Week 10 – 11

Analyzing Common Stocks

Security Analysis
Security Analysis should be part of formulating a successful long-range
investment program.
• Principles of Security Analysis
• Who Needs Security Analysis in an Efficient Market?
Security Analysis
• Principles of Security Analysis
• Security analysis: process of gathering information, organizing it into a logical
framework, and then using the information to determine the intrinsic value of
common stock.
• Intrinsic value: a measure of the underlying worth of a share of stock.
• 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 the stock’s future cash flows
• The discount rate
• The risk associated with future performance
Security Analysis
• Principles of Security Analysis
• The Top-Down Approach to Security Analysis
• Step 1: Economic Analysis
• Assess the general state of the economy and its potential effects on businesses.
• Step 2: Industry Analysis
• Overall outlook for specific industry within which a company operates.
• Level of competition in that industry.
• Step 3: Fundamental Analysis
• Financial condition and operating results of a company.
• Company analysis helps investors formulate expectations about the company’s future
performance.
Security Analysis
• Who Needs Security Analysis in an Efficient Market?
• Security analysis, and fundamental analysis in particular, is based on the
assumption that at least some investors are capable of identifying stocks
whose intrinsic values differ from their market values.
• Fundamental analysis operates on the broad premise that some securities may be
mispriced in the marketplace, at least some of the time.
• The efficient market hypothesis asserts:
• Securities are rarely, if ever, substantially mispriced in the marketplace.
• No security analysis is capable of consistently finding mispriced securities more
frequently than might be expected by random chance.
Security Analysis
• Who Needs Security Analysis in an Efficient Market?
• Fundamental analysis is still of value 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.
Economic Analysis
Economic Analysis: the study of the underlying condition of the
economy and the impact it might have on the behavior of share prices.
• Economic Analysis and the Business Cycle
• Key Economic Factors
• Developing an Economic Outlook
Figure 1 The Economy and the Stock Market
Economic Analysis
• Economic Analysis and the Business Cycle
• The overall performance of the economy has a significant bearing on the
performance and profitability of most companies.
• Business cycle: a series of alternating contractions and expansions which
reflects changes in the total economic activity over time. Two widely followed
measures:
• Gross domestic product (GDP): market value of all goods and services produced in a
country over a given period.
• Industrial production: an indicator of the output produced by industrial companies.
• Normally, GDP and index of industrial production move up and down with the business cycle.
Economic Analysis
• Key Economic Factors
• The state of the economy is affected by a wide range of factors:
• Government Fiscal Policy
• Taxes
• Government Spending
• Debt management
• Monetary Policy
• Money supply
• Interest rates
• Other Factors
• Inflation
• Consumer spending
• Business Investments
• Foreign trade and foreign exchange rates
Table 1
Keeping Track
of the Economy
Economic Analysis
• Developing an Economic Outlook
• Sources that provide summary of economic outlook
• Wall Street Journal
• Barron’s
• Fortune
• Business Week
• Periodic reports from major brokerage houses
• Use the economic outlook information to either:
• Determine areas for further analysis:
• What industries will benefit/be hurt?
• Focus on or avoid companies in industries based on this.
• Or evaluate specific industries or companies:
• How will specific industries or companies be affected by expected development in the economy?
• Outlook for corporate profits and business investments?
• Assessing the Potential Impact on Share Prices
• Investors can use indicators of economic outlook to try and predict where stock prices in the
market may be headed in the future.
• See Table 2
Table 2 Economic Variables and the Stock Market
Economic Analysis
• Developing an Economic Outlook
• The Market as a Leading Indicator
• Changes in stock prices usually occur before the actual forecasted changes become
apparent in the economy.
• The current trend of stock prices is frequently used to help predict the course of the
economy itself.
• So, watching the course of stock prices as well as the course of the general economy can
make for more accurate investment forecasting.
Industry Analysis
Understanding the outlook and risks inherent in an industry gives
valuable insight about the outlook for and risks inherent in individual
companies, and their securities, that makeup that industry.
• Key Issues
• Developing an Industry Outlook
Industry Analysis
• Key Issues
• Industry Analysis: In analyzing an industry, look at such things as its makeup
and basic characteristics, the key economic and operating variables that drive
industry performance, and the outlook for the industry.
• Step 1: establish the competitive position of a particular industry in relation to other
industries.
