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

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IV. Fundamental Analysis A) The Concept B) Financial Statements 1. The Balance Sheet 2. The Income Statement 3. Statement of Cash Flows C) Financial Ratios 1. What Ratios Have to Offer 2. Measuring Liquidity a. Current Ratio b. Net Working Capital

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3. Activity Ratios a. Accounts Receivable Turnover b. Inventory Turnover c. Total Asset Turnover 4. Leverage Measure a. Debt-Equity Ratio b. Times Interest Earned 5. Measuring Profitability 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/Earnings Ratio b. Dividends per Share c. Payout Ratio d. Book Value per Share D) Interpreting the Numbers 1. Using Historical and Industry Standards

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2. Looking at the Competition Concepts in Review

Summary
Putting Your Investment Know-How to the Test Discussion Questions Problems Case Problems 7.1 7.2 Some Financial Ratios Are Real Eye-Openers Doris Looks at an Auto Issue

Excel with Spreadsheets Trading Online with OTIS

Key Concepts
1. An overview of the security analysis process, including its goals and the functions it performs for the individual investor. The role and importance of economic in the stock valuation process. The role and importance of industry analysis in the stock valuation process. The concept of fundamental analysis and how it is used to assess a companys financial position and operating results. The various types of accounting statements and financial ratios used in evaluating the historical performance of a company. 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.

2. 3. 4.

5.

6.

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 decision-making. 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.

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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 analysis are 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 companys 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 firms liquidity position. Bringing in financial statements of a popular or local company typically makes this segment of the course more realistic. 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 companys ratios with industry ratiosand with ratios of some of its major competitorsshows how a particular company performed in contrast to the performance of other companies in similar businesses. The classs understanding of the procedures for computing and interpreting ratios should be checked, and the example in the text should be reviewed thoroughly. 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 a general view or outlook. (b)All analyses of past performance only help in generating estimates for the future. (c) Further development of this chapters concepts follows in Chapter 8.

4.

5.

Answers to Concepts in Review

1. The three major parts of security analysis are economic analysis, industry analysis, and fundamental analysis. Security analysis is important because it enables the investor to establish the expected return and risk for a stock and to evaluate its desirability in a logical, rational manner.

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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 stock might be a good buy under the assumption that the stock will rise up to its intrinsic value. The converse would be true if the intrinsic value is less than the stock price. The stock might be a good sell. A satisfactory investment vehicle is one which 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 investment vehicles. 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 stocks 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 analyses process allows investors to develop a feel for the stock and what to expect of it in the future. 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 perfectly efficient and pricing errors are inevitable. With thorough security analysis, individuals can profit whenever pricing errors occur. Paradoxically, financial market efficiency is achieved only due to the existence of traders who invest time and money in fundamental analysis to root out pricing errors. Security analysis is also useful in assessing an assets liquidity, current income, and risk and in verifying that these match investor criteria. 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 it may be done on a very informal basis. In any event, it deals with such aspects as production and unemployment statistics, inflation, fiscal and monetary policies, and their effects on security returns. This analysis is, indeed, essential to an investors decision-making framework. We live in an economy where firms are affected by general economic conditions; therefore, we cannot talk of security analysis without addressing economic analysis. Theres plenty of real world evidence to demonstrate the high correlation between the performance of stocks and general economic activityi.e., when the economy starts improving, so do stock returns, all of which indicate the importance of economic analysis to the stock selection process. The behavior and current state of the economy is captured in the business cycle, which measures the change in total economic activity over time. When economic prospects are strong (the business cycle is on an upswing), security returns should do well. If economic prospects are poor (the business cycle is on a downswing), the returns from most stocks will deteriorate as well.

3.

4.

5.

6.

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7.

(a) Gross Domestic Product (GDP): This is the broadest measure of an economys performance. GDP is an estimate of the total value of all goods and services produced in a country over the period of a year. (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. The index of leading indicators is a single number that is supposed to predict the direction of the economy. (c) Money Supply: This is a measure of the amount of money in circulation as reported by the Federal Reserve. Actually, there are three measures of the money supply: M1, M2 (which is the most widely followed and includes currency, demand deposits, NOW accounts, time deposits, money market deposit accounts, and money funds), and M3. (d) Producer Prices: This is a measure of price behavior at the wholesale level. It shows the rate of change in prices at various stages of production, and is supposed to be a harbinger of things to come at the consumer price level (i.e., future inflation rates).

