Analyzing Common Stocks

Principles of Security Analysis

Security analysis consists of gathering information, organizing it into a logical framework, and then
using the information to determine the intrinsic value of common stock. That is, given a rate of return
that’s compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a
measure of the underlying worth of a share of stock. It provides a standard to help you judge whether a
particular stock is undervalued, fairly priced, or overvalued. The entire concept of stock valuation is
based on the idea that all securities possess an intrinsic value that their market value will approach over
time.

In investments, the question of value centers on return. That is, a satisfactory investment is one that
offers a level of expected return proportionate to the amount of risk involved. As a result, not only must
an investment be profitable, but it also must be sufficiently profitable—in the sense that you’d expect it to
generate a return that’s high enough to offset the perceived exposure to risk.

The problem, of course, is that returns on securities are difficult to predict. One approach is to buy
whatever strikes your fancy. A more rational approach is to use security analysis to look for promising
candidates. Security analysis addresses the question of what to buy by determining what a stock ought to
be worth and comparing that value to the stock’s market price. Presumably, an investor will buy a stock
only if its prevailing market price does not exceed its worth—its intrinsic value.

Ultimately, intrinsic value depends on several factors:

1. Estimates of the stock’s future cash flows (e.g., the amount of dividends you expect to receive over the
holding period and the estimated price of the stock at time of sale)
2. The discount rate used to translate those future cash flows into a present value
3. The risk associated with future performance, which helps define the appropriate discount rate

The Top-Down Approach to Security Analysis

Traditional security analysis often takes a top-down approach. It begins with economic analysis, moves to
industry analysis, and then arrives at a fundamental analysis of a specific company. Economic analysis
assesses the general state of the economy and its potential effects on businesses. For example, the UBS
research report on Advanced Micro Devices pointed out that a weak economy caused consumers to be
more price-sensitive when they shopped, so they purchased less expensive tablets or laptops rather than
desktop PCs.

Industry analysis deals with the industry within which a particular company operates. It looks at the
overall outlook for that industry and at how companies compete in that industry. In the case of the
computer chip industry, UBS noted that the increasing price sensitivity of consumers favored companies
such as Intel, which focused more on business customers than general consumers. Fundamental analysis
looks at the financial condition and operating results of a specific company. The fundamentals include the
company’s investment decisions, the liquidity of its assets, its use of debt, its profit margins, and its
earnings growth.

Economic Analysis
Economic analysis consists of a general study of the prevailing economic environment, often on both a
global and a domestic basis (although here we’ll concentrate, for the most part, on the domestic
economy). Such analysis is meant to help investors gain insight into the underlying condition of the
economy and the impact it might have on the behavior of share prices. It can go so far as to include a
detailed examination of each sector of the economy, or it may be done on a very informal basis. However,
from a security analysis perspective, its purpose is always the same: to establish a sound foundation for
the valuation of common stock.

Economic Analysis and the Business Cycle

Economic analysis is the first step in the top-down approach. It sets the tone for the entire security
analysis process. Thus, if the economic future looks bleak, you can probably expect most stock returns to
be equally dismal. If the economy looks strong, stocks should do well. The behavior of the economy is
captured in the business cycle, a series of alternating contractions and expansions, which reflects
changes in total economic activity over time.

Two widely followed measures of the business cycle are gross domestic product and industrial
production. Gross domestic product (GDP) is the market value of all goods and services produced in a
country over a given period. When economists say that the economy is in recession, this means that GDP
has been contracting for at least two consecutive quarters. On the other hand, an economic expansion
generally refers to a period when GDP is growing. Industrial production is an indicator of the output
produced by industrial companies. Normally, GDP and the index of industrial production move up and
down with the business cycle.

Key Economic Factors

The state of the economy is affected by a wide range of factors, from the consumption, saving, and
investment decisions made independently by millions of households to major government policy
decisions. Some of the most important factors that analysts examine when conducting a broad economic
analysis include:

Government fiscal policy

Taxes
Government spending
Debt management
Monetary policy
Money supply
Interest rates
Other factors
Inflation
Consumer spending
Business investments
Foreign trade and foreign exchange rates
Industry Analysis
Key Issues
Because all industries do not perform the same, the first step in industry analysis is to establish the
competitive position of a particular industry in relation to others. The next step is to identify companies
within the industry that hold particular promise.

