Fundamental Analysis

and
EFFICIENT MARKET THEORY
 What is Fundamental Analysis?
• Discovering the fundamental value of a
company; what is a business worth?
• Analyze:
– Financial Strength (ex. Financial statements)
– Past Performance
– Growth Potential
– Management
– Get the “grand picture” of the company
 Efficient Market Hypothesis
• In an active market that includes many well-informed
and intelligent investors, securities will be
appropriately priced and reflect all available
information.

• If a market is efficient, no information or analysis can

be expected to result in out performance of an
appropriate benchmark.

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 Efficient Market Hypothesis
• Strong Form Efficiency: Share prices reflect all information
and no one can earn excess returns.

• Semi-strong Form Efficiency: Share prices adjust within an

arbitrarily small but finite amount of time and in an unbiased
fashion to publicly available new information, so that no
excess returns can be earned by trading on that information.

• Weak Form Efficiency: Implies that Technical analysis

techniques will not be able to consistently produce excess
returns, though some forms of fundamental analysis may still
provide excess returns.

http://en.wikipedia.org/wiki/Efficient_market_hypothesis
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 Behavioral Finance
•Studies how cognitive or emotional biases, which are individual
or collective, create anomalies in market prices and returns that may
be inexplicable via EMH alone.

•Example: Stock Market Crash of 1987

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 Where Do I Begin?
• What does the company do?
• How big is it?
• Company Goals
• Financial Health
• Competitive Landscape
• Economic Conditions

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 What Does the Company Do?

• Who are they?

• Do they make products or sell services?
• Who are they targeting?

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 How Big Is The Company?
• Micro-cap: $100 million or less
• Small-cap: $100 million to $500 million
• Mid-cap: $500 million to $5 billion
• Large-cap: $5 billion +

Market Cap = Shares Outstanding x Share Price

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 Financial Statements

• Income Statement
• Cash Flow Statement
• Balance Sheet

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 The Income Statement

• The purpose of the income statement is

to show managers and investors
whether or not the company made or
lost money during the period being
reported.

What does it look like?

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 The Cash flow Statement

• A cash flow statement is a financial

report that shows incoming and
outgoing money during a particular
period.

http://en.wikipedia.org/wiki/Cash_flow_statement#Operating_activi
ties

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 Statement of Retained Earnings
•Shows the change in retained earnings over time
•The Statement of Retained Earnings uses information from the
income statement, and provides information to the balance sheet.

Ending Retained Earnings = Beginning Retained Earnings + Investments - Dividends Paid + Net Income

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 The Balance Sheet
It is a snapshot of a companies current financial position

Assets Liabilities
-Current Assets -Current Liabilities
-Fixed Assets -Fixed Liabilities

Equity

http://en.wikipedia.org/wiki/Balance_sheet

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 Show Me the Numbers!

Price to Sales Price to Book

Price to Earnings Gross Profit Margin

(P/E)
Beta Return on Equity
(ROE)
Current Ratio Debt Ratio

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 Price to Sales

Share Price
P/S =
Revenue Per Share
•P/S ratio can be used in comparison to other
companies
•How much is being paid for per share of sales
•If P/S < 1, it means investors are paying less for
each unit of sales

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 Price to Earnings

Share Price
P/E =
Earnings Per Share
•Companies with no growth do not have a P/E ratio
•A high P/E ratio could mean higher growth in the future

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 Price to Book

Share Price
P/B =
Total Assets - Intangible Assets &Liabilities

•Compares the company’s share price to their

book value
•A low P/B ratio could mean:
•Stock undervalued
•Something very wrong…

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 Gross Profit Margin

Revnues - Cost of Goods Sold

=
Revenue
•How much do they get to keep?
•Use in comparison to other companies to determine who has the highest
Gross Profit Margin

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 Beta

•A method of measure of risk in comparison to the market

•The market has a Beta equal to 1
•Beta > 1 = riskier than the market
•Beta < 1 = less riskier than the market
•Beta = or close to 0 is no risk in comparison to the market

•Get examples

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 Return on Equity (ROE)

Net Income
=
Shareholder's Equity
Useful to comparing the profitability of a firm in regards to its’ competitors.

