1. Chapter 7
Fundamental Analysis

2. Fundamental Analysis vs. Technical Analysis
Fundamental => Based on economic factors
Micro & Macro
Technical => Based on mechanical processes
Charting most common

3. Three Steps of Top-Down Fundamental Analysis
Macroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentals
Industry analysis: evaluates outlook for particular industries
Company analysis: evaluates company’s strengths and weaknesses within industry

4. Business Cycles
Four phases
Expansion
Peak
Contraction
Trough

5. Economic Indicators Leading Indicators Coincident Lagging
Multiple false signals
Coincident
Lagging

6. Leading Indicators Average weekly hours, manufacturing
Average weekly initial claims for unemployment insurance
Manufacturers’ new orders, (inflation adjusted)
Vendor performance, slower deliveries diffusion index
Manufacturers’ new orders, nondefense capital goods
Building permits, new private housing units
Stock prices, S&P 500 Index
Real money supply, M2
Interest rate spread, 10-year Treasury bonds less fed funds
Index of consumer expectations, Univ. of Michigan Survey Research Center

7. Coincident Indicators
Employees on nonagricultural payrolls
Personal income less transfer payments
Industrial production
Manufacturing and trade sales

8. Lagging Indicators Average duration of unemployment
Inventories to sales ratio, mfg. and trade
Labor cost per unit of output, mfg.
Average prime rate
Commercial and industrial loans
Consumer installment credit to personal income ratio
Consumer price index for services

9. Gross Domestic Product (GDP)
Sum of market values of all final goods and services produced annually in economy of a country

10. Three Tools of Fiscal Policy
Adjustment of government’s revenues and expenditures to control economy
Changes in tax code
Management of maturity of government’s outstanding debt
referred to as debt management policy

11. How Fiscal Policy Operates through Government Spending and Taxes
Increased government spending or decreased tax collections stimulate economy through extra spending by consumers
Decreased government spending or increased tax collections restrain the economy through reduced spending by consumers

12. Leakages
Money absorbed by savings, import purchases, or taxes during each round of stimulatory spending or tax reduction
Reduces the impact of fiscal policy

13. Federal Reserve Board (Fed)
Governing body of Federal Reserve System
Composed of seven members appointed by President for long and staggered terms

14. Monetary Policy
Government policy that utilizes money supply to affect the economy
Implemented by Fed through control of required reserves and open market operations

15. Fed’s Principal Policy Tools
Reserve requirement: Increasing (decreasing) required percentage reduces (raises) amount of money supported by given reserve base.
Open market operations: Fed purchases (sales) of government securities increase (decrease) bank deposits available to support money supply.
Discount loans: Increasing (decreasing) discount rate makes banks less (more) willing to borrow funds from Fed to lend to customers

16. Money Supply
M1: Sum of all coin, currency (outside bank holdings), and deposits on which check-like instruments may be written
Most common definition.
M2: M1 plus savings and small time deposits, repurchase agreements, and money market deposit accounts

17. Reserve Requirement
Percentage of reserves Fed requires each bank to have on deposit for each increment of demand or time deposits

18. Open Market Operations
Federal Reserve transactions (buying and selling) in government bond market intended to influence money supply, interest rates, and economic activity

19. Discount Rate vs. Fed Funds Rate
Discount rate interest rate charged by Federal Reserve System on loans to member banks
Federal funds rate interest rate charged between banks in federal funds market
Banks will gravitate toward whichever is cheaper, although don’t like scrutiny of the Fed that comes with its loans

20. Reserve Requirements Required reserves Actual reserves
Excess reserves = Actual – Required
Increases in reserve requirements may cause undue harm to banking industry

21. Economic Effect of Deposits and Loans
Increase in deposits and loans:
Stimulates spending and income
Can increase inflation
Decrease in deposits and loans:
Restrains spending and income
Can reduce inflation

22. Greater Stimulation More likely if… Unemployment is far above target
Inflation rate is near its target
Unemployment is increasing
Inflation decreasing
Dollar strong
Trade deficit large
Substantial amounts of capital flowing into U.S.

23. Greater Restrictiveness
More likely if…
Unemployment near target
Inflation rate far above target
Unemployment is decreasing
Inflation is increasing
Dollar weak
Trade deficit small or trade surplus
Foreign capital threatening to withdraw from or slow flow into the U.S.

24. How MP’s Impact on Interest Rates Affects the Stock Market
Interest rates affect rate at which stocks’ expected future income streams are discounted.
As bonds’ yields to maturity change, some investors may switch from stocks to bonds when rates rise and from bonds to stocks when rates fall.
Interest rates affect borrowing costs for margin investors.

