1. Practical Investment Management A 1 3 FUNDAMENTAL STOCK ANALYSIS

3. Valuation Philosophies  Fundamental analysts believe securities are priced according to fundamental economic data.  Technical analysts think investor behavior and supply and demand factors play the most important role.

5. Valuation Philosophies  Investors’ understanding of risk premiums: Investors are almost always risk-averse.  The time value of money: Everyone agrees on this basic principle.  The importance of cash flows: Most investment research deals with predicting future corporate earnings.  The tax factor: The tax code is complicated and not all investments are taxed equally.

6. Valuation Philosophies  Economy, Industry and Company (EIC) analysis:  The analyst first considers conditions in the overall economy (market risk), then determines which industries are the most attractive in light of the economic conditions, and finally identifies the most attractive companies within the attractive industries.

7. Valuation Philosophies Insert Figure 7-1 here.

8. Value vs. Growth Investing  A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase. The Value Approach to Investing

9. Regression to the Mean Most of the time a security’s long- term return is consistent with its risk. Over the long run, a security cannot survive with a cumulative return that is negative. Cumulative Return Time in the Long Term 0 + - x x x x x x x x x x x x x x x Undervalued stock: Buy Overvalued stock: Sell

10. Value vs. Growth Investing  Growth investors seek steadily growing companies. There are two factions: True growth investors are more willing to wait, but they share the belief that good investment managers can earn above- average returns for their clients. The Growth Approach to Investing

11. The Price-to-Book Ratio  Book value per share is an accounting concept synonymous with equity per share or net asset value.  Share price is not normally equal to book value because of  depreciation, uncollectible debts, goodwill, etc.  economic obsolescence  intangible assets

12. The Price-earnings ratio and Price-to-Book Ratio  The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.  The price-to-book, or P/B ratio, is calculated by dividing a company's stock price by its book value per share, which is defined as its total assets minus any liabilities

13. The Price-earnings ratio and Price-to-Book Ratio P/E RATIO P/B RATIO

14. Some Analytical Factors  A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.

15. Some Analytical Factors  Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.

16. Some Analytical Factors: Ratio Analysis  The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions.  To assist in the analysis, several organizations publish comparative statistics for industry groups. e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.

17. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Solvency Ratios 1.Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities Measures ability to raise cash quickly, ignores inventory 2.Current Ratio = Current Assets/Current Liabilities General measure of liquidity 3.Current Liabilities to Net Worth = Current Liabilities/Net Worth Compares short-term liabilities to permanent invested capital 4.Current Liabilities to Inventory = Current Liabilities/Inventory Measures extent to which payment of current debts relies on sale of inventory 5.Total Liabilities to Net Worth = Total Liabilities/Net Worth Measures firm’s reliance on debt financing 6.Fixed Assets to Net Worth = Fixed Assets/Net Worth Measures proportion of firm’s equity tied up in long-term assets

18. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Efficiency Ratios 7.Collection Period = Accounts Receivable/Credit Sales per Day Measures firm’s efficiency in turning credit sales into cash 8.Sales to Inventory = Annual Net Sales/Inventory Measures speed that inventory moves from shelf to customer 9.Assets to Sales = Total Assets/Net Sales Measures efficiency with which assets are used to produce sales 10.Sales to Net Working Capital = Sales/Net Working Capital Measures aggressiveness or conservatism in financing sales 11.Accounts Payable to Sales = Accounts Payable/Annual Net Sales Measures how rapidly company pays its suppliers

19. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Profitability Ratios 12.Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales Measures profit per dollar of net sales 13.Return on Assets = Net Profit after Taxes/Total Assets Measures company’s efficiency in using assets to produce operating profit 14.Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth Measures return to the suppliers of equity capital

20. Some Analytical Factors: Cooking the Books  All publicly traded firms must have their financial statements audited to ensure they fairly present the company’s financial position.  Still, every year, there is at least one story of accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.