Evaluating Popular Investments Lesson 3 Corporate Fundamental Analysis

Fundamental Security Analysis Aim:  What we can learn about companies by doing fundamental security analysis? Do Now:  Write a definition for the word “fundamental”. Alternately, in sports when the coach says its time to go back and focus on the fundamentals, what does he or she mean?

 Do Now answers: 1.Fundamentals are the basics, the essentials. 2.In sports, it can mean placing oneself in the right position and having one’s weight well distributed to react quickly to the play. Fundamental Security Analysis

Don’t be scared by the above title. Stocks and bonds are paper investments that stand something (ownership or debt), so they’re called securities. We’re going to learn how to do a basic analysis of the companies that offer them to see which are worthy of investment. Example: A company can have significant sales, but be having trouble making a profit. We can compare profits to sales to get the insights we need. Fundamental Security Analysis

Comparing one number to another produces a ratio. Ex: Net Profit / Sales = Net Profit Margin. A company’s financial ratios are typically compared to other companies within the same industry. For example, Walgreen's ratios can be compared to the ratios of CVS and Rite Aid. This real life depiction comparing the three companies is shown at the end of this section. Today we’ll look at liquidity, efficiency and solvency ratios. Fundamental Security Analysis

1.Liquidity Ratios: Measures a company’s ability to pay off debts that are due soon. Liquidity ratios are important to determining if a company is in a sound financial position and can recover if unexpected events occur in the company or the economy. Current Ratio: The ratio of Current Assets / Current Liabilities. It shows a company’s ability to pay off short term debt with its short term assets. A large ratio indicates the company is in a sound position.

Quick Ratio: A measure of how well a company can pay off its short term liabilities with its current assets, not including its inventory. The quick ratio excludes inventory because inventory tends to be less liquid, thus difficult to quickly turn into cash even though it is a current asset. Quick Ratio = Current Assets - Inventory Current Liabilities

2. Efficiency Ratios: measure how much profit a company can generate with either its assets or equity in the business. Return on Assets: A measurement of how profitable a company is based on its assets. It shows how many dollars of net income are generated per dollar of asset owned. ROA = Net Income Total Assets

Return on Equity: A measurement of how profitable a company is based on the equity put into the business from the shareholders. It is the ultimate measure of profitability from the shareholders’ perspective. ROE = Net Income Total Equity

A company made $.50 in profit per share last year. It’s current share price is $9. Its P/E ratio is $9 / $.50 = 18. Price to Earnings (P/E) Ratio: A measure that shows the company’s current share price compared to its profits (ie: earnings) per share. A high P/E ratio means that the investors are expecting the earnings to increase in the future. A lower P/E means that investors do not expect the company’s earnings to increase significantly.

3. Solvency Ratios: A measurement that shows how well a company is able to cover its long-term liabilities. Long-Term Debt to Equity: Measures how much of a company’s long term capital was raised through debt as compared to equity. LT Debt to Equity = LT Debt Total Equity

Times Interest Earned: Measures how easily the company can pay the annual interest on its bonds from the annual profit it earns. Times Interest Earned = Net Profit Annual Interest Expense

Example Refer to the below Income Statement and Balance Sheets from CVS, Rite Aid & Walgreens. Calculate the companies’ current ratios, quick ratios, return on assets, return on equity, and price to earnings ratios. Make a comment on what each ratio says about the company and compare each ratio denoting which company has the strongest ratio. (*Note: These Financial Statements are simplified for the purpose of the example) CVS Caremark: Stock Price= $60.32, Earnings per Share= $3.86 Rite Aid: Stock Price= $3.41, Earnings per Share=($0.43) Walgreens: Stock Price= $50.54, Earnings per Share= $2.43

Example Rite Aid’s Current Ratio is the largest, followed by CVS and then Walgreens. All of the pharmacies have current ratios larger than one meaning they are able to pay off their short term liabilities with their current assets.

Example Quick Ratio: CVS has the largest quick ratio, followed by Rite Aid and then Walgreens. All of the ratios are less than one because of the type of business the companies do. A large portion of their currents assets is inventory and the quick ratio takes out inventory from the calculation.

Example Return on Assets: All three companies have similar ROAs. In comparison to each other, Walgreens has the highest ROA meaning it is more profitable relative to its total assets than CVS and Rite Aid. *Note that a company’s ROAs are generally compared with other companies in the same industry because of the different business structures within industries.

Example Return on Equity: Walgreens and CVS have ROEs of 0.12 and 0.10, respectively. This means that the companies are generating about 10-12% return on the shareholders’ equity investments. Rite Aid generated negative net income and negative shareholders’ equity so it is unprofitable.

Example Price to Earnings: Walgreen’s P/E ratio (20.80) is the largest followed by CVS (15.63). Rite Aid has a negative P/E ratio (-7.93). Walgreen’s and CVS’s ratios indicate the investors expect both company’s earnings to increase. Rite Aid’s P/E ratio shows that there is little investor confidence for the company to increase its earnings.

Lesson Summary 1.What do we call the basic examination of a corporation’s financial results? 2.What do we get when we divide one number into another? 3.Which three companies’ financial results did we compare? Why not throw Home Depot or Disney in there? 4.What types of ratios did we examine, and what does each tell us? 5.What we can learn about companies by doing fundamental security analysis?

Web Challenge #1 Q: Is it possible for a company to be too strong financially? A: Many argue that it is. Some companies are so successful and dominant that they make billions in profit each year. Instead of doing something with the growing pile of cash, it just sits there! Challenge: Research three companies that have enormous cash levels as well as what analysts and activist investors suggest they do with it.

Web Challenge #2 After the Great Recession, interest rates were brought very low by the Federal Reserve. Wanting to take advantage of these low borrowing rates, many companies chose to issue bonds (and not stock) when they needed to raise money. Let’s see if the numbers prove this.  Challenge: Choose three corporations. Look at their last three annual Balance Sheets, calculating their Long-Term Debt to Equity ratios. Have they increased?

Web Challenge #3 Companies that sell software or a service are often more profitable than companies that sell actual goods.  Challenge: Calculate the Net Profit Margin (Net Profit / Sales) of Hewlett Packard, Apple, Microsoft and Google using their last full year Income Statements. Explain the results.