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 the cost of borrowing of firms increases resulting in less investments. Also, as interest rates rise, the return on common stocks becomes less attractive relative to other securities, like bonds and preferred stocks. However, when inflation subsides, common stocks become major beneficiaries, showing substantial price appreciation. 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.

9.

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. (c) The role of big labor: the status of contract talks and general labor regulations. (d)Technological progress: are any technological breakthroughs likely? (e) Financial and operating characteristics: considerations involving labor, material, and capital. Economic forces important to the industry include the demand for the industrys goods and services and the correlation with key economic variables. To the extent that an industry is influenced by economic forces, we would want to determine the economic variables that are of primary importance to an industry; it might be GDP, or the level of interest rates, or the unemployment rate. Also, the future outlook for these variables would be important since they are likely to set the tone for future industry performance. 11. The four stages of an industrys growth cycle are: initial developmentproduct introduction

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rapid expansioneveryone wants one mature growthalmost everyone has one stability or declinethere are other things to want The rapid expansion phase offers the biggest payoff to investors. At this stage, the industrys products have gained acceptance, investors can foresee the industrys future more clearly, and economic variables have little to do with the industrys overall performance. The mature growth stage is most influenced by the economic cycle. 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 issues the stock. An equivalent statement is that the value of a security depends not only on return, but also on riskboth of which are affected to a large extent by the operating characteristics and financial condition of the firm. Fundamental analysis helps to capture insights to these dimensions from financial statements and other information about a company and incorporates them in the valuation process. 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 analysis helps the investor to learn the strengths and weaknesses of a company, identify underlying trends and developments, and evaluate the companys operating efficiency. 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. The most significant contribution of ratio analysis is that it enables the investor to thoroughly assess the firms past and present financial condition and operating results. 15. When historical standards are used, the companys ratios are compared and studied from one period to the next. Industry standards involve a comparison of a companys ratios to that of other companies in the same line of business. In the first case, the investor is looking for developing trends; in the second case, the investor wants to see how the company stacks up to its competitors.

Suggested Answers to Investing in Action Questions

The Ten Commandments of Financial Statement Analysis (p. 304)
(a) Which of the Ten Commandments is most important? (b) Why is it important to carefully read the footnotes? Answers: (a) The answer will vary by student. Perhaps the key is to note that all of each Commandment is important. Paraphrasing the first Commandment, Thou shalt not use any commandment in isolation. Instructors may discuss Point 7 (on the limitations of financial statements) and Point 3 (on the importance of footnotes) in greater detail during class discussions.

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(b) It is very important to read the footnotes carefully while analyzing financial statements. Any change in accounting rules (e.g. change in inventory valuation from FIFO to LIFO etc.) will be disclosed here, which might have important implications on financial performance. Any off-balance sheet items (like leases) or contingent liabilities will also be disclosed in detail here. These disclosures will have important implications for investors. Hence, a substantial amount of time must be spent on analyzing the footnotes.

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Suggested Answers to Ethics in Investing Questions

Cooking the Books: What Were They Thinking? (p. 318)
Will the requirement that external auditors not be permitted to provide internal audits eliminate the conflict of interest? Answer: In the wake of current accounting scandals, separation of internal and external audits and auditor independence has been the focus of the Sarbanes-Oxley Act of 2002 and subsequent ruling of the SEC. The role of internal audit is to perform the assessment of internal controls to and review of financial documentation on behalf of the board and executive management to safeguard against fraud and to strengthen corporate governance. The internal auditor may also provide advisory services in operational matters, and perform special assignments if so directed. The external audit, on the other hand, should give an independent review that the numbers in the accounts, as reported to the shareholders, are a reasonable picture of how the company is doing and how it is serving the interests of the shareholders. By separating both audits and making them independent it has become easier for both auditors to detect instances of accounting irregularities. The passage of the Sarbanes-Oxley Act of 2002 has expanded the role of external audit to attest of the effectiveness of management control over financial reporting rather than rubberstamping the numbers provided by the management

