Analyzing Common Stocks

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Analyzing Common Stocks

Learning Goals1. 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.

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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.

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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.”

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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

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“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

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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

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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

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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

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Key Economic Factors thatAffect 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

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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/ InflationProducer Prices

Employment Business Production

Housing Starts Availability & cost of money

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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?

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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

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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.

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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)?

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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

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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

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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

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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)

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Table 7.3 Corporate Balance Sheet

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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)

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Table 7.4 Corporate Income Statement

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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)

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Table 7.5 Statement of Cash Flows

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Sources for Financial Statements

Company’s Annual Report

Company’s 10K

Company’s 10Q

Securities & Exchange Commission www.sec.gov

Standard & Poor’s or Moody Reports

Internet financial portals

Brokerage firm reports

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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

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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

Current ratio Current assets

Current liabilities

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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

Net working capital Current assets Current liabilities

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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

Accounts receivable turnover Annual sales

Accounts receivable

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Activity Ratios (cont’d)

Inventory Turnover: how quickly the company is selling its inventory

Higher ratio: better Lower ratio: worse

Inventory turnover Annual sales

Inventory

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Activity Ratios (cont'd)

Total Asset Turnover: how efficiently the company is using its assets to support sales

Higher ratio: better Lower ratio: worse

Total asset turnover Annual sales

Total assets

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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

Debt-equity ratio Long-term debt

Stockholders’ equity

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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

Times interest earned Earnings before interest and taxes

Interest expense

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Profitability Ratios

Net Profit Margin: amount of profit earned from sales and other operations

Higher ratio: better Lower ratio: worse

Net profit margin Net profit after taxes

Total revenues

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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

ROA Net profit after taxes

Total assets

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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

ROE Net profit after taxes

Stockholders’ equity

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Breaking DownReturn 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.

ROA Net profit margin Total asset turnover

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Breaking DownReturn 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.

ROE ROA Equity multiplier

Equity multiplier Total assets

Total stockholders’ equity

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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

P/E Market price of common stock

EPS

EPS Net profit after taxes Preferred dividends

Number of common shares outstanding

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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?

EPS $139,700,000

61,815,000 shares or $2.26

Price/Earnings ratio $41.50

$2.26 or 18.4

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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

PEG ratio=Stock’s P/E ratio

3- to 5-year growth rate in earnings

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Common Stock Ratios (cont'd)

Dividends per share: the amount of dividends paid out to common stockholders

Dividends per share Annual dividends paid to common stock

Number of common shares outstanding

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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

Payout ratio Dividends per share

Earnings per share

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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.

Book value per share Common stockholders’ equity

Number of common shares outstanding

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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

Price-to-book-value Market price of common stock

Book value per share

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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

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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