Analyzing Common Stocks

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.
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 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 companys 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 Money supply Interest rates Inflation Consumer spending Business investments Foreign trade Currency exchange rates
10

 

Monetary Policy
      

Other Factors

Other Key Economic Measures

Economic Measure
Index of Leading Indicators Personal Income Retail Sales Money Supply Consumer Prices/ Producer Prices Employment Housing Starts

What It Tracks
Predicts direction of GDP Consumer buying habits Consumer attitudes Growth of economy & inflation Inflation Business Production Availability & cost of money

11

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?

12

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

13

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.

14

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)?
15

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 apid 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 and investors avoid this stage diminishing

16

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
17

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

18

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)

19

Table 7.3 Corporate Balance Sheet

20

Financial Statements: 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 Relative amounts (large vs. small) Relationships (Are expenses growing faster or slower than revenues?) Trends (improving vs. decreasing)

What are we looking for on the income statement?

  

21

Table 7.4 Corporate Income Statement

22

Financial Statements: 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 Relative amounts (more cash or less cash) Liquidity Trends (improving vs. decreasing)

What are we looking for on the cash flow statement?

  

23

Table 7.5 Statement of Cash Flows

24

Sources for Financial Statements

       Companys Annual Report Companys 10K Companys 10Q Securities & Exchange Commission
 [Link]

Standard & Poors or Moody Reports Internet financial portals Brokerage firm reports
25

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
26

   

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

27

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

28

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

29

Activity Ratios (contd)

 Inventory Turnover: how quickly the company is selling its inventory
Annual sales Inventory turnover ! Inventory

 Higher ratio: better  Lower ratio: worse

30

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

31

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

32

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

33

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

34

Profitability Ratios (cont'd)

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

Net profit after taxes ROA ! Total assets

 Higher ratio: better  Lower ratio: worse
35

Profitability Ratios (cont'd)

 Return on Equity: amount of profit earned on each dollar invested by stockholders; measures managements efficiency at using stockholders funds
Net profit after taxes ROE ! Stockholders equity  Higher ratio: better  Lower ratio: worse

36

Breaking Down Return on Assets (ROA)

 Breaking down ROA allows investors to identify the components that are driving company profits.
ROA ! Net profit margin v Total asset turnover

 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.
37

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 v 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.

38

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

Market price of common stock P/E ! EPS

Net profit after taxes  Preferred dividends EPS ! Number of common shares outstanding

 

Higher ratio: more expensive Lower ratio: less expensive

39

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

40

Common Stock Ratios (cont'd)

 Price/Earnings Growth Ratio (PEG): compares companys P/E ratio to the rate of growth in earnings
Stocks 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

  

41

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

42

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

43

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.

44

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

 

45

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
46

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
47