Chapter 7 Analyzing Common Stocks

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-2 Analyzing Common Stocks 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-3 Analyzing Common Stocks 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-4 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.”

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-5 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-6 “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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-7 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-8 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-9 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. EconomyCompany ProfitsStock Prices  

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 , economy goes  Industrial Production: measure of the activity/output in the industrial or productive segment of the economy –Generally, production goes , economy goes 

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Key Economic Measures Economic MeasureWhat It Tracks Index of Leading Indicators“Predicts” direction of GDP Personal IncomeConsumer buying habits Retail SalesConsumer attitudes Money SupplyGrowth of economy & inflation Consumer Prices/Inflation Producer Prices EmploymentBusiness Production Housing StartsAvailability & cost of money

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Key Economic Variables Economic VariableChangeStock Market Effect InflationIncrease  Decrease  Corporate ProfitsIncrease  Decrease  UnemploymentIncrease  Decrease  Federal BudgetSurplus  Deficit 

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Key Economic Variables (cont’d) Economic VariableChangeStock Market Effect U.S. DollarStrong  investments /  trade Weak  investments /  trade Interest RatesIncreasing  Decreasing  Money SupplyModerate Growth  Rapid Growth 

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Sources for Economic Outlook Wall Street Journal Barron’s Fortune, Business Week, Forbes Government Publications Brokerage firm/commercial bank reports

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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)?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Sources for Industry Outlook Trade publications Wall Street Journal Fortune, Business Week, Forbes Standard & Poor’s Industry Surveys

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Activity Ratios Accounts Receivable Turnover: how quickly company is collecting its accounts receivable (sales to customers on credit) Higher ratio: better Lower ratio: worse

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Activity Ratios (cont’d) Inventory Turnover: how quickly the company is selling its inventory Higher ratio: better Lower ratio: worse

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Activity Ratios (cont'd) Total Asset Turnover: how efficiently the company is using its assets to support sales Higher ratio: better Lower ratio: worse

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Profitability Ratios Net Profit Margin: amount of profit earned from sales and other operations Higher ratio: better Lower ratio: worse

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Profitability Ratios (cont'd) Return on Assets: amount of profit earned on each dollar invested in assets; measures management’s efficiency at using assets Higher ratio: better Lower ratio: worse

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Breaking Down Return 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Common Stock Ratios Price/Equity Ratio: shows how the stock market is pricing the company’s common stock –One of most widely used ratios in common stock selection –Often used in stock valuation models Higher ratio: more expensive Lower ratio: less expensive

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Common Stock Ratios (cont'd) Dividends per share: the amount of dividends paid out to common stockholders

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Common Stock Ratios (cont'd) 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Common Stock Ratios (cont'd) Book Value per Share: difference between assets and liabilities (equity) per share A company should be worth more than its book value.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Interpreting Financial Ratios Sources of Ratio Analysis – Standard & Poor’s Stock Reports – Brokerage firm reports – Value Line Reports

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 7.1 Example of Published Report

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 3.5 Example of Value Line

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.