copyright © 2008 pearson addison-wesley. all rights reserved. chapter 7 analyzing common stocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 7

Analyzing Common Stocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 7-2


• Learning Goals1.Discuss the security analysis process, including

goals and functions.2.Appreciate the purpose and contributions of

economic analysis.3.Describe industry analysis and note how it

is used.4.Demonstrate a basic understanding of

fundamental analysis and why it is used.



• Learning Goals (cont'd)5.Calculate a variety of financial ratios and

describe how financial statement analysis is used to gauge the financial vitality of a company.

6.Use various financial measures to assess a company’s performance, and explain how the insights derived form the basic input for the valuation process.


What is Security Analysis?

• “The process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock.”


What is Intrinsic Value?

• 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


“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


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


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


Step 1: Economic Analysis

• “A 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.

Economy Company Profits Stock Prices

CC CDD D


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, GDP goes C, economy goes C

• Industrial Production: measure of the activity/output in the industrial or productive segment of the economy– Generally, production goes C, economy goes C


Key Economic Factors thatAffect 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


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/ InflationProducer Prices

Employment Business Production

Housing Starts Availability & cost of money


Other Key Economic Variables

Economic Variable Change Stock Market Effect

Inflation Increase DDecrease C

Corporate Profits Increase CDecrease D

Unemployment Increase DDecrease C

Federal Budget Surplus CDeficit D


Other Key Economic Variables (cont’d)

Economic Variable Change Stock Market Effect

U.S. Dollar Strong Cinvestments / Dtrade

Weak Dinvestments / Ctrade

Interest Rates Increasing DDecreasing C

Money Supply Moderate Growth CRapid Growth D


Sources for Economic Outlook

• Wall Street Journal

• Barron’s

• Fortune, Business Week, Forbes

• Government Publications

• Brokerage firm/commercial bank reports


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?


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


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.


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)?


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


Sources for Industry Outlook

• Trade publications

• Wall Street Journal

• Fortune, Business Week, Forbes

• Standard & Poor’s Industry Surveys

• Brokerage house reports

• Yahoo! Finance.com


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


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


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)


Table 7.3 Corporate Balance Sheet

For brief descriptions of each of the account entries in the table, go to My Finance Lab at www.aw-bc.com/gitman_joehnk


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)


Table 7.4 Corporate Income Statement

For brief descriptions of each of the account entries in the table, go to My Finance Lab at www.aw-bc.com/gitman_joehnk


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)


Table 7.5 Statement of Cash Flows

For brief descriptions of each of the account entries in the table above, go to My Finance Lab at www.aw-bc.com/gitman_joehnk


Sources for Financial Statements

• Company’s Annual Report

• Company’s 10K

• Company’s 10Q

• Securities & Exchange Commission– www.sec.gov

• Standard & Poor’s or Moody Reports

• Internet financial portals

• Brokerage firm reports


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


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


Liquidity Ratios

• Current Ratio: how many dollars of short-term assets are available for every dollar of short-term liabilities owed

• Higher ratio: better• Lower ratio: worse

Current ratio =Current assetsCurrent liabilities


Liquidity Ratios (cont'd)

• Net Working Capital: how many dollars of working capital are available to pay bills and grow the business

• Higher amounts: better• Lower amounts: worse

Net working capital = Current assets−Current liabilities


Activity Ratios

• Accounts Receivable Turnover: how quickly the company is collecting its accounts receivable (sales to customers on credit)


Accounts receivable turnover =Annual sales

Accounts receivable


Activity Ratios (cont’d)

• Inventory Turnover: how quickly the company is selling its inventory


Inventory turnover =Annual salesInventory


Activity Ratios (cont'd)

• Total Asset Turnover: how efficiently the company is using its assets to support sales


Total asset turnover =Annual salesTotal assets


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

Debt-equity ratio =Long-term debt

Stockholders’ equity


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

Times interest earned =Earnings before interest and taxes

Interest expense


Profitability Ratios

• Net Profit Margin: amount of profit earned from sales and other operations


Net profit margin =Net profit after taxesTotal revenues


Profitability Ratios (cont'd)

• Return on Assets: amount of profit earned on each dollar invested in assets; measures management’s efficiency at using assets


ROA =Net profit after taxes

Total assets


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


ROE =Net profit after taxesStockholders’ equity


Breaking DownReturn on Assets (ROA)

• Breaking down ROA 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.

ROA = Net profit margin ×Total asset turnover


Breaking DownReturn 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.

ROE = ROA ×Equity multiplier

Equity multiplier =Total assets

Total stockholders’ equity


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

P/E =Market price of common stock

EPS

EPS =Net profit after taxes−Preferred dividendsNumber of common shares outstanding


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?

EPS =$139,700,000

61,815,000 shares or $2.26

Price/Earnings ratio =$41.50$2.26

or 18.4



• 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

PEG ratio=Stock’s P/E ratio

3- to 5-year growth rate in earnings



• Dividends per share: the amount of dividends paid out to common stockholders

Dividends per share =Annual dividends paid to common stockNumber of common shares outstanding



• Payout Ratio: how much of its earnings a company pays out to stockholders in the form of dividends– Traditional payout ratios have been 40% to 60%– Recent trends have been lower payout ratios, with more tax

efficient stock buyback programs used frequently– High payout ratios may be difficult to maintain and the stock market

does not like cuts in dividends

Payout ratio =Dividends per shareEarnings per share



• Book Value per Share: difference between assets and liabilities (equity) per share

• A company should be worth more than its book value.

Book value per share =Common stockholders’ equity

Number of common shares outstanding



• 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

Price-to-book-value =Market price of common stock

Book value per share


Interpreting Financial Ratios

• Sources of Ratio Analysis

– Standard & Poor’s Stock Reports

– Brokerage firm reports

– Value Line Reports


Figure 7.2 Example of Published Report


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


Could There Be Trouble Brewing?

The following financial statement developments could indicate a company heading for financial problems:

• Inventories and receivables growing faster than sales

• A falling current ratio, caused by current liabilities increasing faster than current assets

• A high and rapidly increasing debt-to-equity ratio, suggesting problems with servicing debt in future

• Cash flow from operations dropping below net income

• Presence of lots of indecipherable off-balance sheet accounts and extraordinary income entries


Chapter 7 Review

• Learning Goals

1. Discuss the security analysis process, including goals and functions.

2. Appreciate the purpose and contributions of economic analysis.

3. Describe industry analysis and note how it is used.

4. Demonstrate a basic understanding of fundamental analysis and why it is used.


Chapter 7 Review (cont'd)

• Learning Goals (cont’d)5. Calculate a variety of financial ratios and describe how

financial statement analysis is used to gauge the financial vitality of a company.

6. Use various financial measures to assess a company’s performance, and explain how the insights derived form the basic input for the valuation process.


Table 7.1 Keeping Track of the Economy


Table 7.2 Economic Variables and the Stock Market


Figure 7.1 An Example of a Published Industry Report


Table 7.6 Comparative Historical and Industry Ratios


Table 7.7 Comparative Financial Statistics: Universal Office Furnishings and Its Major Competitors (All figures are for year-end 2007 or for the 5-year period ending in 2007; $ in millions)

copyright © 2008 pearson addison-wesley. all rights reserved. chapter 7 analyzing common stocks

Documents

pearson addisonwesley

security analysis process

financial statement

industry analysis outlook

risk slide

inevitable slide

efficient financial

valuation of common