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CHAPTER FOURTEEN

FINANCIAL ANALYSIS OF COMMON STOCKS

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FINANCIAL ANALYSIS

• WHAT IS FINANCIAL ANALYSIS?– DEFINITION: the activity of providing inputs

to the portfolio management process

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FINANCIAL ANALYSIS

• PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS– THE ASSOCIATION OF INVESTMENT

MANAGEMENT AND RESEARCH (AIMR)• acts as an advocate for the financial analyst

profession• it hosts conferencing and workshops

– designed to enhance the knowledge base of the memberships

• it also publishes the Financial Analysts Journal

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FINANCIAL ANALYSIS

• PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS– THE ASSOCIATION OF INVESTMENT

MANAGEMENT AND RESEARCH (AIMR)• acts as an advocate for the financial analyst

profession• it host conferencing and workshops

– designed to enhance the knowledge base of the memberships

• it also publishes the Financial Analysts Journal

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FINANCIAL ANALYSIS

• REASONS FOR FINANCIAL ANALYSIS– TWO PRIMARY REASONS

• to determine certain securities’ characteristics

• to attempt to identify mispriced securities

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FINANCIAL ANALYSIS

• REASON #1: DETERMNING SECURITY CHARACTERISTICS– estimate future sensitivity to major factors– estimate dividend yield

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FINANCIAL ANALYSIS

• REASON #2: ATTEMPTING TO IDENTIFY MISPRICED SECURITIES– use fundamental analysis– approaches

• valuation determines the intrinsic value compared to the current market value

• estimate key financial variables such as– EPS next year

– income growth next year

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TECHNICAL ANAYSIS

• DEFINITION: a form of security analysis that attempts to forecast price changes based on historical price and volume trends

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TECHNICAL ANAYSIS

• Two Groups of Strategies Used:1. Momentum and Contrarian Strategies

2. Moving Average and Trading Range Breakout

Strategies

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TECHNICAL ANAYSIS

1. Momentum and Contrarian Strategies– METHDOLOGY:

• examine the returns over a time period just ended to identify

– momentum investors who seek out stocks recently rising in price for purchase; falling for sale

– contrarians who follow the opposite strategy of most investors

» contrarians base their strategy on the overreation theory

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TECHNICAL ANAYSIS

2. Moving Average and Trading Range Breakout Strategies– MOVING AVERAGE STRATEGY:

• calculate a moving average over the last 200 days of closing prices

• divdied today’s closing price into the moving average (SHORT-TO-LONG RATIO)

• if short-to-long ratio is greater than 1, buy

• if ratio is less than 1, sell

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TECHNICAL ANAYSIS

• 2. Moving Average and Trading Range Breakout Strategies– TRADING RANGE BREAKOUT

STRATEGY:• high and low prices for past 200 trading days are

identified

• if today’s close is greater than the high = buy!

• if today’s close is less than the low = sell!

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FUNDAMENTAL ANALYSIS

• TOP-DOWN V. BOTTOM UP– TOP-DOWN APPROACH

• attempts to forecast in the following order

1. economic activity

2. industry performance

3. firm’s performance

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FUNDAMENTAL ANALYSIS

• TOP-DOWN V. BOTTOM UP– BOTTOM-UP APPROACH:

• attempts to estimate prospects in the following order:

1. The firm

2. The Industry

3. The economy

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FUNDAMENTAL ANALYSIS

• FINANCIAL STATMENT ANALYSIS– INTEGRAL PART OF FUNDAMENTAL

ANALYSIS• it helps the analyst understand a firm’s current

condition

• where it is headed

• what factors affect it

• how the factors affect it

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FUNDAMENTAL ANALYSIS

• FINANCIAL STATMENT ANALYSIS– Review of Accounting Statements

• includes a study of the three major statements prepared monthly by most accountants:

– the balance sheet

– the income statement

– the statment of cash flows

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FUNDAMENTAL ANALYSIS

• FINANCIAL STATMENT ANALYSIS– RATIO ANALYSIS

• DEFINITION: a technique used to examine a company’s financial statements

• Use of Ratios– as an absolute standard

– as a comparative indicator

– as a trend over time

– in combination with technical analysis

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FUNDAMENTAL ANALYSIS

• FINANCIAL STATMENT ANALYSIS– RATIO ANALYSIS

• Types of Ratios– internal liquidity

– operating performance

– risk analysis

– growth analysis

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FUNDAMENTAL ANALYSIS

• internal liquidity ratios:– indicate the ability of the firm to meet future

short-term financial obligations– some liquidity ratios:

• current ratio

• quick ratio

• cash ratio

• receivables turnover

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FUNDAMENTAL ANALYSIS

• operating performance ratios:– indicate how well the management is operating

the business– some examples:

• total asset turnover

• net fixed asset turnover

• equity turnover

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FUNDAMENTAL ANALYSIS

• risk analysis ratios:– indicates the uncertainty of income flows for

the total firm and for the individual sources of capital (debt and stock)

– some examples:• debt to equity ratio

• long-term debt/total capital ratio

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FUNDAMENTAL ANALYSIS

• growth analysis ratios:– indicate how fast a firm should grow– it involves analysis using several other ratios

• net profit margin

• total asset turnover

• total assets/equity