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Analyzing Common Stocks

2 ANALYZING COMMON STOCKS


Learning Goals
1. Discuss the security analysis process, including goals
and functions.
2. Appreciate the purpose and contributions of economic
analysis.
3. Describe industry analysis and note how it
is used.
4. Demonstrate a basic understanding of fundamental
analysis and why it is used.

3 ANALYZING COMMON STOCKS


Learning Goals (cont'd)
5. Calculate a variety of financial ratios and describe how
financial statement analysis is used to gauge the
financial vitality of
a company.
6. Use various financial measures to assess a companys
performance, and explain how the insights derived
form the basic input for the valuation process.

4 WHAT IS SECURITY ANALYSIS?


The process of gathering and organizing
information and then using it to determine the
intrinsic value of a share of
common stock.

5 WHAT IS INTRINSIC VALUE?


Intrinsic Value
The underlying or inherent value of a stock, as
determined through fundamental analysis
A prudent investor will only buy a stock if its
market price does not exceed what the
investor thinks the stock is worth.
Intrinsic value depends upon several factors:
Estimates of future cash flows
Discount rate
Amount of risk

6 TOP DOWN APPROACH TO


TRADITIONAL SECURITY ANALYSIS
Step 1: Economic Analysis
State of overall economy

Step 2: Industry Analysis


Outlook for specific industry
Level of competition in industry

Step 3: Fundamental Analysis


Financial condition of specific company
Historical behavior of specific companys
stock

7 EFFICIENT MARKET

HYPOTHESIS

Efficient Market: the concept that the


market is so efficient in processing new
information that securities trade very close
to or at their correct values at all times
Efficient market advocates believe:
Securities are rarely substantially mispriced in
the marketplace
No security analysis is capable of finding
mispriced securities more frequently than
using random chance

8 WHO NEEDS SECURITY ANALYSIS


IN AN EFFICIENT MARKET?
Fundamental analysis is still
important because:
All of the people doing fundamental analysis is the
reason the market is efficient
Financial markets may not be perfectly efficient
Pricing errors are inevitable

9 KEY ECONOMIC MEASURES


Gross Domestic Product (GDP): market
value of all goods and services produced in
a country over the period of a year
Generally, GDP goes

C, economy goes C

Industrial Production: measure of the


activity/output in the industrial or
productive segment of the economy
Generally, production goes

C, economy goes C

10 KEY ECONOMIC FACTORS THAT

AFFECT THE BUSINESS CYCLE


Government Fiscal Policy
Taxes
Government spending
Debt management

Monetary Policy
Money supply
Interest rates

Other Factors

Inflation
Consumer spending
Business investments
Foreign trade
Currency exchange rates

11 OTHER KEY ECONOMIC

MEASURES

Economic Measure What It Tracks


Index of Leading Indicators
Personal Income

Predicts direction of GDP

Consumer buying habits

Retail Sales Consumer attitudes


Money Supply

Growth of economy & inflation

Consumer Prices/
Producer Prices
Employment

Inflation

Business Production

Housing Starts Availability & cost of money

12 HOW DO WE USE

THE ECONOMIC OUTLOOK?


Use it to identify areas for
additional research
What industries will benefit?
What industries will be hurt?

Use it to evaluate individual companies


Will sales/profits go up or down?

13 IMPORTANT POINT TO

REMEMBER!

Stock prices usually change before the actual


forecasted changes become apparent in the
economy
Stock price trends are another leading indicator
often used to help predict the direction of the
economy itself

14 STEP 2: INDUSTRY ANALYSIS


Evaluate the competitive position of a
particular industry in relation to
other industries
Looking for new opportunities &
growth potential

Identify companies within the industry


that look promising
Looking for strong market positions, pricing
leadership, economies of scale, etc.

15 ISSUES THAT AFFECT AN

INDUSTRY

What is the nature of the industry?


Is the industry regulated?
What role does labor play in the industry?
How important are technological
developments?
Which economic forces have the most impact
on the industry (e.g., interest rates, foreign
trade)?
What are the important financial and operating
considerations (e.g., access to capital)?

