Chapter 6: Fundamental Analysis

of the Stock Market

By: Mario Rodríguez

The importance to maximize your investments on industries you are related to.

How to identify solid stocks by understanding how cash flow.

What ratios to use and which to avoid.

The key financial statements.

This Presentation Will Teach You:

Portfolio worth $1.6 million on 2002 His secret was “he believed he could succeed as

a stock investor and never gave up-he stock to his investing plan”

Tip 1: Maximize your employer’s retirement benefits (stocks, 401k, IRA, etc.)

Tip 2: Don’t invest your disposable income on “nice things”, invest it on “your retirement”.

Tip 3: Don’t lose sight of your investment goal and strategy. Take advantage of stocks you are related to by the industry you work on

Sticking To Your Investment StrategyHank’s Stock Market Journey

Stock picks are based on Fundamental or Technical Analysis.

Fundamental analysis uses fundamental factors that describe the corporation’s operations and profits.

Fundamental factors are obtained from financial statements:• Income Statement (P&L)• Balance Sheet• Statement of Cash Flows

Type of Analysis:• Dividend Discount Model• Price Ratio Analysis• Earnings & Cash Flow Analysis

Fundamental Analysis

Useful to evaluate the value of common stock.

The value is calculated as the sum of all expected future dividend payments.

Dividends are adjusted for risk and time value of money.

Dividend Discount Model

D(t) = Dividend paid in t years.k = Adjustment for risk and inflation.

Very popular among financial analysts. Don’t place all your trust in these

methods. Price-earnings ratio (P/E)• Current stock price ÷ Earnings per share

Earnings per share (EPS)• Yearly Profits ÷ Avg. # of Shares Outstanding

Earnings Yield (E/P)• Earnings per share ÷ Current stock price

Price Ratio Analysis

Growth Stocks have High P/E ratio Value Stocks have Low P/E ratio

BE CAREFUL… JUST BECAUSE A STOCK HAS A HIGH P/E RATIO DOESN’T MEAN

IT WONT TANK

Price Ratio Analysis

Price-Cash Flow ratio (P/CF) is an alternative to P/E ratio

P/CF = Current Stock Price ÷ Annual Cash Flow per share.

Cash Flow is reported quarterly and obtained from the financial statements.

Cash Flow = Net Income + Depreciation.

A good sign of solid earnings from a corporation is when P/CF is higher than EPS.• It could mean that earnings are not an accounting

gimmick.

Price-Cash Flow Ratios

Alternative view of the company’s performance

P/S = Stock Price ÷ Annual Sales Revenue per Share

Focuses on the company’s ability to generate sales growth• High P/S supposedly indicates that a high sales

growth, earnings, cash flow, etc.

P/S RATIO TELLS YOU LESS THAN P/CF OR EARNINGS RATIO. ITS NOT

RECOMMENDED AT ALL TO MAKE DECISIONS.

Price Sales Ratios

Also call the market-book ratio. It’s a measure of the company’s

outstanding stock divided by the book value of its equity.

Book value = All Assets – Liabilities• Book value can be manipulated by management.• Its not a measure of creating value.

P/B ratio is a dangerous way to measure financial performance of a company.

Price Book Ratios

The three most popular gauges used today (P/E, P/B, and E/P) have a problem:

Dividend Yield Ratio:• Few corporations pay dividends today.• Investors don’t care about dividend because of higher

taxes are paid as ordinary income.

Book Value Ratio:• Book value can be distorted over the years with stock

repurchases and accounting rules.

Price Earning Ratio:• Reported earnings have been depressed by special

charges and should be adjusted for interest rates and inflation.

Flaws in Market Gauges

Cash flow is the corporation’s lifeblood, and the primary source of earnings.

Despite that the relationship between stock price increases and cash flow is very strong.

To understand Cash Flow and Earnings investors need to have a basic understanding on how to read financial statements• Balance Sheet• Income Statement• Cash Flow Statement

Earnings and Cash Flow Analysis

Gives you a snapshot view of the company’s assets and liabilities on a particular date.

The Balance Sheet is based on the fundamental accounting equation:• Assets= Liabilities + Equity (stock)

Assets have four major categories:• Current Assets – Cash, Inventory or things convertible to cash in a year.• Fixed Assets – Life of > than 1 year. Can be tangible or intangible.• Investments- Securities held for investment purposes.

• Other Assets- Miscellaneous assets that don’t fit in the other assets.

Financial StatementsBalance Sheet

Liabilities have three major categories:• Current – have to be paid within a year (eg. Accounts payable and taxes)• Long term – includes notes, bonds and loans with maturity > 1 year.• Other – miscellaneous items not belonging to any other liability

category.

Shareholder Equity• Difference between Assets and Liabilities.• Includes “Paid in capital”, which is the amount received from issuing

stock.• Retained Earnings that is cash saved out and not paid on dividends.

Financial StatementsBalance Sheet

Measures the operating performance during an accounting period (quarterly or annual basis)

Summarizes the company revenues and expenses.

Net Income is the outcome of the Income Statement and represents what the company generated during that period after subtracting cost of good sold, operating expenses, interest expenses and taxes out of the Net Sales.

Net Income is also called the bottom line.

Financial StatementsIncome Statement

Reports how cash was generated and used over the accounting period.

The cash flow categories• Operating cash flow• Investment cash flow• Financing cash flow

Net Income is equal to Cash Flow because NI contains non-cash items.

Operating Cash Flow adjusts Net Income for non-cash items

Financial StatementsStatement of Cash Flows

Operating Cash Flow – is the adjustment of Net Income and non-cash items.

Investment Cash Flow – includes purchases and sales of fixed assets and investments.

Financing Cash Flow – includes any funds raised by issuance of securities or repurchase of outstanding securities.

Financial StatementsStatement of Cash Flows

Profitability Ratios help understand the company’s operating efficiency (below is an example for Company “A” on 2005)

Performance Ratios

Ratios of book value, earnings and operating cash flow per share need the number of common shares outstanding.

CFPS is calculated with the Operating Cash Flow, not the bottom line on the cash flow statement.

Performance Ratios

Using a year-end price of $40 per share we get the following price ratios for Company A:

Price Ratios

Ratios appears to be successful in predicting bankruptcies.

Beaver found that financial ratios of troubled companies deteriorated rapidly.

Altman found that five financial ratios predicted bankruptcy up to five years prior to collapse• Z-Model• Z Ratio

What are ratios good for?