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CHAPTER FOURTEEN

FINANCIAL ANALYSIS OF COMMON STOCKS

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FINANCIAL ANALYSIS

• REASONS FOR FINANCIAL ANALYSIS– TWO PRIMARY REASONS

• to determine certain securities’ characteristics

• to attempt to identify mispriced securities

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FINANCIAL ANALYSIS

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

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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

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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

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Business Cycle Sensitivity

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140

1963

1965

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1987

1989

1991

1993

Ind

ust

ry S

ale

s (1

963=

100)

Cigarette Sales Passenger Car Sales

FUNDAMENTAL ANALYSIS

Economic Analysis

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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

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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

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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

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FUNDAMENTAL ANALYSIS

• FINANCIAL STATEMENT ANALYSIS– RATIO ANALYSIS

• Types of Ratios– internal liquidity

– operating performance

– risk analysis

– growth analysis

– profitability

– market ratios

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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

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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

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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

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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

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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

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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

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• 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

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Sources of Information• Annual reports

• Wall Street Journal

• Value Line

• Standard & Poor’s

• Research Insight

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Sources of Information• Internet

– NYSE (www.nyse.com)

– Nasdaq (www.nasdaq.com)

– Text (www.mhhe.com/cj)

– CNNfn.com

– CNBC.com

– Yahoo.com

– Zacks.com

– Smartmoney.com

– Multex.com

– MSNBC.com

– Quicken.com

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Sources of Information

• SEC– EDGAR

– 10K & 10Q reports

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TECHNICAL ANALYSIS

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

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TECHNICAL ANALYSIS

• Two Groups of Strategies Used:1. Momentum and Contrarian Strategies

2. Moving Average and Trading Range Breakout

Strategies

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Technical Analysis

• Support and resistance areas– Support level / Bottom feeders

– Resistance level / Topping out / profit taking

– Breakouts

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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

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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

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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!

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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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DiariesNYSE TUE MON WK AGOAdvances 1,187 1,203 1,642Declines 1,878 1,879 1,414Unchanged 487 504 477New highs 36 44 19New lows 316 285 275zAdv vol (000) 319,260 291,385 493,942zDecl vol (000) 525,920 452,626 381,351Ztotal vol (000) 868,959 765,631 900,037Closing tick -130 -175 -240Closing Arms (trin) 1.04 1.01 0.9zBlock trades 18,775 15,988 19,985

STOCK MARKET DATA BANK

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Examples• Closing Arms: Trin

Values > 1 considered bearish

Trin = Declining volume / Declines

Advancing volume / Advances

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Examples• Advance/Decline Line Calculation

Issues Issues

Weekday Advancing Declining Difference Cumulative

THU 1,162 1,888 -726 -726

FRI 2,275 1,198 1,077 351

MON 1,203 1,849 -646 -295

TUE 1,187 1,878 -691 -986

WED 1,739 1,311 428 -558

THU 2,193 910 1,283 725

FRI 2,178 974 1,204 1,929

MON 1,540 1,525 15 1,944

TUE 1,660 1,540 120 2,064

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Advance/Decline Line

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

1 2 3 4 5 6 7 8 9

Cumulative

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Examples

• Relative strength:

Charts performance relative to industry or market

Value Line Timeliness*

Price performance/Average performance of V-L Stocks

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• Moving AverageTime Mini Dow MA

1 112 123 14 12.334 13 13.005 16 14.336 17 15.337 19 17.338 18 18.009 17 18.0010 18 17.67

11 + 12 + 14 = 12.33

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12 + 14 + 13 = 13.00

3

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Moving Average Graph

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0 1 2 3 4 5 6 7 8 9 10 11

Time

Sto

ck

Pri

ce

s

Mini Dow MA

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Candlestick MakingHigh

Upper Shadow

Low

Lower Shadow

Open

Bullish Bearish

Body

Close

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Head and Shoulders Formation

Neckline

LeftShoulder

Head

RightShoulder

ThrowBack