CHAPTER FOURTEEN

FINANCIAL ANALYSIS OF COMMON STOCKS

FINANCIAL ANALYSIS
REASONS FOR FINANCIAL ANALYSIS
TWO PRIMARY REASONS
to determine certain securities characteristics to attempt to identify mispriced securities

FINANCIAL ANALYSIS
REASON #1: DETERMINING SECURITY CHARACTERISTICS
estimate future sensitivity to major factors estimate dividend yield

FINANCIAL ANALYSIS
REASON #2: ATTEMPTING TO IDENTIFY MISPRICED SECURITIES
use fundamental analysis approaches
valuation determines the intrinsic value compared to the current market value estimate key financial variables such as
EPS next year income growth next year
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FUNDAMENTAL ANALYSIS
TOP-DOWN V. BOTTOM UP
TOP-DOWN APPROACH
attempts to forecast in the following order 1. economic activity 2. industry performance 3. firms performance

FUNDAMENTAL ANALYSIS
Economic Analysis
Business Cycle Sensitivity
140 Industry Sales (1963=100) 120 100 80 60 40 20 0 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993

Cigarette Sales

Passenger Car Sales

FUNDAMENTAL ANALYSIS
FINANCIAL STATEMENT ANALYSIS
INTEGRAL PART OF FUNDAMENTAL ANALYSIS
it helps the analyst understand a firms current condition where it is headed what factors affect it how the factors affect it

FUNDAMENTAL ANALYSIS
FINANCIAL STATEMENT ANALYSIS
Review of Accounting Statements
includes a study of the three major statements prepared monthly by most accountants:
the balance sheet the income statement the statement of cash flows

FUNDAMENTAL ANALYSIS
FINANCIAL STATEMENT ANALYSIS
RATIO ANALYSIS
DEFINITION: a technique used to examine a companys financial statements Use of Ratios
as an absolute standard as a comparative indicator as a trend over time

FUNDAMENTAL ANALYSIS
FINANCIAL STATEMENT ANALYSIS
RATIO ANALYSIS
Types of Ratios
internal liquidity operating performance risk analysis growth analysis profitability market ratios

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FUNDAMENTAL ANALYSIS
internal liquidity ratios:
indicate the ability of the firm to meet future short-term financial obligations some liquidity ratios:
current ratio quick ratio cash ratio receivables turnover
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FUNDAMENTAL ANALYSIS
operating performance ratios:
indicate how well the management is operating the business some examples:
total asset turnover net fixed asset turnover equity turnover

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FUNDAMENTAL ANALYSIS
risk analysis ratios:
indicates the uncertainty of income flows for the total firm and for the individual sources of capital (debt and stock) some examples:
debt to equity ratio long-term debt/total capital ratio

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FUNDAMENTAL ANALYSIS
growth analysis ratios:
indicate how fast a firm should grow it involves analysis using several other ratios
net profit margin total asset turnover total assets/equity

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FUNDAMENTAL ANALYSIS
Profitability Ratios Gross Margin
Gross profit / Sales

Operating Margin
Operating income / Sales

ROA
Net income / Total assets

ROE
Net income / Owners equity
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FUNDAMENTAL ANALYSIS
Per Share Calculations Book Value Per Share (BVPS)
Total equity / # shares outstanding

Earnings Per Share (EPS)

Net income / # shares outstanding

Cash Flow Per Share (CFPS)

Operating cash flow / # shares outstanding

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FUNDAMENTAL ANALYSIS
Market Value Ratios Price / Book (or Market / Book)
Stock price / BVPS

Price / Earnings (P/E)

Stock price / EPS

Price / Cash flow (P/CF)

Stock price / CFPS
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Sources of Information
Annual reports Wall Street Journal Value Line Standard & Poors Research Insight

