Analyzing Common Stocks

Chapter 7
Analyzing
Common Stocks
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.
7-2
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
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
company’s performance, and explain how the
insights derived form the basic input for the
valuation process.
7-3
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.”
7-4
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
7-5
“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 company’s stock
7-6
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
7-7
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
7-8
Step 1: Economic Analysis
• “A study of general economic conditions that is used in

the valuation of common stock.”
• Stock prices are heavily influenced by the state of the
economy and by economic events.
Economy Company Profits Stock Prices


7-9
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 , economy goes 
• Industrial Production: measure of the

activity/output in the industrial or productive
segment of the economy
– Generally, production goes , economy goes 
7-10
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
7-11
Other Key Economic Measures
Economic Measure What It Tracks

Index of Leading Indicators “Predicts” direction of GDP
Personal Income Consumer buying habits
Retail Sales Consumer attitudes
Money Supply Growth of economy & inflation
Consumer Prices/ Inflation
Producer Prices
Employment Business Production
Housing Starts Availability & cost of money
7-12
Other Key Economic Variables
Economic Variable Change Stock Market Effect

Inflation Increase 
Decrease 
Corporate Profits Increase 
Decrease 
Unemployment Increase 
Decrease 
Federal Budget Surplus 
Deficit 
7-13
Other Key Economic
Variables (cont’d)
Economic Variable Change Stock Market Effect
U.S. Dollar Strong investments / trade
Weak investments / trade
Interest Rates Increasing 
Decreasing 
Money Supply Moderate Growth 
Rapid Growth 
7-14
Sources for Economic Outlook
• Wall Street Journal

• Barron’s
• Fortune, Business Week, Forbes
• Government Publications
• Brokerage firm/commercial bank reports
7-15
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?
7-16
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.
7-17
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.
7-18
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)?
7-19
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
7-20
Sources for Industry Outlook
• Trade publications
• Wall Street Journal
• Fortune, Business Week, Forbes
• Standard & Poor’s Industry Surveys
7-21
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.
7-22
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.
7-23
Financial Statements:
The Balance Sheet
• Summary of a company’s 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)
7-24
The Income Statement
• Summary of a company’s 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?)
7-25
The Statement of Cash Flows
• Summary of a company’s cash flows and other events that
caused changes in company’s 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
7-26
Sources for Financial Statements
• Company’s Annual Report

• Company’s 10K
• Company’s 10Q
• Securities & Exchange Commission
– www.sec.gov
• Standard & Poor’s or Moody Reports
• Internet financial portals
• Brokerage firm reports
7-27
Key Financial Ratios
• Study of the relationships between financial

statement accounts
• Purpose is to develop information about the past
that can be used to get a handle on the future
– “X-rays” of the financial statements to look for
meaningful relationships between numbers
– Looks at company’s historical trends to see if
improving or declining
– Looks at industry standards to see how company
compares to competitors
7-28
Major Groups of Financial Ratios
• Liquidity Ratios: the company’s ability to meet day-to-day

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
7-29
Liquidity Ratios
• Current Ratio: how many dollars of short-term

assets are available for every dollar of short-term
liabilities owed
Current assets
Current ratio 
Current liabilities
• Higher ratio: better
• Lower ratio: worse
7-30
Liquidity Ratios (cont'd)
• Net Working Capital: how many dollars of

working capital are available to pay bills and grow
the business
Net working capital  Current assets  Current liabilities
• Higher amounts: better

• Lower amounts: worse
7-31
Activity Ratios
• Accounts Receivable Turnover: how quickly

company is collecting its accounts receivable (sales to
customers on credit)
Annual sales
Accounts receivable turnover 
Accounts receivable

7-32
Activity Ratios (cont’d)
• Inventory Turnover: how quickly the company is

selling its inventory
Annual sales
Inventory turnover 
Inventory

7-33
Activity Ratios (cont'd)
• Total Asset Turnover: how efficiently the

company is using its assets to support sales
Annual sales
Total asset turnover 
Total assets
7-34
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
Long-term debt
Debt-equity ratio 
Stockholders’ equity
• Higher ratio: more risk

• Lower ratio: less risk
7-35
Leverage Ratios (cont'd)
• Time Interest Earned: measures the ability of the

firm to meet its fixed interest payments
Earnings before interest and taxes

Times interest earned 
Interest expense
• Higher ratio: less risk

• Lower ratio: more risk
7-36
Profitability Ratios
• Net Profit Margin: amount of profit earned from

sales and other operations
Net profit after taxes

Net profit margin 
Total revenues

7-37
Profitability Ratios (cont'd)
• Return on Assets: amount of profit earned on

each dollar invested in assets; measures
management’s efficiency at using assets

ROA 
Total assets

7-38
Profitability Ratios (cont'd)
• Return on Equity: amount of profit earned

on each dollar invested by stockholders;
measures management’s efficiency at using
stockholders’ funds
ROE 
Stockholders’ equity
7-39
Breaking Down
Return on Assets (ROA)
• Breaking down ROA allows investors to identify
the components that are driving company profits.
ROA  Net profit margin  Total asset turnover
• Investors want to know if ROA is moving up (or

down) because of improvement (or deterioration)
in the company’s profit margin and/or its total
asset turnover.
7-40
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  Equity multiplier