Suggested Answers to Discussion Questions

1. (a) Fiscal policy would usually remain fairly strict during a strong economy with automatic stabilizers such as tax rates restraining inflation. (b)Interest rates influenced by the Fed would tend to move higher if inflation threatened. (c) Industrial production would grow at more than 3 to 5% annually. (d)Retail sales would tend to hold or increase. (e) Product prices would tend to rise given pressure to produce more and with the beginnings of the wage-price spiral. 2. (a) Airline stock: production growth, fuel prices, and employment (b)A Cyclical stock: current business cycle, future predictions of economic activity (c) An electrical utility stock: interest rates, monetary policy (d)A building materials stock: national production growth, real estate sales, interest rates (e) An aerospace firm: government spending and contract size, employment 3. (a) Profitability: d, e (b)Activity: a, f (c) Liquidity: c (d)Leverage: b, h (e) Common stock: g, i, j

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Solutions to Problems
1. From abbreviated financial statements (dollars in millions) Liquidity (1) (2) Net working capital Current ratio = Current assets Current liabilities = $150 $100 = $50 = Current assets/Current liabilities = $150/$100 = 1.50 Activity (3) Total asset turnover = Sales/Total assets = $500/$350 = 1.43 Leverage (4) (5) Debtequity ratio = Long-term debt/Stockholders equity = $50/$200 = 0.25 Times interest earned = Earnings before interest and taxes/interest = $65/$10 = 6.50 Profitability (6) (7) (8) Net profit margin = Net profits after taxes/Sales = $35/$500 = 7.0% Return on total assets = Net profits after taxes/Total assets Return on equity = $35/$350 = 10.0% = Net profits after taxes/Stockholders equity = $35/$200 = 17.5% Common Stock Ratios (9) Earnings per share = (Net profits after taxes Preferred dividends)/ Number of shares of common stock outstanding (10) Price/Earnings ratio (11) Price-to-Sales ratio (12) Dividends per share = $35 0/10 = $3.50 per share = Share price/EPS = $75/$3.50 = 21.43 times = Share price/Sales per share = $75/($500/10) = 1.50 = Total common dividends paid/ Common Shares outstanding = $10/10 = $1.00 per share = Dividends per share/Share price = $1.00/$75 = 1.33% = Dividends per share/EPS

(13) Dividend yield (14) Payout ratio

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= $1.00/$3.50 = 29% (15) Book value per share = Common equity/Common shares outstanding (16) Price-to-book value 2. Book Value = $200/10 = $20 = Share price/Book value per share

= $75/$20 = $3.75 = Assets Liabilities Preferred Stock = $550,000,000 400,000,000 0 = $150,000,000

Book Value per shares = Book Value/Number of Shares = $150M/300M = $0.50 per share 3. 4. Price-to-Book Value = $5.50/$0.50 = 11 (a) EPS For Amherst: EPS = $10,000,000 $0 = $4 per share 2,500,000 = Net profits after taxes Preferred dividends Number of common shares outstanding

(Note: Only preferred dividends, zero here, are subtracted from net profits after taxes. Common dividends are part of EPS.) Stockholers' equity (b) Book value per share = number of common shares outstanding For Amherst: Book Value per share = Price-to-book value = For Amherst: $20.00 = 1.11 $18.00 Market price of stock (c) Price/earnings (P/E) ratio = EPS For Amherst: $20 P/E = = 5 times $4 net profit after taxes (d) Net profit margin = total revenues For Amherst: $10,000,000 = 6.7% Net profit margin = $150,000,000 Price-to-Book value = $45, 000,000 = $18.00 per share 2,500, 000 Market price of common stock book value per share

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(e) Dividend payout ratio = For Amherst: Dividend payout ratio = Dividend yield For Amherst: Dividend yield (f) PEG Ratio 5. P/E = 15 and P = $25 =

Dividends per share EPS

$1 = 25% $4 dividens per share = market price of common stock $1.00 = 5% $20.00 Stocks P/E Ratio = 5 / 7.5 = 0.667 = 35 years growth rate in earnings

$25/E = 15$25/15 = E = $1.67 6. PEG = P/E (Earnings Growth Rate 100) Earnings Growth Rate: Ending Earnings Beginning Earnings gives you the future value factor for five years; Scanning across the fifth row of the FVIF table gives you can identify the column (return) that results in that calculated amount. $3.22/ $2.00 = 1.61; FVIF10%, 5 periods = 1.611 PEG = 15/10 = 1.5 7. (a) Total asset turnover For Highgate Computer: Total asset turnover Net profit margin For Highgate Computer: Net profit margin = $2,000,000 = 7.14% $28,000,000 Net profits after taxes Total assets $2,000,000 = 13.33% $15,000,000 = = $28,000,000 = 1.87 times $15,000,000 Net profits after taxes Annual sales = Annual sales Total assets