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Sources of Information
Internet
NYSE (www.nyse.com) Nasdaq (www.nasdaq.com) Text (www.mhhe.com/cj) CNNfn.com CNBC.com Yahoo.com Zacks.com Smartmoney.com Multex.com MSNBC.com Quicken.com

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Sources of Information
SEC
EDGAR 10K & 10Q reports

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TECHNICAL ANALYSIS
DEFINITION: a form of security analysis that attempts to forecast price changes based on historical price and volume trends

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TECHNICAL ANALYSIS
Two Groups of Strategies Used:
1. Momentum and Contrarian Strategies 2. Moving Average and Trading Range Breakout Strategies

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Technical Analysis
Support and resistance areas
Support level / Bottom feeders Resistance level / Topping out / profit taking Breakouts

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TECHNICAL ANALYSIS
1. Momentum and Contrarian Strategies
METHDOLOGY:
examine the returns over a time period just ended to identify
momentum investors who seek out stocks recently rising in price for purchase; falling for sale contrarians who follow the opposite strategy of most investors contrarians base their strategy on the overreaction theory
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TECHNICAL ANALYSIS
2. Moving Average and Trading Range Breakout Strategies
MOVING AVERAGE STRATEGY:
calculate a moving average over the last 200 days of closing prices divide todays closing price into the moving average (SHORT-TO-LONG RATIO) if short-to-long ratio is greater than 1, buy if ratio is less than 1, sell
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TECHNICAL ANALYSIS
2. Moving Average and Trading Range Breakout Strategies
TRADING RANGE BREAKOUT STRATEGY:
high and low prices for past 200 trading days are identified if todays close is greater than the high = buy! if todays close is less than the low = sell!
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TECHNICAL ANALYSIS
Reading the tea leaves
Advance / decline line: Closing Arms or Trin Relative strength Moving averages Candlestick chart Chart formations: head-and-shoulders

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STO K MARKET DATA ANK Dia ies NY E Advance Dec ne Unchanged New h gh New ow zAdv vo (000) zDec vo (000) Ztotal vol (000) lo ng t ck lo ng Arm (tr n) zBlock trade TUE MON WK AGO 1,187 1,203 1,642 1,878 1,879 1,414 487 504 477 36 44 19 316 285 275 319,260 291,385 493,942 525,920 452,626 381,351 868,959 765,631 900,037 -130 -175 -240 1.04 1.01 0.9 18,775 15,988 19,985

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Examples
Closing Arms: Trin
Trin = Declining volume / Declines A v ncing volume / A v nces

Values > 1 considered bearish

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Examples
Advance/Decline Line Calculation
Issues Weekday Advancing Cumulative THU 1,162 FRI 2,275 MON 1,203 TUE 1,187 WED 1,739 THU 2,193 FRI 2,178 MON 1,540 TUE 1,660 Issues Declining 1,888 1,198 1,849 1,878 1,311 910 974 1,525 1,540 Difference -726 1,077 -646 -691 428 1,283 1,204 15 120 -726 351 -295 -986 -558 725 1,929 1,944 2,064

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Advance/Decline Line
2,500 2,000 1,500 1,000 500 0 -500 -1,000 -1,500 Cumulative
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Examples
Relative strength: Charts performance relative to industry or market Value Line Timeliness* Price performance/Average performance of V-L Stocks

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 Moving Average
Time 1 2 3 4 5 6 7 8 9 10 ini Dow 11 12 14 13 16 17 19 18 17 18 MA 11 + 12 + 14 = 12.33 12.33 13.00 14.33 15.33 17.33 18.00 18.00 17.67 3

12 + 14 + 13 = 13.00 3

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Moving Average Graph

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Stock Prices

18 17 16 15 14 13 12 11 10 0 1 2 3 4 5 6 7 8 9 10 11

Time
Mini Dow MA

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Candlestick Making
High Uppe Shad w Close Body pen L we Shad w L w u ish Bea ish
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Head and Shoulders Formation

ead

Left Shoulder

Right Shoulder

Neckline Throw Back

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