CSC Volume 2 Section 1 PDF

Fundamental and Technical Analysis 13 CHAPTER OVERVIEW In this chapter, you will learn how analysts use statistical, market, and industry information to value securities and make recommendations on their purchase...

Fundamental and Technical Analysis 13 CHAPTER OVERVIEW In this chapter, you will learn how analysts use statistical, market, and industry information to value securities and make recommendations on their purchase or sale. You will learn about two methods of analysis: fundamental analysis and technical analysis. LEARNING OBJECTIVES CONTENT AREAS 1 | Compare and contrast fundamental and Methods of Equity Analysis technical analysis. 2 | Describe how the three macroeconomic Fundamental Macroeconomic Analysis factors affect investor expectations and the price of securities. 3 | Explain how industries are classified and how Fundamental Industry Analysis industry classifications impact a company’s stock valuation. 4 | Describe the tools used in technical analysis. Technical Analysis © CANADIAN SECURITIES INSTITUTE 13 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. blue-chip head-and-shoulders formation chart analysis mature industries continuation pattern moving average contrarian investors neckline cycle analysis quantitative analysis cyclical industry random walk theory declining industries rational expectations hypothesis defensive industries resistance levels economies of scale reversal pattern efficient market hypothesis sentiment indicators emerging growth industries speculative industry fundamental analysis support levels growth industry technical analysis © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 3 INTRODUCTION A great deal of information is available to help investors and their advisors make investment decisions. Resources include market and economic data, stock charts, industry and company characteristics, and a wealth of financial statistical data. All this information can add clarity and perspective to the investment-making process, but the sheer amount can be overwhelming. Fundamental and technical techniques for analysis are widely discussed in the financial press; however, their use and interpretation is often misunderstood. To make investment recommendations based on either type of analysis, you must have an understanding of how to interpret the results. For example, suppose you are considering an investment in the stock of a cyclical company, and you hear reports that an economic slowdown is imminent, what does that information mean for the economy? What does it mean for the industry? And, most pertinent to your decision, what effect will it have on the investment? This chapter will give you the tools to answer those and other questions. METHODS OF EQUITY ANALYSIS 1 | Compare and contrast fundamental and technical analysis. Two methods of analysis are used to evaluate equities: fundamental analysis and technical analysis. Fundamental analysis is a method of assessing the short-, medium-, and long-range prospects of different industries and companies to shed light on security prices. Technical analysis is the study of historical stock prices and stock market behaviour to predict future prices and behaviour. OVERVIEW OF FUNDAMENTAL ANALYSIS Fundamental analysis is a method of evaluating capital market conditions, economic conditions (both domestic and global), industry conditions, and the condition of individual companies in an attempt to measure the intrinsic or fundamental value of a security. The ultimate goal is to compare the intrinsic value against a security’s current price so that you can determine whether the security is overvalued or undervalued. Fundamental analysts study everything that can affect a security’s value. Subjects under scrutiny include macroeconomic factors, such as the economic outlook for Canada’s trading partners, and industrial factors, such as the growth stage of a particular industry. But by far the most important factor affecting a security’s price is the actual or expected profitability of the issuer. In this regard, fundamental analysts use profitability ratios to determine whether a company can properly service its debt and pay current dividends. Given the broad range of factors that can influence stock valuation, we examine fundamental analysis in this chapter from a macroeconomic and industry perspective. In Chapter 14, we focus exclusively on company analysis and profitability ratios. DID YOU KNOW? Our focus in this chapter is the use of fundamental analysis in valuing equities. However, you can use this method to value most types of securities. For example, you could look at an economic forecast for the future direction of interest rates or the credit rating of an issuer to determine the value of a bond. © CANADIAN SECURITIES INSTITUTE 13 4 CANADIAN SECURITIES COURSE      VOLUME 2 OVERVIEW OF TECHNICAL ANALYSIS Technical analysis is a method of determining the future price direction of a security based on past price movements. Essentially, technical analysts attempt to understand the market sentiment behind the trend in a stock’s price instead of its fundamental attributes. They look for recurring patterns that allow them to predict future stock price movements. Technical analysts believe that, by studying the “price action” of the market, they will have better insights into the emotions and psychology of investors. They contend that, because most investors fail to learn from their mistakes, identifiable patterns exist. Despite these methods of analysis, in times of uncertainty, investors may act irrationally under the influence of mass psychology. Market news can cause investors to overreact and buy or sell quickly en masse, which causes prices to rise or drop suddenly. Sophisticated computerized trading strategies (called program trading or high- frequency trading) can also have an unintended effect on market prices in a way that is unrelated to the expected earnings of the stocks or their historical price movements. EXAMPLE The 2008–2009 subprime mortgage crisis caused extreme uncertainty among investors. As a result, healthy stocks with proven long-term track records collapsed along with weaker stocks. By early 2009, the stock market fell by approximately 50% and did not return to its pre-crisis peak until 2013. In another example, in May 2010, the Dow Jones Industrial Average fell almost 600 points in less than five minutes but rebounded within 20 minutes. Some argue that the so-called “flash crash” was exacerbated by computerized high-frequency trading. MARKET THEORIES Three theories help to explain the behaviour of stock markets: the efficient market hypothesis, the random walk theory, and the rational expectations hypothesis. All three theories suggest that stock markets are efficient and that a stock’s price is therefore the best available estimate of its true value; essentially this implies investors cannot consistently ‘beat’ the market. Table 13.1 describes the unique assumptions and conclusions of each theory. Table 13.1 | Stock Market Theories Assumptions Conclusions Efficient market Profit-seeking investors in the marketplace react A stock’s price fully reflects all available hypothesis quickly to the release of information. When new information and represents the best information about a stock appears, investors estimate of the stock’s true value. reassess the intrinsic value of the stock and adjust their estimation of its price accordingly. Random walk New information concerning a stock is Past price changes contain no useful theory disseminated randomly over time. Price changes information because any developments are therefore random and bear no relation to affecting the company have already been previous prices. reflected in the current price of the stock. Rational People are rational and have access to all Past mistakes can be avoided by using expectations necessary information. People use information available information to anticipate hypothesis intelligently in their own self-interests and make change. intelligent decisions after weighing all available information. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 5 DID YOU KNOW? If all investors reacted to new information in the same way and at the same time, no investor would be able to outperform others. In fact, however, some investors are sometimes able to consistently outperform index averages like the S&P/TSX Composite Index. There are three variations of the efficient market hypothesis: weak, semi-strong, and strong. Each variation assumes that a different amount of information is reflected in the prices of securities: The weak form assumes that all past market information is fully reflected in current prices. With this form, technical analysis is considered to have little or no value. The semi-strong form assumes that all publicly available information is fully reflected in current prices. With this form, both fundamental analysis and technical analysis have little or no value. The strong form assumes that all information is fully reflected in current prices, including both publicly available and insider information. In other words, no single investor has information that provides an advantage over any other investor. Many studies have been conducted over the years to test the three stock market theories. Some evidence supports the theories, whereas other evidence supports capital market inefficiencies. Those inefficiencies may occur for any of the following reasons: New information is not available to everyone at the same time. Investors do not react in the same way to the same