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34 Cards in this Set
- Front
- Back
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What is Security Analysis?
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“The process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock.”
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What is Intrinsic Value?
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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 |
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“Top Down” Approach to Traditional Security Analysis
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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 |
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Efficient Market:
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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 |
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Who Needs Security Analysis in an Efficient Market?
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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 |
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Analyzing Common Stocks
- 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 |
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Gross Domestic Product (GDP):
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market value of all goods and services produced in a country over the period of a year
Generally, as GDP goes the economy goes |
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Industrial Production:
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measure of the activity/output in the industrial or productive segment of the economy
Generally, as production goes the economy goes |
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Analyzing Common Stocks
- 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. |
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Step 3: Fundamental Analysis
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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 |
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Step 3: Fundamental Analysis - Where Do We Start?
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Interpreting Financial Statements
Using Financial Ratios Fundamental analysis is often the most demanding and most time-consuming phase of stock selection |
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The Statement of Cash Flows
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Summary of a company’s cash flows and other events that caused 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 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 -Trends (improving vs. decreasing) |
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Liquidity Ratios:
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the company’s ability to meet day-to-day operating expenses and satisfy short-term obligations as they become due
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Activity Ratios:
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how well the company is managing its assets
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Leverage Ratios
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amount of debt used by the company
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Profitability Ratios:
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measures how successful the company is at creating profits
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Common Stock Ratios
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converts key financial information into per-share basis to simplify financial analysis
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Liquidity Ratios: Current Ratio:
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how many dollars of short-term assets are available for every dollar of short-term liabilities owed
Higher ratio: more liquidity Lower ratio: less liquidity Current assets / Current Liabilities |
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Liquidity Ratios: Net Working Capital:
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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 Current assets - Current Liabilities |
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Activity Ratios - Accounts Receivable Turnover
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how quickly the company is collecting its accounts receivable (sales to customers on credit)
Higher ratio: better Lower ratio: worse Annual Sales / Accts receivable |
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Activity Ratios - Inventory Turnover:
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how quickly the company is selling its inventory
Higher ratio: better Lower ratio: worse Annual sales / inventory |
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Activity Ratios - Total Asset Turnover
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how efficiently the company is using its assets to support sales
Higher ratio: better Lower ratio: worse Annual sales / Total assets |
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Leverage Ratios - Debt-Equity Ratio:
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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 LT debt / Stockholder Equity |
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Leverage Ratios - Time Interest Earned:
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measures the ability of the firm to meet its fixed interest payments
Higher ratio: less risk Lower ratio: more risk EBIT / Interest Expense |
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Profitability Ratios - Net Profit Margin:
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amount of profit earned from sales and other operations
Higher ratio: better Lower ratio: worse Net Profit after taxes / Total Revenues |
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Profitability Ratios - Return on Assets:
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amount of profit earned on each dollar invested in assets; measures management’s efficiency at using assets
Higher ratio: better Lower ratio: worse Net Profit after taxes / Total assets |
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Profitability Ratios - Return on Equity:
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amount of profit earned on each dollar invested by stockholders; measures management’s efficiency at using stockholders’ funds
Higher ratio: better Lower ratio: worse Net Profit after taxes / Stockholder EQ |
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Common Stock Ratios - Price/Equity Ratio:
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shows how the stock market is pricing the 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 expensive Net price of Common stock / EPS |
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Common Stock Ratios - Price/Earnings Growth Ratio (PEG):
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compares company’s 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 Stocks PE Ratio / 3-5 year growth rate in earnings |
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Common Stock Ratios - Dividends per share:
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the amount of dividends paid out to common stockholders
Annual dividends paid in common stock / # of common shares outstanding |
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Common Stock Ratios - Payout Ratio:
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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 Dividend per share / Earnings per share |
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Common Stock Ratios - Book Value per Share:
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difference between assets and liabilities (equity) per share
A company should be worth more than its book value. Common Shareholders EQ / # of common shares outstanding |
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Common Stock Ratios - Price-to-Book Ratio:
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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 MArket price of common stock / Book value per share |
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Interpreting Financial Ratios
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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 |
