11 CHAPTER FOURTEEN FINANCIAL ANALYSIS OF COMMON STOCKS

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

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

4 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

5 FUNDAMENTAL ANALYSIS TOP-DOWN V. BOTTOM UP –TOP-DOWN APPROACH attempts to forecast in the following order 1. economic activity 2. industry performance 3. firm’s performance

6 FUNDAMENTAL ANALYSIS Economic Analysis

7 FUNDAMENTAL ANALYSIS FINANCIAL STATEMENT ANALYSIS –INTEGRAL PART OF FUNDAMENTAL ANALYSIS it helps the analyst understand a firm’s current condition where it is headed what factors affect it how the factors affect it

8 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

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

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

11 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

12 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

13 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

14 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

15 Profitability Ratios Gross Margin –Gross profit / Sales Operating Margin –Operating income / Sales ROA –Net income / Total assets ROE –Net income / Owner’s equity FUNDAMENTAL ANALYSIS

16 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 FUNDAMENTAL ANALYSIS

17 Price / Book (or Market / Book) –Stock price / BVPS Price / Earnings (P/E) –Stock price / EPS Price / Cash flow (P/CF) –Stock price / CFPS FUNDAMENTAL ANALYSIS Market Value Ratios

18 Sources of Information Annual reports Wall Street Journal Value Line Standard & Poor’s Research Insight

19 Sources of Information Internet –NYSE ( –Nasdaq ( –Text ( –CNNfn.com –CNBC.com –Yahoo.com –Zacks.com –Smartmoney.com –Multex.com –MSNBC.com –Quicken.com

20 Sources of Information SEC –EDGAR –10K & 10Q reports

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

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

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

24 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

25 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 today’s 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

26 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 today’s close is greater than the high = buy! if today’s close is less than the low = sell!

27 Reading the tea leaves… Advance / decline line: Closing Arms or Trin Relative strength Moving averages Candlestick chart Chart formations: head-and-shoulders TECHNICAL ANALYSIS

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29 Examples Closing Arms: Trin Values > 1 considered bearish Trin = Declining volume / Declines Advancing volume / Advances

30 Examples Advance/Decline Line Calculation IssuesIssues Weekday AdvancingDecliningDifference Cumulative THU 1,1621, FRI 2,2751,1981, MON 1,2031, TUE 1,1871, WED 1,7391, THU 2, , FRI 2, ,2041,929 MON 1,5401,525151,944 TUE 1,6601, ,064

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32 Examples Relative strength: Charts performance relative to industry or market Value Line Timeliness* Price performance/Average performance of V-L Stocks

33 Moving Average = =

34 Moving Average Graph

35 Candlestick Making

36 Head and Shoulders Formation