Total assets
Equity multiplier 
Total stockholders’ equity
• Investors want to know if ROE is moving up (or down)

because of how much debt the company is using or because
of how the firm is managing its assets
and operations.
7-41
Common Stock Ratios
• Price/Equity Ratio: shows how the stock market is pricing

the company’s common stock
– One of most widely used ratios in common stock selection
– Often used in stock valuation models
Market price of common stock

P/E 
EPS
Net profit after taxes  Preferred dividends
EPS 
Number of common shares outstanding
• Higher ratio: more expensive

• Lower ratio: less expensive
7-42
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 price of $41.50 per share?
$139,700,000
EPS  or $2.26
61,815,000 shares
$41.50
Price/Earnings ratio  or 18.4
$2.26
7-43
• Price/Earnings Growth Ratio (PEG): compares

company’s P/E ratio to the rate of growth
in earnings
Stock’s P/E ratio
PEG ratio=
3- to 5-year growth rate in earnings
• Ratio > 1: stock may be fully valued

• PEG = 1: stock price in line with
earnings growth
• Ratio < 1: stock may be undervalued
7-44
• Dividends per share: the amount of

dividends paid out to common stockholders
Annual dividends paid to common stock

Dividends per share 
7-45
• 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
– High payout ratios may be difficult to maintain and the
stock market does not like cuts in dividends
Dividends per share
Payout ratio 
Earnings per share
7-46
• Book Value per Share: difference between assets

and liabilities (equity) per share
Common stockholders’ equity

Book value per share 
• A company should be worth more than its

book value.
7-47
• Price-to-Book Ratio: compares stock price to book

value to see how aggressively the stock is being
priced
Market price of common stock
Price-to-book-value 
Book value per share
• Higher ratio: stock is fully-priced or overpriced

• Lower ratio: stock may be fairly priced
or underpriced
7-48
Interpreting Financial Ratios
• Sources of Ratio Analysis

– Standard & Poor’s Stock Reports
– Brokerage firm reports
– Value Line Reports
7-49
Figure 7.1
Example
of Published
Report
7-50
Figure 3.5
Example of
Value Line
7-51
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.
7-52
Chapter 7 Review
• 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.
7-53
Chapter 7 Review (cont'd)
• 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
company’s performance, and explain how the
insights derived form the basic input for the
valuation process.
7-54

Analyzing Common Stocks

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Analyzing Common Stocks

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Chapter 7

• Learning Goals (cont'd)

• “The process of gathering and organizing

• Efficient Market: the concept that the market is

• “A study of general economic conditions that is used in

Economy Company Profits Stock Prices

• Gross Domestic Product (GDP): market value of

• Industrial Production: measure of the

Economic Measure What It Tracks

Economic Variable Change Stock Market Effect

• Wall Street Journal

• Use it to identify areas for

• Use it to evaluate individual companies

• Stock prices usually change before the

• Stock price trends are another leading

• Evaluate the competitive position of a

• What is the nature of the industry?

• Evaluate the financial condition and operating

• Interpreting Financial Statements

• What are we looking for on the income statement?

• Company’s Annual Report

• Study of the relationships between financial

• Liquidity Ratios: the company’s ability to meet day-to-day

• Current Ratio: how many dollars of short-term

• Net Working Capital: how many dollars of

Net working capital  Current assets  Current liabilities

• Higher amounts: better

• Accounts Receivable Turnover: how quickly

• Higher ratio: better

• Inventory Turnover: how quickly the company is

• Higher ratio: better

• Total Asset Turnover: how efficiently the

• Debt-Equity Ratio: how much debt the company

• Higher ratio: more risk

• Time Interest Earned: measures the ability of the

Earnings before interest and taxes

• Higher ratio: less risk

• Net Profit Margin: amount of profit earned from

Net profit after taxes

• Higher ratio: better

• Return on Assets: amount of profit earned on

Net profit after taxes

• Higher ratio: better

• Return on Equity: amount of profit earned

ROA  Net profit margin  Total asset turnover

• Investors want to know if ROA is moving up (or

ROE  ROA  Equity multiplier

• Investors want to know if ROE is moving up (or down)

• Price/Equity Ratio: shows how the stock market is pricing

Market price of common stock

• Higher ratio: more expensive

• What is the P/E ratio for a company with profits of $139.7

• Price/Earnings Growth Ratio (PEG): compares

• Ratio > 1: stock may be fully valued

• Dividends per share: the amount of

Annual dividends paid to common stock

• Payout Ratio: how much of its earnings a

• Book Value per Share: difference between assets

Common stockholders’ equity

• A company should be worth more than its

• Price-to-Book Ratio: compares stock price to book

• Higher ratio: stock is fully-priced or overpriced

• Sources of Ratio Analysis