Analyzing Common Stock

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Analyzing Common Stocks
 Learning Goals
1. 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 that
Affect 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/ Inflation
Producer 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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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?)

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Table 7.4 Corporate Income Statement

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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

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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)
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
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
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
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
ROA =
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
ROE =
Stockholders’ equity

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Breaking Down
Return 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 Down
Return 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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 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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 Dividends per share: the amount of dividends paid out to
common stockholders
Dividends per share =
Annual dividends paid to common stock

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 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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 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

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 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

Analyzing Common Stock

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