information. Not everyone can make accurate forecasts and correct valuation decisions. Mass investor psychology and greed may at times cause investors to act irrationally. DID YOU KNOW? Investors who believe in the efficient market hypothesis, particularly the strong form, favour a passive investment approach. They are likely to follow a buy-and-hold strategy or invest in market indexes and exchange-traded funds. Investors who reject the hypothesis are likely to use a more active approach, which involves more buying and selling in an attempt to beat the stock market’s average returns. FUNDAMENTAL MACROECONOMIC ANALYSIS 2 | Describe how the three macroeconomic factors affect investor expectations and the price of securities. The macroeconomic factors affecting investor expectations (and, therefore, the price of securities) can be grouped into three categories: fiscal policy, monetary policy, and inflation. Unpredictable events can affect the economy and the prices of securities either favourably or unfavourably. Such events might include international crises such as war, unexpected election results, regulatory changes, technological innovation, and debt defaults. In addition, dramatic changes in the prices of important agricultural, metal, and energy commodities can affect the prices of securities. Many commodity price swings can be predicted by examining supply and demand conditions. Other price changes may not be easy to predict. For example, the Organization of the Petroleum Exporting Countries (OPEC) coordinates production policies of its member countries, thereby affecting the price of oil. © CANADIAN SECURITIES INSTITUTE 13 6 CANADIAN SECURITIES COURSE      VOLUME 2 THE FISCAL POLICY IMPACT The two most important tools of fiscal policy are government expenditure and taxation. These tools are important to market participants because they affect overall economic performance and influence the profitability of individual industries. Levels of expenditure and taxation are usually disclosed in federal and provincial budgets. TAX CHANGES By changing tax levels, governments can alter the spending power of individuals and businesses. When governments increase sales or personal income tax levels, people have less disposable income, which curtails their spending. A reduction in tax levels has the opposite effect. Corporations are similarly affected by tax changes. Higher taxes on profits generally reduce the amount businesses can pay out in dividends or spend on expansion. On the other hand, a reduction in corporate taxes gives companies an incentive to expand. Several factors limit the effectiveness of fiscal policy. One such factor is the lengthy time lag required to get parliamentary approval for tax legislation. A lag also exists between the time fiscal action is taken and the time the action affects the economy. GOVERNMENT SPENDING Governments can affect aggregate spending in the economy by increasing or decreasing their own spending on goods, services, and capital programs. On the simplest level, an increase in government spending stimulates the economy in the short run, whereas a spending cutback has the opposite effect. Conversely, tax increases lower consumer spending and business profitability, whereas tax cuts boost profits and common share prices. This type of expansionary fiscal policy of tax cuts and spending initiatives can help to spur the economy. Governments can then target certain sectors of the economy with fiscal policy measures. For example, tax incentives to stimulate growth in housing or investment in technology industries. Fiscal policies can also be designed to achieve government policy goals. For example, the dividend tax credit and the exemption from tax of a portion of capital gains were designed to encourage greater share ownership of Canadian companies by Canadians. Savings by individuals are encouraged through measures such as registered retirement savings plans and tax-free savings accounts. Such policies increase the availability of cash for investments, thereby increasing the demand for securities. GOVERNMENT DEBT Higher levels of government debt have a tendency to restrict both fiscal and monetary policy options. Fiscal and monetary decisions affect the overall level of interest rates, the rate of economic growth, and the rate of corporate profit growth. All these factors affect the valuation of stocks. DID YOU KNOW? High levels of government and consumer indebtedness impair the government’s ability to reduce taxes or increase spending. For example, a government with a high level of debt will find it challenging to use an expansionary fiscal policy of increased spending because the spending will generally need to be financed by borrowing more, thus adding to the debt level and increasing overall interest payments on the outstanding debt. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 7 THE MONETARY POLICY IMPACT The primary role of the Bank of Canada (the Bank) is to promote Canada’s economic and financial welfare, which it does through monetary policy. The Bank achieves this by attempting to preserve the value of the Canadian dollar by keeping inflation low, stable, and predictable. For example, during periods of economic expansion, demand for credit grows (i.e., bank loans for individuals and businesses) and the prices for goods and services generally rise thus creating inflationary pressures. If the Bank believes these pressures are having a negative impact, they can try to restrain the growth rate of money and credit by raising short-term interest rates. On the other hand, if the economy appears to be slowing down, the Bank may increase the money supply and the availability of credit by reducing short-term interest rates. Changes in monetary policy affect both interest rates and corporate profits, which are the two most important factors affecting the prices of securities. MONETARY POLICY AND THE BOND MARKET When economic growth begins to accelerate, bond yields tend to rise. If inflation begins to rise during an expansion, the Bank most often raises short-term interest rates to slow economic growth and contain inflationary pressures. This action may lead to a more moderate economic growth rate or even a growth recession (i.e., a temporary slowdown that does not become a full recession). DID YOU KNOW? When the Bank raises short-term rates to slow the rate of economic growth, a fall in long-term bond yields may result. This effect signals that investors approve of the degree of economic slowing. When short-term yields rise and long-term yields fall, the change in the yield curve is called a tilting of the yield curve. The process is generally as follows: As short-term interest rates rise, the rate at which bond yields increase slows down. Long-term bond yields continue to rise, but at a slower pace. As the rise in short-term rates continues, economic growth usually slows. Long-term bond prices begin to stabilize and briefly fall below those of equities. Suddenly, with each short-term interest rate increase, long-term bond yields fall. Investors purchase long-term bonds under the assumption that a slower economic growth rate will alleviate the need for higher interest rates in the near future. The increased purchase of long-term bonds pushes their yields lower. This drop in yield is crucial evidence for the analyst that bond market participants are satisfied with the slowing of the economy to a more sustainable level of growth. A decline in long-term rates reduces competition between equities and bonds. On the other hand, higher real bond yields over time increase the degree of competition between bonds and equities and slowly undermine equity markets. THE IMPACT OF INFLATION Inflation creates widespread uncertainty and undermines confidence in the future. These factors tend to result in higher interest rates, lower corporate profits, and lower price-earnings multiples. Inflation leads to higher inventory and labour costs for manufacturers. To maintain their profitability, manufacturers generally try to pass these higher costs on to consumers in the form of higher prices. But higher costs cannot be © CANADIAN SECURITIES INSTITUTE 13 8 CANADIAN SECURITIES COURSE      VOLUME 2 passed on indefinitely; buyers eventually resist. The resulting squeeze on corporate profits is reflected in lower common share prices. DID YOU KNOW? An inverse relationship exists between the rate of inflation and a corporation’s price-earnings multiples. When inflation rises, the value of future cash flows paid by the corporation will fall. Therefore, if inflation is rising, an investor is more likely to pay a lower price for the earnings of the company. Note that we look at the concept of the price-to-earnings ratio in more detail in the next chapter. FUNDAMENTAL INDUSTRY ANALYSIS 3 | Explain how industries are classified and how industry classifications impact a company’s stock valuation. Industry and company profitability have more to do with the structure of the industry than with the products or services it sells. Industry structure results from the strategies that companies pursue relative to their competition. Companies pursue the strategies they feel will give them a sustainable competitive advantage and lead to long- term growth. Pricing strategies and company cost structures affect not just long-term growth, but also the volatility of sales and earnings. For this reason, industry structure affects a company’s stock valuation. CLASSIFYING INDUSTRIES BY PRODUCT OR SERVICE A natural way to classify an industry is by the product or service it produces; for example, the automobile industry comprises companies that manufacture cars. This common classification system is used by investment dealers to define the coverage universe of their equity analysts. Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), two well-known providers of equity indexes, have developed a comprehensive industry and sector classification system known as the Global Industry Classification Standard (GICS). S&P and MSCI assign every company within their indexes to one of 163 sub- industries. Each sub-industry belongs to one of 74 industries that are apportioned into 25 industry groups and then into 11 sectors. Table 13.2 lists the 11 sectors and their 25 associated industry groups. Note that some sectors have only one industry group. Table 13.2 | Sectors and Industry Groups Based on the Global Industry Classification Standard Sector Industry Groups Communication Services Telecommunication Services Media and Entertainment Consumer Discretionary Automobiles and Components Consumer Durables and Apparel Consumer Services Consumer Discretionary Distribution and Retail © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 9 Table 13.2 | Sectors and Industry Groups Based on the Global Industry Classification Standard Sector Industry Groups Consumer Staples Consumer Staples Distribution and Retail Food, Beverage, and Tobacco Household and Personal Products Energy Energy Financials Banks Financial Services Insurance Health Care Health Care Equipment and Services Pharmaceuticals, Biotechnology and Life Sciences Industrials Capital Goods Commercial and Professional Services Transportation Information Technology Software and Services Technology Hardware and Equipment Semiconductors and Semiconductor Equipment Materials Materials Real Estate Equity Real Estate Investment Trusts (REITs) Real Estate Management and Development Utilities Utilities Source: “Global Industry Classification Standard (GICS)”, MSCI, www.msci.com/our-solutions/indexes/gics One problem with classifying an industry by the product or service it sells is that some companies operate in more than one industry. For example, before Canadian Pacific Limited was broken up into several entities, its revenue came from hotels, shipping, and rail. It was a complex process for analysts to compare the company to any other company or analyze its growth potential. However, for companies that operate solely in one industry, analysis provides insight into their short-term behaviour. For example, Barrick Gold Corporation is easily identified as a gold producer, and thus its classification has relevance. CLASSIFYING INDUSTRIES BY LIFE CYCLE In theory, all industries exhibit a life cycle characterized by four stages: emerging growth, growth, maturity, and decline. However, the length of each stage varies from industry to industry and from company to company. © CANADIAN SECURITIES INSTITUTE 13 10 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? The entire railway industry life cycle in Canada, from its beginnings to its present state of decline, is more than 150 years. In contrast, some high-technology industries have gone through a complete life cycle in just a few years. Determining where an industry is in its life cycle is an important factor in the valuation process. Throughout that life cycle, sales volume at a company in the industry grows or declines. Therefore, each stage in the cycle affects the relationship between the firm’s pricing strategies and its unit cost structure. EMERGING GROWTH INDUSTRIES New industries are continually developing to provide products and services that meet society’s changing needs and demands. These industries are known as emerging growth industries. Today, rapid innovation is particularly evident in software and hardware development in the computer industry. Emerging growth industries, and companies within them, tend to share certain financial characteristics. Typically, they are unprofitable at first, although future prospects may be promising. Large start-up investments may even lead to negative cash flows. It is sometimes impossible to predict which companies will ultimately survive in a new industry. DID YOU KNOW? Emerging growth industries are not always directly accessible to equity investors, especially if privately owned companies dominate the industry, or if the new product or service is only one activity of a diversified corporation. GROWTH INDUSTRIES A growth industry is one in which sales and earnings are consistently expanding at a faster rate than in most other industries. Companies in these industries are called growth companies, and their common shares are called growth stocks. A growth company should have an above-average rate of earnings on invested capital over a period of several years. The company should also be able to continue to achieve similar or better earnings on additional invested capital. It should show increasing sales in terms of both dollars and units, coupled with a firm control of costs. During the growth period, companies that survive experience lower costs of production, increased competition, rising demand, and growth in profits. Cash flow may or may not remain negative. Growth stocks typically maintain above-average growth over several years, and growth is expected to continue. These companies generally do not pay out large dividends because their growth is often financed through retained earnings. Growth companies therefore tend to exhibit high price-to-earnings ratios and low dividend yields. DID YOU KNOW? If the marketplace expects that future growth in a specific growth industry will not meet expectations, growth companies within that industry are likely to have an above average risk of a price decline. MATURE INDUSTRIES Mature industries usually experience slower, more stable growth in sales and earnings that more closely matches the overall rate of economic growth. Both earnings and cash flow tend to be positive. Within the same industry, it is more difficult to identify differences in products between companies. For this reason, price competition increases, profit margins usually fall, and some companies expand into new businesses with better growth prospects. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 11 During recessions, stable growth companies usually demonstrate a decline in earnings that is less than that of the average company. Companies in the mature stage usually have sufficient financial resources to weather difficult economic conditions. DECLINING INDUSTRIES As industries move from the mature/stable to the declining stage, they tend to stop growing and begin to decline. Declining industries produce products for which demand has declined because of changes in technology, an inability to compete on price, or changes in consumer tastes. Cash flow may be large, because there is no need to invest in new plant and equipment. At the same time, profits may be low. CLASSIFYING INDUSTRIES BY COMPETITIVE FORCES In his book Competitive Strategy: Techniques for Analyzing Industries and Competitors (Free Press, 1980), Michael Porter described five basic competitive forces that determine the attractiveness of an industry. According to Porter, those five factors can drastically alter the future growth and valuation of companies within the industry. Table 13.3 outlines and describes Porter’s five forces. Table 13.3 | Porter’s Five Competitive Forces 1. Threat of new entry The ease of entry for new Companies choose to enter an industry competitors to that industry depending on the amount of capital required, opportunities to achieve economies of scale, the existence of established distribution channels, regulatory factors and product differences. 2. Competitive rivalry The degree of competition between This factor depends on the number of existing firms competitors, their relative strength, the rate of industry growth, and the extent to which products are unique (rather than simply ordinary commodities). 3. Threat of substitutes The potential for pressure from Other industries may produce similar substitute products products that compete with the industry’s products. 4. Bargaining power The extent to which buyers of the The degree of influence depends largely on of buyers product or service can put pressure buyers’ sensitivity to price. on the company to lower prices 5. Bargaining power The extent to which suppliers can The costs of suppliers’ raw materials or of suppliers put pressure on the company to pay inputs affect profit margins or product more for the resources they supply quality. In the final analysis, companies can thrive only if they meet customers’ needs. Therefore, profit margins can be large only if customers perceive enough value in the goods or services the companies provide. CLASSIFYING INDUSTRIES BY REACTION TO THE ECONOMIC CYCLE Industries can be broadly classified according to how they react to the cyclical nature of the economy. Three typical classifications are cyclical, defensive, and speculative. © CANADIAN SECURITIES INSTITUTE 13 12 CANADIAN SECURITIES COURSE      VOLUME 2 CYCLICAL INDUSTRIES Few, if any, industries are immune from the adverse effects of an overall downturn in the business cycle; thus, all industries are cyclical to a degree. However, the term cyclical industry is reserved for industries in which the effect on earnings is most pronounced. Most cyclical S&P/TSX Composite Index companies are large international exporters of commodities such as lumber, base metals (e.g., copper and nickel), or oil. These industries are sensitive to global economic conditions, swings in the prices of