Analyzing Common Stock


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Analyzing Common Stock

  1. 1. Analyzing Common Stocks
  2. 2. 2Analyzing Common Stocks Learning Goals1. Discuss the security analysis process, includinggoals and functions.2. Appreciate the purpose and contributions ofeconomic analysis.3. Describe industry analysis and note how itis used.4. Demonstrate a basic understanding of fundamentalanalysis and why it is used.
  3. 3. 3Analyzing Common Stocks Learning Goals (contd)5. Calculate a variety of financial ratios and describehow financial statement analysis is used to gaugethe financial vitality ofa company.6. Use various financial measures to assess acompany’s performance, and explain how theinsights derived form the basic input for thevaluation process.
  4. 4. 4What is Security Analysis? “The process of gathering and organizinginformation and then using it to determine theintrinsic value of a share ofcommon stock.”
  5. 5. 5What is Intrinsic Value? Intrinsic Value The underlying or inherent value of a stock, as determinedthrough fundamental analysis A prudent investor will only buy a stock if its market pricedoes not exceed what the investor thinks the stock isworth. Intrinsic value depends upon several factors: Estimates of future cash flows Discount rate Amount of risk
  6. 6. 6“Top Down” Approach toTraditional 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
  7. 7. 7Efficient Market Hypothesis Efficient Market: the concept that the market is soefficient in processing new information thatsecurities trade very close to or at their correctvalues at all times Efficient market advocates believe: Securities are rarely substantially mispriced inthe marketplace No security analysis is capable of finding mispricedsecurities more frequently than using random chance
  8. 8. 8Who Needs Security Analysisin an Efficient Market? Fundamental analysis is stillimportant because: All of the people doing fundamental analysis isthe reason the market is efficient Financial markets may not be perfectly efficient Pricing errors are inevitable
  9. 9. 9Key Economic Measures Gross Domestic Product (GDP): market value ofall goods and services produced in a country over theperiod of a year Generally, GDP goes C, economy goes C Industrial Production: measure of theactivity/output in the industrial or productivesegment of the economy Generally, production goes C, economy goes C
  10. 10. 10Key Economic Factors thatAffect 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
  11. 11. 11Other Key Economic MeasuresEconomic Measure What It TracksIndex of Leading Indicators “Predicts” direction of GDPPersonal Income Consumer buying habitsRetail Sales Consumer attitudesMoney Supply Growth of economy & inflationConsumer Prices/ InflationProducer PricesEmployment Business ProductionHousing Starts Availability & cost of money
  12. 12. 12How Do We Usethe Economic Outlook? Use it to identify areas foradditional research What industries will benefit? What industries will be hurt? Use it to evaluate individual companies Will sales/profits go up or down?
  13. 13. 13Important Point to Remember! Stock prices usually change before the actualforecasted changes become apparent in theeconomy Stock price trends are another leadingindicator often used to help predict thedirection of the economy itself
  14. 14. 14Step 2: Industry Analysis Evaluate the competitive position of a particularindustry in relation toother industries Looking for new opportunities &growth potential Identify companies within the industry that lookpromising Looking for strong market positions, pricing leadership,economies of scale, etc.
  15. 15. 15Issues 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 theindustry (e.g., interest rates, foreign trade)? What are the important financial and operatingconsiderations (e.g., access to capital)?
  16. 16. 16Growth Cycle Stagesand Investments Growth Cycle reflects the vitality of an industry or acompany over time. Initial Development: industry is new and risks arevery high Rapid Expansion: product acceptance is growing andinvestors become very interested Mature Growth: expansion comes from growth in theeconomy and returns are more predictable Stability or Decline: demand for product is diminishingand investors avoid this stage
  17. 17. 17Step 3: Fundamental Analysis Evaluate the financial condition and operating resultsof a specific company Competitive position Composition and growth in sales Profit margins and dynamics of earnings Asset mix (i.e. cash balance, inventory, accountsreceivable, fixed assets) Financing mix ( i.e. debt, stock) The value of a stock is influenced by the financialperformance of the company that issued the stock
  18. 18. 18Where Do We Start? Interpreting Financial Statements Using Financial Ratios Fundamental analysis is often the mostdemanding and most time-consuming phaseof stock selection
  19. 19. 19Financial Statements:The Balance Sheet Summary of a company’s assets, liabilities, andshareholders’ 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 inthe company What are we looking for on the balance sheet? Relative amounts (large vs. small) Trends (improving vs. decreasing)
  20. 20. 20Table 7.3 Corporate Balance Sheet
  21. 21. 21Financial Statements:The Income Statement Summary of a company’s operating results over a specificperiod of time, usually one year Revenues: funds received for providing products and/or services Expenses: funds used to pay for materials, labor, and other businesscosts 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 slowerthan revenues?) Trends (improving vs. decreasing)
  22. 22. 22Table 7.4 Corporate Income Statement
  23. 23. 23Financial Statements:The Statement of Cash Flows Summary of a company’s cash flows and other events thatcaused 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 ofoperating 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)
  24. 24. 24Table 7.5 Statement of Cash Flows
  25. 25. 25Sources for Financial Statements Company’s Annual Report Company’s 10K Company’s 10Q Securities & Exchange Commission Standard & Poor’s or Moody Reports Internet financial portals Brokerage firm reports
