LN07 Smart3075419 12 FI C07

Chapter 7
Analyzing
Common Stocks
Analyzing Common Stocks

Learning Goals
1. Discuss the security analysis process, including
its goals and functions.
2. Understand the purpose and contributions of
economic analysis.
3. Describe industry analysis and note how it is
used.
4. Demonstrate a basic appreciation of
fundamental analysis and why it is used.
Copyright 2014 Pearson Education, Inc. All rights reserved.
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
companys performance, and explain how the
insights derived from the basic input for the
valuation process.
7-3
What is Security Analysis?

The process of gathering information,
organizing it into a logical framework, and
then using it to determine the intrinsic value
of a share of common stock.
7-4
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
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 companys stock
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
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
7-8
Step 1: Economic Analysis

Economic Analysis is the 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.
The behavior of the economy is captured in the
business cycle, which reflects changes in total
economic activity over time
7-9
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, as GDP goes the economy goes
Industrial Production: measure of the

activity/output in the industrial or productive
segment of the economy
Generally, as production goes the economy goes
7-10
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
7-11
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
7-12
Table 7.2 Economic Variables and the

Stock Market
7-13
Sources for Economic Outlook

Wall Street Journal
Barrons
Fortune, Business Week, Forbes
Government Publications
Brokerage firm/commercial bank reports
7-14
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?
7-15
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
7-16
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.
7-17
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)?
7-18
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
7-19
Sources for Industry Outlook

Trade publications
Wall Street Journal
Fortune, Business Week, Forbes
Standard & Poors Industry Surveys
Brokerage house reports
Yahoo! Finance.com
7-20
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
7-21
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
7-22
Financial Statements:
The Balance Sheet
Summary of a companys 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)
7-23
Table 7.3
Corporate
Balance
Sheet
7-24
The Income Statement
Summary of a companys 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?)
7-25
Table 7.4 Corporate Income Statement
7-26
The Statement of Cash Flows
Summary of a companys cash flows and other events that
caused changes in companys 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
7-27
Table 7.5 Statement of Cash Flows
7-28
Sources for Financial Statements

Companys Annual Report
Companys 10K
Companys 10Q
Securities & Exchange Commission
www.sec.gov
Standard & Poors or Moody Reports

Internet financial portals
Brokerage firm reports
7-29
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 companys historical trends to see if
improving or declining
Looks at industry standards to see how company
compares to competitors
7-30
Major Groups of Financial Ratios

Liquidity Ratios: the companys 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
7-31
Liquidity Ratios
Current Ratio: how many dollars of shortterm assets are available for every dollar of
short-term liabilities owed
Higher ratio: more liquidity

Lower ratio: less liquidity
7-32
Liquidity Ratios (cont'd)

Net Working Capital: how many dollars of
working capital are available to pay bills
and grow the business
Higher amounts: firm makes large

investments in working capital
Lower amounts: firms operates with less
working capital
7-33
Activity Ratios
Accounts Receivable Turnover: how quickly the
company is collecting its accounts receivable (sales to
customers on credit)
Higher ratio: better

Lower ratio: worse
7-34
Activity Ratios (contd)

Inventory Turnover: how quickly the company is
selling its inventory

Lower ratio: worse
7-35
Activity Ratios (cont'd)

Total Asset Turnover: how efficiently the
company is using its assets to support sales

Lower ratio: worse
7-36
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
Higher ratio: more risk

Lower ratio: less risk
7-37
Leverage Ratios (cont'd)

Time Interest Earned: measures the
ability of the firm to meet its fixed interest
payments
Higher ratio: less risk

Lower ratio: more risk
7-38
Profitability Ratios
Net Profit Margin: amount of profit earned from
sales and other operations

Lower ratio: worse
7-39
Profitability Ratios (cont'd)

Return on Assets: amount of profit earned
on each dollar invested in assets; measures
managements efficiency at using assets

Lower ratio: worse
7-40
Profitability Ratios (cont'd)

Return on Equity: amount of profit earned
on each dollar invested by stockholders;
measures managements efficiency at using
stockholders funds

Lower ratio: worse
7-41
Breaking Down
Return on Assets (ROA)
Breaking down ROA allows investors to
identify the components that are driving
company profits.
Investors want to know if ROA is moving up

