7.4 investment analysis and strategies

formula for book value per share

(tangible assets - liabilities - par value of preferred stock) / shares of common stock outstanding = book value per share

depreciating assets

- Because fixed assets (e.g., buildings, equipment, and machinery) wear out as they are used, they decline in value over time. This decline in value is called depreciation. A company's tax bills are reduced each year the company depreciates fixed assets used in the businesses.

capital asset pricing model

- CAPM - is a securities market investment theory that attempts to derive the expected return on an asset on the basis of the assets systematic risk

COGS

- costs of goods sold - is the costs of labor, material, and production used to create finished goods. The two major methods of accounting for material costs are the first in, first out method (FIFO) and last in, first out method (LIFO)

tools of fundamental analysis (12)

- financial statements - balance sheet - assets - liabilities - shareholder equity - working capital - changes that affect the balance sheet - capital structure - income statement - valuation ratios - statement of cashflow - corporate SEC filings - annual reports

defensive industries

- least affected by normal business cycles. Companies in defen- sive industries generally produce nondurable consumer goods, such as food, pharmaceuticals, tobacco, and energy. Public consumption of such goods remains fairly steady throughout the business cycle. - During recessions and bear markets, stocks in defensive industries generally decline less than stocks in other industries. During expansions and bull markets, defensive stocks may advance less. Investments in defensive industries tend to involve less risk and, consequently, lower investment returns.

components of the income statement

- revenues - COGS - pretax income - the income statement shows what came in, what went out, how much is left (before taxes)

assets

- what a company owns - appear on the balance sheet in order of liquidity, which is the ease with which they can be turned into cash. Assets that are most readily convertible into cash are listed first, followed by less liquid assets. Balance sheets commonly identify three types of assets: current assets (cash and assets easily convertible into cash), fixed assets (physical assets that could eventually be sold), and other assets (usually intangible and only of value to the corporation that owns them).

book value per share

-In the case of a corporation, it is basically the liquidation value of the enterprise - A fundamental analyst is described as one who focuses on the company's books. Therefore, one of the key numbers computed is the book value per share. The calculation is almost identical to one we have already studied—NAV per share of an investment company. - let's assume we sold all of our assets, paid back everyone we owe, and then split what is left among the stockholders. But, remember, before we can hand over anything to the common shareholders, we must take care of any outstanding preferred stock. So, from the funds that are left after we pay off all of the liabilities, we give the preferred shareholders back their par (or stated) value and the rest belongs to the common stockholders. But, there is one more thing. In the case of liquidation, some of the assets on our books might not really be worth what we're carrying them at. In particular, those that are known as intangible assets (goodwill, patents, trademarks, copyrights, etc.). That is why the analyst uses only the tangible assets, computed by subtracting those intangibles from the total assets

investment analysis terminology (15)

-alpha - arbitrage - a benchmark portfolio - beta coefficient - capital asset pricing model - earning multiplier - efficient market theory - eurobond - monte carlo simulation - optimal portfolio - risk free rate - sharpe ratio - standard deviation - systematic risk - unsystematic risk

capitalization

A company's capitalization is the combined sum of its long-term debt and equity accounts.

capital structure and its elements

A corporation builds its capital structure with equity and debt (optional) including the following four elements: ■ Long-term debt ■ Capital stock (common and preferred) ■ Capital in excess of par ■ Retained earnings (earned surplus)

balancing the balance sheet

Balance sheets, by definition, must balance. Every financial change in a business requires two offsetting changes on the company books, known as double-entry bookkeeping. For example, when a company pays a previously declared cash dividend, cash (a current asset) is reduced while dividends payable (a current liability of the same amount) is eradicated. This results in no change to working capital or net worth because each side of the balance sheet has been lowered by the same amount.

