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FINANCIAL ANALYSIS OF
COMMON STOCKS

Fundamental Analysis
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FINANCIAL ANALYSIS
WHAT IS FINANCIAL ANALYSIS?
DEFINITION: the activity of providing inputs
to the portfolio management process

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FINANCIAL ANALYSIS
REASONS FOR FINANCIAL ANALYSIS
TWO PRIMARY REASONS
to determine certain securities characteristics
to attempt to identify mispriced securities
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FINANCIAL ANALYSIS
REASON #1: DETERMNING SECURITY
CHARACTERISTICS
estimate future sensitivity to major factors
estimate dividend yield
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FINANCIAL ANALYSIS
REASON #2: ATTEMPTING TO
IDENTIFY MISPRICED SECURITIES
use fundamental analysis
approaches
valuation determines the intrinsic value compared to
the current market value
estimate key financial variables such as
EPS next year
income growth next year
FINANCIAL ANALYSIS
1. Fundamental analysis three levels of analyses
i. Macroeconomic analysis
ii. Industry analysis
iii.Company analysis
2. Technical analysis
Technical analysis and stock valuation
Analytical tools of technical analysis
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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Second Step :
Industry analysis
Industry: 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)
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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.
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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.
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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.
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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.
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Third Step: Company Analysis
This 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.
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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).
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FINANCIAL STATMENT ANALYSIS
INTEGRAL PART OF FUNDAMENTAL
ANALYSIS
it helps the analyst understand a firms current
condition
where it is headed
what factors affect it
how the factors affect it
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FINANCIAL STATMENT ANALYSIS
Review of Accounting Statements
includes a study of the three major statements
prepared monthly by most accountants:
the balance sheet
the income statement
the statment of cash flows
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FINANCIAL STATMENT ANALYSIS
RATIO ANALYSIS
DEFINITION: a technique used to examine a
companys financial statements
Use of Ratios
as an absolute standard
as a comparative indicator
as a trend over time
in combination with technical analysis
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FINANCIAL STATMENT ANALYSIS
RATIO ANALYSIS
Types of Ratios
internal liquidity
operating performance
risk analysis
growth analysis
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internal liquidity ratios:
indicate the ability of the firm to meet future
short-term financial obligations
some liquidity ratios:
current ratio
quick ratio
cash ratio
receivables turnover
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operating performance ratios:
indicate how well the management is operating
the business
some examples:
total asset turnover
net fixed asset turnover
equity turnover
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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 ratio
long-term debt/total capital ratio
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growth analysis ratios:
indicate how fast a firm should grow
it involves analysis using several other ratios
net profit margin
total asset turnover
total assets/equity
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TOP-DOWN V. BOTTOM UP
BOTTOM-UP APPROACH:
attempts to estimate prospects in the following
order:

1. The firm
2. The Industry
3. The economy