• Step 2: Identify companies within the industry that hold particular promise.
• Look for strong market positions, pricing leadership, economies of scale, etc.
Industry Analysis
• Key Issues
• Seek to answers to questions such as:
• 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 are especially important to the industry?
• What are the important financial and operating considerations?
Industry Analysis
• Key Issues
• The Industry Growth Cycle
• Growth cycle: an industry’s growth cycle reflects the vitality of the industry 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 the long-term nature of
the industry becomes more apparent.
• Stability or Decline: demand for the industry’s products is diminishing and companies are
leaving the industry.
Industry Analysis
• Developing an Industry Outlook
• Sources for Industry information
• S&P Industry Surveys
• Brokerage house reports
• Articles in the popular financial media
• Morningstar, Value Line, Mergent
• Yahoo.com, zacks.com, businessweek.com, bigcharts.com
• Assess the expected industry response to forecasted economic developments.
• Demand for product
• Industry sales
• Research & Development
• What are the prospects for industry growth?
• Take a closer look at any firm(s) that stand out.
Fundamental Analysis
Fundamental analysis: the study of the financial affairs of a business
for the purpose of understanding the company that issued the
common stock.
• The Concept
• Financial Statements
• Financial Ratios
• Interpreting the Numbers
Fundamental Analysis
• The Concept
• The value of a stock is influenced by the performance of the company that
issued the stock.
• Company analysis: a historical analysis of the financial strength of the firm,
using financial statements of the firm.
• The competitive position of the company
• The types of assets owned and growth rate of sales
• Profit margins and dynamics of earnings
• Composition and liquidity of assets (asset mix)
• Capital structure (financing mix)
• Time consuming and demanding phase, so investors may rely on published
reports and financial websites as well.
Fundamental Analysis
• Financial Statements
• Balance Sheet: statement of what a company owns and what it owes at one
specific time.
• Assets: what the company owns (i.e., cash, inventory, accounts receivable, equipment,
buildings, land)
• Liabilities: what the company owes (i.e. bills, debt)
• Stockholders’ equity: difference between assets and liabilities; claim held by the firm’s
stockholders.
• A firm’s total assets must equal the sum of its liabilities and equity.
Table 3
Corporate
Balance
Sheet
Fundamental Analysis
• Financial Statements
• Income Statement: provides a financial summary of the operating results of
the firm over a period of time such as a quarter or a year.
• Revenues (i.e. sales)
• Expenses
• Profit/Loss
• The income statement shows how successful the firm has been in using the assets listed
on the balance sheet.
Table 4 Corporate Income Statement
Fundamental Analysis
• Financial Statements
• The Statement of Cash Flows: provides a summary of the firm’s cash flow and
other events that caused changes in its cash position.
• Helps investors determine how much cash a firm actually spent and received in a
particular year.
• A company’s reported earnings vs. cash flow
• A firm that shows positive profits on its income statement may be spending more cash than it
is taking in, which could lead to financial distress.
• Net cash flow from operating activities: Amount of cash (“cash flow”) generated by the
company and available for investment and financing.
• Net increase (decrease) in cash
Table 5 Statement of Cash Flows
Fundamental Analysis
• Financial Ratios
• Ratio analysis: study of the relationships between various financial statement
accounts.
• What Ratios Have to Offer
• Investors use financial ratios to evaluate the financial condition and operating results of a
company and to compare those results to historical or industry standards.
• Compare a company’s ratios from one year to the next.
• Compare a company’s ratios to those of other companies in the same line of business.
• Understanding a company’s past performance allows a forecast of its future performance
with some degree of confidence.
Fundamental Analysis
• Financial Ratios
• What Ratios Have to Offer
• Five groups of financial ratios:
• Liquidity
• Activity
• Leverage
• Profitability
• Common Stock (Market) measures
Fundamental Analysis
• Financial Ratios
• Liquidity Ratios
• Liquidity ratios: company’s ability to meet its day-to-day operating expenses and satisfy
its short-term obligations as they come due.
• Current Ratio: measures a company’s ability to meet its short-term liabilities with its
short-term assets.
• One of the best measures of a company’s financial health
• Higher ratio: more liquidity
Fundamental Analysis
• Financial Ratios
• Liquidity Ratios
• Quick Ratio: Similar to the current ratio, but it excludes inventory in the numerator.
• Inventory is often the least liquid asset on a firm’s balance sheet.
• During periods of declining sales, firms may have difficulty selling its inventory and converting
it to cash.
Fundamental Analysis
• Financial Ratios
• Liquidity Ratios
• Net Working Capital: indicates the dollar amount of equity in the working capital
position of the firm.