straight line vs accelerated depreciation

Compared with straight line, accelerated depreciation generates larger deductions (lower taxable income) during the early years and smaller deductions (higher taxable income) during the later years

earnings per share after dilution

If a corporation has rights, warrants, convertible preferred stock, or convertible bonds outstanding, the EPS could be diluted by an increase in the number of shares of common outstanding. That is, if the same amount of earnings available to common stockholders were allocated to more shares of stock, earnings would be less for each share. EPS is sometimes called primary earnings per share or basic earnings per share to differentiate it from earnings after dilution. EPS after dilution assumes that all convertible securities have been converted into the common. Because of tax adjustments, the calculations for figuring EPS after dilution can be complicated and will not be tested.

current ratio

Knowing the amount of working capital is useful, but it becomes an even better indica- tor when paired together with the current ratio. This computation uses the same two items, current assets and current liabilities, but expresses them as a ratio of one to the other. -Simply divide the current assets by the current liabilities and the higher the ratio, the more liquid the company is.

fiscal year accounting

Many business entities prefer to end their accounting year on a date other than December 31 (calendar year accounting). Any 12-month period used by a company, whether organized as a partnership, LLC, or corporation, that ends other than on December 31, is known as a fiscal year. this term is will be used many times when referring to require filings by investment advisors

quick asset ratio (ACID TEST RATIO)

Sometimes it is important for the analyst to use an even stricter test of a company's ability to meet its short-term obligations (as such, "pass the acid test"). The quick asset ratio uses the company's quick assets instead of all of the current assets. Quick assets are current assets minus the inventory. Then divide these quick assets by the current liabilities to arrive at the quick ratio.

debt to equity ratio

The best way to measure the amount of financial leverage being employed by the company is by calculating the debt-to-equity ratio. It is really a misnomer—it should be called the debt- to-total capitalization ratio because that is what it is. For example, using the numbers in our capitalization chart above, we see that the total capital employed in the business is $90 mil- lion. Of that, $50 million is long-term debt. So, we want to know how much of the $90 million total is represented by debt capital. The answer is simple: $50 million of the $90 million, or 55.55%. That is the debt-to-equity ratio.

dividends

When a cash dividend is declared, retained earnings are lowered and current liabilities are increased. The declaration of a cash dividend establishes a current liability until it is paid. Once paid, it reduces cash in current assets and also reduces current liabilities. Distribution of stock dividends has no effect on corporate assets or liabilities, nor does it change the stockholders' proportionate equity in the corporation. The number of shares each stockholder owns increases, but each single share represents a smaller slice of ownership in the corporation

convertible securities

When an investor converts a convertible bond into shares of common stock, the amount of liabilities decreases, and the owners' equity increases. The changes are on the same side of the balance sheet, so there is no change to the assets.

bond redemption

When bonds are redeemed, liabilities on the balance sheet are reduced. The offsetting change would be a decrease in cash on the asset side of the balance sheet. The company would have less debt outstanding, but it would also have less cash. The balance sheet balances. Therefore, because the current asset (cash) was used to redeem the long-term liability (bond), working capital is reduced.

example of eurobond

a bond issued in france denominated in british pounds

financial leverage

a companys ability to use long term debt to equity is said to be highly leveraged - stock holders benefit from leverage if the reurn on borrowed money exceeds the debt service costs. but leverage is risky because excessive increases in debt raise the possibility of default in a business downturn. - In general, industrial companies with debt-to-equity ratios of 50% or higher are consid- ered highly leveraged. However, utilities, with their relatively stable earnings and cash flows, can be more highly leveraged without subjecting stockholders to undue risk. If a company is highly leveraged, it is also affected more by changes in interest rates.

arbitrage

a legal strategy that generates a guaranteed profit from a transaction. A com- mon form of arbitrage is the simultaneous purchase and sale of the same security in different markets at different prices to lock in a profit

bench mark portfolio

a model portfolio of a large number of assets such as the S&P 500 against which the performance of a fund or portfolio is measured

optimal portfolio

a portfolio that provides the highest expected returns for a given level of risk

how does depreciation affect a company (2)

accumulated depreciation reduces the value of fixed assets on the balance sheet, and the annual depreciation deduction reduces tax- able income on the income statement.

