Chapter 2 Securities Markets and Transactions 15
Chapter 7
Analyzing Common Stocks
Outline
Learning Goals
I. Security Analysis
A. Principles of Security Analysis
1. The Top-Down Approach to Security Analysis
B. Who Needs Security Analysis in an Efficient Market?
Concepts in Review
II. Economic Analysis
A. Economic Analysis and the Business Cycle
B. Key Economic Factors
C. Developing an Economic Outlook
1. Assessing the Potential Impact on Share Prices
2. The Market as a Leading Indicator
Concepts in Review
III. Industry Analysis
A. Key Issues
1. The Industry Growth Cycle
B. Developing an Industry Outlook
Concepts in Review
IV. Fundamental Analysis
A. The Concept
B. Financial Statements
1. The Balance Sheet
2. The Income Statement
3. The Statement of Cash Flows
C. Financial Ratios
1. What Ratios Have to Offer
2. Liquidity Ratios
a. Current Ratio
b. Quick Ratio
c. Net Working Capital
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
3. Activity Ratios
a. Accounts Receivable Turnover
b. Inventory Turnover
c. Total Asset Turnover
4. Leverage Ratios
a. Debt-Equity Ratio
b. Equity Multiplier
c Times Interest Earned
5. Profitability Ratios
a. Net Profit Margin
b. Return on Assets
c. Return on Equity
6. Breaking Down ROA and ROE
a. Going from ROA to ROE
b. An Expanded ROE Equation
7. Common-Stock Ratios
a. Price-to-Earnings Ratio
b. Dividends per Share
c. Payout Ratio
d. Book Value per Share
D. Interpreting the Numbers
1. Using Historical and Industry Standards
2. Looking at the Competition
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
7.1 Some Financial Ratios Are Real Eye-Openers
7.2 Doris Looks at an Auto Issue
Excel@Investing
Chapter-Opening Problem
Key Concepts
1. An overview of the security analysis process, including its goals and the functions it performs for
the individual investor
2. The role and importance of economics in the stock valuation process
3. The role and importance of industry analysis in the stock valuation process
4. The concept of fundamental analysis and how it is used to assess a company’s financial position
and operating results
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Chapter 2 Securities Markets and Transactions 17
5. The various types of accounting statements and financial ratios used in evaluating the historical
performance of a company
6. An overview of fundamental analysis at work, including the need to evaluate company
performance against historical and industry standards, and how such comparisons form the basic
input for the valuation process
Overview
This chapter and the next two analyze principles and concepts of sound common stock investing.
1. The principles of security analysis are first presented, beginning with the three basic ingredients of
any viable analysis: (1) gathering relevant information, (2) organizing it into a logical framework,
and (3) determining the intrinsic value of the stock. Knowledge of the intrinsic value of a stock is
important in investment decisionmaking. An investor can decide whether a stock is overvalued or
undervalued relative to the market price only if he or she has an indication of the intrinsic worth of
the stock. Attention should be paid to the need for security analysis in an efficient market.
2. The next section looks at the information-gathering process in detail. The instructor might mention
that information for security analysis is usually collected and analyzed in a top-down fashion, in this
order: economic analysis, industry analysis, and fundamental analysis.
a. Economic analysis usually takes both the economy and the stock market into account. Key
factors that affect the economy are: governmental regulations, monetary and fiscal policies,
inflation, spending by consumers and businesses, and foreign trade/balance of payments. These
key economic indicators should be mentioned in class. Students should realize that only after
assimilating this information can the investor prepare an economic outlook. Specific reports on
the state of the economy (as noted in the text) should be mentioned.
b. The key factors that bear on industry analysisare considered next. Again, the instructor should
mention specific sources of published reports on industry outlooks.
c. Fundamental analysis is the analysis of a particular company and is described below.
3. In order to do company analysis, relevant financial statements are required. The most important of
these are the company’s balance sheet and income statement. The usefulness of these financial
statements in revealing information about the company under consideration should be emphasized.
