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Chapter 7 Analyzing Common Stocks

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Page 1: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

Chapter 7

Analyzing Common Stocks

Page 2: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

2

Analyzing Common Stocks

Learning Goals1. Discuss the security analysis process.

2. Appreciate the purpose and contributions of economic analysis.

3. Describe industry analysis.

4. Demonstrate a basic understanding of fundamental analysis and why it is used.

Page 3: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

3

Analyzing Common Stocks

Learning Goals5. 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.

Page 4: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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What is Security Analysis?

“The process of gathering and organizing information and then using it to calculate the intrinsic value of a share of common stock.”

Page 5: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 (r)

Page 6: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 7: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 8: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 9: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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.

Page 10: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 & Economy go to the same direction

Industrial Production: measure of the activity/output in the industrial or productive segment of the economy Generally, production goes to the same direction as

Economy.

Page 11: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 12: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 13: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Other Key Economic Variables

Economic Variable Change Stock Market Effect

Inflation Increase DeclineDecrease Expand

Corporate Profits Increase EDecrease D

Unemployment Increase DDecrease E

Federal Budget Surplus EDeficit D

Page 14: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Other Key Economic VariablesEconomic Variable Change Stock Market

Effect

U.S. Dollar Strong EWeak D

Interest Rates Increasing DDecreasing E

Money Supply Moderate Growth ERapid Growth D

Page 15: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Sources for Economic Outlook

Wall Street Journal

Barron’s

Fortune, Business Week, Forbes

Government Publications

Brokerage firm/commercial bank reports

Page 16: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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?

Page 17: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 18: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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.

Page 19: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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)?

Page 20: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 21: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Sources for Industry Outlook

Trade publications

Wall Street Journal

Fortune, Business Week, Forbes

Standard & Poor’s Industry Surveys

Brokerage house reports

Yahoo! Finance.com

Page 22: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 23: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 24: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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)

Page 25: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Net Income: 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)

Page 26: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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)

Page 27: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 28: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 29: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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.

Page 30: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 31: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Liquidity Ratios

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

Page 32: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 33: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Activity Ratios

Inventory Turnover: how quickly the company is selling its inventory

Higher ratio: better Lower ratio: worse

Inventory turnover Annual sales

Inventory

Page 34: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Activity Ratios

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

Page 35: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 (Worse) Lower ratio: less risk (Better)

Debt-equity ratio Long-term debt

Stockholders’ equity

Page 36: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Leverage Ratios

Time Interest Earned: measures the ability of the firm to meet its fixed interest payments

Higher ratio: less risk (Better) Lower ratio: more risk (Worse)

Times interest earned Earnings before interest and taxes

Interest expense

Page 37: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 38: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Profitability Ratios

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

Page 39: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Profitability Ratios

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

Page 40: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 41: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Breaking DownReturn on Equity

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

Page 42: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 (better) Lower ratio: less expensive (worse)

P/E Market price of common stock

EPS

EPS Net profit after taxes Preferred dividends

Number of common shares outstanding

Page 43: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Common Stock Ratios

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

Page 44: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Common Stock Ratios

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

Page 45: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Common Stock Ratios

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

Page 46: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Common Stock Ratios

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

Page 47: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Common Stock Ratios

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

Page 48: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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

Page 49: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Interpreting Financial Ratios

Sources of Ratio Analysis

Standard & Poor’s Stock Reports

Brokerage firm reports

Value Line Reports

Page 50: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 find 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

Page 51: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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 incomprehensible off-balance sheet accounts and extraordinary income entries

Page 52: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Review

1. Discussed the security analysis process.

2. Stated the purpose and contributions of economic analysis.

3. Described industry analysis and noted how it is used.

4. Demonstrated a basic understanding of fundamental analysis and why it is used.

Page 53: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Chapter 7 Review

5. Calculated a variety of financial ratios and described how financial statement analysis is used to gauge the financial vitality of a company.

6. Used various financial measures to assess a company’s performance, and explained how the insights derived form the basic input for the valuation process.

Page 54: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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The End !

Page 55: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Table 7.1 Keeping Track of the Economy

Page 56: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Table 7.2 Economic Variables and the Stock Market

Page 57: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Figure 7.1 An Example of a Published Industry Report

Page 58: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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Table 7.6 Comparative Historical and Industry Ratios

Page 59: Chapter 7 Analyzing Common Stocks. 2 Learning Goals 1. Discuss the security analysis process. 2. Appreciate the purpose and contributions of economic

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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)