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.
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.
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.”
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
“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
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
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
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
 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
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
How Do We Use
the Economic Outlook?
 Useit 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?
Important Point to Remember!
 Stockprices usually change before the actual
forecasted changes become apparent in the
economy
 Stockprice trends are another leading indicator
often used to help predict the direction of the
economy itself
Step 2: Industry Analysis
 Evaluate the competitive position of a
particular industry in relation to
other industries
 Looking for new opportunities &
growth potential
 Identifycompanies within the industry that
look promising
 Looking for strong market positions, pricing
leadership, economies of scale, etc.
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)?
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
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
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
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)
Table 7.3 Corporate Balance Sheet
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)
Table 7.4 Corporate Income Statement
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)
Table 7.5 Statement of Cash Flows
 Sources for Financial
Company’s Annual Report Statements
 Company’s 10K
 Company’s 10Q
 Securities & Exchange Commission
 www.sec.gov

 Standard & Poor’s or Moody Reports

 Internet financial portals
 Brokerage firm reports
 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
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
Liquidity Ratios (cont'd)
 NetWorking Capital: how many dollars of
working capital are available to pay bills and
grow the business
Net working capital  Current assets  Current liabilities

 Higheramounts: better
 Lower amounts: worse
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
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
Activity Ratios (cont'd)
 TotalAsset 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
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
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
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
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
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
 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

 Investorswant 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.
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

Total assets
Equity multiplier 
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.
Common Stock Ratios

 Price/EquityRatio: 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

Market price of common stock

P/E 
EPS
 Higher ratio: more expensive
Net
 Lower ratio: less profit after taxes  Preferred dividends
expensive
EPS 
Number of common shares outstanding
Common Stock Ratios (cont'd)
 Whatis 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
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=
 Ratio 3- to may
> 1: stock 5-year
be growth rate in earnings
fully valued
 PEG = 1: stock price in line with
earnings growth
 Ratio < 1: stock may be undervalued
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
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
 Common Stock Ratios (cont'd)
 Book Value per Share: difference between assets and
liabilities (equity) per share

Common stockholders’ equity

Book value per share 
 A company should beNumber of common
worth more shares outstanding
than its
book value.
 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
 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
 Tryto 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
 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