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Chapter 7
Analyzing
Common
Stocks
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
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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7-2
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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7-3
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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7-5
“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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7-6
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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7-7
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.
Economy
Company Profits
Stock Prices
C
C
C
D
D
D
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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/
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
D
C
C
D
D
C
C
D
Decrease
Corporate Profits
Increase
Decrease
Unemployment
Increase
Decrease
Federal Budget
Surplus
Deficit
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Other Key Economic
Variables (cont’d)
Economic Variable
Change
Stock Market Effect
U.S. Dollar
Strong
Cinvestments / Dtrade
Dinvestments / Ctrade
Weak
Interest Rates
Increasing
Decreasing
Money Supply
Moderate Growth
Rapid Growth
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D
C
C
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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Table 7.3 Corporate Balance
Sheet
For brief descriptions of each of the
account entries in the table, go to
My Finance Lab at
www.aw-bc.com/gitman_joehnk
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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
– 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?)
– Trends (improving vs. decreasing)
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Table 7.4 Corporate Income
Statement
For brief descriptions of
each of the account entries
in the table, go to
My Finance Lab at
www.aw-bc.com/gitman_joehnk
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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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Table 7.5 Statement of Cash Flows
For brief descriptions of
each of the account entries
in the table above,
go to My Finance Lab at
www.aw-bc.com/gitman_joehnk
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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
Current assets
Current ratio 
Current liabilities
• Higher ratio: better
• Lower ratio: worse
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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
Net working capital  Current assets  Current liabilities
• Higher amounts: better
• Lower amounts: worse
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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
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Activity Ratios (cont’d)
• Inventory Turnover: how quickly the company is
selling its inventory
Annual sales
Inventory turnover 
Inventory
• Higher ratio: better
• Lower ratio: worse
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Activity Ratios (cont'd)
• 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
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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
Long-term debt
Debt-equity ratio 
Stockholders’ equity
• Higher ratio: more risk
• Lower ratio: less risk
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Leverage Ratios (cont'd)
• 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
• Lower ratio: more risk
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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
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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
Net profit after taxes
ROA 
Total assets
• Higher ratio: better
• Lower ratio: worse
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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
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.
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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.
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
• Lower ratio: less expensive
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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?
$139,700,000
EPS 
or $2.26
61,815,000 shares
$41.50
Price/Earnings ratio 
or 18.4
$2.26
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7-46
Common Stock Ratios (cont'd)
• 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
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Common Stock Ratios (cont'd)
• 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
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7-48
Common Stock Ratios (cont'd)
• 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
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7-49
Common Stock Ratios (cont'd)
• 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.
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7-50
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
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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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Figure 7.2 Example
of Published Report
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7-53
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
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7-55
Chapter 7 Review
• 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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7-56
Chapter 7 Review (cont'd)
• 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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7-57
Chapter 7
Additional
Chapter Art
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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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7-61
Table 7.6 Comparative Historical
and Industry Ratios
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7-62
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)
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