Analyzing an industry means looking at such things as its makeup and basic characteristics, the key
economic and operating variables that drive industry performance, and the outlook for the industry. You
will also want to keep an eye out for specific companies that appear well situated to take advantage of
industry conditions.
Companies with strong market positions should be favored over those with less secure positions. Such
dominance indicates an ability to maintain pricing leadership and suggests that the firm will be in a
position to enjoy economies of scale and low-cost production. Market dominance also enables a company
to support a strong research and development effort, thereby helping it secure its leadership position for
the future.

Normally, you can gain valuable insight about an industry by seeking answers to the following questions.
1. What is the nature of the industry? Is it monopolistic or are there many competitors? Do a few set the
trend for the rest, and if so, who are those few?
2. Is the industry regulated? If so, how and by what agency is it regulated? How “friendly” are the
regulatory bodies?
3. What role does labor play in the industry? How important are labor unions? Are there good labor
relations within the industry? When is the next round of contract talks?
4. How important are technological developments? Are any new developments taking place? What impact
are potential breakthroughs likely to have?
5. Which economic forces are especially important to the industry? Is demand for the industry’s goods
and services related to key economic variables? If so, what is the outlook for those variables? How
important is foreign competition to the health of the industry?
6. What are the important financial and operating considerations? Is there an adequate supply of labor,
material, and capital? What are the capital spending plans and needs of the industry?

The Industry Growth Cycle

Questions like these can sometimes be answered in terms of an industry’s growth cycle, which reflects
the vitality of the industry over time.

In the first stage—initial development—investment opportunities are usually not available to most
investors. The industry is new and untried, and the risks are very high.

The second stage is rapid expansion, during which product acceptance is spreading and investors can see
the industry’s future more clearly. At this stage, economic and financial variables have little to do with the
industry’s overall performance. Investors will be interested in investing almost regardless of the
economic climate. This is the phase that is of substantial interest to investors, and a good deal of work is
done to find such opportunities. Unfortunately, most industries do not experience rapid growth for long.

Instead, they eventually slip into the next category in the growth cycle, mature growth, which is the one
most influenced by economic developments. In this stage, expansion comes from growth of the economy.
It is a slower source of overall growth than that experienced in stage two. In stage three, the long-term
nature of the industry becomes apparent. Industries in this category include defensive ones, like food and
apparel, and cyclical ones, like autos and heavy equipment.

The last stage is either stability or decline. In the decline phase, demand for the industry’s products is
diminishing, and companies are leaving the industry. Investment opportunities at this stage are almost
nonexistent, unless you are seeking only dividend income. Certainly, growth-oriented investors will want
to stay away from industries at the decline stage of the cycle. Other investors may be able to find some
investment opportunities here, especially if the industry (like, say, tobacco) is locked in the mature,
stable phase. The fact is, however, that very few really good companies ever reach this final stage because
they continually bring new products to the market and, in so doing, remain at least in the mature growth
phase.

Fundamental Analysis
Fundamental analysis is the study of the financial affairs of a business for the purpose of understanding
the company that issued the common stock. First, we will deal with several aspects of fundamental
analysis. We will examine the general concept of fundamental analysis and introduce several types of
financial statements that provide the raw material for this type of analysis. We will then describe some
key financial ratios that are widely used in company analysis and will conclude with an interpretation of
those financial ratios. It’s important to understand that this represents the more traditional approach to
security analysis. This approach is commonly used in any situation where investors rely on financial
statements and other databases to at least partially form an investment decision.

The Concept
Fundamental analysis rests on the belief that the value of a stock is influenced by the performance of the
company that issued the stock. If a company’s prospects look strong, the market price of its stock is likely
to reflect that and be bid up. However, the value of a security depends not only on the return it promises
but also on its risk exposure. Fundamental analysis captures these dimensions (risk and return) and
incorporates them into the valuation process. It begins with a historical analysis of the financial strength
of a firm: the company analysis phase. Using the insights obtained, along with economic and industry
analyses, an investor can then formulate expectations about the growth and profitability of a company.

In the company analysis phase, the investor studies the financial statements of the firm to learn its
strengths and weaknesses, identify any underlying trends and developments, evaluate operating
efficiencies, and gain a general understanding of the nature and operating characteristics of the firm. The
following points are of particular interest.

• The competitive position of the company

• The types of assets owned by the company and the growth rate of sales
• Profit margins and the dynamics of company earnings
• The composition and liquidity of corporate resources (the company’s asset mix)
• The company’s capital structure (its financing mix)

This phase is in many respects the most demanding and time-consuming. Because most investors have
neither the time nor the inclination to conduct such an extensive study, they rely on published reports
and financial websites for the background material.