25. Goals of Monetary & Fiscal Policy
Price Stability
Inflation
Disinflation
Deflation
Stagflation
Full Employment

26. Price Stability Absence or low level of inflation or deflation
Prices of specific goods would still fluctuate in response to market forces (supply and demand changes), but overall level of prices stable

27. Full Employment
Unemployment rate thought to be minimum level before inflationary pressures accelerate
Economists generally consider optimal because a certain percentage of workforce is likely to be looking for better jobs at any point in time
Opinions on level have varied over time from about 4 percent to 6 percent.

28. Unemployment Rate
Percentage of workforce actually out of work and actively seeking employment

29. Life Cycle of an Industry
Start-up stage: many new firms; grows rapidly (example: genetic engineering)
Consolidation stage: shakeout period; growth slows (example: video games)
Maturity stage: grows with economy (example: automobile industry)
Decline stage: grows slower than economy (example: railroads)

30. Cyclical Industry
Industry in which sales tend to move with the business cycle
Consumer durables are a classic example

31. Non-Cyclical Industry
Industry that involves a product people purchase regardless of the level of economic activity
Food is a classic example

32. Company Analysis Competitive Position Management Quality
Financial Soundness
Financial Ratios

33. Balance sheet: a financial statement showing a firm’s or individual’s financial position that lists assets, liabilities, and net worth (equity) as of a particular point in time
Income statement: a financial statement of earnings that provides a financial accounting of revenues and expenses during a specified period—for example, one quarter or one year
Statement of changes in financial position: financial statement showing cash flows into and out of a firm during the reporting period — formerly known as sources and uses of funds statement
Pro forma: a hypothetical accounting statement that projects what that statement is expected to look like at some point in the future

34. Basic Balance Sheet Assets
Current Assets Cash Inventories Accounts receivable    Long-Term Assets Plant Equipment Land Market value of patents and royalties    Other Assets
Liabilities and Net Worth
Current Liabilities Accounts Payable Short-term notes    Long-Term Liabilities Corporate debt   
Net Worth Stockholders’ equity
Total Assets =
Total Liabilities and Net Worth

35. Income Statement Net Sales - Cost of Goods Sold
= Gross Profit (or income)
- Cash & Depreciation (noncash) expenses
= Earnings Before Interest & Taxes (EBIT)
- Interest & Taxes
= Net Profit (or income)

36. Ratio Analysis
Balance sheet and income statement analysis that utilizes ratios of financial aggregates to assess a company’s financial position, usually by looking for trends in financial ratios, by comparing a company’s financial ratios with the industry average, or both

37. Liquidity Ratios (1 of 2)
Ratios that measure a firm’s ability to meet short-term obligations. They shed light on the question of whether or not the firm will be able to meet its cash obligations over the period of the next few months or so.

38. Liquidity Ratios (2 of 2) Current: current assets/current liabilities
Quick (or acid test): (current assets – inventories)/current liabilities
Inventory turnover: cost of goods sold/average yearly inventory
Average collection period: net accounts receivable/daily sales

39. Debt Ratios (1 of 2)
Ratios that examine the extent to which the firm uses debt to finance its assets, and the impact of that debt financing on its profitability.

40. Debt Ratios (2 of 2) Debt-equity: total debt/shareholders’ equity
Debt-asset: total debt/total assets
Equity Multiplier: Total assets/Total equity
Times-interest-earned: profit before interest payments and tax/interest payments

41. Profitability Ratios (1 of 2)
Ratios that look at the profitability or success of the firm, relative to different measures of resources.

42. Profitability Ratios (2 of 2)
Return on equity (ROE): Net income/equity
Return on assets (ROA): Net income/total assets
Net profit margin (NPM): Net income/total revenues

43. Efficiency Ratios
Ratios that examine the ability of various resources to support or generate sales.
Total Asset turnover: Net Sales/Total assets
Fixed Asset Turnover: Net Sales / Net Fixed Assets
May say more about age of assets than efficiency

44. Dupont Analysis (Also called Decomposition Analysis)
Looks at components of ROE
Simple form
ROE = ROA x Equity multiplier
More elaborate form
ROA = NPM x Asset turnover
ROE = NPM x Asset turnover x Equity multiplier

45. Other Ratios
Earnings per share (EPS): (Net income after taxes – preferred dividends)/ number of shares
Price-earnings (P/E): Price per share/expected EPS
Dividend yield: Indicated annual dividend/price per share
Dividend payout: Dividends per share/EPS
Cash flow per share: (After-tax profits + depreciation and other noncash expenses)/number of shares
Book value per share: Net worth attributable to common shareholders/number of shares

46. Fundamental Analysis vs. Market Efficiency
Fundamental analysis critical when dealing with private companies
Necessary condition for market efficiency of publicly traded companies (although worthless at the margin)
Earnings surprises major component of performance