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 Debt Ratio

Total Debts
=
Total Assets
Debt Ratio > 1= company has more debt than
assets
Debt Ratio < 1 = company has more assets than
debt

*Used as a tool to measure risk of companies

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 Current Ratio

Current Assets
=
Current Liabilities
•Measure of ability to pay short-term liabilities
•Higher ratios means the more capable a company is to
paying back short-term debt

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 Is This Company Profitable?

•Gross Margin/Profit/Income, Net Income

•Look at company’s income statement
•Look at historical gross margin
•How much does it sell and how much does the company get to keep?
•More income = more for future business operations, return to investors
•Look for companies to perform better than their competitors!

•Citigroup Annual Income Statement

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 Stock Performance

•What has the stock price done in the past year? 5 years? All of its history?
•Does it show solid performance or very volatile performance?
•Google Stock Performance
•Yahoo! Stock Performance

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 Management

•Is management stable?

•Recent change in management?
•Has change in management affected the stock
price?
•HP Probe

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 Competitive Landscape

•How are they performing in regards to competitors?

•Compare to their industry, compare to the overall market
•Compare:
•Share price
•Profit margins
•Financial ratios
•Strategies
•Target markets

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 Dividends
Defined:
Payments made by a company to its shareholders.

Important Dates:

• Declaration Date
• Date of Record
• Ex-Dividend Date (usually before Date of Record)

• Can be cash, stock, or assets.

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 Dividends

• The power of dividends.

GE 1996 Dividend: $.35
GE 2006 Dividend:$1.00

That’s a 186% increase in dividends over the past

11years!

• Average Annual increase 16.9%

• If this were to continue, a share of GE bought today,
would yield a $4.08 dividend ten years from now.

@13%= $3.00 per share

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 Dividends
Not always a good thing?

•Can indicate lack of growth

•Dividend may be unsustainable

•The effects of cutting a dividend

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 Stock Splits
• Ordinary stock splits occur when a publicly held company
distributes more stock to holders of existing stock.

• 2-for-1: is when a company simply issues one additional

share for every one outstanding.

• The company's net assets didn't increase, only the

number of outstanding shares.

• Companies issue splits to make the stock more attractive

to investors whether it be an ordinary split or a reverse
split.

http://invest-faq.com/articles/stock-split.html

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 Stock Buybacks

• Income Statement

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 A Nastie Example
…for tying the importance of financial statements
together

http://finance.yahoo.com/q?s=tsty

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Benchmarking – How do we
compare?
The most widely accepted benchmark
is the performance of the Standard and
Poor’s 500 Index.

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 Benchmarking Continued
• S&P 500 used to compare stock
performance of a single firm against the
500 largest American publicly traded
companies
– Only useful when the company in
consideration is equivalent in size and stature
to the components of this index.
– For example, one would not wish to compare
the performance of a BB stock against the
$SPX

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 ANF up 300% in past five
years

Standard and Poor’s Fortune 500 Index up

less than 50% in past five years

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 Other Methods of Benchmarking
• Financial ratios used to compare a firm’s
financial performance to a competitor’s
• Popular ratios are Profit Margin, Return on
Assets, Inventory Turnover, and the Quick
Ratio

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Key Ratios, using the Industry as a Benchmark
Industry Market
Profitability Company
Median Median1

Gross Profit Margin 66.70% 35.10% 51.80%

Pre-Tax Profit Margin 19.40% 6.40% 6.30%

Net Profit Margin 12.00% 4.20% 4.80%

Return on Equity 36.7% 18.3% 9.3%

Return on Assets 20.4% 9.4% 1.6%

Return on Invested Capital 27.6% 12.3% 4.2%

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 Industry Market
Valuation Company
Median Median1
Price/Sales Ratio 2.10 0.96 2.15
Price/Earnings Ratio 17.37 19.03 18.62

Industry Market
Operations Company
Median Median1
Days of Sales Outstanding 11.62 5.36 57.47
Inventory Turnover 2.4 4.7 5.6

Industry Market
Financial Company
Median Median1
Current Ratio 1.90 2.18 1.71
Quick Ratio 1.0 0.9 1.2

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ANF and the Competitive Landscape

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Where to Invest?

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 How Can I Find More Information?
• Yahoo! Finance
• MSN Money Central
• Hoovers Online through RIT
• Mergent Online through RIT
• Investext
• S&P NetAdvantage through RIT
• SmartMoney.com
• Annual Reports

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