performance evaluation and valuation: Forecasting: simple
forecasting and full information forecasting. Empirical evidence on the behaviour
of accounting rates of return, residual earnings, economic value added, financial
leverage, and determinants of business profitability. Present value of expected
residual earnings.
Securities valuation
Securities valuation:Introduction to valuation methods based on dividends, free
cash flows, residual earnings, and economic value added. Inferences on valuation
accuracy. Comparison of valuation methods: empirical evidence.
Implications for price-to-earnings and price-to-book ratios:Determinants of price-to-
book ratios. Residual earnings growth. Determinants of price-to-earnings
ratios. Empirical evidence. Strategic taxonomy. Implications of strategic
taxonomy for price-to-book and price-to-earnings ratios. Empirical evidence on
the joint distribution of price-to-book and price-to-earnings ratios.
Financial Information and Stock Prices: Usefulness of earnings to investors: the
empirical evidence from capital markets research. Earnings response coefficients.
The Lev critique. Competing hypotheses to explain the earnings response
conundrum. Relevance of financial versus non-financial information. Application
to internet stocks.
Applications
Mergers and acquisitions:Motivation for mergers and acquisitions. Strategic and
financial analysis of mergers and acquisitions. Acquisition pricing. Accounting
issues. Acquisition financing. Acquisition outcome.
Credit analysis and distress predictions:The market for credit. The credit analysis
process. Financial analysis for credit evaluation. Prospective analysis for credit
analysis. Financial analysis and public debt. Predictions of financial distress and
turnaround.
Empirical evidence on returns to fundamental and technical analysis
Measuring returns to active investment strategies:Introduction to common
performance measures. Concepts of abnormal return. Measures of market timing
ability
Returns to fundamental analysis:Contrarian strategies. Implications of current
earnings for future earnings. Do stock prices fully reflect information in accruals
and cash flows about future earnings? Earnings management and the long run
performance of IPOs.

Returns to technical analysis:Contrarian strategies. Momentum strategies.
Reconciliation of empirical evidence.
Essential reading
Palepu, K., V. Bernard and P. Healy. Business Analysis & Valuation. (South-Western
College Publishing, 2003) third edition [ISBN 978-0324118940].
Penman, S. Financial Statement Analysis & Security Valuation. (McGraw-Hill,
2007) third edition [ISBN 9780073127132].
Assessment
This unit is assessed by a three hour unseen written examination.