Transcript Document 7653808

Chapter
6
Common Stock
Valuation: Selecting
Stocks
Objective
• Our objective in this lecture is to get a preliminary
understanding of what to look for when selecting firms to
invest in within an industry.
• We will do this by understanding and evaluating firms
along two lines:
– What is the firm’s relative competitive position within its industry?
– What is the firm’s competitive strategy and how well is the
company executing its strategy?
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Relative competitive position
• To assess a firm relative to its peers, we must first
understand what are the factors that allow firms to
succeed in the industry.
• The overall industry may be driven by certain macroeconomic variables which are unique to the industry (or
to a subset of industries).
• However, traditional ratio analysis can be used to assess
the firm’s strength relative to its peers.
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Relative competitive position
• Sales growth: This is a sign of a healthy business.
– How does this compare to its competitors?
– How is the firm achieving this growth? Pricing? Unit sales?
Acquisitions?
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Relative competitive position
• Ratio analysis – the study of the relationship between
various financial statement accounts.
• Ratio analysis should examine historical trends for a firm
and at allow the analyst to compare the firm with its
peers.
• We will look briefly at three categories of ratios:
– Profitability
– Leverage
– Liquidity
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Relative competitive position
• Profitability / performance:
– Profitability measures provide an indication of how efficiently a
company is running its business. Ratios used here:
– Gross Profit margin = Gross profit/Sales
– Net Profit margin = Net Income/Sales
– Return on Assets (ROA) = Net Income/Total Assets
– The first ratio is potentially more volatile as it will typically include
raw materials costs.
– Ideally, we would like to see declining expenses and costs over
time (and increasing ratios) and ratios that are higher than the
firm’s peers.
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Relative competitive position
• Leverage:
– Leverage measures look at the amount of debt and equity in the
firm’s capital structure.
– More debt in a firm’s capital structure will result in higher returns
to its shareholders, but it may also mean that the firm is more
risky and may not have the funds for future projects.
– Debt-Equity ratio = Long-term debt / shareholder’s equity
– In an economic environment where debt is difficult for firms to
raise, firms that have lower leverage ratios may be more
attractive.
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Relative competitive position
• Liquidity:
– Liquidity is concerned with the firm’s abillity to meet its day-to-day
operating expenses and satisfy its short-term obligations as they
come due.
– current ratio = Current asset / current liabilities
– Ratios below 1 suggest that the firm may have difficulty in
meeting near-term liabilities.
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Competitive Strategy
• General strategies (from Porter’s competitive forces) for
achieving above-average performance are:
– Cost leadership – being the lowest cost producer while offering
products that are comparable to those of other companies (so
that prices are similar).
– Differentiation – offering unique products or services along some
dimensions that are valued by buyers so that the company can
command premium prices.
– Focus – seeking a competitive advantage within a target segment
based either on cost leadership or differentiation.
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Readings
• Reserve Material in my office.
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