international commodities markets, and changes in the level of the Canadian dollar. When business conditions are improving, earnings tend to rise dramatically. In general, cyclical industries fall into three main groups: Commodity basic cyclical, such as forest products, base metals, and chemicals Industrial cyclical, such as transportation, capital goods, and basic industries (steel and building materials) Consumer cyclical, such as merchandising and automobile industries The energy and gold industries are also cyclical, but they tend to demonstrate slightly different patterns. The rate of expansion or contraction in the U.S. business cycle tends to significantly influence the profitability of cyclical Canadian companies. Exchange rates are an important secondary factor. Most cyclical industries benefit from a declining Canadian dollar because their exportable products become cheaper for international buyers. DEFENSIVE INDUSTRIES Defensive industries have a relatively stable return on investor equity and tend to do relatively well during recessions. The term blue-chip denotes shares of top investment-quality companies, which maintain earnings and dividends through good times and bad. This record usually reflects a dominant market position, strong internal financing, and effective management. Many investors consider shares of the major Canadian banks to be blue-chip industries; however, bank stock prices are typically sensitive to changes in interest rates. As interest rates rise, banks must raise the rate they pay on deposits to attract funds. At the same time, a large part of their revenue is derived from mortgages with fixed interest rates. The result is a profit squeeze. Bank stock prices are particularly sensitive to changes in long bond yields. The shares of utility companies (gas, water, electricity) are also considered defensive, blue-chip stocks given their ability to generate consistent earnings over most economic cycles. However, utility stocks that carry large amounts of debt tend to be sensitive to interest rates. SPECULATIVE INDUSTRIES All investment in common shares is speculative to some degree because of the risk of ever-changing stock market values. However, the term speculative industry usually applies to industries in which risk and uncertainty are unusually high because analysts lack definitive information. Shares in these companies are called speculative shares. Emerging industries are often considered speculative. The profit potential of a new product or service attracts many new companies, and initial growth may be rapid. Inevitably, as the industry consolidates, many of the original participants are forced out of business, and a few companies emerge as the leaders. The success of these leaders in weathering the developmental period may result from better management, better financial planning, better products and services, or better marketing. The term speculative can also describe any company, even a large one, whose shares are treated as speculative. For example, shares of growth companies can be bid up to high multiples of estimated earnings per share as investors anticipate continuing exceptional growth. If, for any reason, investors begin to doubt these expectations, the price of the stock will fall. In such cases, investors are speculating on the likelihood of continued future growth that may not materialize. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 13 FUNDAMENTAL INDUSTRY ANALYSIS How is fundamental industry analysis used to determine the value of a stock? Complete the online learning activity to assess your knowledge. TECHNICAL ANALYSIS 4 | Describe the tools used in technical analysis. Technical analysis is the process of analyzing historical market action in an effort to determine probable future price trends. Technical analysts view the range of data studied by fundamental analysts as too massive and unmanageable to pinpoint price movements with any real precision. Instead, they focus on the market itself, whether it is the commodity, equity, interest rate, or foreign exchange market. They study, and plot on charts, the past and present movements of prices, the volume of trading, and statistical indicators. In the case of equity markets, they track the number of stocks advancing and declining. The purpose of these activities is to identify recurrent and predictable patterns that can be used to predict future price moves. Market action includes three primary sources of information: price, volume, and time. Technical analysis is based on the following three assumptions involving these sources of information: 1. All influences on market action Technical analysts believe that all known market influences are fully are automatically accounted for reflected in market prices. They believe that there is little advantage to or discounted in price activity. be gained through fundamental analysis; all that is required is that you study the price action itself. By studying price action, technicians attempt to measure market sentiment and expectations. In effect, the technical analyst believes that the market itself indicates the direction and the extent of its next price move. 2. Prices move in trends, and Given this assumption, the primary task of a technical analyst is to identify those trends tend to persist for a trend in its early stages and carry positions in that direction until the relatively long periods of time. trend reverses itself. 3. The future repeats the past. Technical analysts believe that markets essentially reflect investor psychology and that the behaviour of investors tends to repeat itself. Investors tend to fluctuate between pessimism, fear, and panic on one side, and optimism, greed, and euphoria on the other. By comparing current investor behaviour as reflected through market action with comparable historical market behaviour, the analysts attempt to make predictions. Even if history does not repeat itself exactly, we can still learn a lot from the past, they believe. COMPARING TECHNICAL ANALYSIS TO FUNDAMENTAL ANALYSIS In comparing technical analysis with fundamental analysis, remember that the demand and supply factors that technicians observe are the result of fundamental developments in a company’s earnings. The main difference between technical and fundamental analysis is the subject of study. The technical analyst studies the effects of supply and demand, which are reflected in price and volume. The fundamental analyst, on the other hand, studies the causes of price movements. Both types of analysts might come to the same conclusion based on very different observations. © CANADIAN SECURITIES INSTITUTE 13 14 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? A fundamental analyst might suggest that a general and prolonged rising trend in equity prices (i.e., a bull market) will likely come to an end as a result of rising interest rates. A technical analyst, on the other hand, might predict that an upward trend is about to reverse based on the appearance of a certain chart formation. A study of fundamentals can give you a sense of the long-term price prospects for an asset, which might be the first step in making an investment decision. However, at the point where you decide when and at what level to enter or leave a market, technical analysis can serve a vital role. COMMONLY USED TOOLS IN TECHNICAL ANALYSIS Technical analysts use four methods to identify trends and possible trend turning points, either alone or in conjunction with each other: chart analysis, quantitative analysis, analysis of sentiment indicators, and cycle analysis. CHART ANALYSIS Chart analysis is the analysis of graphic representations of relevant market data. Charts offer a visual sense of where the market has been, which helps analysts project where it might be going. The most common type of chart is one that graphs the high, low, and close (or last trade) of a particular asset (such as a stock, market average, or commodity). Activity may be tracked hourly, daily, weekly, monthly, or even yearly. This type of chart, called a bar chart, often displays the volume of trading at the bottom. Figure 13.1 shows an example of a bar chart. Other price charts, not discussed here, include candlestick charts, line charts, and point and figure charts. Figure 13.1 | Daily Bar Chart – S&P 500 A daily bar chart of the S&P 500 Index from February 7 to June 7. Source: Chart courtesy of StockCharts.com © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 15 Technical analysts use price charts to identify support levels and resistance levels, along with regular price patterns. A support level is the bottom price of the trading range for a security. It is the price at which most investors sense value and are willing to buy the security; therefore, demand begins to grow. Most existing holders (or potential short sellers) are unwilling to sell at this price; therefore, supply is low. As demand begins to exceed supply, prices tend to rise above support levels. A resistance level is the top price of the trading range, where most investors are willing to sell a security and most buyers are unwilling to buy it. At this point, supply exceeds demand and prices tend to fall. Figure 13.2 illustrates support and resistance levels. Figure 13.2 | Varying Levels of Support and Resistance The Euro index, for example, broke above the resistance level of $1.345 in January 2011 starting a new up trend. This same price level ($1.345) proves to be key support in mid-February during a short-term pullback. Now $1.38 was the new resistance line, but by March, that level too had