chapter 7 analyzing common stocks. 2 learning goals 1. discuss the security analysis process. 2....
TRANSCRIPT
Chapter 7
Analyzing Common Stocks
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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.
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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.
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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.”
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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)
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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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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.
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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.
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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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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
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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
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Sources for Economic Outlook
Wall Street Journal
Barron’s
Fortune, Business Week, Forbes
Government Publications
Brokerage firm/commercial bank reports
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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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Sources for Industry Outlook
Trade publications
Wall Street Journal
Fortune, Business Week, Forbes
Standard & Poor’s Industry Surveys
Brokerage house reports
Yahoo! Finance.com
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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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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)
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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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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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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
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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
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
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
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 (Worse) Lower ratio: less risk (Better)
Debt-equity ratio Long-term debt
Stockholders’ equity
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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
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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
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
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 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
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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
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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
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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
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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
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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
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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
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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
Sources of Ratio Analysis
Standard & Poor’s Stock Reports
Brokerage firm reports
Value Line Reports
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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
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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
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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.
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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.
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The End !
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Table 7.1 Keeping Track of the Economy
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Table 7.2 Economic Variables and the Stock Market
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Figure 7.1 An Example of a Published Industry Report
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Table 7.6 Comparative Historical and Industry Ratios
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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)