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investment chapter 7 (ii. What is Intrinsic Value? (Intrinsic value…
investment chapter 7
ii. What is Intrinsic Value?
The underlying or inherent value of a stock, as determined through fundamental analysis
A prudent investor will only buy a stock if its market price does not exceed what the investor thinks the stock is worth.
Intrinsic value depends upon several factors:
Estimates of future cash flows
Discount rate
Amount of risk
iii. “Top Down” Approach to Traditional Security Analysis
Step 1: Economic Analysis
State of overall economy
Economic Analysis is the study of general economic conditions that is used in the valuation of common stock.
Stock prices are heavily influenced by the state of the economy and by economic events on both a global and domestic basis.
The behavior of the economy is captured in the business cycle, which reflects changes in total economic activity over time
Key Economic Measures
Gross Domestic Product (GDP):
market value of all goods and services produced in a country over the period of a year
Generally, as GDP goes the economy goes
Industrial Production
measure of the activity/output in the industrial or productive segment of the economy
Generally, as production goes the economy goes
Key Economic Factors that Affect the Business Cycle
Government Fiscal Policy
Taxes
Government spending
Debt management
Monetary Policy
Money supply
Interest rates
Other Factors
Inflation
Consumer spending
Business investments
Foreign trade
Currency exchange rates
Sources for Economic Outlook
Wall Street Journal
Fortune, Business Week, Forbes
Government Publications
Brokerage firm/commercial bank reports
Important Point to Remember!
Stock prices usually change before the actual forecasted changes become apparent in the economy
Stock price trends are another leading indicator often used to help predict the direction of the economy itself
Step 2: Industry Analysis
Outlook for specific industry
Level of competition in industry
Looking for new opportunities & growth potential
Issues that Affect an Industry
What is the nature of the industry?
Is the industry regulated?
What role does labor play in the industry?
How important are technological developments?
Which economic forces have the most impact on the industry (e.g., interest rates, foreign trade)?
What are the important financial and operating considerations (e.g., access to capital)?
Growth Cycle Stages and Investments
Growth Cycle reflects the vitality of an industry or a company over time.
Initial Development
industry is new and risks are very high
Rapid Expansion
product acceptance is growing and investors become very interested
Mature Growth
expansion comes from growth in the economy and returns are more predictable
Stability or Decline
demand for product is diminishing and investors avoid this stage
Sources for Industry Outlook
Trade publications
Wall Street Journal
Fortune, Business Week, Forbes
Brokerage house reports
Step 3: Fundamental Analysis
Financial condition of specific company
Historical behavior of specific company’s stock
Evaluate the financial condition and operating results of a specific company
Competitive position
Composition and growth in sales
Profit margins and dynamics of earnings
Asset mix (i.e. cash balance, inventory, accounts receivable, fixed assets)
Financing mix ( i.e. debt, stock)
The value of a stock is influenced by the financial performance of the company that issued the stock
Financial Statements:The Balance Sheet
Assets
what the company owns (i.e. cash, inventory, accounts receivable, equipment, buildings, land)
Liabilities
what the company owes (i.e. bills, debt)
Equity
capital the stockholders have invested in the company
What are we looking for on the balance sheet?
Relative amounts (large vs. small)
Trends (improving vs. decreasing)
Financial Statements:The Income Statement
Summary of a company’s operating results over a specific period of time, usually one year
Revenues
funds received for providing products and/or services
Expenses
funds used to pay for materials, labor, and other business costs
Profit/Loss
revenues less expenses
What are we looking for on the income statement?
Relative amounts (large vs. small)
Relationships (Are expenses growing faster or slower than revenues?)
Trends (improving vs. decreasing)
v. Fundamental analysis is still important because:
All of the people doing fundamental analysis is the reason the market is efficient
Financial markets may not be perfectly efficient
Pricing errors are inevitable
iv. efficient market hypothesis
Efficient Market
: the concept that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times
Efficient market advocates believe:
Securities are rarely substantially mispriced in the marketplace
No security analysis is capable of finding mispriced securities more frequently than using random chance
i. What is Security Analysis?
“The process of gathering information, organizing it into a logical framework, and then using it to determine the intrinsic value of a share of common stock.”