Understanding the Determinants of Security Value: Step 2

Step 2 involves delving into the financial metrics that directly impact a company’s security value: the cost of capital and growth forecast.

(a) Cost of Capital

The cost of capital is the average rate of return a company expects to earn on its investments. It’s a crucial metric as it represents the hurdle rate that projects need to clear to be considered worthwhile.

Components of Cost of Capital:

1. Cost of Debt: This is the interest rate a company pays on its debt obligations. It can be calculated using the weighted average interest rate on all outstanding debt.
2. Cost of Equity: This is the return that equity investors expect to earn on their investment. It can be estimated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the market risk premium, and the company’s beta.  
3. Weighted Average Cost of Capital (WACC): This is the average cost of financing for the company, considering both debt and equity. It’s calculated by weighting the cost of debt and equity based on the proportion of debt and equity in the company’s capital structure.

(b) Growth Forecast

The growth forecast is an estimate of a company’s future earnings growth rate. It’s a vital factor in determining the future value of a security.

Methods for Growth Forecasting:

1. Internal Measurements: This involves analyzing the company’s historical growth rates, management’s projections, and strategic plans.
2. External Data: This includes industry analysis, macroeconomic analysis, and competitive landscape assessments.

Key Factors to Consider in Growth Forecasting:

• Industry Trends: The overall growth rate of the industry in which the company operates.
• Economic Conditions: The state of the economy, including factors like interest rates, inflation, and GDP growth.
• Company-Specific Factors: The company’s competitive advantage, product innovation, market share, and management effectiveness.

Calculations and Analysis:

• Calculate the cost of debt and equity using the appropriate methods.
• Determine the company’s capital structure to calculate the weighted average cost of capital (WACC).
• Analyze historical growth rates and industry trends to estimate future growth rates.
• Consider the impact of economic conditions and company-specific factors on the growth forecast.

By carefully analyzing these factors, investors can gain a better understanding of a company’s future prospects and make more informed decisions about its securities.

Note: To complete this step accurately, you’ll need to gather financial data from the company’s financial statements, industry reports, and macroeconomic data sources. The Library Research Guide on your Ulearn site can provide valuable resources for this research.