Security Analysis:

Security analysis consists of (1) gathering information, (2) organizing it into a logical framework, and (3) using the information to determine the intrinsic value of common stock. Intrinsic value provides a measure of the underlying worth of a share of stock that is whether undervalued, fairly priced, or overvalued.

A satisfactory investment is one that offers a level of expected return proportionate to the amount of risk involved.

Intrinsic value depends on the following: (1) estimates of the stock's future cash flows, (2) the discount rate used to translate those future cash flows into a present value, and (3) the risk associated with future performance.

The three steps in security analysis should enable investors to identify satisfactory investments. First, economic analysis assesses the general state of the economy and its potential effects on security returns. Industry analysis examines specific industries and the characteristics and outlook of those industries. Finally, fundamental analysis looks at the financial condition and operating results of a particular company in depth. Together, they enable the investor to develop expectations about a stock's future course of behaviorwhat kind of return to expect and what kind of risk is likely to be involved. By examining variables such as future earnings, dividends, and so on, the security analysis process allows investors to develop a feel for the stock and what to expect of it in the future.

There are others who do not accept the assumptions of fundamental analysis. These efficient market advocates believe that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times and that even when securities are misplaced, it is nearly impossible to determine which stocks are overvalued and which are undervalued.

Economic Analysis:

As a rule, stock prices tend to move up when the economy is strong, and they retreat when the economy starts to weaken.

Economic analysis consists of a general study of the prevailing economic environment. The behavior of the economy is captured in the business cycle, which reflects changes in total economic activity overtime.

Gross domestic product (GDP) and industrial production are the two measures of the business cycle. GDP is the market value of all goods and services produced in a country over a given period. Industrial production is an indicator production move up and down with the business cycle.

The most important factors in economic analysis can be examined in three groups: (1) Government fiscal policy - which includes taxes, government spending, and debt management; (2) Monetary policy - which includes money supply, and interest rates; and (3) other factors - which include inflation, consumer spending, business investments, and foreign trade and foreign exchange rates.

Investors use the economic outlook to get a handle on the market and to identify developing industry sectors.

Industry Analysis:

Industry analysis is the part of the security analysis process involving the study of stocks in terms of their industry groupings. Industry analysis is important because stock prices are influenced, at least in part, by industry effects. Industry analysis can be used to establish the competitive position for a particular industry and to assess the nature of the opportunity the industry offers for the future. It also enables the investor to identify promising firms in an industry.

Industry analysis includes:

1. The nature of the industry

2. The extend of the regulation the industry has

3. The role of labor in the industry

4. The importance of technological developments

5. Financial and operating characteristics of the industry.

Growth cycle reflects the vitality of the industry over time. The growth cycle can be examined in four stages: initial development, rapid expansion, mature growth and stability or decline.

Fundamental Analysis:

Fundamental analysis is the study of the financial affairs of a business for the purpose of better understanding the company that issued the common stock. It is also called the company analysis. The investor studies the financial statements of the firm to learn about its strengths and weaknesses, identify any trends and developments, evaluate operating efficiencies, and gain a general understanding of the nature and operating characteristics of the firm. The investors pay close attention to the competitive position of the company, its position and growth in sales, profit margins and the dynamics of company earnings, the composition and liquidity of corporate resources, and the company's capital structure.

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: the balance sheet, the income statement, and statement of cash flows. Financial statements are generally prepared quarterly and at the end of each year or fiscal year.

The balance sheet is a statement of the company's assets, liabilities, and stockholder's equity. The assets represent the resources of the company (the things the company owns). The liabilities are its debt. Equity is the difference between a firm's assets and its liabilities.

The income statement provides a financial summary of the operating results of the firm. It shows the amount of revenues generated over a period of time, the costs and expenses incurred over the same period, and the company's profits.

The statement of cash flows provides a summary of the firm's cash flow and other events that caused changes in its cash position.

Financial Ratios:

Ratio analysis is the study of the relationships between various financial statement accounts. Ratio analysis helps the investor to better understand the liquidity, activity, or profitability of the firm. Investors use financial ratios to evaluate the financial condition and operating results of the company and to compare those results to historical or industry standards.

Liquidity Measures:

Liquidity measures are concerned with the firm's ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due. Liquidity measures are current ratio, and net working capital.

Current ratio = Current assets / Current liabilities

Net working capital = Current assets - Current liabilities

Activity Ratios:

Activity ratios compare company sales to various asset categories in order to measure how well the company is utilizing its asset. Activity ratios are accounts receivable turnover, inventory turnover, and total asset turnover.

Accounts receivable turnover = Annual sales / Accounts receivable

Inventory turnover - Annual sales / Inventory

Total assets turnover = Annual sales / Total assets

Leverage Measures:

Leverage measures look at the firm's financial structure. It indicates the amount of the debt being used to support the resources and operations of the company. The leverage measures are debt-equity ratio, and times interest earned.

Debt-equity ratio = Long-term debt / Stockholder's equity

Times interest earned = Earnings before interest and taxes / Interest expense

Profitability Measures:

Profitability is a relative measure of success. The profitability measures relate the returns (profit) of a company to its sales, assets, or equity. The profitability measures are net profit margin, return on assets (ROA), and return on equity (ROE).

Net profit margin = Net profit after taxes / Total revenues

ROA = Net profit after taxes / Total assets

ROE = Net profit after taxes / Stockholders' equity

ROA = Net profit margin x Total asset turnover

ROE = ROA x Equity multiplier

Equity multiplier = Total assets / Total stockholders' equity

Common-Stock Ratios:

Common-stock ratios convert key bits of information about the company to a per-share basis. These ratios are also called market ratios. Common-stock ratios are price/earnings ratio, dividends per share, payout ratio, and book value per share.

Earnings per share (EPS) = (Net profit -Preferred dividends) / Number of common shares outstanding

P/E = Net price of common stock / EPS

Dividends per share = Annual dividends paid to common stock / Number of common shares outstanding

Payout Ratio = Dividends per share / Earnings per share

Book value per share = Common stockholders' equity / Number of common shares outstanding

Price-to-book value = Market price of common stock / Book value per share

Interpreting Numbers:

The financial services firms generally publish reports that include the financial ratios which is very convenient for the investors.

Financial statement analysis uses two types of performance standards: historical and industrial. With historical standards, various financial ratios and measures are run on the company for a period of three or five years (or longer). In contrast, industrial standards enable you to compare the financial ratios of the company with comparable firms or with the average results for the industry as a whole.

In addition to analyzing the historical and industrial standards, it is useful to evaluate the firm relative to two or three of its major competitors.

1.Why is industrial analysis important?

2.What are the key issues in industrial analysis?

3.Explain the importance of ratio analysis.

4.Why is it necessary to base the analysis on historical and industrial standards?