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.

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 welldiversified

portfolio of stocks." Do you agree? Why or why not?

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?

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?

5. Three months ago, Intergalactic Software Company went public. 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?

The market capitalization

The average number of shares traded per day

The bid-ask spread for the stock

Whether the underwriter that brought the firm public is a Top Five investment

banking firm

Whether its audit company is a Big Six firm

Whether there are analysts from major brokerage firms following the company

Whether the stock is held mostly by retail or institutional investors

518 Equity Security Analysis

Part 3 Business Analysis and Valuation Applications

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6. 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?

7. 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?

8. 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?

9. 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 percent and its book

value is expected to grow at 5 percent per year indefinitely, what is the market's assessment

of its steady state return on equity? 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?

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?