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Chapter 7
Fundamental Analysis
Fundamental Analysis vs.
Technical Analysis
• Fundamental => Based on economic factors
– Micro & Macro
• Technical => Based on mechanical
processes
– Charting most common
Three Steps of Top-Down
Fundamental Analysis
• Macroeconomic analysis: evaluates current
economic environment and its effect on industry
and company fundamentals
• Industry analysis: evaluates outlook for particular
industries
• Company analysis: evaluates company’s strengths
and weaknesses within industry
Business Cycles
• Four phases
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Expansion
Peak
Contraction
Trough
Economic Indicators
• Leading Indicators
– Multiple false signals
• Coincident
• Lagging
Leading Indicators
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Average weekly hours, manufacturing
Average weekly initial claims for unemployment insurance
Manufacturers’ new orders, (inflation adjusted)
Vendor performance, slower deliveries diffusion index
Manufacturers’ new orders, nondefense capital goods
Building permits, new private housing units
Stock prices, S&P 500 Index
Real money supply, M2
Interest rate spread, 10-year Treasury bonds less fed funds
Index of consumer expectations, Univ. of Michigan Survey
Research Center
Coincident Indicators
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Employees on nonagricultural payrolls
Personal income less transfer payments
Industrial production
Manufacturing and trade sales
Lagging Indicators
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Average duration of unemployment
Inventories to sales ratio, mfg. and trade
Labor cost per unit of output, mfg.
Average prime rate
Commercial and industrial loans
Consumer installment credit to personal
income ratio
• Consumer price index for services
Gross Domestic Product (GDP)
• Sum of market values of all final goods and
services produced annually in economy of a
country
Three Tools of Fiscal Policy
• Adjustment of government’s revenues and
expenditures to control economy
• Changes in tax code
• Management of maturity of government’s
outstanding debt
– referred to as debt management policy
How Fiscal Policy Operates through
Government Spending and Taxes
• Increased government spending or decreased
tax collections stimulate economy through
extra spending by consumers
• Decreased government spending or increased
tax collections restrain the economy through
reduced spending by consumers
Leakages
• Money absorbed by savings, import
purchases, or taxes during each round of
stimulatory spending or tax reduction
• Reduces the impact of fiscal policy
Federal Reserve Board (Fed)
• Governing body of Federal Reserve System
• Composed of seven members appointed by
President for long and staggered terms
Monetary Policy
• Government policy that utilizes money
supply to affect the economy
• Implemented by Fed through control of
required reserves and open market
operations
Fed’s Principal Policy Tools
• Reserve requirement: Increasing (decreasing)
required percentage reduces (raises) amount of
money supported by given reserve base.
• Open market operations: Fed purchases (sales) of
government securities increase (decrease) bank
deposits available to support money supply.
• Discount loans: Increasing (decreasing) discount
rate makes banks less (more) willing to borrow
funds from Fed to lend to customers
Money Supply
• M1: Sum of all coin, currency (outside bank
holdings), and deposits on which check-like
instruments may be written
– Most common definition.
• M2: M1 plus savings and small time
deposits, repurchase agreements, and
money market deposit accounts
Reserve Requirement
• Percentage of reserves Fed requires each
bank to have on deposit for each increment
of demand or time deposits
Open Market Operations
• Federal Reserve transactions (buying and
selling) in government bond market
intended to influence money supply, interest
rates, and economic activity
Discount Rate vs. Fed Funds Rate
Discount rate
interest rate charged by Federal Reserve System on loans
to member banks
Federal funds rate
interest rate charged between banks in federal funds
market
Banks will gravitate toward whichever is cheaper,
although don’t like scrutiny of the Fed that comes
with its loans
Reserve Requirements
• Required reserves
• Actual reserves
• Excess reserves = Actual – Required
• Increases in reserve requirements may cause
undue harm to banking industry
Economic Effect of
Deposits and Loans
• Increase in deposits and loans:
– Stimulates spending and income
– Can increase inflation
• Decrease in deposits and loans:
– Restrains spending and income
– Can reduce inflation
Greater Stimulation
• More likely if…
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Unemployment is far above target
Inflation rate is near its target
Unemployment is increasing
Inflation decreasing
Dollar strong
Trade deficit large
Substantial amounts of capital flowing into U.S.
Greater Restrictiveness
• More likely if…
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Unemployment near target
Inflation rate far above target
Unemployment is decreasing
Inflation is increasing
Dollar weak
Trade deficit small or trade surplus
Foreign capital threatening to withdraw from or slow
flow into the U.S.
How MP’s Impact on Interest Rates
Affects the Stock Market
• Interest rates affect rate at which stocks’ expected
future income streams are discounted.
• As bonds’ yields to maturity change, some
investors may switch from stocks to bonds when
rates rise and from bonds to stocks when rates fall.
• Interest rates affect borrowing costs for margin
investors.