capital in excess of par

also called net worth or owners' equity , is the stockholder claims on a company's assets after all of its creditors have been paid. Shareholder equity equals total assets less total liabilities. On a balance sheet, three types of shareholder equity are identified: capital stock at par, capital in excess of par, and retained earnings

shareholder equity and 3 types

also called net worth or owners' equity , is the stockholder claims on a company's assets after all of its creditors have been paid. Shareholder equity equals total assets less total liabilities. On a balance sheet, three types of shareholder equity are identified: capital stock at par, capital in excess of par, and retained earnings

working capital

amount of capital or cash a company has available. is a measure of a firms liquidity which is its ability to quickly turn assets into cash to meet short term obligations

accounts payable

amounts owed to suppliers of materials and other business costs

dividends per share formula

annual cash dividends / number of common shares outstanding

earnings multiplier

another term for the price to earn (PE) ratio - is the price of the stock divded by its earnings per share

current long term debt

any portion of long term debt due within 12 months

current liabilities and what they include

are corporate debt obligations due for payment within the next 12 months - include: - accounts payable - accrued wages payable - current longterm debt - notes payable - accrued taxes

earnings available to common

are the remaining earnings after the preferred dividend has been paid. Earnings per share relates to common stock only. Preferred stockholders have no claims to earnings beyond the stipulated preferred stock dividends.

balance sheet equation

assets= liabilities + owners equity assets- liabilities = owners equity

technical analysts

attempt to predict the direction of prices on the basis of charts reflecting price and trading volume patterns of specific securities without regard to the issuers profitability

notes payable

balance due on equipment purchased on credit or cash borrowed

issuing securities

balance sheet indicates the company issued 1 million shares of $1 par common stock. If it issues another 1 million shares, the net worth (shareholders' equity) will increase by the additional capital raised, and the amount of cash on the asset side of the balance sheet will increase.

changes that affect the balance sheet

balancing the balance sheet - depreciating assets

efficient market theory

believes that prices of securities rapidly reflect simultaneous access to all information

how do they do fundamental analysis

by examining the company in detail, including the financial statements and company management. We could compare this to an individual receiving a full physical examination which, in addition to all kinds of tests, would include a detailed family medical history. With a company, the financial statement analysis is like the blood tests, x-rays, stress test - look for companies in industries that offer better than average opportunities within the current business cycle

how is sharpe ratio calculated

calculated as the portfolios average return that is in excess of the risk free rate divided by the standard deviation of the portfolio

straight line method

companies may elect this when a company depreciates fixed assets by an equal amount each year over the assets useful life. a piece of equipment costing $1 million with a 10-year useful life will generate a depreciation deduction of $100,000 per year.

inventory

cost of raw materials work in process and finished goods ready for sale

formula for working capital

current assets- current liabilities = working capital

4 types of industries regarding business cycles

defensive, cyclical, growth, special situation

eps formula

earnings available to common / number of shares outstanding

EPS

earnings per share - one of the most widley used statistics EPS measures the value of a companys earnings for each common share

fundamental analysts

evaluate broad based economic trends current business conditions within an industry and the quality of a particular corporations business finances and management

growth industries

every industry passes through 4 phases during its existence: intro, growth maturity and decline. An industry is considered in its growth phase if the industry is grow- ing faster than the economy as a whole because of technological changes, new products, or changing consumer tastes. Computers and bioengineering are current growth industries. Because many growth companies retain nearly all of their earnings to finance their business expansion, growth stocks usually pay little or no dividends.

long term liabilities

financial obligations due for payment after 12 months. Examples would include bonds and mortgages.

cyclical industries

highly sensitive to business cycles and inflation trends. mostly produce durable goods such as heavy machinery and cars as well as raw materials like steel - During recessions, the demand for durable goods declines as manufacturers post- pone investments in new capital goods and consumers postpone purchases of automobiles.