Financial Statements
Financial statements are a vital part of company analysis. They enable investors to develop an opinion
about the operating results and financial condition of a firm. Investors use three financial statements in
company analysis: the balance sheet, the income statement, and the statement of cash flows. The first two
statements are essential to carrying out basic financial analysis because they contain the data needed to
compute many of the financial ratios. The statement of cash flows is used primarily to assess the
cash/liquidity position of the firm.

Companies prepare financial statements quarterly (abbreviated statements compiled for each three-
month period of operation) and at the end of each calendar year or fiscal year. (The fiscal year is the 12-
month period the company has defined as its operating year, which may or may not end on December
31.)
Companies must hire independent certified public accountants (CPAs) to audit their financial statements
to confirm that firms prepared those statements in accordance with generally accepted accounting
principles. By themselves, corporate financial statements are an important source of information to the
investor. When used with financial ratios, and in conjunction with fundamental analysis, they become
even more powerful. But to get the most from financial ratios, you must have a good understanding of the
uses and limitations of the financial statements themselves.

The Balance Sheet

The balance sheet is a statement of what a company owns and what it owes at a specific time. A balance
sheet lists a company’s assets, liabilities, and stockholders’ equity. The assets represent the resources of
the company (the things the company owns). The liabilities are debts owed to various creditors that have
lent money to the firm. A firm’s creditors may include suppliers, banks, or bondholders. Stockholders’
equity is the difference between a firm’s assets and its liabilities, and as such it represents the claim held
by the firm’s stockholders. As the term balance sheet implies, a firm’s total assets must equal the sum of
its liabilities and equity.

The Income Statement

The income statement provides a financial summary of the operating results of the firm over a period of
time such as a quarter or year. It shows the revenues generated during the period, the costs and expenses
incurred, and the company’s profits (the difference between revenues and costs). Income statements
generally list revenues (i.e., sales) first, followed by various types of expenses, and ending with profits or
net income. In contrast to a balance sheet, which shows a firm’s financial position at a single point in time,
the income statement describes what happens over a period of time.

The Statement of Cash Flows

The statement of cash flows provides a summary of the firm’s cash flow and other events that caused
changes in its cash position. This statement essentially brings together items from both the balance sheet
and the income statement to show how the company obtained its cash and how it used this valuable
liquid resource.

Financial Ratios
To see what accounting statements really have to say about the financial condition and operating results
of a firm, we have to turn to financial ratios. Such ratios provide a different perspective on the financial
affairs of the firm—particularly with regard to the balance sheet and income statement—and thus
expand the information content of the company’s financial statements. Simply stated, ratio analysis is
the study of the relationships between various financial statement accounts. profitability, and (5)
common-stock, or market, measures. Using the 2016 figures from the Universal financial statements
(Tables 7.3 and 7.4), we will now identify and briefly discuss some of the more widely used ratios in each
of these categories.

Liquidity Ratios

Liquidity ratios focus on the firm’s ability to meet its day-to-day operating expenses and satisfy its
short-term obligations as they come due. Of major concern is whether a company has adequate cash and
other liquid assets on hand to service its debt and operating needs in a prompt and timely fashion. Three
ratios that investors use to assess a firm’s liquidity position are the current ratio, the quick ratio, and the
working capital ratio.

Current Ratio
One of the most commonly cited of all financial ratios is the current ratio. The current ratio measures a
company’s ability to meet its short-term liabilities with its short-term assets and is one of the best
measures of a company’s financial health.

Current ratio = current assets/ current liabilities

Quick Ratio
Of all the current assets listed on a firm’s balance sheet, the least liquid is often the firm’s inventory
balance. Particularly when a firm is going through a period of declining sales, it can have difficulty selling
its inventory and converting it into cash. For this reason, many investors like to subtract out inventory
from the current assets total when assessing whether a firm has sufficient liquidity to meet its near-term
obligations. Thus, the quick ratio is similar to the current ratio but it excludes inventory in the numerator.

Quick ratio= current assets-inventory/ current liabilities

Net Working Capital
Although technically not a ratio, net working capital is often viewed as such. Actually, net working capital
is an absolute measure, which indicates the dollar amount of equity in the working capital position of the
firm. It is the difference between current assets and current liabilities.

Net working capital= current assets- current liabilities

Activity Ratios
Measuring general liquidity is only the beginning of the analysis. We must also assess the composition
and underlying liquidity of key current assets and evaluate how effectively the company is managing
these resources.