(or down) because of improvement (or
deterioration) in the companys profit
margin and/or its total asset turnover.
7-42
Breaking Down
Return on Assets (ROA) (cont'd)
Breaking down ROE allows investors to identify the
impact of financial leverage on company return.
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.
7-43
Common Stock Ratios

Price/Equity Ratio: shows how the stock market
is pricing the companys common stock
One of the most widely used ratios in common stock
selection
Often used in stock valuation models
Net profit after taxes Preferred dividends

EPS
Number of common shares outstanding
Higher ratio: more expensive

Lower ratio: less expensive
7-44
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
7-45

Price/Earnings Growth Ratio (PEG): compares
companys P/E ratio to the rate of growth in
earnings
Ratio > 1: stock may be fully valued

PEG = 1: stock price in line with earnings growth
Ratio < 1: stock may be undervalued
7-46

Dividends per share: the amount of dividends paid out to
common stockholders
7-47

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
7-48

Book Value per Share: difference
between assets and liabilities (equity) per
share
A company should be worth more than

its book value.
7-49

Price-to-Book Ratio: compares stock price to
book value to see how aggressively the stock is
being priced
Higher ratio: stock is fully-priced or overpriced

Lower ratio: stock may be fairly priced or
underpriced
7-50
Interpreting Financial Ratios

Sources of Ratio Analysis
Standard & Poors Stock Reports
Brokerage firm reports
Value Line Reports
7-51
Figure 7.1 An
Example of a
Published
Report with
Financial
Statistics
(Source: Mergent, July 25, 2012. 2012)

7-52
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
7-53
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
7-54
Chapter 7 Review
Learning Goals
1. Discuss the security analysis process, including
its goals and functions.
2. Understand the purpose and contributions of
economic analysis.
3. Describe industry analysis and note how it is
used.
4. Demonstrate a basic appreciation of
fundamental analysis and why it is used.
7-55
Chapter 7 Review (cont'd)

Learning Goals (contd)
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
companys performance, and explain how the
insights derived from the basic input for the
valuation process.
7-56
Chapter 7
Additional
Chapter Art
Table 7.1
Keeping Track
of the
Economy
7-58
Table 7.6 Comparative Historical and

Industry Ratios
7-59
Table 7.7 Comparative Financial Statistics: Universal Office

Furnishings and Its Major Competitors (All figures are for yearend 2013 or for the five-year period ending in 2013; $ in
millions)
7-60

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Chapter 7

Analyzing Common Stocks

Copyright 2014 Pearson Education, Inc. All rights reserved.

Analyzing Common Stocks

Copyright 2014 Pearson Education, Inc. All rights reserved.

What is Security Analysis?

Copyright 2014 Pearson Education, Inc. All rights reserved.

What is Intrinsic Value?

Copyright 2014 Pearson Education, Inc. All rights reserved.

Top Down Approach to

Step 2: Industry Analysis

Step 3: Fundamental Analysis

Copyright 2014 Pearson Education, Inc. All rights reserved.

Efficient Market Hypothesis

Who Needs Security Analysis in an

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Economic Analysis

Copyright 2014 Pearson Education, Inc. All rights reserved.

Key Economic Measures

Industrial Production: measure of the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Key Economic Factors that Affect the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Other Key Economic Measures

Index of Leading Indicators

Predicts direction of GDP

Consumer buying habits

Growth of economy & inflation

Availability & cost of money

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7.2 Economic Variables and the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Sources for Economic Outlook

Copyright 2014 Pearson Education, Inc. All rights reserved.

How Do We Use the Economic

Use it to evaluate individual companies

Copyright 2014 Pearson Education, Inc. All rights reserved.

Important Point to Remember!

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 2: Industry Analysis

Looking for new opportunities & growth potential

Identify companies within the industry that

Copyright 2014 Pearson Education, Inc. All rights reserved.

Issues that Affect an Industry

Copyright 2014 Pearson Education, Inc. All rights reserved.

Growth Cycle Stages

Copyright 2014 Pearson Education, Inc. All rights reserved.

Sources for Industry Outlook

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Fundamental Analysis

The value of a stock is influenced by the

Copyright 2014 Pearson Education, Inc. All rights reserved.

What are we looking for on the balance sheet?

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Revenues: funds received for providing products and/or

What are we looking for on the income statement?

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7.4 Corporate Income Statement

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7.5 Statement of Cash Flows

Copyright 2014 Pearson Education, Inc. All rights reserved.