current assets and what is included (4)

include all cash and other items expected to be converted into cash within the next 12 months, cash and equivalents, accounts receivable, inventory, prepaid expenses

accounts receivable

include amounts due from customers for goods delivered or services rendered reduced by the allowance for bad debts

cash equivalents

include cash and short term safe investment such as money market instruments that can be readily sold as well as other marketable securities

capital stock at par

includes preferred and common stock listed at par value

revenues

indicate the firms total sales during the period that the money came in

other assets

intangible assets - nonphysical properties, such as formulas, brand names, contract rights, and trademarks. Goodwill, also an intangible asset, reflects the corporation's reputation and relationship with its clients.

eurobond

is a bond denominated in a currency other than the currency of the country it is issued. The most tested form of eurobond is the eurodollar bond. These bonds are most commonly issued by an overseas company outside of the U.S., as well as the issuer's home country. These bonds are not limited to European issuers; that's just where they originated.

monte carlo simulation

is a statistical method to determine the return profile of a secu- rity or portfolio that recreates potential outcomes by generating random values on the basis of the risk and return characteristics of the securities themselves.

standard deviation

is a volatility measurement. It compares the amounts by which a security's or portfolio's returns vary from their mean (average) return.

pretax margin

is determined by subtracting COGS and other operating costs (such as depreciation) from sales to arrive at gross operating profit. The resulting figure is [earnings before interest and taxes] (EBIT).

prepaid expenses

items a company has already paid for but has not yet benefited from such as prepaid advertising rents insurance and operating supplies

LIFO

last in first out - Under LIFO accounting, COGS normally will reflect higher costs of more recently purchased inventory (last items in). As a result of higher reported production costs under LIFO, reported income is reduced. The oppo- site is true if the FIFO method is used.

stock splits

like a stock dividend a stock split does not affect shareholders equity. on the balance sheet only the par value per share and number of shares outstanding change.

sharpe ratio

measure of a portfolio's (or individual security's) risk in comparison to its expected return - the higher the sharpe ratio the more attractive an investment becomes

beta coefficient

measure of its volatility in relation to overall market. a security that has a beta of 1 moves in line with the market. a security with a beta of greater than 1 is generally going to be more volatile than the overall market. the reverse is true when the beta is less than 1

accelerated depreciation

method that depreciates fixed assets more during the earlier years of their useful life and less during the later years

fixed assets

property, plant, and equipment. Unlike current assets, they are not easily converted into cash. Fixed assets, such as factories, have limited useful lives because wear and tear eventually reduce their value. For this reason, their cost can be depreciated over time or deducted from taxable income in annual installments to compensate for loss in value.

financial statements

provide a fundamental analyst with the information needed to assess that corporation's profitability, financial strength, and operating efficiency. By examining how certain numbers from one statement relate to prior statements and how the resulting ratios relate to the company's competitors, the analyst can determine how financially viable the company is. - companies issue quarterly and annual financial reports to the SEC. a companys balance sheet and income statement are included in these reports

balance sheet

provides a snapshot of a company's financial position at a specific point in time. It identifies the value of the company's assets (what it owns) and its liabilities (what it owes). - balance sheet does not indicate whether the company's business is improving or deteriorating. The balance sheet gets its name from the fact that its two sides must balance. The balance sheet equation mathe- matically expresses the relationship between the two sides of the balance sheet. Simply stated, everything that is owned (assets) minus everything that is owed (liabilities) is equal to the net worth (owners' or shareholders' equity) of the entity.

risk free rate

refers to the interest rate of a 90 day US treasury bill

capital structure

relative amounts of debt and equity that compose a companys capitalization. some companies finance their business with a large proportion of borrowed funds; others finance growth with retained earnings from normal operations and little or no debt

fiscal

something that pertains to financial matters

retained earnings

sometimes called earned surplus , are profits that have not been paid out in dividends. Retained earnings represent the total of all earnings held since the corpora- tion was formed less dividends paid to stockholders. Operating losses in any year reduce the retained earnings from prior years.