been broken and acted afterward as a support line. Source: Chart courtesy of StockCharts.com Chart formations reflect market participant behavioural patterns that tend to repeat themselves. They can indicate either a trend reversal (reversal pattern), or a pause in an existing trend (continuation pattern). Reversal patterns are formations on charts that usually precede a sizeable advance or decline in stock prices. There are many types of reversal patterns, but probably the most frequently observed pattern is the head-and-shoulders formation. This formation can occur at either a market top, where it is called a head-and-shoulders top formation, or at a market bottom, where it is called either an inverse head-and-shoulders or a head-and-shoulders bottom formation. © CANADIAN SECURITIES INSTITUTE 13 16 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 13.3 illustrates a bottom formation. Figure 13.3 | Head-and-Shoulders Bottom Formation neckline A G C E left shoulder right shoulder B F D head Legend: ABC = Left shoulder of formation CDE = Head of formation EFG = Right shoulder of formation As Figure 13.3 indicates, the following actions take place: A to B A lengthy decline in price occurs, during which time the volume of shares traded can increase as decline deepens, although this may not necessarily occur. B to C A minor recovery in price occurs, usually with no substantial increase in volume. C to D Price declines again to D, often on increased volume, below the level of the left shoulder (B). D to E This second recovery may not consist of any significant increase in volume. E to F Another decline occurs, during which volume may or may not increase. F to G Further recovery occurs; the greater the symmetry of the right shoulder to the left shoulder, the greater the reliability of the pattern. The line joining the two recovery points in a head-and-shoulders formation is the neckline (points C to E in Figure 13.3, indicated by the broken line). The neckline can extend out to the right of the chart pattern. The final step that confirms a reversal pattern is a price move that carries the stock either below the neckline on increased volume (in a top formation) or above the neckline on increased volume (in a bottom formation). At that point, we see either a downside break-out (in a top formation) or an upside break-out (points F to G in Figure 13.3). © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 17 Figure 13.4 is an example of a downside break-out of a head-and-shoulders top formation in the S&P 500 index. Figure 13.4 | Head-and-Shoulders Top Formation The head-and-shoulders formation was confirmed on the break below the neckline from the right shoulder in August 2011. The market sold off severely on the break. Source: Chart courtesy of StockCharts.com Continuation patterns are pauses on price charts before the prevailing trend continues. They typically appear in the form of sideways price movements. These patterns are quite normal and healthy in a trending market and are referred to as a consolidation of an existing trend. One continuation pattern, called a symmetrical triangle, is shown in Figure 13.5. Figure 13.5 | Symmetrical Triangle A B C In the Figure 13.5 formation, the stock trades in a clearly defined area (CB to AB) during a period ranging from three weeks to six months or more. The triangle represents a fairly even struggle between buyers and sellers. The buyers move into the stock at the bottom line (CB) and the sellers move out of the stock at the top line (AB). This activity repeats itself back and forth until one side proves stronger and the stock price breaks out of the triangle. © CANADIAN SECURITIES INSTITUTE 13 18 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 13.6 illustrates a triangle that broke to the downside. Figure 13.6 | Symmetrical Triangle and Price Projections A symmetrical triangle formed over three weeks from October 26 to November 13, with a break to the downside on November 16. Source: CQG, Inc In most cases, a symmetrical triangle is just a pause in a bull or bear market trend. At times, however, it can indicate a reversal formation. There is no clear way to distinguish whether a triangle indicates a continuation or a reversal, so you must pay close attention to the direction of the break-out. QUANTITATIVE ANALYSIS Quantitative analysis is a form of technical analysis that relies on statistics and has thus been greatly enhanced by computer technology. One general category of quantitative analysis tools used to supplement chart analysis is the moving average. A moving average is simply a device for smoothing out fluctuating values in an individual stock or in the aggregate market as a whole. In doing so, either week-to-week or day-to-day, it shows long-term trends. By comparing current prices with the moving average line, you can see whether a change is signalled. A moving average is calculated by adding the closing prices for a stock over a predetermined period and dividing the total by the number of days or weeks in the period selected. You can follow the same procedure with a market index. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 19 The calculation for a five-week moving average is shown in Table 13.4. (We show a five-week average for simplicity; technical analysts commonly use a 40-week, or 200-day, moving average.) Table 13.4 | Calculation of Five-Week Moving Average for a Particular Stock Closing Price Closing Price Five-Week Moving Average Week 1 $17.50 – Week 2 18.00 – Week 3 18.75 – Week 4 18.35 – Week 5 19.25 18.37 Week 6 19.42 18.75 Week 7 20.22 19.20 Week 8 22.50 19.95 Week 9 21.75 20.63 Based on the calculation in Table 13.4, an amount of $18.37 is plotted on a chart at the end of five weeks. Note that it takes at least five weeks of closing prices to calculate a five-week moving average. In the next week, the closing price from Week 1 is then dropped, and a new five-week total is calculated for Week 6. The average derived from the new total ($18.75) is then plotted on the chart next to the previous average. If the overall trend has been down, the moving average line will generally be above the current individual prices, as shown in Figure 13.7. Figure 13.7 | Buy Signal moving average b stock prices a If the price breaks through the moving average line from below on heavy volume (line a–b in Figure 13.7), and if the moving average line itself starts to move higher, it means that the declining trend has reversed. In other words, it is a buy signal. © CANADIAN SECURITIES INSTITUTE 13 20 CANADIAN SECURITIES COURSE      VOLUME 2 If the overall trend has been up, the moving average line will generally be below the current individual prices, as shown in Figure 13.8. Figure 13.8 | Sell Signal stock prices c moving average d If the price breaks through the moving average line from above on heavy volume (line c–d in Figure 13.8), and if the moving average line itself starts to fall, it means that the upward trend has reversed. In other words, it is a sell signal. Figure 13.9 demonstrates a 65-week moving average. Figure 13.9 | Moving Average The 65-week moving average provided support on several occasions throughout this chart. Although the price of gold dipped below the moving average in late 2008, key support at around $700 held and the moving average itself remained in an upward trend. Source: Chart courtesy of StockCharts.com © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 21 SENTIMENT INDICATORS Sentiment indicators are a measure of investor expectations. Contrarian investors use these indicators to determine what the majority of investors expect prices to do in the future, so that they can move in the opposite direction. The contrarian believes, for example, that if the vast majority of investors expect prices to rise, then there probably is not enough buying power left to push prices much higher. The concept is well proven, but sentiment indicators should only be used as evidence to support other technical indicators. A number of services measure the extent to which market participants are bullish or bearish. If, for example, one of these services indicates that 80% of those surveyed are bullish, it may mean that the market is overbought and that caution is warranted, especially if other indicators provide similar evidence. CYCLE ANALYSIS The tools described above can help you forecast the market’s probable direction and the probable extent of movement in that direction. Cycle analysis, on the other hand, can help you forecast when the market will start moving in a particular direction and when it will ultimately reach its peak or trough. The theory of cycle analysis is based on the assumption that cyclical forces drive price movements in the marketplace. Cycles can last for periods as short as a few days or as long as decades. There are four general categories of cycle lengths: Long-term (greater than two years) Seasonal (one year) Primary/intermediate (nine to 26 weeks) Trading (four weeks) Cycle analysis is complicated by the fact that, at any given point, a number of cycles may be operating. Cycle analysis is useful in identifying a time window when a market peak or trough is expected. However, when it comes to trading, you must supplement cycle analysis with other technical tools, such as trend analysis and chart formations. These tools and formations help confirm that a turn has indeed taken place and that you should take action. © CANADIAN SECURITIES INSTITUTE 13 22 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 13.10 identifies a 4-year market cycle. Figure 13.10 | 4-Year Cycle The 40-month or 4-year cycle. Notice the various developments that occurred at the end of each 40-month period. Source: Chart courtesy of StockCharts.com TECHNICAL ANALYSIS How is technical analysis used to identify patterns to predict price trends in the future? Complete the online learning activity to assess your knowledge. CASE SCENARIO Akeilia, one of your favorite clients, has some questions for you about how industries are classified. Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      FUNDAMENTAL AND TECHNICAL ANALYSIS 13 23 SUMMARY In this chapter, we discussed the following key aspects of fundamental and technical analysis: Both fundamental and technical analysis are used to predict changes in the prices of securities. The difference is that technical analysts study the effects of supply and demand on prices, whereas fundamental analysts study the causes of price movements. The efficient market hypothesis states that stock prices reflect all available information and thus represent true value. The random walk theory assumes that price changes are random and bear no relation to previous price changes. The rational expectations hypothesis assumes that people are rational and make intelligent economic decisions after weighing all available information. Fundamental analysts study three categories of macroeconomic factors: fiscal policy, monetary policy, and inflation. A change in any one of these factors requires a change in investment strategies. Three industry classifications are cyclical, defensive, and speculative. Industries can be further classified by their stage in the life cycle. The four stages are emerging growth, growth, maturity, and decline. Competitive forces in an industry affect growth and risk levels, and therefore help determine stock values. Technical analysts chart past and present movements of security prices, volume of trading, and other statistical indicators to identify recurrent and predictable price patterns. Three key assumptions underlie technical analysis: all market influences are reflected in price activity, prices move in persistent trends, and the future repeats the past. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 13 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 13 FAQs. © CANADIAN SECURITIES INSTITUTE  Company Analysis 14 CHAPTER OVERVIEW In the previous chapter, we examined fundamental analysis from a macroeconomic and an industrial perspective. In this chapter, we discuss company analysis, which fundamental analysts use to measure the actual or expected profitability of the securities issuer. You will learn to examine financial statements and use various financial ratios to determine whether a company is a good prospect for investment. LEARNING OBJECTIVES CONTENT AREAS 1 | Identify the factors involved in performing Performing Company Analysis company analysis to determine whether a company represents a good investment. 2 | Explain how to analyze a company’s financial Interpreting Financial Statements statements using trend analysis and external comparisons. 3 | Assess company performance using financial Analyzing Financial Ratios ratios. 4 | Distinguish among the criteria used in Assessing Preferred Share Investment assessing the investment quality of preferred Quality shares. © CANADIAN SECURITIES INSTITUTE 14 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. asset coverage ratio inventory turnover ratio capital structure liquidity ratios cash flow net current assets cash flow-to-total debt outstanding ratio net profit margin ratio current ratio operating performance ratios debt-to-equity ratio preferred dividend coverage ratio dividend discount model price-to-earnings ratio dividend payout ratio quick ratio dividend yield return on common equity ratio earnings per common share risk analysis ratios equity value per common share ratio trend ratios financial ratios value ratios gross profit margin ratio working capital interest coverage ratio working capital ratio © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 3 INTRODUCTION As we learned in the previous chapter, some form of fundamental analysis of relevant factors is necessary to make successful investment choices. In that chapter, we discussed the macroeconomic and industrial factors that are used in fundamental analysis. In this chapter, we focus on company analysis, during which analysts narrow their focus to examine the investment potential of the issuing company itself. Company analysis is the process of examining company-specific factors that can influence investment decisions. During this process, analysts scrutinize a company’s financial information in an effort to answer the following questions: Are the company’s securities a good investment? Do they fit into an investment strategy? How will general or specific changes in economic or market factors affect the company? Are there risk factors or strengths hidden in the financial statements that may not be readily apparent after a quick review of the company? Is there more to the company than is reported in its press releases or in news stories? In short, what do the financial numbers tell you about the company? One of the goals in performing company analysis is to identify risks and opportunities. This analysis does not eliminate risk, but it can help reduce it. This chapter provides you with tools to analyze a company’s financial statements to determine its investment potential. PERFORMING COMPANY ANALYSIS 1 | Identify the factors involved in performing company analysis to determine whether a company represents a good investment. Fundamental analysts use a company’s financial statements to determine its financial health and potential profitability. You may want to review the accounting principles learned in Chapter 11 before proceeding through this chapter. STATEMENT OF COMPREHENSIVE INCOME ANALYSIS The analysis of a company’s comprehensive income tells you whether management is making good use of the company’s resources. REVENUE A company’s ability to increase revenue is an important indicator of its investment quality. Clearly, revenue growth is desirable, whereas flat or declining revenue trends are less favourable. Likewise, high growth is usually preferable to a low or moderate rate. However, an analyst should keep informed of the reasons for increase in a company’s revenue. A company’s revenue might increase for any of the following reasons: It increased the prices or volumes of its products. It introduced new products. It expanded into a new geographic market. © CANADIAN SECURITIES INSTITUTE 14 4 CANADIAN SECURITIES COURSE      VOLUME 2 It consolidated with another company acquired in a takeover. It received an initial contribution from a new plant or diversification program. It gained market share at the expense of competitors. It launched an aggressive advertising and promotional campaign. It benefited from new industry legislation. Sales temporarily increased when a strike occurred at a major competitor. An upswing in the business cycle occurred. With this knowledge, the analyst can isolate the main factors affecting revenue and evaluate developments for their positive or negative impact on future performance. OPERATING COSTS After studying revenue, the next step is to look at cost of sales. By calculating cost of sales as a percentage of revenue, you can determine whether costs are rising, stable, or falling in relation to sales. A rising trend over several years may indicate that a company is having difficulty keeping overall costs under control and is therefore losing potential profits. A falling trend suggests that a company is operating cost effectively and is likely to be more profitable in the future. You should determine the main reasons for any changes in a company’s ability to pay its operating costs, which you can measure using the gross profit margin ratio. Although it may be difficult to identify the causes, it is important to understand them because of the effect they can have on a company’s cost structure. DID YOU KNOW? The cost at which a company obtains its raw materials has a major impact on its gross profit margin. Companies that rely on commodities such as copper or nickel, for example, may have to cope with wide swings in raw material costs from one year to another. On the other hand, the introduction of new products or services with wider profit margins can improve profitability. DIVIDEND RECORD A company’s dividend record shows how much it generally pays out in the form of dividends to shareholders. The company may have an unusually high dividend payout rate (more than 65%, for example) for any of several reasons: Stable earnings that allow a high payout Declining earnings, which may indicate a future cut in the dividend Earnings based on resources that are being depleted, as in the case of some mining companies Similarly, a low payout may reflect any of the following factors: Earnings reinvested back into a growth company’s operations Growing earnings, which may indicate a future increase in the dividend amount Cyclical earnings at their peak, along with a company policy to maintain the same dividend in good and bad times A company policy of buying back shares, rather than distributing earnings through higher dividend payouts © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 5 STATEMENT OF FINANCIAL POSITION ANALYSIS A thorough analysis of the statement of financial position helps you understand a company’s overall financial situation. It can reveal important aspects of the company’s operations and other factors that may affect its earnings. For