  26. 26. 26Major Groups of Financial Ratios Liquidity Ratios: the company’s ability to meet day-to-dayoperating expenses and satisfy short-term obligations as theybecome due Activity Ratios: how well the company is managingits assets Leverage Ratios: amount of debt used by the company Profitability Ratios: measures how successful the companyis at creating profits Common Stock Ratios: converts key financial informationinto per-share basis to simplify financial analysis
  27. 27. 27Liquidity Ratios Current Ratio: how many dollars of short-termassets are available for every dollar of short-termliabilities owed Higher ratio: better Lower ratio: worseCurrent ratio =Current assetsCurrent liabilities
  28. 28. 28Liquidity Ratios (contd) Net Working Capital: how many dollars ofworking capital are available to pay bills and growthe business Higher amounts: better Lower amounts: worseNet working capital = Current assets − Current liabilities
  29. 29. 29Activity Ratios Accounts Receivable Turnover: how quickly thecompany is collecting its accounts receivable (sales tocustomers on credit) Higher ratio: better Lower ratio: worseAccounts receivable turnover =Annual salesAccounts receivable
  30. 30. 30Activity Ratios (cont’d) Inventory Turnover: how quickly the company isselling its inventory Higher ratio: better Lower ratio: worseInventory turnover =Annual salesInventory
  31. 31. 31Activity Ratios (contd) Total Asset Turnover: how efficiently the companyis using its assets to support sales Higher ratio: better Lower ratio: worseTotal asset turnover =Annual salesTotal assets
  32. 32. 32Leverage Ratios Debt-Equity Ratio: how much debt the company isusing to support its business compared to how muchstockholders’ equity it is using to supportits business Higher ratio: more risk Lower ratio: less riskDebt-equity ratio =Long-term debtStockholders’ equity
  33. 33. 33Leverage Ratios (contd) Time Interest Earned: measures the ability of thefirm to meet its fixed interest payments Higher ratio: less risk Lower ratio: more riskTimes interest earned =Earnings before interest and taxesInterest expense
  34. 34. 34Profitability Ratios Net Profit Margin: amount of profit earned fromsales and other operations Higher ratio: better Lower ratio: worseNet profit margin =Net profit after taxesTotal revenues
  35. 35. 35Profitability Ratios (contd) Return on Assets: amount of profit earned on eachdollar invested in assets; measures management’sefficiency at using assets Higher ratio: better Lower ratio: worseROA =Net profit after taxesTotal assets
  36. 36. 36Profitability Ratios (contd) Return on Equity: amount of profit earnedon each dollar invested by stockholders;measures management’s efficiency at usingstockholders’ funds Higher ratio: better Lower ratio: worseROE =Net profit after taxesStockholders’ equity
  37. 37. 37Breaking DownReturn on Assets (ROA) Breaking down ROA allows investors to identify thecomponents that are driving company profits. Investors want to know if ROA is moving up (ordown) because of improvement (or deterioration) inthe company’s profit margin and/or its total assetturnover.ROA = Net profit margin × Total asset turnover
  38. 38. 38Breaking DownReturn on Assets (ROA) (contd) Breaking down ROE allows investors to identify the impactof 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 becauseof how the firm is managing its assetsand operations.ROE = ROA × Equity multiplierEquity multiplier =Total assetsTotal stockholders’ equity
  39. 39. 39Common Stock Ratios Price/Equity Ratio: shows how the stock market is pricingthe 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 expensiveP/E =Market price of common stockEPSEPS =Net profit after taxes − Preferred dividendsNumber of common shares outstanding
  40. 40. 40Common Stock Ratios (contd) What is the P/E ratio for a company with profits of $139.7million, 61,815,000 outstanding shares of common stock anda current market price of $41.50 per share?EPS =$139,700,00061,815,000 sharesor $2.26Price/Earnings ratio =$41.50$2.26or 18.4
  41. 41. 41Common Stock Ratios (contd) Price/Earnings Growth Ratio (PEG): compares company’sP/E ratio to the rate of growthin earnings Ratio > 1: stock may be fully valued PEG = 1: stock price in line withearnings growth Ratio < 1: stock may be undervaluedPEG ratio=Stock’s P/E ratio3- to 5-year growth rate in earnings
  42. 42. 42Common Stock Ratios (contd) Dividends per share: the amount of dividends paid out tocommon stockholdersDividends per share =Annual dividends paid to common stockNumber of common shares outstanding
  43. 43. 43Common Stock Ratios (contd) Payout Ratio: how much of its earnings a company pays outto stockholders in the formof dividends Traditional payout ratios have been 40% to 60% Recent trends have been lower payout ratios, with more tax efficientstock buyback programs used frequently High payout ratios may be difficult to maintain and the stock marketdoes not like cuts in dividendsPayout ratio =Dividends per shareEarnings per share
  44. 44. 44Common Stock Ratios (contd) Book Value per Share: difference between assetsand liabilities (equity) per share A company should be worth more than itsbook value.Book value per share =Common stockholders’ equityNumber of common shares outstanding
  45. 45. 45Common Stock Ratios (contd) Price-to-Book Ratio: compares stock price to book value tosee how aggressively the stock is being priced Higher ratio: stock is fully-priced or overpriced Lower ratio: stock may be fairly pricedor underpricedPrice-to-book-value =Market price of common stockBook value per share
  46. 46. 46Interpreting Financial Ratios Look at historical ratio trends for the company Look at ratios for the industry Evaluate the firm relative to two or three majorcompetitors Try to determine if the financial information istelling you a good story about the company or a badstory Use the story to decide if you think the stock hasintrinsic value for you as an investor
  47. 47. 47Could There Be Trouble Brewing?The following financial statement developments could indicate acompany heading for financial problems: Inventories and receivables growing faster than sales A falling current ratio, caused by current liabilities increasingfaster than current assets A high and rapidly increasing debt-to-equity ratio, suggestingproblems with servicing debt in future Cash flow from operations dropping below net income Presence of lots of indecipherable off-balance sheet accountsand extraordinary income entries