(b) Return on assets (ROA) = For Highgate Computer: ROA =

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Note: The instructor might want to show that ROA can also be found by multiplying the firms total asset turnover by its net profit margin. This approach can be used to demonstrate that ROA is a function of a companys profitability and its asset productivity. In the case of Highgate Computer, we have: ROA = Total asset turnover Net profit margin = 1.87 0.0714 = 13.3% Net profits after taxes Return on Equity (ROE) = Stockholder's equity For Highgate Computer: ROE Book value per share For Highgate Computer: Book value per share 8. TIE2003 = $550/$200 = 2.75 TIE2004 = $600/$250 = 2.40 Interest coverage fell. The company is less able to meet its interest payments in 2004. 9. (a) (i) EPS = Net profits after taxes Preferred dividends Number of common shares outstanding = $6,000,000 = $12 per share 500,000 = = $2, 000, 000 = 33.33% $6, 000, 000 Stockholders' equity # of shares of common stock outsatnding

For Financial Learning Systems: EPS = (ii) Price/Earning (P/E) ratio = $6,850,000 $500,000 = $2.54 2,500,000

Market price of stock EPS For Financial Learning Systems: P/E = $45.00 = 17.72 $2.54

(iii) Book value per share =

Stockholders' equity number of common shares outstanding

For Financial Learning Systems: $78, 000,000 $32, 000, 000 $5m Book value per share = 2,500,000 = $16.40 per share

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(b) If the EPS rises to $3.75: 17.72 = Market price of stock = $66.45 If the EPS drops to $1.50: market price of stock $1.50 Market price of stock = $26.58 17.72 = (c) If the EPS rises to $3.75 and P/E jumps to 25: market price of stock $3.75 Market price of stock = $93.75 25 = (d) Both the EPS and P/E dropto $1.50 and 10 times earnings: market price of stock $1.50 Market price of stock = $15.00 10 = (e) As shown in the case of Financial Learning Systems, higher earnings improve the stock price for a given P/E multiple, and when the P/E multiple rises, for a given level of earnings, the stock price rises. 10. We will use the following three ratios: Return on assets Net profit margin = Net profit after taxes/Total assets = Net profit after taxes/Sales market price of stock $3.75

Total asset turnover = Sales/Total assets (a) In this problem, we cannot calculate ROA until we find out what profits are. To do this, we must determine sales and then apply the net profit margin to this sales figure to determine net profits. That is, using the total asset turnover ratio, sales must be $20,000,000: 2.0 = Sales/$10 million Solving for sales: Sales = $10 million 2.0 = $20 million Using the equation for net profit margin, net profits after taxes must be $3,000,000: 0.15 = net profits after taxes/$20 million Solving for net profits: Net profits = $20 million 0.15 = $3 million Given this information, we can compute ROA as: $3,000,000/$10,000,000 = 30% (Note: Or this problem can also be solved by simply multiplying the companys asset turnover by its profit margin; i.e., 2.0 0.15 = 30%).

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(b) To solve this part of the problem, first find the firms equity. We know it has $10 million in assets and the problem states that 40% of the assets are financed with equity. Therefore: Equity = $10,000,000 0.40 = $4,000,000 Now, to find ROE: ROE = Net Profits $3,000,000 = = 75% Equity $4,000,000

(Note: Comparing ROE to ROA, we see that ROE is much larger [75% vs. 30%]. The reason is the firms high debt/financial leveragei.e., 60% of the firms assets are financed with debt, which acts to magnify profitability.) Market price of the stock 11. Price/Earnings (P/E) ratio = EPS First, find EPS: EPS = Net profit after taxes Number of shares of stock outstanding

Since: Net profit after taxes = Sales net profit margin: $150,000,000 0.10 $15, 000, 000 = = $3 per share 5, 000,000 5,000, 000 $25 P/E ratio = = 8.3 times $3 Market price of stock Price-to-sales ratio = Sales per share EPS = Find sales per share: SPS = Sales $150, 000, 000 = Number of shares outstanding 5, 000, 000 = $30 per share

