1 CHAPTER FOURTEEN FINANCIAL ANALYSIS OF COMMON STOCKS

2 FINANCIAL ANALYSIS WHAT IS FINANCIAL ANALYSIS? –DEFINITION: the activity of providing inputs to the portfolio management process

3 FINANCIAL ANALYSIS PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS –THE ASSOCIATION OF INVESTMENT MANAGEMENT AND RESEARCH (AIMR) acts as an advocate for the financial analyst profession it hosts conferencing and workshops –designed to enhance the knowledge base of the memberships it also publishes the Financial Analysts Journal

4 FINANCIAL ANALYSIS PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS –THE ASSOCIATION OF INVESTMENT MANAGEMENT AND RESEARCH (AIMR) acts as an advocate for the financial analyst profession it host conferencing and workshops –designed to enhance the knowledge base of the memberships it also publishes the Financial Analysts Journal

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

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

7 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

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

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

10 TECHNICAL ANAYSIS 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 overreation theory

11 TECHNICAL ANAYSIS 2. Moving Average and Trading Range Breakout Strategies –MOVING AVERAGE STRATEGY: calculate a moving average over the last 200 days of closing prices divdied 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

12 TECHNICAL ANAYSIS 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!

13 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

14 FUNDAMENTAL ANALYSIS TOP-DOWN V. BOTTOM UP –BOTTOM-UP APPROACH: attempts to estimate prospects in the following order: 1. The firm 2. The Industry 3. The economy

15 FUNDAMENTAL ANALYSIS FINANCIAL STATMENT 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

16 FUNDAMENTAL ANALYSIS FINANCIAL STATMENT 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 statment of cash flows

17 FUNDAMENTAL ANALYSIS FINANCIAL STATMENT 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 –in combination with technical analysis

18 FUNDAMENTAL ANALYSIS FINANCIAL STATMENT ANALYSIS –RATIO ANALYSIS Types of Ratios –internal liquidity –operating performance –risk analysis –growth analysis

19 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

20 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

21 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

22 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