systematic risk

sometimes called market risk, is the risk in the return of an investment that is associated with the macroeconomic factors that affect all risky assets. systematic plus unsystematic risk equals the total risk of an investment

income statement

sometimes referred to as the profit and loss or P&L statement summarizes a companys revenues (sales) and expenses for a fiscal period, usually quarterly, year to date, or the full year. Compares revenue against costs and expenses during the period. - Fundamental analysts use the income statement to judge the efficiency and profitability of a company's operation. Just as with the balance sheet, technical analysts generally ignore this information—it is not relevant to their charting schemes.

unsystematic risk

specific risk associated with an investment. is not related to macroeconomic factors

special situation stocks

stocks of a company with unusual profit potential resulting from nonrecurring circumstances, such as new management, the discovery of a valuable natu- ral resource on corporate property, or the introduction of a new product.

countercyclical industries

tend to turn down as the economy heats up and rise when the economy turns down - gold mining has historically been a countercyclical industry

pretax income

the amount of tax- able income, is operating income less interest payment expenses. If dividends are paid to stockholders, they are paid out of net income after taxes have been paid. After dividends have been paid, the remaining income is added to retained earnings and is available to invest in the business.

owners equity or net worth

the difference between its assets and liabilities

dividends per share

the dollar amount of cash dividends paid on each common share during the year

alpha

the extent to which an assets or portfolios actual return exceeds or falls short of its expected return - a positive alpha rather than a negative one is desirable.

fundamental analysis

the study of the business prospects of an individual company within the context of its industry and the overall economy

par value

the total dollar value assigned to stock certificates when a corporations owners first contributed capital. par value of common stock is an arbitrary value with no relationship to market price

reason for issuing eurobonds

they are free from the requirement to register with the SEC resulting in lower issuance costs. however because the liquidity is not as great as with domestic issues and because the political and country risks tend to be higher yields are generally higher

footnotes

to the financial statements identify significant financial and management issues that may affect the companys overall performance such as accounting methods used, extraordinary items, pending litigation, management philosophy - Typically, a company separately discloses details about its long-term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years. - Also disclosed in the footnotes would be off the books financing arrangements such as debt guarantees.

investment analysis and strategies

two approaches commonly used to select investments are fundamental and technical analysis - both attempt to forecast prices or values of securities and markets

accrued taxes

unpaid federal state and local taxes

accrued wages payable

unpaid wages salaries commissions and interest

valuation ratios

used by analysts to compare companies within an industry as well as in different industries

liabilities and 2 types

what a company owes - on a balance sheet represent all financial claims by creditors against the corporation's assets. Balance sheets usually include two main types of liabilities: current liabilities and long-term liabilities.

accounting for depreciation

when reviewing the balance sheet, fixed assets are shown at their cost minus accumulated depreciation. For these assets, which wear out over a period of time, tax law requires that the loss of value be deducted over the asset's useful life, longer for some assets, shorter for others (you won't have to know depreciation schedules). On the income statement, the allowable portion for the year is shown as an expense and, for our purposes, will generally be part of COGS. Remember, if the company uses accelerated depreciation, the expenses will be higher in the early years resulting in lower pretax income (and lower income taxes) but higher income later on.

advantages of Eurodollar bonds to investors (3)

■ because they are U.S.-dollar denominated, they bear no currency risk to U.S. inves- tors; ■ they are rated by U.S. rating agencies so the risk is clear; and ■ they may offer higher yields than domestic bonds from the same issuer.

factors that affect working capital

■ increases in working capital, such as profits, sale of securities (long-term debt or equity), and sale of noncurrent assets; and ■ decreases in working capital, such as dividends declared, paying off long-term debt, and net loss

disadvantages of Eurodollar bonds (as with foreign bonds in general) (4)

■ since they are not registered with the SEC, there may be a lack of transparency; ■ they have political and country risk (taken into consideration by the rating agen- cies); ■ they have less liquidity than domestic issues; and ■ currency risk (if denominated in a currency other than one's home country)