example, a company with low interest coverage will be limited in its dividend policy and financing options. In analyzing the statement of financial position, you should consider the capital structure and the effect of leverage. THE CAPITAL STRUCTURE The capital structure of a company refers to the distribution of debt and equity that comprise the company’s finances. Analysis of a company’s capital structure provides an overall picture of its financial soundness because it reveals the amount of debt used in its operations. Analysis may indicate the need for future financing. As well as the type of security that might be used. For example, common shares are suitable for a company with a heavy debt load. In analyzing capital structure, you should consider the following issues: A large debt issue approaching maturity may have to be refinanced by a new securities issue or by other means. Retractable securities may also have to be refinanced if investors choose to retract. A similar possibility exists for extendible bonds. Convertible securities represent a potential decrease in earnings per common share (EPS) through dilution. Any outstanding warrants or stock options represent a potential increase in the number of common shares outstanding. THE EFFECT OF LEVERAGE The earnings of a company are said to be leveraged if the capital structure contains debt or preferred shares. The presence of these securities accelerates any cyclical rise or fall in earnings. In comparison to companies without leverage, earnings increase faster during an upswing in the business cycle and collapse more quickly as economic conditions deteriorate. The leverage effect of preferred shares on common share earnings is similar to what occurs in a company that uses debt to finance its operations. In either case, a relatively small increase in revenue can produce a magnified increase in EPS. The reverse is true when revenue declines. The market action of shares in leveraged companies shows considerable volatility. Table 14.1 illustrates the leverage effect of preferred shares on common share earnings at one company in comparison to another company that is unleveraged. Table 14.1 | The Effect of Leverage on per Share Earnings Year One Year Two Year Three Company A (No Leverage) Earnings available for dividends $50,000 $100,000 $25,000 Preferred dividends Nil Nil Nil Available for common $50,000 $100,000 $25,000 Per common share $0.50 $1.00 $0.25 Percentage of return earned on common shares 5% 10% 2.5% © CANADIAN SECURITIES INSTITUTE 14 6 CANADIAN SECURITIES COURSE      VOLUME 2 Table 14.1 | The Effect of Leverage on per Share Earnings Year One Year Two Year Three Company B (50% Leverage) Earnings available for dividends $50,000 $100,000 $25,000 Preferred dividends $25,000 $25,000 $25,000 Available for common $25,000 $75,000 Nil Per common share $0.50 $ 1.50 Nil Percentage of return earned on common shares 5% 15% 0% Using the figures outlined in Table 14.1 above, you can calculate the percentage return on common shares for both Company A and Company B. EXAMPLE Assume that two companies, Company A and Company B, each have a total capitalization of $1 million and each have earned the following profit: Year One: $50,000 Year Two: $100,000 Year Three: $25,000 Company A’s capitalization consists of 100,000 common shares of no par value. Company A’s common share capitalization is equal to its total capitalization of $1 million. Company B’s capitalization consists of 50,000 5% preferred shares of $10 par value and 50,000 common shares of no par value. Company B’s preferred share capitalization is $500,000 (calculated as 50,000 preferred shares multiplied by $10 par value). Its common share capitalization is also $500,000. In Table 14.1, consider the effect of the variation in earnings on the EPS for the two companies. To calculate the percentage return on common shares in Year One for Company A, divide the $50,000 available for common shares by the $1,000,000 common share capitalization to arrive at 5%, in percentage terms. To calculate the percentage return on common shares in Year One for Company B, divide the $25,000 available for common shares by the $500,000 common share capitalization to arrive at 5%, in percentage terms. The stock of Company A is less risky than the stock of Company B, which must pay out interest on senior preferred capital before it can pay dividends to common shareholders. Stock A also has more stable earnings, because it is less vulnerable to shrinkage in earnings, though it is also less sensitive to any increase in earnings. OTHER FEATURES OF COMPANY ANALYSIS Other features of company analysis include qualitative analysis, liquidity of common shares, and continuous monitoring. Qualitative analysis Qualitative analysis is used to assess management effectiveness and other intangibles that cannot be measured with concrete data. The quality of a company’s management is unquestionably a key factor in its success. However, it is not a topic that we can cover in this course. The ability to evaluate the quality of management comes with years of contact with industry and company executives, experience, judgment, and even intuition. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 7 Liquidity of common Liquidity is a measure of how easy it is to sell or buy a security on a stock exchange shares without causing significant movement in its price. Trading should be sufficient to absorb transactions without undue distortion in the market price. Institutional investors dealing in large blocks of shares require a high degree of liquidity. Information on trading volume is readily available from most financial news and stock exchange publications. Continuous Company analysis involves monitoring the operations of the company for changes that monitoring might affect the price of its shares and the dividends it pays. Quarterly financial reports to shareholders are an especially important source of information, which you should scrutinize in detail. You can also glean useful material from prospectuses, trade journals, and financial publications. INTERPRETING FINANCIAL STATEMENTS 2 | Explain how to analyze a company’s financial statements using trend analysis and external comparisons. You must use caution when analyzing and interpreting financial statements. Companies must adhere to a number of disclosure requirements and accounting rules; however, International Financial Reporting Standards allow flexibility. To attract investors, management sometimes selects accounting practices that show the company’s finances in the best possible light. It is also important to look over the statements in general and read the notes to the financial statements very carefully before delving into ratio analysis. You can often find clues that the financial health of the company may be deteriorating before financial ratios relay the same information. FOR INFORMATION ONLY Warning Signs Found in the Notes to the Financial Statements CHANGES IN ACCOUNTING PRACTICES OR AUDITORS Look for changes in accounting practices that increase revenue or decrease expenses when the actual operation of the company did not change. The company may be trying to appear more prosperous than it really is. Look also for changes in accounting practices that decrease revenue or increase expenses when the actual operation of the company did not change. The company may be trying to deflate its current profit level so that it can appear to be growing in profitability in the next few years. A change in the company’s auditors may signal a fundamental disagreement between the auditors and company management concerning how certain transactions should be treated. A SERIES OF MERGERS AND TAKEOVERS Companies have been known to acquire a series of smaller companies to manipulate the consolidated statement of financial position in their favour. A series of mergers or takeovers may also be an attempt to hide the unprofitability of the parent company. If any of the above notes are present, it does not necessarily mean that the company is a bad investment. For example, companies often change accounting practices simply in response to new situations, changes in industry practice, or directives from accounting boards. The point is to be aware of these issues when you find them and research further for explanations. © CANADIAN SECURITIES INSTITUTE 14 8 CANADIAN SECURITIES COURSE      VOLUME 2 TREND ANALYSIS Ratios calculated from a company’s financial statements for only one year have limited value on their own. They only become meaningful when compared with other ratios. Internally, they can be compared with the same ratios collected from the same company in different years. Externally, they can be compared with the same ratios collected from similar companies or with industry averages. Analysts identify trends by selecting a base period, treating the figure or ratio for that period as 100, and then dividing it into the comparable ratios for subsequent periods. Table 14.2 shows this calculation for a typical pulp and paper company. Table 14.2 | Pulp and Paper Company A—Earnings per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $1.18 $1.32 $1.73 $1.76 $1.99 1.18 1.32 1.73 1.76 1.99 1.18 1.18 1.18 1.18 1.18 Trend 100 112 147 149 169 Table 14.2 uses Year 1 as the base period. The EPS for that year, which is $1.18, is treated as equivalent to 100. The trend ratios for subsequent years are easily calculated by dividing 1.18 into the EPS for each subsequent year. A similar trend line over the same period for Pulp and Paper Company B is shown in Table 14.3. Table 14.3 | Pulp