Now, the Price-Sales Ratio is: $25 PSR = = 0.833 $30 Dividends per share EPS Dividend payout ratio* Dividend Yield = = Market price of common Market price of common $3 0.35 $1.05 = = 4.2% $25 $25 *Note: Dividends per share = EPS Dividend payout ratio. Stock's P/E Ratio PEG Ratio = 35 years growth rate in earnings This implies: Growth Growth Stocks P/E Ratio PEG Ratio = 8.3/2 = 4.15% =

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12. ROA = Net Profit Margin Total Asset Turnover = 0.08 2 = 0.16 or 16%. 13. ROE = ROA Equity Multiplier ROA = Net Profit Margin Total Asset Turnover Equity Multiplier = Total Assets/Total Equity ROA 0.08 2 = 0.16 Equity Multiplier = $1B/$500M = 2 ROE = 0.16 2 = 0.32 or 32% 14. Sales: Total Asset Turnover X Assets Total Asset Turnover = 2 and Total Assets = $1B Sales = 2 $1B = $2B Net Profit = Net Profit Margin Sales Net Profit = 0.08 $2B = $160M 15. There is no set solution to this problem, since the answer will vary with the stock selected by the student. The students should be encouraged (or required) to actually compute the requested ratios from the recent financial statements of the companies they select. They can use annual reports, Mergent, or S&P to obtain needed balance sheet and income statement information. The Internet also has several useful sites. This problem may result in some interesting and possibly confusing responses, because students will get their information from many diverse sources. Frequently the ratio calculations will differ. This presents the instructor with the opportunity to discuss refinements to ratio calculations, the importance of consistency, and the fact that the ratios are only tools to be used in the stock evaluation and selection process. 16. There is no set solution to this problem. In developing an answer, the students can either pick up the ratios/information from Value Line or a similar source, or they can be required to actually compute requested ratios from the recent financial statements of the companies they select. Annual reports, Mergent or S&P will provide the needed balance sheet and income statement information. The following information was taken from Part 1 of the Value Line Investment Survey.

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Value Lines Timeliness Ranking Wal-Mart Target Sara Lee Campbell Soup IBM Intel Tupperware Ball Liz Claiborne Quicksilver General Dynamics 3 2 5 3 3 2 4 2 3 3 3

Beta 1.05 1.20 0.55 0.65 1.05 1.35 0.75 0.95 0.95 1.00 0.75

P/E Ratio 27.3 19.5 13.5 17.2 20.6 41.6 20.0 14 13.8 16.3 16.5

Dividen d Yield 0.7 0.7 3.7 2.4 0.7 0.2 5.9 1.1 0.6 0 0

Earnings Per Share 0.46 0.33 0.29 0.18 1.02 0.25 0 1.34 0.89 0.21 0.6

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Boeing

1.00

38.7

1.7

0.32

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17. (a) All of the following ratios for Otago Bay Marine are based on the 2003 and 2004 financial statements ($ in thousands) and are computed using the formulas in the chapter: (1)Current ratio 2003 2004 Industry (2)Total asset turnover = Sales/Total assets 2003 2004 Industry (3)Debt-equity ratio 2003 2004 Industry (4)Net profit margin 2003 2004 Industry (5)ROA 2003 2004 Industry (6)ROE 2003 2004 Industry (7)EPS 2003 2004 Industry (8)P/E Ratio 2003 2004 Industry = shared price/EPS $80.75/$2.95 $74.25/$3.27 = 27.37 = 22.71 = 19.87 = $32,032/$224,470 $35.442/$303,940 $32,032/$245,424 $35,442/$259,593 $20,268/$181,704 $40,735/$212,343 $245,424/$224,470 $259,593/$303,940 = 1.09 = 0.85 = 1.27 = Long-term debt/Stockholders equity = 11.15% = 19.18% = 10.0 % = Net profit after taxes/Total Revenues = 13.05% = 13.65% = 9.30% = Net profit after taxes/Total assets = 14.27% = 11.66% = 15.87% = Net profit after taxes/Stockholders Equity $32,032/$181,704 $35,442/$212,343 = 17.63% = 16.69% = 19.21% Net profit after taxes Preferred dividends Number of common shares outstanding $32,032 $0 10,848 $35,442 $0 10,848 = $2.95 per share = $3.27 per share = $1.59 = Current assets/Current liabilities $133,212/$22,498 $111,914/$50,862 = 5.92 = 2.20 = 2.36

