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Chapter 7
Analyzing Common Stocks
Analyzing Common Stocks
 Learning Goals
1. 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.
2
Analyzing Common Stocks
 Learning Goals
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.
3
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.”
4
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
7
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.
10
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/
Producer Prices
Inflation
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
Decrease
Corporate Profits
Increase
Decrease
Unemployment
Increase
Decrease
Federal Budget
Surplus
Deficit
Decline
Expand
E
D
D
E
E
D
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Other Key Economic
Variables
Economic Variable
Change
U.S. Dollar
Strong
Stock Market Effect
Weak
Interest Rates
Increasing
Decreasing
Money Supply
Moderate Growth
Rapid Growth
E
D
D
E
E
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
15
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
17
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
20
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
22
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
23
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)
24
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)
26
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
27
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
28
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.
29
Liquidity Ratios
 Current Ratio: how many dollars of short-term
assets are available for every dollar of short-term
liabilities owed
Current assets
Current ratio 
Current liabilities
 Higher ratio: better
 Lower ratio: worse
30
Liquidity Ratios
 Net Working Capital: how many dollars of working
capital are available to pay bills and grow the
business
Net working capital  Current assets  Current liabilities
 Higher amounts: better
 Lower amounts: worse
31
Activity Ratios
 Accounts Receivable Turnover: how quickly the
company is collecting its accounts receivable (sales to
customers on credit)
Annual sales
Accounts receivable turnover 
Accounts receivable
 Higher ratio: better
 Lower ratio: worse
32
Activity Ratios
 Inventory Turnover: how quickly the company is
selling its inventory
Annual sales
Inventory turnover 
Inventory
 Higher ratio: better
 Lower ratio: worse
33
Activity Ratios
 Total Asset Turnover: how efficiently the company is
using its assets to support sales
Annual sales
Total asset turnover 
Total assets
 Higher ratio: better
 Lower ratio: worse
34
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
Long-term debt
Debt-equity ratio 
Stockholders’ equity
 Higher ratio: more risk (Worse)
 Lower ratio: less risk (Better)
35
Leverage Ratios
 Time Interest Earned: measures the ability
of the firm to meet its fixed interest payments
Earnings before interest and taxes
Times interest earned 
Interest expense
 Higher ratio: less risk (Better)
 Lower ratio: more risk (Worse)
36
Profitability Ratios
 Net Profit Margin: amount of profit earned from
sales and other operations
Net profit after taxes
Net profit margin 
Total revenues
 Higher ratio: better
 Lower ratio: worse
37
Profitability Ratios
 Return on Assets: amount of profit earned on each
dollar invested in assets; measures management’s
efficiency at using assets
Net profit after taxes
ROA 
Total assets
 Higher ratio: better
 Lower ratio: worse
38
Profitability Ratios
 Return on Equity: amount of profit earned
on each dollar invested by stockholders;
measures management’s efficiency at using
stockholders’ funds
Net profit after taxes
ROE 
Stockholders’ equity
 Higher ratio: better
 Lower ratio: worse
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Breaking Down
Return on Assets (ROA)
 Breaking down ROA allows investors to identify the
components that are driving company profits.
ROA  Net profit margin  Total asset turnover
 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.
40
Breaking Down
Return on Equity
 Breaking down ROE allows investors to identify the impact of
financial leverage on company return.
ROE  ROA  Equity multiplier
Equity multiplier 
Total assets
Total stockholders’ equity
 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.
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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
P/E 
Market price of common stock
EPS
Net profit after taxes  Preferred dividends
EPS 
Number of common shares outstanding
 Higher ratio: more expensive (better)
 Lower ratio: less expensive
(worse)
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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?
$139,700,000
EPS 
or $2.26
61,815,000 shares
$41.50
Price/Earnings ratio 
or 18.4
$2.26
43
Common Stock Ratios
 Price/Earnings Growth Ratio (PEG): compares
company’s P/E ratio to the rate of growth in earnings
Stock’s P/E ratio
PEG ratio=
3- to 5-year growth rate in earnings
 Ratio > 1: stock may be fully valued
 PEG = 1: stock price in line with earnings growth
 Ratio < 1: stock may be undervalued
44
Common Stock Ratios
 Dividends per share: the amount of dividends paid out to
common stockholders
Annual dividends paid to common stock
Dividends per share 
Number of common shares outstanding
45
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
Dividends per share
Payout ratio 
Earnings per share
46
Common Stock Ratios
 Book Value per Share: difference between assets
and liabilities (equity) per share
Common stockholders’ equity
Book value per share 
Number of common shares outstanding
 A company should be worth more than its
book value.
47
Common Stock Ratios (cont'd)
 Price-to-Book Ratio: compares stock price to book value to
see how aggressively the stock is being priced
Market price of common stock
Price-to-book-value 
Book value per share
 Higher ratio: stock is fully-priced or overpriced
 Lower ratio: stock may be fairly priced or underpriced
48
Interpreting Financial Ratios
 Sources of Ratio Analysis

Standard & Poor’s Stock Reports

Brokerage firm reports

Value Line Reports
49
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
50
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
51
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.
52
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.
53
The End !
54
Table 7.1 Keeping Track of the
Economy
55
Table 7.2 Economic Variables and the
Stock Market
56
Figure 7.1 An Example of a
Published Industry Report
57
Table 7.6 Comparative Historical and
Industry Ratios
58
Table 7.7 Comparative Financial Statistics: Universal Office
Furnishings and Its Major Competitors (All figures are for yearend 2007 or for the 5-year period ending in 2007; $ in millions)
59