Activity ratios (also called efficiency ratios) compare company sales to various asset categories in order
to measure how well the company is using its assets. Three of the most widely used activity ratios deal
with accounts receivable, inventory, and total assets. Other things being equal, high or increasing ratio
values indicate that a firm is managing its assets efficiently, though there may be instances when activity
ratios can be too high, as was the case with liquidity ratios.

Accounts Receivable Turnover

The accounts receivable turnover ratio captures the relationship between a firm’s receivables balance
and its sales.
Accounts receivable turnover= sales revenue/ accounts receivable
Inventory Turnover
Control of inventory is important to the well-being of a company and is commonly assessed with the
inventory turnover measure.
Inventory turnover= sales revenue/ inventory
Total Asset Turnover

Total asset turnover indicates how efficiently a firm uses its assets to support sales. It is calculated as
follows:

Total asset turnover= sales revenue/ total assets

Leverage Ratios
Leverage ratios (sometimes called solvency ratios) look at the firm’s financial structure. They indicate
the amount of debt being used to support the resources and operations of the company. The amount of
indebtedness within the financial structure and the ability of the firm to service its debt are major
concerns to potential investors. There are three widely used leverage ratios. The first two, the debt-
equity ratio and the equity multiplier, measure the amount of debt that a company uses. The third, times
interest earned, assesses how well the company can service its debt.

Debt-Equity Ratio
The debt-equity ratio measures the relative amount of funds provided by lenders and owners. It is
computed as follows:

debt-equity ratio= long-term debt/ stockholders’ equity

Equity Multiplier
The equity multiplier (also known as the financial leverage ratio) provides an alternative measure of a
firm’s debt usage. The formula for the equity multiplier appears below. Equity multiplier= total assets/
stockholders’ equity

Times Interest Earned

Times interest earned is called a coverage ratio. It measures the ability of the firm to meet (“cover”) its
fixed interest payments. It is calculated as follows:

times interest earned= earnings before interest and taxes/ interest expense
Profitability Ratios
Profitability is a relative measure of success. Each of the various profitability measures relates the
returns (profits) of a company to its sales, assets, or equity. There are three widely used profitability
measures: net profit margin, return on assets, and return on equity. Clearly, the more profitable the
company, the better—
thus, other things being equal, higher or increasing measures of profitability are what you’d like to see.

Net Profit Margin

This is the “bottom line” of operations. Net profit margin indicates the rate of profit being earned from
sales and other revenues. It is computed as follows:

Net profit margin= net profit after taxes/ sales revenue

Return on Assets
As a profitability measure, return on assets (ROA) looks at the amount of resources needed to support
operations. Return on assets reveals management’s effectiveness in generating profits from the assets it
has available, and it is perhaps the most important measure of return. ROA is computed as follows:

ROA= Net profit after taxes/ total assets

Return on Equity
A measure of the overall profitability of the firm, return on equity (ROE) is closely watched by investors
because of its direct link to the profits, growth, and dividends of the company. Return on equity—or
return on investment (ROI), as it’s sometimes called—measures the return to the firm’s stockholders by
relating profits to shareholder equity.

ROE = Net profit after taxes/ stockholders’ equity

Breaking Down ROA and ROE
ROA and ROE are both important measures of corporate profitability. But to get the most from these two
measures, we have to break them down into their component parts. ROA, for example, is made up of two
key components: the firm’s net profit margin and its total asset turnover. Thus, rather than using
Equation 7.11 to find ROA, we can use the net profit margin and total asset turnover figures that we
computed earlier

ROA = Net profit margin x total asset turnover

that it shows you what’s driving company profits. As an investor, you want to know if ROA is moving up
(or down) because of improvement (or deterioration) in the company’s profit margin and/or its total
asset turnover. Ideally, you’d like to see ROA moving up (or staying high) because the company is doing a
good job in managing both its profits and its assets.

Going from ROA to ROE Just as ROA can be broken into its component parts, so too can the return on
equity (ROE) measure. Actually, ROE is nothing more than an extension of ROA. It brings the company’s
financing decisions into the assessment of profitability. That is, the expanded ROE measure indicates the
extent to which financial leverage (i.e., how much debt the firm uses) can increase return to stockholders.
The use of debt in the capital structure, in effect, means that ROE will always be greater than ROA. The
question is how much greater. Rather than using the abbreviated version of ROE in Equation 7.12, we can
compute ROE as follows.

ROE= ROA X Equity multiplier

Here we can see that the use of debt (the equity multiplier) has magnified—in this case, tripled—returns
to stockholders.