• How much liquidity is enough?

• Investors generally want firms to maintain enough liquidity to cover their short-term
obligations, but they do not want firms to hold excessive amounts of liquid assets.
Fundamental Analysis
• Financial Ratios
• Activity Ratios
• Activity Ratios: compare company sales to various asset categories in order to measure
how well the company is using its assets.
• also called efficiency ratios.
• High or increasing ratio values generally indicate the firm is managing its assets efficiently.
Fundamental Analysis
• Financial Ratios
• Activity Ratios
• Account Receivable Turnover Ratio: Captures the relationship between a firm’s
receivables balance and its sales.

• A high receivables turnover indicates a firm generates sales without having to extend credit
for long periods.
Fundamental Analysis
• Financial Ratios
• Activity Ratios
• Inventory Turnover Measure: How quickly the company is selling its inventory.

• Generally, a higher turnover ratio indicates a firm is doing a better job managing its inventory.
• Unless a firm is holding too little inventory.
• Some analysts prefer to use Cost of Goods Sold in the numerator of equation 7.5, rather than
sales.
Fundamental Analysis
• Financial Ratios
• Activity Ratios
• Total Asset Turnover: indicates how efficiently a firm uses its assets to support sales.

• A high total asset turnover figure suggests that corporate resources are being well managed
and that the firm is able to realize a high level of sales (profits) from its asset investments.
Fundamental Analysis
• Financial Ratios
• Leverage Ratios
• Leverage ratios: Indicate the amount of debt being used to support the resources and
operations of the company.
• Sometimes called solvency ratios
• Investors are concerned with:
• The amount of indebtedness
• Ability of firm to service its debt
Fundamental Analysis
• Financial Ratios
• Leverage Ratios
• Debt-Equity Ratio: measures the relative amount of funds provided by lenders and
owners.

• Particularly helpful in assessing a stock’s risk exposure (risk of defaulting on their loans)
• Lower or declining ratio indicates lower risk exposure.
Fundamental Analysis
• Financial Ratios
• Leverage Ratios
• Equity Multiplier (financial leverage ratio): measures a firm’s use of debt.

• Total Assets is the sum of liabilities and equity.

• Holding equity fixed, the more debt the firm uses, the higher will be its total assets, and the
higher will be the equity multiplier.
Fundamental Analysis
• Financial Ratios
• Leverage Ratios
• Times Interest Earned: measures the ability of the firm to meet (“cover”) its fixed
interest payments.
• Also called a “coverage ratio”

• As a rule, a ratio 8 to 9 times earnings is strong.

• Usually little concern until times interest earned drops to something less than 2 or 3 times
earnings.
Fundamental Analysis
• Financial Ratios
• Profitability Ratios
• Profitability: a relative measure of success; Three widely used profitability measures
relates the returns (profits) of a company to its sales, assets, or equity.
• Higher or increasing measures of profitability are what investors would like to see.
• Net Profit Margin: indicates the rate of profit being earned from sales and other
revenues; the “bottom line” of operations.
Fundamental Analysis
• Financial Ratios
• Profitability Ratios
• Return on Assets (ROA): measures management’s efficiency at using assets to generate
profits.