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(9) Dividend yield 2003 2004 Industry (10)Dividend payout ratio 2003 2004 Industry

= Dividends per share/Market price per share $0.27/$80.75 $0.35/$74.25 = Dividends per share/EPS $0.27/$2.95 $0.35/$3.27 = 9.15% = 10.70% = 26.00% = 0.33% = 0.47% = 0.44%

(11)Price-to-book value ratio = Share price/Book value per share stockholder's equity Book value per share = number of common shares outstanding 2003 BV 2004 BV Price-to-book-value: 2003 2004 = = $181,704 = $16.75 10,848 $212,343 = $19.57 10,848 = 4.82 = 3.79

= $80.75/$16.75 = $74.25/$19.57

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Industry

= 6.65

(b) Based on the comparison to industry average ratios, the financial condition of Otago Bay Marine (OBM) appears to be deteriorating. First, OBMs current ratio has declined 63%, indicating its ability to meet short-term obligations has weakened substantially. OBMs current liabilities, which have grown 126% over the past year, are driving this weakened position in liquidity. Also, the activity measuretotal asset turnoverwhich was below the industry average last year, has declined even further, suggesting that corporate resources are being poorly managed. With respect to leverage, OBMs ratio has grown to nearly twice the industry average, indicating a need to control and reduce the amount of debt in the capital structure. Despite the high leverage ratio, the firms ROE, which indicates the extent to which leverage has enhanced the returns to stockholders, has declined even further below the industrys average. Similarly, OBMs ROA has declined even further below the industrys average ROA. The decline in ROA is related to the large increase (115%) in PPE, and the 107% increase in other long-term assets. A complete analysis would necessarily include an analysis of these assets. For example, the increase in PPE could indicate that the company is anticipating future growth, or that the company has updated its PPE and will be much more profitable in the future due to the efficiencies of modern equipment. The market appears to reflect this deterioration in OBMs financial picture from 2003 to 2004. The stock price has declined 8% and the P/E ratio has declined 17%, and the price-to-book value has decline another 1% to about half of the industry average. In summary, despite the relatively small percentage increases in net profit after taxes, Otago Bay Marine seems poorly managed. Gone unchecked, OBMs financial condition will deteriorate further and be reflected in profitability measures well below industry averages. Although OBMs ratios are only one part of their total financial outlook, they seem to indicate that problems exist within the firm.

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18. (a)

FOR 2000 net earnings = Profit margin net sales = $20.2 $179.3

Asset turnover

= 11.27% net sales = total assets $179.3 = $136.3 = 1.32

Using profit margin and asset turnover to calculate ROA: net earnings net sales net sales total assets ROA = 11.27% 1.32 = 14.88% ROE = ROA Equity multiplier ROA = Where Equity multiplier = Total assets/stockholders equity = $136.3/$109.6 = 1.24 ROE (b)For 2004: ROA = Profit margin Total asset turnover = 13.65% = 11.60% ROE = ROA = 11.60% = 11.60% = 16.59% (c) Between 2000 and 2004, Otago Bay Marines ROA and ROE measures both deteriorated. With respect to ROA, total assets have grown faster than net sales, thereby affecting total asset turnoverand consequently, ROAadversely: Whereas net sales grew 44%, total assets grew 123%. The second component of ROA, the profit margin, grew slightly. Thus, the decline in ROA is attributable mainly to the dramatic increase in total assets (ROA fell from 14.88% in 2000 to 11.6% in 2004). The growth in total assets is also a main contributor to the decline in ROE, which is composed of ROA, multiplied by the equity multiplier. The higher equity multiplier reflects the fact that total assets also outgrew stockholders equity (a large portion of new assets were debt-financed). However, the multiplier was not large enough to reverse the effects of the decline in ROA on ROE. Thus, through the sharp increase in total assets, ROA and ROE declined. Equity multiplier ($303,940/$212,343) 1 .43 0.85 = 14.88% 1.24 = 18.45%

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(d)Generally, these changes from 2000 to 2004 do not appear fundamentally healthy for Otago Bay Marine. The higher total assets, a large percentage of which was financed by debt, appears to have reduced OBMs profitability and its future ability to meet short and long-term obligations. The decline in ROA is related to the large increase (115%) in PPE, and the 107% increase in other long term assets. A complete analysis would necessarily include an analysis of these assets. For example, the increase in PPE could indicate that the company is anticipating future growth, or that the company has updated its PPE and will be much more profitable in the future due to the efficiencies of modern equipment.

