week 19 Analyzing Common Stocks

• Security analysis is essential for a successful long-range investment program.

Principles of Security Analysis

• Security analysis involves gathering and organizing information to determine a common stock's intrinsic value.

• Intrinsic value is the underlying worth of a stock share.

• Investors should buy stocks only if the market price is below their perceived intrinsic value.

• Intrinsic value depends on estimated future cash flows, discount rate, and risk.

The Top-Down Approach to Security Analysis

• Step 1: Economic Analysis - Assess the economy's state and its potential effects on businesses.

• Step 2: Industry Analysis - Analyze the outlook and competition within a company's specific industry.

• Step 3: Fundamental Analysis - Evaluate a company's financial condition and operating results to predict future performance.

Who Needs Security Analysis in an Efficient Market?

• Security analysis assumes some investors can identify mispriced stocks.

• The efficient market hypothesis asserts securities are rarely mispriced, and security analysis cannot consistently find mispriced securities by chance.

• Fundamental analysis is valuable because it contributes to market efficiency, and financial markets may have inevitable pricing errors.

Fundamental Analysis

• Fundamental analysis studies a business's financial affairs to understand the company issuing stock.

The Concept

• Stock value is influenced by the issuing company's performance.

• Company analysis includes historical financial strength, competitive position, assets, sales growth, profit margins, asset mix, and capital structure.

• Investors may use published reports and financial websites due to the demanding nature of company analysis.

Financial Statements

• Balance Sheet: A snapshot of a company's assets, liabilities, and equity at a specific time. Total assets equal liabilities plus equity.

• Income Statement: Summary of a firm's operating results over time, including revenues, expenses, and profit/loss. It shows how well assets are used.

• The Statement of Cash Flows: Summary of a firm’s cash flow, showing cash spent and received. It helps investors understand the difference between reported earnings and actual cash flow; includes net cash flow from operating activities and overall increase/decrease in cash.

Financial Ratios

• Ratio analysis evaluates relationships between financial statement accounts.

• Investors use ratios to assess financial condition, operating results, and compare to standards.

• Five groups of financial ratios: liquidity, activity, leverage, profitability, and common stock measures.

Liquidity Ratios

• Liquidity ratios measure a company’s ability to meet short-term obligations.

• Current Ratio: Measures ability to meet short-term liabilities with short-term assets; higher ratio indicates more liquidity.

• Quick Ratio: Similar to the current ratio but excludes inventory, as inventory may be difficult to convert to cash.

Activity Ratios

• Activity Ratios: Compare sales to assets to measure asset efficiency; high or increasing ratios indicate efficient asset management.

• Inventory Turnover: Measures how quickly inventory is sold; a higher ratio suggests good inventory management unless inventory is too low.

• Total Asset Turnover: Indicates how efficiently a firm uses assets to support sales; a high figure suggests good management and high sales from asset investments.

Leverage Ratios

• Leverage ratios indicate debt used to support company resources and operations; assess the amount of debt and the ability to service it.

• Debt-Equity Ratio: Measures funds from lenders vs. owners; a lower ratio indicates lower risk.

• Times Interest Earned: Measures the firm's ability to cover fixed interest payments; a ratio of 8-9 is strong, concern arises below 2-3.

Profitability Ratios

• Profitability measures a company's relative success, relating returns to sales, assets, or equity. Higher measures are preferred.

• Net Profit Margin: Indicates profit rate from sales and revenues.

• Return on Assets (ROA): Measures management’s efficiency in using assets to generate profits. Higher ROA is desirable.

• Return on Equity (ROE): Measures return to shareholders by relating profits to shareholder equity; decreasing ROE may indicate trouble.

Common-Stock Ratios

• Price-to-Earnings Ratio (P/E): Determines market pricing of common stock. Rising P/E ratios are desirable, but high ratios may signal overvaluation.

• Dividends Per Share: Dividends paid to stockholders on a per-share basis.

• Payout Ratio: Indicates earnings paid as dividends. Traditional ratios are 30-50%; growth companies may have low or zero ratios. Rising ratios may indicate falling earnings, and dividend cuts are unfavorable.

• Book Value Per Share: The difference between total assets and liabilities. Stocks should sell above book value; otherwise, there may be significant issues.

• Price-to-book-value ratio: Relates book value to market price, showing pricing aggressiveness. Most stocks are above 1.0; high ratios may indicate full or overpricing.