16 GROWTH CYCLE STAGES

AND INVESTMENTS

Growth Cycle reflects the vitality of an industry or


a company over time.
Initial Development: industry is new and risks
are
very high
Rapid Expansion: product acceptance is
growing and investors become very interested
Mature Growth: expansion comes from growth
in the economy and returns are more predictable
Stability or Decline: demand for product is
diminishing and investors avoid this stage

17 STEP 3: FUNDAMENTAL

ANALYSIS

Evaluate the financial condition and


operating results of a specific company

Competitive position
Composition and growth in sales
Profit margins and dynamics of earnings
Asset mix (i.e. cash balance, inventory, accounts
receivable, fixed assets)
Financing mix ( i.e. debt, stock)

The value of a stock is influenced by the


financial performance of the company that
issued the stock

18 WHERE DO WE START?
Interpreting Financial Statements
Using Financial Ratios
Fundamental analysis is often the most
demanding and most time-consuming phase of
stock selection

19 FINANCIAL STATEMENTS:

THE BALANCE SHEET

Summary of a companys assets, liabilities, and


shareholders equity at a point in time
Assets: what the company owns (i.e. cash,
inventory, accounts receivable, equipment,
buildings, land)
Liabilities: what the company owes (i.e. bills, debt)
Equity: capital the stockholders have invested in
the company

What are we looking for on the balance sheet?


Relative amounts (large vs. small)
Trends (improving vs. decreasing)

20 TABLE 7.3 CORPORATE

BALANCE SHEET

21 FINANCIAL STATEMENTS:

THE INCOME STATEMENT


Summary of a companys operating results over
a specific period of time, usually one year

Revenues: funds received for providing products


and/or services
Expenses: funds used to pay for materials, labor, and
other business costs
Profit/Loss: revenues less expenses

What are we looking for on the income


statement?

Relative amounts (large vs. small)


Relationships (Are expenses growing faster or slower
than revenues?)
Trends (improving vs. decreasing)

22 TABLE 7.4 CORPORATE

INCOME STATEMENT

23 FINANCIAL STATEMENTS:
THE STATEMENT OF CASH FLOWS
Summary of a companys cash flows and other
events that caused changes in companys cash

Sources of Cash: proceeds from sale of products/


services, sales of equipment, borrowing money, sale
of stock
Use of Cash: payment of wages and/or materials,
payment of operating expenses, purchases of
equipment, payment of debt, payment of dividends

What are we looking for on the cash flow statement?


Relative amounts (more cash or less cash)
Liquidity
Trends (improving vs. decreasing)

24 TABLE 7.5 STATEMENT OF

CASH FLOWS

25 SOURCES FOR FINANCIAL

STATEMENTS

Companys Annual Report


Companys 10K
Companys 10Q
Securities & Exchange Commission
www.sec.gov

Standard & Poors or Moody Reports


Internet financial portals
Brokerage firm reports

26 MAJOR GROUPS OF FINANCIAL

RATIOS

Liquidity Ratios: the companys ability to meet day-today operating expenses and satisfy short-term
obligations as they become due
Activity Ratios: how well the company is managing
its assets
Leverage Ratios: amount of debt used by the company
Profitability Ratios: measures how successful the
company is at creating profits
Common Stock Ratios: converts key financial
information into per-share basis to simplify financial
analysis

27 LIQUIDITY RATIOS
Current Ratio: how many dollars of
short-term assets are available for every
dollar of short-term liabilities owed

Currentassets
Currentratio
Currentliabilities

Higher ratio: better


Lower ratio: worse

28 LIQUIDITY RATIOS (CONT'D)


Net Working Capital: how many
dollars of working capital are available
to pay bills and grow the business
Networkingcapital Currentassets Currentliabilities

Higher amounts: better


Lower amounts: worse

29 ACTIVITY RATIOS
Accounts Receivable Turnover:

how quickly the company is collecting


its accounts receivable (sales to
customers on credit)
Annualsales
Accountsreceivableturnover
Accountsreceivable

Higher ratio: better


Lower ratio: worse

30 ACTIVITY RATIOS (CONTD)


Inventory Turnover: how quickly
the company is selling its inventory
Annualsales
Inventoryturnover
Inventory
Higher ratio: better
Lower ratio: worse

31 ACTIVITY RATIOS (CONT'D)


Total Asset Turnover: how
efficiently the company is using its
Annualsales
assets
to
support
sales
Totalassetturnover

Totalassets

Higher ratio: better


Lower ratio: worse

32 LEVERAGE RATIOS
Debt-Equity Ratio: how much debt the
company is using to support its business
compared to how much stockholders
equity it is using to support
its business

Longtermdebt
Debtequityratio
Stockholdersequity

Higher ratio: more risk


Lower ratio: less risk

33 LEVERAGE RATIOS (CONT'D)


Time Interest Earned: measures the
ability of the firm to meet its fixed
interest payments
Earningsbeforeinterestandtaxes
Timesinterestearned
Interestexpense

