1. Analyzing Common Stocks
Chapter 7
Analyzing Common Stocks

2. What is Security Analysis?
“The process of gathering information, organizing it into a logical framework, and then using it to determine the intrinsic value of a share of common stock.”

3. What is 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

4. 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

5. 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

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 company’s stock

7. Step 1: Economic Analysis
Economic Analysis is the 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 on both a global and domestic basis.
The behavior of the economy is captured in the business cycle, which reflects changes in total economic activity over time

8. 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, as GDP goes the economy goes
Industrial Production: measure of the activity/output in the industrial or productive segment of the economy
Generally, as production goes the economy goes

9. 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

10. 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

11. Table 7.2 Economic Variables and the Stock Market

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 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)

20. Table 7.3 Corporate Balance Sheet

21. Financial Statements: 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?)
Trends (improving vs. decreasing)

22. Table 7.4 Corporate Income Statement

23. Financial Statements: 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
Trends (improving vs. decreasing)

24. Table 7.5 Statement of Cash Flows

25. Sources for Financial Statements
Company’s Annual Report
Company’s 10K
Company’s 10Q
Securities & Exchange Commission
Standard & Poor’s or Moody Reports
Internet financial portals
Brokerage firm reports

26. 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

27. 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

28. Liquidity Ratios
Current Ratio: how many dollars of short-term assets are available for every dollar of short-term liabilities owed
Higher ratio: more liquidity
Lower ratio: less liquidity

29. Activity Ratios (cont'd)
Total Asset Turnover: how efficiently the company is using its assets to support sales
Higher ratio: better
Lower ratio: worse

30. 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
Higher ratio: more risk
Lower ratio: less risk

31. Leverage Ratios (cont'd)
Time Interest Earned: measures the ability of the firm to meet its fixed interest payments
Higher ratio: less risk
Lower ratio: more risk

32. Profitability Ratios
Net Profit Margin: amount of profit earned from sales and other operations
Higher ratio: better
Lower ratio: worse

33. 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
Higher ratio: better
Lower ratio: worse

34. Breaking Down Return on Equity (ROE)
Breaking down ROE allows investors to identify the components that are driving company profits.
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.

35. Breaking Down Return on Assets (ROA) (cont'd)
Breaking down ROE allows investors to identify the impact of financial leverage on company return.
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.

36. Common Stock Ratios
Price/Equity Ratio: shows how the stock market is pricing the company’s common stock
One of the most widely used ratios in common stock selection
Often used in stock valuation models
Higher ratio: more expensive
Lower ratio: less expensive

37. 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?

38. Common Stock Ratios (cont'd)
Price/Earnings Growth Ratio (PEG): compares company’s P/E ratio to the rate of growth in earnings
Ratio > 1: stock may be fully valued
PEG = 1: stock price in line with earnings growth
Ratio < 1: stock may be undervalued

39. Common Stock Ratios (cont'd)
Price-to-Book Ratio: compares stock price to book value to see how aggressively the stock is being priced
Higher ratio: stock is fully-priced or overpriced
Lower ratio: stock may be fairly priced or underpriced

40. 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

41. Fundamental Analysis the easy way
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Part 4