Goals of Monetary & Fiscal Policy
• Price Stability
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Inflation
Disinflation
Deflation
Stagflation
• Full Employment
Price Stability
• Absence or low level of inflation or
deflation
– Prices of specific goods would still fluctuate in
response to market forces (supply and demand
changes), but overall level of prices stable
Full Employment
• Unemployment rate thought to be minimum
level before inflationary pressures
accelerate
• Economists generally consider optimal
because a certain percentage of workforce is
likely to be looking for better jobs at any
point in time
• Opinions on level have varied over time
from about 4 percent to 6 percent.
Unemployment Rate
• Percentage of workforce actually out of
work and actively seeking employment
Life Cycle of an Industry
• Start-up stage: many new firms; grows rapidly
(example: genetic engineering)
• Consolidation stage: shakeout period; growth
slows (example: video games)
• Maturity stage: grows with economy (example:
automobile industry)
• Decline stage: grows slower than economy
(example: railroads)
Cyclical Industry
• Industry in which sales tend to move with the
business cycle
• Consumer durables are a classic example
Non-Cyclical Industry
• Industry that involves a product people purchase
regardless of the level of economic activity
• Food is a classic example
Company Analysis
• Competitive Position
• Management Quality
• Financial Soundness
– Financial Ratios
• Balance sheet: a financial statement showing a firm’s or
individual’s financial position that lists assets, liabilities,
and net worth (equity) as of a particular point in time
• Income statement: a financial statement of earnings that
provides a financial accounting of revenues and expenses
during a specified period—for example, one quarter or one
year
• Statement of changes in financial position: financial
statement showing cash flows into and out of a firm during
the reporting period — formerly known as sources and
uses of funds statement
• Pro forma: a hypothetical accounting statement that
projects what that statement is expected to look like at
some point in the future
Basic Balance Sheet
Assets
Liabilities and Net Worth
Current Assets
Cash
Inventories
Accounts receivable
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Long-Term Assets
Plant
Equipment
Land
Market value of patents and
royalties
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Other Assets
Total Assets
Current Liabilities
Accounts Payable
Short-term notes
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Long-Term Liabilities
Corporate debt
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Net Worth
Stockholders’ equity
=
Total Liabilities and Net Worth
Income Statement
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Net Sales
- Cost of Goods Sold
= Gross Profit (or income)
- Cash & Depreciation (noncash) expenses
= Earnings Before Interest & Taxes (EBIT)
- Interest & Taxes
= Net Profit (or income)
Ratio Analysis
Balance sheet and income statement
analysis that utilizes ratios of financial
aggregates to assess a company’s
financial position, usually by looking
for trends in financial ratios, by
comparing a company’s financial ratios
with the industry average, or both
Liquidity Ratios (1 of 2)
• Ratios that measure a firm’s ability to
meet short-term obligations. They shed
light on the question of whether or not
the firm will be able to meet its cash
obligations over the period of the next
few months or so.
Liquidity Ratios (2 of 2)
• Current: current assets/current liabilities
• Quick (or acid test): (current assets –
inventories)/current liabilities
• Inventory turnover: cost of goods
sold/average yearly inventory
• Average collection period: net accounts
receivable/daily sales
Debt Ratios (1 of 2)
• Ratios that examine the extent to which the
firm uses debt to finance its assets, and the
impact of that debt financing on its
profitability.
Debt Ratios (2 of 2)
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Debt-equity: total debt/shareholders’ equity
Debt-asset: total debt/total assets
Equity Multiplier: Total assets/Total equity
Times-interest-earned: profit before interest
payments and tax/interest payments
Profitability Ratios (1 of 2)
• Ratios that look at the profitability or
success of the firm, relative to different
measures of resources.
Profitability Ratios (2 of 2)
• Return on equity (ROE): Net
income/equity
• Return on assets (ROA): Net
income/total assets
• Net profit margin (NPM): Net
income/total revenues
Efficiency Ratios
• Ratios that examine the ability of various
resources to support or generate sales.
• Total Asset turnover: Net Sales/Total assets
• Fixed Asset Turnover: Net Sales / Net Fixed
Assets
– May say more about age of assets than efficiency
Dupont Analysis
(Also called Decomposition Analysis)
Looks at components of ROE
• Simple form
– ROE = ROA x Equity multiplier
• More elaborate form
– ROA = NPM x Asset turnover
– ROE = NPM x Asset turnover x Equity
multiplier
Other Ratios
• Earnings per share (EPS): (Net income after taxes –
preferred dividends)/ number of shares
• Price-earnings (P/E): Price per share/expected EPS
• Dividend yield: Indicated annual dividend/price per
share
• Dividend payout: Dividends per share/EPS
• Cash flow per share: (After-tax profits + depreciation
and other noncash expenses)/number of shares
• Book value per share: Net worth attributable to
common shareholders/number of shares
Fundamental Analysis vs.
Market Efficiency
• Fundamental analysis critical when dealing
with private companies
• Necessary condition for market efficiency
of publicly traded companies (although
worthless at the margin)
• Earnings surprises major component of
performance