Solutions to Case Problems

Case 7.1 Some Financial Ratios are Real Eye-Openers
The objective of this case is to have students calculate and interpret ratios as part of the fundamental analysis of a firm. 1. All the ratios below for South Plains Chemical are computed according to the formulas in the chapter. South Plains Chemical (dollars in thousands) Liquidity (a) Net working capital = Current assets Current liabilities = $21,250 $10,000 = $11,250 (b) Current ratio Activity (c) Receivables turnover = Sales/Accounts receivable = $50,000/$8,000 = 6.25 (d) Inventory turnover = Sales/Inventory = $50,000/$12,000 = 4.17 (e) Total asset turnover = Sales/Total assets = $50,000/$30,000 = 1.67 Leverage (f) Debt-equity ratio = Long-term debt/Stockholders equity = $8,000/$12,000 = 0.67 (g) Times interest earned = Earnings before interest and taxes/interest = $10,000/$2,500 = 4.0 Profitability (h) Net profit margin = Net profits after taxes/Sales = $5,000/$50,000 = 1 or 10% (i) Return on total assets = Net profits after taxes/Total assets = Current assets/Current liabilities = $21,250/$10,000 = 2.12

146Gitman/JoehnkFundamentals of Investing, Ninth Edition

= $5,000/$30,000 = 0.166 or 16.67% (j) Return on equity = Net profits after taxes/Stockholder equity = $5,000/$12,000 = 0.4167 or 41.67%

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Common Stock Ratios (k) Earnings per share = (Net profits after taxes Preferred dividends) /# of shares of common stock outstanding = $5,000 0/5,000 = $1/share (l) Price/Earnings ratio = Share price/EPS = $25/$1 = 25 times (m) Dividends per share = Total common dividends paid/ Common shares outstanding = $1,250/5,000 = $0.25/sh. (n) Dividend yield (o) Payout ratio = Dividends per share/Share price = $0.25/$25.00 = 0.01 or 1% = Dividends per share/EPS = $ 0.25 / $1.00 = 0.25 or 25% (p) Book value per share = Common equity/Common shares outstanding = $12 million/5 million = $2.40 (q) Price-to-book value = Share price/Book value per share = $25/$2.40 = 10.42 2. Comparing the ratios computed in question 1 to the latest industry averages, we find: (a) Liquidity: South Plains is more liquid than the average firm in its industry. (b) Activity: Here South Plains is weak; the low ratios suggest poor utilization of assets. Since accounts receivable and inventory are close to the industry figures, the deviation seems to come from excess fixed assets. (c) Leverage: The firm uses more debt than average, and its ability to cover interest is much lower than the average firm. (d) Profitability: The results are mixed here. The firm has higher margins and higher ROE. The lower return on assets reflect the poor activity ratios mentioned above. (The fact that the firm can have low ROA and high ROE is due to its high leverage. Since a smaller percentage of South Plains is financed with equity, the ROE is magnified more than for the typical firm.) (e) Common stock: All the measures relative to dividends are low for this firm, yet its price/earnings ratio is higher than average. This suggests that the market anticipates above-average profitability and returns in the future. That is why, although its current dividend yield is low, investors are willing to pay a high price/earnings ratio. The same goes for price-to-book value; like the P/E ratio, its much higher than average and provides further support that the market is anticipating good things from South Plains. 3. The firm seems to have good prospects for attractive returns but also has high risk. For Jack to continue his evaluation of South Plains Chemical, he must feel the opportunities for the firm are promising and commensurate with the risk involved. Due to South Plains strong profitability, he should now proceed with a more in-depth analysis. (Although not discussed in the case, fundamental analysis should not be performed alone; careful economic and industry analyses are also important.)