• As a rule you would like to see a company maintain as high an ROA as possible.
Fundamental Analysis
• Financial Ratios
• Profitability Ratios
• Return on Equity (ROE): measures the return to the firm’s shareholders by relating
profits to shareholder equity.
• Sometimes called return on investment (ROI)
• Shows annual profit earned by the firm as a percentage of the equity that stockholders have
invested in the firm.

• Generally speaking, look out for a falling ROE, as it could mean trouble later on.
Fundamental Analysis
• Financial Ratios
• Breaking Down ROA and ROE
• 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
Fundamental Analysis
• Financial Ratios
• Breaking Down ROA and ROE
• Going from ROA to ROE

• ROE is nothing more than an extension of ROA

• Expanded ROE measure indicates the extent to which financial leverage (i.e. how much debt
the firm uses) can increase the return to stockholders.
Fundamental Analysis
• Financial Ratios
• Breaking Down ROA and ROE
• An Expanded ROE Equation

• Investors want to know if ROE is moving up simply because of how much debt the company is
using or because of how the firm is managing its assets and operations.
• High ROE means the firm is currently very profitable and if some of those profits are
reinvested in the firm, the firm may grow rapidly.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Common-Stock Ratios: They tell the investor exactly what portion of total profits,
dividends and equity is allocated to each share of stock.
• Also called valuation ratios; market ratios.
• We already examined two of these measures earlier: earnings per share and dividend yield.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Price-to-Earnings Ratio (P/E): used to determine how the market is pricing the company’s
common stock.

• Investors would like to find stocks with rising P/E ratios

• Watch out for P/E ratios that become too high; may be a signal that the stock is becoming
overvalued and ready to fall.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• 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

• Ratio = 1: stock price in line with earnings growth
• Ratio < 1: stock may be undervalued
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Dividends Per Share: the amount of dividends paid out to common stockholders, on a
per share basis.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Payout Ratio: indicates how much of its earnings a company pays out to stockholders in
the form of dividends.

• Traditional payout ratios have been 30% to 50%;growth-oriented companies often have low
or zero payout ratios.
• A rising dividend payout ratio is often a sign that a company’s earnings are falling.
• High payout ratios may be difficult to maintain and the stock market does not like cuts in
dividends.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Book Value Per Share: represents the difference between total assets and total
liabilities.
• Another term for equity (or net worth).

• A stock should sell for more than its book value, otherwise it could indicate something is
seriously wrong with the company’s outlook and profitability.
Fundamental Analysis
• Financial Ratios
• Common-Stock Ratios
• Price-to-book-value ratio: relates the book value of a company to the market price of its
stock, to show how aggressively the stock is being priced.

• Most stocks have a price-to-book-value ratio of more than 1.0.

• In a strong bull market, it is not uncommon to find stocks trading at 4 or 5 (or more) times
their book values.
• Too high a price-to-book-value ratio may indicate the stock is already fully priced, or perhaps
even overpriced.
Fundamental Analysis
• Interpreting the Numbers
• Rather than compute all the numbers themselves, most investors rely on
published reports for such information.
• Many large brokerage houses and financial services firms publish such reports.
• These reports provide vital information in a convenient, easy-to-read format and relieves
the investor of the chore of computing the financial ratios themselves.
• As an investor, though, you must be able to evaluate this information.
Fundamental Analysis
• Interpreting the Numbers
• Using Historical and Industry Standards
• Look at historical ratio trends for the company.
• Look at ratios for the industry.
• Compare and evaluate how the company performed relative to its industry.
• Looking at the Competition
• Evaluate the firm relative to two or three major competitors.
• A lot can be gained from seeing how a company stacks up against its competitors and by
determining whether it is, in fact, positioned to take advantage of unfolding
developments.
Table 6 Comparative Historical and Industry Ratios
Table 7 Comparative Financial Statistics: Universal Office Furnishings and Its Major Competitors (All figures are
for year-end 2016 or for the five-year period ending in 2016; $ in millions)