Higher ratio: less risk


Lower ratio: more risk

34 PROFITABILITY RATIOS
Net Profit Margin: amount of profit
earned from sales and other
operations
Netprofitaftertaxes

Netprofitmargin

Higher ratio: better


Lower ratio: worse

Totalrevenues

35 PROFITABILITY RATIOS

(CONT'D)

Return on Assets: amount of profit


earned on each dollar invested in
assets; measures managements
efficiency at using assets

Netprofitaftertaxes
ROA
Totalassets

Higher ratio: better


Lower ratio: worse

36 PROFITABILITY RATIOS

(CONT'D)

Return on Equity: amount of profit


earned
on each dollar invested by stockholders;
measures managements efficiency at
using stockholders funds

Netprofitaftertaxes
ROE
Stockholdersequity

Higher ratio: better


Lower ratio: worse

37 BREAKING DOWN

RETURN ON ASSETS (ROA)


Breaking down ROA allows investors to
identify the components that are driving
company profits.

ROA Netprofitmargin Totalassetturnover


Investors want to know if ROA is moving
up (or down) because of improvement (or
deterioration) in the companys profit
margin and/or its total asset turnover.

38 BREAKING DOWN

RETURN ON ASSETS (ROA) (CONT'D)


Breaking down ROE allows investors to identify the
impact of financial leverage on company return.

ROE ROA Equitymultiplier


Totalassets
Totalstockholdersequity
Investors want to know if
ROE is moving up (or
Equitymultiplier

down) because of how much debt the company is


using or because of how the firm is managing its
assets
and operations.

39 COMMON STOCK RATIOS


Price/Equity Ratio: shows how the stock
market is pricing the companys common stock
One of the most widely used ratios in common stock
selection
Often used in stock valuation models

P/E

Marketpriceofcommonstock
EPS

Netprofitaftertaxes Preferreddividends
EPS
Numberofcommonsharesoutstanding
Higher ratio: more expensive
Lower ratio: less expensive

40 COMMON STOCK RATIOS

(CONT'D)

What is the P/E ratio for a company


with profits of $139.7 million,
61,815,000 outstanding shares of
common stock
and a current market
$139,700,000

priceEPS
of $41.50
per share? or $2.26

61,815,000 shares

$41.50
Price/Earningsratio
or18.4
$2.26

41 COMMON STOCK RATIOS

(CONT'D)

Price/Earnings Growth Ratio (PEG):


compares companys P/E ratio to the rate of
growth
StocksP/Eratio
in earnings

PEGratio=

Ratio
PEG
Ratio

3to5yeargrowthrateinearnings

> 1: stock may be fully valued


= 1: stock price in line with
earnings growth
< 1: stock may be undervalued

42 COMMON STOCK RATIOS

(CONT'D)

Dividends per share: the amount of


dividends paid out to common
stockholders

Annualdividendspaidtocommonstock
Dividendspershare
Numberofcommonsharesoutstanding

43 COMMON STOCK RATIOS

(CONT'D)

Payout Ratio: how much of its


earnings a company pays out to
stockholders in the form
of dividends
Traditional payout ratios have been 40% to
60%
Recent trends have been lower payout
ratios, with more tax efficient stock buyback
programs used frequently
Dividendspershare
Payoutratio
High payout
ratios may be difficult to
maintain and theEarningspershare
stock market does not like
cuts in dividends

44 COMMON STOCK RATIOS

(CONT'D)

Book Value per Share: difference between


assets and liabilities (equity) per share

Commonstockholdersequity
Bookvaluepershare
Numberofcommonsharesoutstanding
A company should be worth more than
its
book value.

45 COMMON STOCK RATIOS

(CONT'D)

Price-to-Book Ratio: compares stock price


to book value to see how aggressively the
Marketpriceofcommonstock
stock
is
being
priced
Pricetobookvalue

Bookvaluepershare

Higher ratio: stock is fully-priced or


overpriced
Lower ratio: stock may be fairly priced
or underpriced

46 INTERPRETING FINANCIAL

RATIOS

Look at historical ratio trends for the


company
Look at ratios for the industry
Evaluate the firm relative to two or three
major competitors
Try to determine if the financial information is
telling you a good story about the company
or a bad story
Use the story to decide if you think the stock
has intrinsic value for you as an investor

47 COULD THERE BE TROUBLE

BREWING?

The following financial statement developments could


indicate a company heading for financial problems:
Inventories and receivables growing faster than sales
A falling current ratio, caused by current liabilities
increasing faster than current assets
A high and rapidly increasing debt-to-equity ratio,
suggesting problems with servicing debt in future
Cash flow from operations dropping below net income
Presence of lots of indecipherable off-balance sheet
accounts and extraordinary income entries