148Gitman/JoehnkFundamentals of Investing, Ninth Edition

Case 7.2 Doris Looks at an Auto Issue

This case allows the student to experience the three steps of security analysis. (a) Other economic information that Doris might find helpful includes government fiscal policy (taxes, spending, debt management); monetary policy (money supply growth, interest rates); consumer spending and the investment plans of businesses; energy situation (oil imports, cost and availability of supplies, domestic oil prospects); foreign trade and the balance of payments (especially the value of the dollar); and the inflation rate. Although each is important, the three most important are probably interest rates, foreign trade and the cost of oil. Interest rates are important since most automobiles are purchased on credit. Foreign trade is important because of the impact that auto imports and exports have on auto sales; also foreign trade affects the value of the dollar, which in turn makes U.S. cars more or less expensive relative to imports. Finally, the cost of gas and oil is closely watched by drivers, and can impact the demand for gas guzzlers versus more fuel efficient cars. (b) 1. Auto imports: Trends in auto imports more clearly define potential growth for domestic producers. The recent growth of imports has been at the expense of U.S. producers. Federal restrictions on foreign imports would greatly alter industry conditions for domestic firms. 2. The relationship of the United Auto Workers (UAW) and the auto makers is an important part of the analysis. A better relationship leads to lower costs of production; a poor relationship may mean strikes, slowdowns, higher wage contracts, and so on. One important date here is the expiration date of the existing contract. 3. Interest Rates: As mentioned above, automobiles are usually purchased with borrowed funds. The cost and availability of these funds is quite important in the sale of new cars. 4. The cost of gas: Since most cars need gasoline to run, it is very important to assess the course of gasoline prices in the future. If gasoline prices become extremely high, the auto industry is bound to suffer. (Note to the instructor: The situation can be more complex. For example, if the gas price is very high, consumers will tend to get rid of their old gas guzzlers and buy small economy cars. Thus, the issue can also revolve around whether or not the company we are considering is planning to produce small cars. If this is so, then increasing gasoline prices can boost the sales of cars, at least in the short run.) (c) 1. Sales can be found from the total asset turnover ratio: Common shares outstanding = From the case: 1.5 = Solving for sales, we have: Sales = 1.5 $25 billion = $37.5 billion. Sales $25 billion Sales Total assets

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2. Profits can be found from the net profit margin: Net profit margin = From the case: 0.15 = Net profit after taxes $37.5 billion Solving for net profits, we have: Net profits after taxes = 0.15 $37.5 billion = $5.625 billion 3. We can find current assets using the figure for current liabilities and the net working capital formula: Net working capital = Current assets Current liabilities. From the case: $3.4 billion = Current assets $5 billion Solving for current assets, we have: Current assets = $3.4 billion + $5 billion = $8.4 billion Therefore, the current ratio equals: Current assets $8.4 billion = = 1.68 Current liabilities $5 billion 4. The price of the stock can be found from the P/E ratio: Price/Earnings ratio = From the case: 12.5 = Solving for share price, we have: Price per share = 12.5 $3 = $37.50 Price per share $3 Price per share EPS Net profits after taxes Sales

150Gitman/JoehnkFundamentals of Investing, Ninth Edition

5. To find the dividend yield, we first have to find dividends, using the dividend payout ratio: Dividend payout ratio = From the case: 0.4 = Solving for dividends, we have: Dividends per share = $3 0.4 = $1.20 Therefore, dividend yield equals: Dividends per share $1.20 = = 3.2% Price per share $37.50 Dividends per share $3 Dividends per share EPS

Outside Project
Chapter 7 Going to the Source: The Annual Report
Most financial statements and stock valuation examples found in college textbooks tend to be couched in fairly simple terms. The question that students often ask is: How close to reality are we working? This project will get you as close to reality as possible by having you look at the actual numbers of a real corporation. Get an annual report of any corporation. It does not have to be the most recent one, but it should be a large company in a nonregulated, nonfinancial industry. Avoid utilities and financial institutions, like banks, as the accounting for these companies is very different and could be confusing. Companies will usually send annual reports if you simply ask them, or libraries often have annual report files. Once you have an annual report, find the income statements and balance sheets, and calculate all the ratios you possibly can. Use the liquidity, activity, leverage, profitability, and common stock formulas presented in the text. You will have to look in the financial news for current price and dividend information. Note that there is little value in knowing a ratio for one year. You need to look at several years, and the annual report will have a five or ten year summary of the most important information. After youve run the ratios (you should have the financial data to run the ratios for at least two years), take a few minutes and analyze your results: What do the numbers tell you that you like? That you dont like? When doing this project, take time to think through and read the report; the annual report is not just numbers. The discussion of the company by its chairman usually provides information about the recent past and the prospects for the future; in addition, theres considerable information in these reports about product lines, corporate developments, and the like. This report is designed to bring stockholders up-to-date on company operations. Share your comments and notes about the report with the class.