An Expanded ROE Equation

Alternatively, we can expand Equation 7.14 still further by breaking ROA into its component parts. In this
case, we could compute ROE as

ROE = ROA X Equity multiplier = (Net profit margin x total asset turnover) x equity multiplier
This expanded version of ROE is especially helpful because it enables investors to assess the company’s
profitability in terms of three key components: net profit margin, total asset turnover, and financial
leverage. In this way, you can determine whether ROE is moving up simply because the firm is employing
more debt, which isn’t necessarily beneficial, or because of how the firm is managing its assets and
operations, which certainly does have positive long-term implications. To stockholders, ROE is a critical
measure of performance. A high ROE means that the firm is currently very profitable, and if some of those
profits are reinvested in the business, the firm may grow rapidly.

Common-Stock Ratios
Finally, there are a number of common-stock ratios (sometimes called valuation ratios) that convert key
bits of information about the company to a per-share basis. Also called market ratios, they tell the
investor exactly what portion of total profits, dividends, and equity is allocated to each share of stock.
Popular common-stock ratios include earnings per share, price-to-earnings ratio, dividends per share,
dividend yield, payout ratio, and book value per share.

Price-to-Earnings Ratio
This measure, an extension of the earnings per share ratio, issued to determine how the market is pricing
the company’s common stock. The price-to-earnings (P/E) ratio relates the company’s earnings per share
(EPS) to the market price of its stock. To compute the P/E ratio, it is necessary to first know the stock’s
EPS.

EPS= Net profit after taxes – preferred dividends/ number of common shares outstanding
P/E= Price of common stock/ EPS
Price-to-earnings multiples are widely quoted in the financial press and are an essential part of many
stock valuation models. Other things being equal, you would like to find stocks with rising P/E ratios
because higher P/E multiples usually translate into higher future stock prices and better returns to
stockholders. But even though you’d like to see them going up, you also want to watch out for P/E ratios
that become too high (relative either to the market or to what the stock has done in the past). When this
multiple gets too high, it may be a signal that the stock is becoming overvalued (and may be due for a
fall).

One way to assess the P/E ratio is to compare it to the company’s rate of growth in earnings. The market
has developed a measure of this comparison called the PEG ratio. Basically, it looks at the latest P/E
relative to the three- to five-year rate of growth in earnings. (The earnings growth rate can be all
historical—the last three to five years—or perhaps part historical and part forecasted.)
The PEG ratio is computed as:
PEG ratio= stock’s P/E ratio/ 3-5 year growth rate in earnings
Dividends per Share
The principle here is the same as for EPS: to translate total common dividends paid by the company into a
per-share figure. (Note: If not shown on the income statement, the amount of dividends paid to common
stockholders can usually be found on the statement of cash flows—see Table 7.5.) Dividends per share is
measured as follows:
dividends per share= annual dividends paid to common stock/ number of common shares outstanding
Payout Ratio
Another important dividend measure is the dividend payout ratio. It indicates how much of its earnings a
company pays out to stockholders in the form of dividends. Well-managed companies try to maintain
target payout ratios. If earnings are going up over time, so will the company’s dividends. The payout ratio
is calculated as follows:

dividend payout ratio= dividends per share/ earnings per share

maintain its current level of dividends. That generally means that dividends will have to be cut back to
more reasonable levels unless earnings grow rapidly. And if there’s one thing the market doesn’t like, it’s
cuts in dividends; they’re usually associated with big cuts in share prices.

Book Value per Share

The last common-stock ratio is book value per share, a measure that deals with stockholders’ equity.
Actually, book value is simply another term for equity (or net worth). It represents the difference
between total assets and total liabilities.

Note that in this case we’re defining equity as common stockholders’ equity, which would exclude
preferred stock.
That is, common stockholders’ equity = total equity – preferred stocks.
(Universal has no preferred outstanding, so its total equity equals its common stockholders’ equity.)

Book value per share is computed as follows:

Book value per share= stockholders’ equity/ number of common shares outstanding
A convenient way to relate the book value of a company to the market price of its stock is to compute the
price-to-book-value ratio.
Price-to-book-value= market price of common stock/ book value per share
Interpreting the Numbers
Rather than compute all the financial ratios themselves, most investors rely on published reports for such
information. Many large brokerage houses and a variety of financial services firms publish such reports.

Even so, as an investor, you must be able to evaluate this published information. To do so, you need not
only a basic understanding of financial ratios but also some performance standard, or benchmark, against
which you can assess trends in company performance.

Basically, financial statement analysis uses two types of performance standards:

historical and industry. With historical standards, various financial ratios and measures are run on the
company for a period of three to five years (or longer). You would use these to assess developing trends
in the company’s operations and financial condition.