1. Chapter 7
Analyzing Common Stocks

2. Analyzing Common Stocks
Learning Goals
Discuss the security analysis process, including goals and functions.
Appreciate the purpose and contributions of economic analysis.
Describe industry analysis and note how it is used.
Demonstrate a basic understanding of fundamental analysis and why it is used.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

3. Analyzing Common Stocks
Learning Goals (cont'd)
Calculate a variety of financial ratios and describe how financial statement analysis is used to gauge the financial vitality of a company.
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 © 2008 Pearson Addison-Wesley. All rights reserved.

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 © 2008 Pearson Addison-Wesley. All rights reserved.

5. What is 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 © 2008 Pearson Addison-Wesley. All rights reserved.

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 © 2008 Pearson Addison-Wesley. All rights reserved.

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 © 2008 Pearson Addison-Wesley. All rights reserved.

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 © 2008 Pearson Addison-Wesley. All rights reserved.

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 on both a global and domestic basis.
Economy Company Profits Stock Prices
C C C
D D D
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

10. 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

11. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

12. 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/ Inflation Producer Prices
Employment Business Production
Housing Starts Availability & cost of money
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

13. Other Key Economic Variables
Economic Variable Change Stock Market Effect
Inflation Increase D
Decrease C
Corporate Profits Increase C
Decrease D
Unemployment Increase D
Federal Budget Surplus C
Deficit D
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

14. Other Key Economic Variables (cont’d)
Economic Variable Change Stock Market Effect
U.S. Dollar Strong Cinvestments / Dtrade
Weak Dinvestments / Ctrade
Interest Rates Increasing D
Decreasing C
Money Supply Moderate Growth C
Rapid Growth D
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

15. Sources for Economic Outlook
Wall Street Journal
Barron’s
Fortune, Business Week, Forbes
Government Publications
Brokerage firm/commercial bank reports
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

16. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

17. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

18. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

19. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

20. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

21. Sources for Industry Outlook
Trade publications
Wall Street Journal
Fortune, Business Week, Forbes
Standard & Poor’s Industry Surveys
Brokerage house reports
Yahoo! Finance.com
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

22. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

23. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

24. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

25. Table 7.3 Corporate Balance Sheet
For brief descriptions of each of the account entries in the table, go to My Finance Lab at
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

26. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

27. Table 7.4 Corporate Income Statement
For brief descriptions of each of the account entries in the table, go to My Finance Lab at
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

28. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

29. 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

30. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

31. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

32. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

33. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

34. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

35. Activity Ratios
Accounts Receivable Turnover: how quickly the company is collecting its accounts receivable (sales to customers on credit)
Higher ratio: better
Lower ratio: worse
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

36. Activity Ratios (cont’d)
Inventory Turnover: how quickly the company is selling its inventory
Higher ratio: better
Lower ratio: worse
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

37. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

38. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

39. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

40. Profitability Ratios
Net Profit Margin: amount of profit earned from sales and other operations
Higher ratio: better
Lower ratio: worse
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

41. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

42. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

43. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

44. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

45. 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

46. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

47. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

48. Common Stock Ratios (cont'd)
Dividends per share: the amount of dividends paid out to common stockholders
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

49. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

50. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

51. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

52. Interpreting Financial Ratios
Sources of Ratio Analysis
Standard & Poor’s Stock Reports
Brokerage firm reports
Value Line Reports
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

53. Figure 7.2 Example of Published Report
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

54. 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 © 2008 Pearson Addison-Wesley. All rights reserved.

55. 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

56. Chapter 7 Review Learning Goals
Discuss the security analysis process, including goals and functions.
Appreciate the purpose and contributions of economic analysis.
Describe industry analysis and note how it is used.
Demonstrate a basic understanding of fundamental analysis and why it is used.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

57. Chapter 7 Review (cont'd)
Learning Goals (cont’d)
Calculate a variety of financial ratios and describe how financial statement analysis is used to gauge the financial vitality of a company.
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 © 2008 Pearson Addison-Wesley. All rights reserved.

58. Chapter 7
Additional Chapter Art

59. Table 7.1 Keeping Track of the Economy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

60. Table 7.2 Economic Variables and the Stock Market
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

61. Figure 7.1 An Example of a Published Industry Report
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

62. Table 7.6 Comparative Historical and Industry Ratios
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

63. 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.