Check the Vital Signs

Why Invest?

• Possibility of high returns

• Learn about companies and the people and products behind them

Share on companies and products you already know – Who owns what, who produces what?

Methods for Valuing Stock

• Market Value– Worth what people are willing to pay– Doesn’t capture underlying value of company’s

future• Book Value (stockholders’ equity)– What company is worth (accounting)– Ignores intangible assets– Value of hard assets are distorted– Incomplete picture

Fundamental Analysis

• Search for intrinsic value– How does the company

make money– What products does it sell– What is its position in the

industry– What are their

management practices– Sales Trends– Earnings trends

Fundamental Analysis

• Qualitative measures:– How does the company make money– Product Mix– Level of competition– Management – Strategy– Strength of brand

How do they Make Money?

• Sherwin-Williams• Exxon• Coca-Cola• Hilton• Amazon.com• (How is the company’s business model)

Exemplars

• Name companies that exemplify each of these qualitative measures– Strong product mix– Intense industry competition– Exceptional management– Effective strategy– Strong brand

Quantitative Measures

• Number comparisons and ratios that can be used to determine financial health

• After what you’ve learned about financial statements what might be some useful qualitative measures?– Earnings– Sales– P/E ratios– Current Ratio

• Past performance is not necessarily and indicator of the future.

Estimate of Value

• Last step in fundamental analysis• Compare to current stock price– Overvalued stocks are too expensive– Undervalued stocks are “on sale.”

• Many valid approaches– Some look at a few, widely accepted ratios– Some are more systematic and thorough– All recommend a good look at a company’s financial

statements.

Measures are relative

• No single measure stands out as the only measure to watch

• Everything needs to be put in context• Meaning comes when used:– As part of overall picture of the company– Over time– In comparison to other companies in the same

industry.

Know the Company (Qualitative)

• What does the company do?

• How and where does it make its money?

• What is special about it?

Company Basics

• What does the company do? What is its business model?

• What is its product or service? Is there long-lasting appeal? Are there new products or services being developed?

• Where does the company do business? National, international or global?

• Who are its customers? Are they part of a specific demographic?

Company Basics

• Who’s running the company? Are they effective managers?

• How big is it? What are its annual sales, number of outstanding shares, capitalization, and number of stores or buyers?

• Is there a strategy for growth and for dealing with competition?

• What is special about the company? The brand, a product, a patent, a certain way of doing business?

Company Basics

• Who’s running the company? Are they effective managers?

• How big is it? What are its annual sales, number of outstanding shares, capitalization, and number of stores or buyers?

• Is there a strategy for growth and for dealing with competition?

• What is special about the company? The brand, a product, a patent, a certain way of doing business?

Competition

• Sector and Industry– Unique characteristics that affect the profit potential

of companies in it– A sector is a subset of the economy in which

companies share related products and services– Broader than industries and include things like

energy, healthcare and consumer goods.– Industry is all business within afof work, utilities,

hospitals, and retail apparel.

Competition

• Affects profit potential• Intense competition affects strategic issues like:– Pricing decisions– Availability of suppliers and raw materials– Opportunities for growth

• Level of competition not tied to number of companies (soft drinks, few players, fierce competition).

Competition

• Barriers to entry– Low barriers may lead to intense competition– High barriers means that a steady stream of new

competitors is unlikely

Quantitative Measures

Quantitative measures are especially valuable in making comparisons.• Ratios

– Show the relationship between numbers on a company’s financial statements

– Provide insight into how a company operates• Use reputable secondary sources when comparing companies

– Standard and Poor’s or Value Line– Often available free through public libraries– Time-savers that consolidate current and historical financial

information into– easy-to-read, standardized formats

Quantitative Measures

• Sales– Healthy sales drive business, yet are an incomplete picture of

company performance.– Companies with similar sales are likely to vary in profitability,

depending on the following factors:• Cost of goods sold• Efficiency of operations• Mergers and acquisitions• Plans for new products, etc.

– Amount of sales is not as important as sales growth.– Investors want to see a steady pattern of growth.– View sales as a first, general indicator that is part of a larger

picture.

Quantitative Measures

Earnings per share (EPS)• Earnings are profits.• Reveals how much profit goes to each share of common stock• Calculated by dividing net earnings by the number of shares

outstanding• Increasing EPS means company is well run.• Example: McDonald’s Corp. (NYSE: MCD)

– EPS = net earnings / # of outstanding shares of common stock– 2004 net earnings = $2,279,000,000– 2004 # of outstanding shares of common stock = 1,270,000,000 shares– $2,279,000,000 / 1,270,000,000 = 1.79– In 2004, McDonald’s earned $1.79 for each share of outstanding

common stock.

Quantitative Measures

Various ways of calculating EPS• Usually a trailing indicator based on past

earnings• Sometimes a forward indicator based on

projected earnings• Sometimes a combination of trailing and forward• Compare “apples with apples” when you use EPS

to compare companies.

Quantitative Measures

Profitability• Expressed as the percentage of sales retained as

profit• From the income statement, various levels of income

are divided by sales.– Gross profit margin—percentage of sales left after

subtracting the direct cost of producing the goods– Net profit margin or so-called “bottom line”—percentage

of sales left after subtracting all expenses• 3. Measures how well managers extract a profit from

each dollar of sales

Quantitative Measures

Profitability• Example: McDonald’s Corp. (NYSE: MCD)– Net profit margin = net income / sales– 2004 total sales = $19.065 billion (billion!)– 2004 net income = $2.279 billion– 2.279 / 19.065 = 12%– Put another way, McDonald’s had a net income of

12¢ of every dollar in sales.