CHAPTER FOURTEEN FINANCIAL ANALYSIS OF COMMON STOCKS 1

CHAPTER FOURTEEN FINANCIAL ANALYSIS OF COMMON STOCKS 1

FINANCIAL ANALYSIS • WHAT IS FINANCIAL ANALYSIS? – DEFINITION: the activity of providing inputs to the portfolio management process 2

FINANCIAL ANALYSIS • PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS – THE ASSOCIATION OF INVESTMENT MANAGEMENT AND RESEARCH (AIMR) • acts as an advocate for the financial analyst profession • it hosts conferencing and workshops – designed to enhance the knowledge base of the memberships • it also publishes the Financial Analysts Journal 3

FINANCIAL ANALYSIS • PROFESSIONAL FINANCIAL ANALYSIS ORGANIZATIONS – THE ASSOCIATION OF INVESTMENT MANAGEMENT AND RESEARCH (AIMR) • acts as an advocate for the financial analyst profession • it host conferencing and workshops – designed to enhance the knowledge base of the memberships • it also publishes the Financial Analysts Journal 4

FINANCIAL ANALYSIS • REASONS FOR FINANCIAL ANALYSIS – TWO PRIMARY REASONS • to determine certain securities’ characteristics • to attempt to identify mispriced securities 5

FINANCIAL ANALYSIS • REASON #1: DETERMNING SECURITY CHARACTERISTICS – estimate future sensitivity to major factors – estimate dividend yield 6

FINANCIAL ANALYSIS • REASON #2: ATTEMPTING TO IDENTIFY MISPRICED SECURITIES – use fundamental analysis – approaches • valuation determines the intrinsic value compared to the current market value • estimate key financial variables such as – EPS next year – income growth next year 7

TECHNICAL ANAYSIS • DEFINITION: a form of security analysis that attempts to forecast price changes based on historical price and volume trends 8

TECHNICAL ANAYSIS • Two Groups of Strategies Used: 1. Momentum and Contrarian Strategies 2. Moving Average and Trading Range Breakout Strategies 9

TECHNICAL ANAYSIS 1. Momentum and Contrarian Strategies – METHDOLOGY: • examine the returns over a time period just ended to identify – momentum investors who seek out stocks recently rising in price for purchase; falling for sale – contrarians who follow the opposite strategy of most investors » contrarians base their strategy on the overreation theory 10

TECHNICAL ANAYSIS 2. Moving Average and Trading Range Breakout Strategies – MOVING AVERAGE STRATEGY: • calculate a moving average over the last 200 days of closing prices • divdied today’s closing price into the moving average (SHORT-TO-LONG RATIO) • if short-to-long ratio is greater than 1, buy • if ratio is less than 1, sell 11

TECHNICAL ANAYSIS • 2. Moving Average and Trading Range Breakout Strategies – TRADING RANGE BREAKOUT STRATEGY: • high and low prices for past 200 trading days are identified • if today’s close is greater than the high = buy! • if today’s close is less than the low = sell! 12

FUNDAMENTAL ANALYSIS • TOP-DOWN V. BOTTOM UP – TOP-DOWN APPROACH • attempts to forecast in the following order 1. economic activity 2. industry performance 3. firm’s performance 13

FUNDAMENTAL ANALYSIS • TOP-DOWN V. BOTTOM UP – BOTTOM-UP APPROACH: • attempts to estimate prospects in the following order: 1. The firm 2. The Industry 3. The economy 14

FUNDAMENTAL ANALYSIS • FINANCIAL STATMENT ANALYSIS – INTEGRAL PART OF FUNDAMENTAL ANALYSIS • it helps the analyst understand a firm’s current condition • where it is headed • what factors affect it • how the factors affect it 15

FUNDAMENTAL ANALYSIS • FINANCIAL STATMENT ANALYSIS – Review of Accounting Statements • includes a study of the three major statements prepared monthly by most accountants: – the balance sheet – the income statement – the statment of cash flows 16

FUNDAMENTAL ANALYSIS • FINANCIAL STATMENT ANALYSIS – RATIO ANALYSIS • DEFINITION: a technique used to examine a company’s financial statements • Use of Ratios – – as an absolute standard as a comparative indicator as a trend over time in combination with technical analysis 17

FUNDAMENTAL ANALYSIS • FINANCIAL STATMENT ANALYSIS – RATIO ANALYSIS • Types of Ratios – – internal liquidity operating performance risk analysis growth analysis 18

FUNDAMENTAL ANALYSIS • internal liquidity ratios: – indicate the ability of the firm to meet future short-term financial obligations – some liquidity ratios: • • current ratio quick ratio cash ratio receivables turnover 19

FUNDAMENTAL ANALYSIS • operating performance ratios: – indicate how well the management is operating the business – some examples: • total asset turnover • net fixed asset turnover • equity turnover 20

FUNDAMENTAL ANALYSIS • risk analysis ratios: – indicates the uncertainty of income flows for the total firm and for the individual sources of capital (debt and stock) – some examples: • debt to equity ratio • long-term debt/total capital ratio 21

FUNDAMENTAL ANALYSIS • growth analysis ratios: – indicate how fast a firm should grow – it involves analysis using several other ratios • net profit margin • total asset turnover • total assets/equity 22