Chapter 7 Analyzing Common Stocks Security Analysis Process of gathering, organizing, and using information to determine the intrinsic value of a common stock. Intrinsic value is the underlying or inherent value of a stock Estimate future cash flows Determine appropriate discount rate Factor in risk 7-2 Top-Down Approach Economic analysis general state of the economy and potential effects on security returns. Industry analysis outlook for the industry within which particular companies operate. Fundamental company analysis Helps formulate expectations about the future performance of the company and its stock. 7-3 7-1
Economic Analysis Business cycle indication of the change in total economic activity over time. Measures Gross Domestic Product (GDP) = value of all goods and services produced in the country during one year Index of industrial production - measures industrial services in the economy. 7-4 Economic Analysis Key Economic Factors Government Fiscal Policy Taxes, spending, & debt management Monetary Policy Money supply, interest rates Other factors Inflation, consumer spending, business investments, foreign trade & exchange rates 7-5 Industry Analysis Studies industry groupings Assesses the competitive position of a particular industry vis-à-vis others identifies companies within the industry that show promise 7-6 7-2
Industry Analysis (2 of 3) Questions to address in the context of the industry growth cycle What is the nature of the industry? Is it monopolistic or competitive? To what extent is it regulated? What role, if any, does organized labor play? How important are technological developments? Which economic forces are especially important? What are the important financial and operating considerations? inputs, capital expenditure plans, foreign competition 7-7 Growth Cycle Analysis A reflection of business vitality (industry or company) over time. Stages: Initial development Rapid expansion Mature growth Stability & decline 7-8 Fundamental Analysis The value of a stock is influenced by the performance of the company that issued it. Begins with historical analysis, considering: Competitive position Composition and growth of sales Profit margins and dynamics of its earnings Asset mix - composition and liquidity of corporate resources Capital structure (financing mix) 7-9 7-3
Fundamental Analysis Sources of Information Financial statements Balance Sheet Income Statement Statement of Cash Flows (assesses liquidity) Financial Ratios 7-10 Ratio Analysis Studies the relationship among and between various financial statements to assess historical performance. Ratios are organized into groups for easier interpretation. Liquidity measures Activity ratios Leverage measures Profitability ratios Common stock ratios 7-11 Liquidity Measures Focus on ability to meet day-to-day operating expenses and satisfy shortterm obligations Current ratio = current assets / current liabilities Net working capital = current assets - current liabilities 7-12 7-4
Activity Ratios Assesses utilization of assets Accounts receivable turnover = sales / accounts receivable Inventory turnover = sales / inventory Total asset turnover = sales / total assets 7-13 Leverage Measures Measures amount of debt used to support operations & ability to service debt Debt-to-equity ratio= long-term debt / shareholders' equity Times interest earned = EBIT/interest expense 7-14 Profitability Ratios Measures relative success by comparing profits to sales, assets, or equity. Net profit margin = net profit after taxes / total revenues Return on total assets = net profit after taxes / total assets 7-15 7-5
Profitability Ratios Return on equity = net profit after taxes / shareholder's equity ROE = ROA x Equity Multiplier, where Equity multiplier = total assets / shareholders equity 7-16 Common Stock Ratios Equates performance to per share results Price/earnings ratio = market price of common stock / EPS EPS = (net profit after taxes - preferred dividends) / number of common shares outstanding 7-17 Common Stock Ratios (2 of 3) PEG Ratio = stock's PE ratio / 3-5 year growth-rate in earnings Price-to-sales ratio =stock price / annual sales per share Dividend per share = annual dividend / # of common shares outstanding 7-18 7-6
Common Stock Ratios (3 of 3) Payout ratio = dividend per share / earnings per share Book value per share = shareholders' equity / number of common shares outstanding Price-to-book = market price / book value per share 7-19 Interpretation & Use of Ratios Ratio Comparison Company to industry Company's current ratios to its historical ratios Proper interpretation helps identify strengths, weaknesses, and trends 7-20 7-7