The components of both the balance sheet and the income statement, and exactly what they measure,
should be indicated. Time should also be spent describing the statement of cash flows and how it can
be used by investors to assess the firm’s liquidity position. Bringing in financial statements of a
popular or local company typically makes this segment of the course more realistic. Statements of
most listed companies are readily available online and instructors should make students aware of
some sources like Mergent and Yahoo Finance which provide access not only to statements, but also
to industry benchmarks and some useful analysis.
4. Ratio analysis provides insights into the performance of a company. The instructor should point
out that the historical ratios of a company reflect past performance. Also, comparing the company’s
ratios with industry ratios—and with ratios of some of its major competitors—shows how a particular
company performed in contrast to the performance of other companies in similar businesses. The
instructor should check the class’s understanding of the procedures for computing and interpreting
ratios and review the example in the text thoroughly.
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
5. These additional points might also be mentioned in class:
a. In all three types of analysis, the investor does not come up with a number but instead with a
general view or outlook.
b. All analyses of past performance only help in generating estimates for the future.
c. Further development of this chapter’s concepts follows in Chapter 8.
Answers to Concepts in Review
7.1 The three major parts of security analysis are economic analysis, industry analysis, and fundamental
7.2 Intrinsic value, the end product of security analysis, is the measure of the underlying worth of a stock
and provides a standard for helping investors to judge whether a particular stock is undervalued,
fairly priced, or overvalued. If the intrinsic value of a stock is more than the market price, then the
7.3 A satisfactory investment is one that offers an expected return, from the combination of current
income and capital gains, that is commensurate with its perceived exposure to risk. 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.
7.4 If the stock market is efficient in the strongest form, then securities are never substantially mispriced
and hence there would be no need for security analysis. But in reality, the financial markets are not
7.5 Economic analysis involves studying the underlying nature of the economic environment in which a
firm operates. Economic analysis also helps the investor form expectations about the future course of
the economy. Such an analysis could be a detailed examination of the economy, sector by sector, or
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Chapter 2 Securities Markets and Transactions 19
7.6 The behavior and current state of the economy is captured in the business cycle, which measures the
change in total economic activity over time. Not all stocks react the same way to changes in the
7.7 a. Gross domestic product (GDP). This is the broadest measure of an economy’s
b. Leading indicators. This is an index that combines the behavior of a dozen key measures, each of
which tends to be an indication of things to come in the economy. They include employment
c. Money supply. This is a measure of the amount of money in circulation as reported by the Federal
d. Producer prices. This is a measure of price behavior at the “wholesale” level. It shows the rate
7.8 The effects of high rates of inflation on common stocks can be devastating. In inflationary times, the
quality of earnings declines as profit margins are squeezed and the purchasing power of the dollar
deteriorates. An increase in inflation results in an increase in interest rates. Hence, firms’ borrowing
7.9 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
7.10 Some important aspects of industry analysis include:
a. The nature of the industry: whether it is monopolistic or competitive.
b. The extent of regulation: whether regulation is minimal or intense.
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
Economic forces important to the industry include the demand for the industry’s goods and
services and the correlation with key economic variables. To the extent that an industry is influenced
7.11 The four stages of an industry’s growth cycle are:
a. Initial development—product introduction.
d. Stability or decline—there are other things to want.
The rapid expansion phase offers the biggest payoff to investors. At this stage, the industry’s
7.12 Fundamental analysis is the study of the financial affairs of a business. It is essential to the valuation
process to the extent that the value of a stock is influenced by the performance of the company that
7.13 Historical analysis provides some insight, along with economic and industry figures, for formulating
expectations about the future growth prospects and profitability of a company. In particular, historical
7.14 Ratio analysis is the study of relationships that exist among and between various financial statement
accounts. Ratio analysis provides a different perspective on the operating results and financial
condition of the firm by expanding the information content of the financial statements. By studying
7.15 When historical standards are used, the company’s ratios are compared and studied from one period
to the next. Industry standards involve a comparison of a company’s ratios to that of other companies
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