*FINANCIAL ANALYSIS OF COMMON STOCKS

Fundamental Analysis

*FINANCIAL ANALYSISWHAT IS FINANCIAL ANALYSIS?DEFINITION: the activity of providing inputs to the portfolio management process

*FINANCIAL ANALYSISREASONS FOR FINANCIAL ANALYSISTWO PRIMARY REASONSto determine certain securities characteristics to attempt to identify mispriced securities

*FINANCIAL ANALYSISREASON #1: DETERMNING SECURITY CHARACTERISTICSestimate future sensitivity to major factorsestimate dividend yield

*FINANCIAL ANALYSISREASON #2: ATTEMPTING TO IDENTIFY MISPRICED SECURITIESuse fundamental analysisapproachesvaluation determines the intrinsic value compared to the current market valueestimate key financial variables such asEPS next yearincome growth next year

FINANCIAL ANALYSIS1. Fundamental analysis three levels of analysesi. Macroeconomic analysisii. Industry analysisiii.Company analysis2. Technical analysis Technical analysis and stock valuation Analytical tools of technical analysis*

Fundamental Analysis (FA)FA: concerned with the calculation of estimated (or intrinsic) value (EV) of an investment by examining variables such as current and future earnings, interest rates and risk variables.At its base level, FA deals with individual company data, such as earnings growth, dividends, retention ratios and the investor's required rate of return.Estimates of these variables are influenced by other areas of the economy or business (or industry) sector.*

In order to analyse a particular company, FA requires a larger perspective than just the individual company level.In FA, the estimated value of investment is determined by underlying economic variables centred around the national (domestic) economy and the international economy.FA: used in buy/sell decisions on securities.*

FA advocates that both economy/market and industry have significant effects on the total returns of individual stocks.FA is a three-step process involving, firstly, the economy or the market, secondly, industry analysis, and finally, analysis of the particular company (RB, p.362, Exhibit 11.1)This is known as top-down investment analysis process*

*

*

These policies affect corporate earnings:Corporate tax rate fiscal policy.Changes in government expenditure fiscal policy.Changes in nominal money supply (affecting interest rates) monetary policy.Consumer/Investor sentiments fiscal and monetary policy: very important.Potential output (GDP) fiscal and monetary policy.*

International (global) economy influences the domestic economy through exchange rate which is influenced by differences in interest rates, inflation rates and GDP growth between countries: show cyclical behaviour.To benefit from market timing, forecasting the market by analysis of general economic factors eg. business cycle is necessary.*

Cyclical approach to forecasting: estimation of turning points in business cycle, thus more robust prediction of stock price direction.Basically three types of indicators can help to forecast the business cycle: Leading indicators: anticipate the trends in the level of economic activity, eg. All Ordinaries Index (AOI), new business formations, new building permits, orders for plant and equipment. Coincident indicators: contemporaneously track the level of economic activity, eg. number of employees on non-agricultural payrolls. Lagging indicators: adjust after changes in the level of economic activity eg. average duration of employment, consumer debt.*

Why is analysis of the economy (market) important? If the market goes up strongly - most investors make money.Empirical evidence: the market (incorporating systemic risk) is the largest single factor explaining fluctuations in individual stocks and portfolios of stocks. For a diversified portfolio, 90% of return variability is due to the market.*

Bangladeshi market environment: Most quoted measure of market performance is All Ordinaries Index (AOI) = DSE All Share or DSE General Price Index in Bangladesh reflects daily changes in share prices (capital gain or loss).Also All Ordinaries Accumulation Indices (AOAI) reflects capital gain or loss plus reinvestment of dividends.*

Second Step :Industry analysisIndustry: a set of businesses producing similar products.Need to identify promising sectors of the economy (sector rotation) to obtain good returns.Two sources of Bangladeshi industry classification:1. Dhaka Stock Exchange industry segmentation: sectoral indices for banking, textile, pharmaceutical etc.2. Bangladesh Standard Industrial Classification of All Economic Activities (BSIC-2001)*

Stocks in different industries perform differently in the business cycle (RB, p.464, Exhibit 13.2).Every industry has its unique characteristics and usually follows some form of life cycle (RB, p.469, Exhibit 13.3) The life cycle allows analysts to estimate potential sales growth for the industry.*

*

Pioneering stage: gradual growth in demand, sales and earnings for some companies. Tough competition and firms battle for survival.Investment risk is high - difficult to screen out survivors. Expansion (rapid growth and mature growth stages combined) stage: easier to identify the survivors. Growth continues at a more rapid rate. Firms are more stable and tend to improve their products, reduce costs and lower prices.*

Stabilising stage: less growth and sales increase at a lower rate; more product standardisation while competition is fierce.Declining stage: profit margins continue to be squeezed and some firms experience losses.Unique Characteristics of Industries:Growth industries - earnings are expected to exceed the average of all industries, eg. Cellular phones.Defensive industries - those least effected by recessions and economic adversity, eg. food.Cyclical industries - are most volatile and usually do well in a boom - worse than average in a recession, eg. durable goods.*

Counter cyclical industries - move opposite to the prevailing economic trend, eg. gold mining industry.Interest sensitive industries - highly sensitive to expected changes in interest rates, eg. banking.An analytical framework for industry analysis (with five competitive forces) is provided by Porter (1980, 1998) RB, p. 471, Exhibit 13.4.*

Third Step: Company AnalysisThis final step concentrates mostly on company financial statement data published.May also use more timely news announcements - financial press and analysts reports etc.Also essential to analyse the quality and integrity of management of the particular company: a better run company should present itself as a less risky investment.*

Growth vs Value: growth stocks generate higher rates of return than other stocks in the market with similar characteristics.Value stocks appear undervalued for reasons other than earnings growth potential and have low P/E ratios or low price-to-book ratios.Based on the macroeconomic analysis, top-down analysts identify industries and companies, which can offer attractive returns in the future.Fundamental analysis is used due to lack of faith in efficient market hypothesis (EMH).*

*FINANCIAL STATMENT ANALYSISINTEGRAL PART OF FUNDAMENTAL ANALYSISit helps the analyst understand a firms current conditionwhere it is headedwhat factors affect ithow the factors affect it

*FINANCIAL STATMENT ANALYSISReview of Accounting Statementsincludes a study of the three major statements prepared monthly by most accountants:the balance sheetthe income statementthe statment of cash flows

*FINANCIAL STATMENT ANALYSISRATIO ANALYSISDEFINITION: a technique used to examine a companys financial statementsUse of Ratiosas an absolute standardas a comparative indicatoras a trend over timein combination with technical analysis

*FINANCIAL STATMENT ANALYSISRATIO ANALYSISTypes of Ratiosinternal liquidityoperating performancerisk analysisgrowth analysis

*internal liquidity ratios:indicate the ability of the firm to meet future short-term financial obligationssome liquidity ratios:current ratioquick ratiocash ratioreceivables turnover

*operating performance ratios:indicate how well the management is operating the businesssome examples:total asset turnovernet fixed asset turnoverequity turnover

*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 ratiolong-term debt/total capital ratio

*growth analysis ratios:indicate how fast a firm should growit involves analysis using several other ratiosnet profit margintotal asset turnovertotal assets/equity

*TOP-DOWN V. BOTTOM UPBOTTOM-UP APPROACH:attempts to estimate prospects in the following order:

1. The firm2. The Industry3. The economy