and Paper Company B—Earnings per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $0.71 $0.80 $0.90 $0.84 $0.78 0.71 0.80 0.90 0.84 0.78 0.71 0.71 0.71 0.71 0.71 Trend 100 113 127 118 110 The trend line of each of these two companies shows the characteristic fluctuations of pulp and paper company earnings. For example, adding new machinery often causes temporary over-capacity and reduces earnings until demand catches up with supply. The trend line for Company B suggests some over-capacity in recent years, as earnings show a decline. Trend ratio calculations are useful because they clearly show changes. They are also simple to do and easier to interpret than the alternative, which is a two-step method of calculating percentage changes from year to year. DID YOU KNOW? A trend line is misleading when the base period is not truly representative. It is also impossible to apply the method if the base period figure is negative, which happens when a loss was sustained in the base year. EXTERNAL COMPARISONS Ratios are most useful for comparing financial results of companies in the same or similar industries, for example, when a distiller is compared with a brewer. Differences shown by the trend lines help to put the EPS of each © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 9 company in historical perspective. They also show how each company has fared in relation to others. Different industries may have different standards for the same ratio, and they often employ a range rather than a specific target number. Industry standards are different from industry ratios in that the ratios change each year, whereas the standards are relatively static. Ratios show the industry average, which changes depending on the performance of the industry in a particular year. Standards provide a longer-term view and remain the same regardless of the performance of the industry or the economy. For your analysis to be fair and thorough, you must compare the company to both the current average of the industry and the historical industry standard. EXAMPLE Assume the current ratio standard for hotels is 1.10 (current assets / current liabilities = 1.10). In the past six months, Granite Hotel Group has an average current ratio of 0.91, which is above all other hotel chains in the industry. Since all companies in the hotel industry are below the current ratio standard, Granite would be considered a top performer in an industry that is underperforming. ANALYZING FINANCIAL RATIOS 3 | Assess company performance using financial ratios. Having learned what the financial statements reveal about the financial condition of a company, the next step is to put that knowledge to work by testing the investment merits of the company’s bonds and stocks. The tool most commonly used to analyze financial statements is called a ratio, which shows the relationship between two numbers. Four types of ratios are commonly used to analyze a company’s financial statements: Liquidity ratios Liquidity ratios are used to judge the company’s ability to meet its short-term commitments. An example is the working capital ratio, which shows the relationship between current assets and current liabilities. Risk analysis ratios Risk analysis ratios show how well the company can deal with its debt obligations. For example, the debt-to-equity ratio shows the relationship between the company’s borrowing and the capital invested in it by shareholders. Operating Operating performance ratios illustrate how well management is making use of the performance ratios company’s resources. For example, the net profit margin ratio indicates how efficient the company is managed after taking both expenses and taxes into account. These ratios include profitability and efficiency measures. Value ratios Value ratios show the investor what the company’s shares are worth, or the return on owning them. An example is the price-to-earnings ratio (P/E ratio), which links the market price of a common share to EPS, and thus allows investors to rate the shares of companies within the same industry. Ratios must be used in context. One ratio alone does not tell an investor very much. Ratios are not proof of present or future profitability, only clues. An analyst who spots an unsatisfactory ratio may suspect unfavourable conditions. Conversely, analysts may conclude that a company is financially strong after compiling a series of ratios. © CANADIAN SECURITIES INSTITUTE 14 10 CANADIAN SECURITIES COURSE      VOLUME 2 The significance of any ratio is not the same for all companies. In analyzing a manufacturing company, for example, analysts pay particular attention to the working capital ratio, which is a measure of the use of current assets. In an electric utility company, however, the working capital ratio is not as important, because electric power is not stored in inventory, but produced at the same time that it is used. In the sections that follow, we show how to calculate and use the various financial ratios. To make it easier for you to follow and understand the method, we have numbered the items to correspond to the related items in sample financial statements. You can find these statements at the end of this chapter in Appendix A: Financial Statements of Trans-Canada Retail Stores Ltd. DID YOU KNOW? For the Canadian Securities Course exam 2, you will not be required to calculate ratios. However, you may be asked to interpret ratio results, compare results between similar companies, and determine how a ratio might be affected by changes in a key ratio component. LIQUIDITY RATIOS Liquidity ratios help investors evaluate the ability of a company to turn assets into cash to meet its short-term obligations. If a company is to remain solvent, it must be able to meet its current liabilities, and therefore it must have an adequate amount of working capital (also called net current assets). Frequent causes of business failure are the lack of sufficient working capital and the inability to liquidate current assets readily. You can find a company’s working capital by subtracting its total current liabilities from its total current assets. EXAMPLE The working capital for Trans-Canada Retail Stores Ltd. is calculated as follows: Current Assets (Item 9) $12,238,000 Less:  Current Liabilities (Item 22) $4,313,000 Equals:  Working Capital $7,925,000 WORKING CAPITAL RATIO The working capital ratio, sometimes expressed as the working capital position (and also called the current ratio), is calculated as follows: Current Assets Current Liabilities The ability of a company to meet its obligations, expand its volume of business, and take advantage of financial opportunities as they arise is, to a large extent, determined by this ratio position. EXAMPLE The working capital ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 9 12,238,000 = = 2.84 1 Item 22 4,313,000 The working capital ratio of 2.84 to 1 means Trans-Canada Retail has $2.84 of cash and equivalents to pay for every $1 of its current liabilities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 14      COMPANY ANALYSIS 14 11 CURRENT ASSETS Current assets are cash and other company possessions that can be readily turned into cash (and normally would be) within one year. Current liabilities are liabilities of the company that must be paid within the year. How you interpret the ratio depends on the type of business, composition of current assets, inventory turnover rate, and credit terms. A current ratio of 2 to 1 is good but not exceptional, because it means that the company has $2 cash and equivalents to pay for each $1 of its debt. However, suppose 50% of Company A’s current assets are cash, whereas 90% of Company B’s current assets are in inventory. If each company has a current ratio of 2 to 1, Company A is more liquid than B because it can pay its current debts more easily and quickly. The current ratio does not easily translate into multiples. For example, although a current ratio of 2 to 1 is good, it doesn’t follow that a ratio of 20 to 1 is 10 times as good. A company that consistently maintains a current ratio that exceeds 5 to 1 may have an unnecessary accumulation of funds. This situation can arise from sales problems in the form of too much inventory or from financial mismanagement. Different businesses have different working capital requirements. In a business such as a distillery, for example, several years may elapse before the raw materials are processed and sold as finished products. Consequently, these businesses require a large amount of working capital to finance operations until they receive cash from sales. In a business such as meat packing, the manufacturing process is much shorter, and cash from sales is available to pay current debts sooner. Such a business can safely operate with less working capital. QUICK RATIO (THE ACID TEST) The second of the two most common corporate liquidity ratios—the quick ratio (also called the acid test) — is shown below: Current Assets - Inventories Current Liabilities This ratio is a more stringent test than the current ratio. Current assets generally include inventories that can be difficult to convert into cash. For the quick ratio, inventories are subtracted from current assets. The quick ratio, therefore, offers a more conservative test of a company’s ability to meet its current obligations. It shows how well current liabilities are covered by cash and by items with a ready cash value. EXAMPLE The quick ratio for Trans-Canada Retail Stores Ltd. is calculated as follows: Item 9 - Item 5 or Item 22 12,238,000 - 9,035,000 3,203,000 = = 0.74 1 4,313,000 4,313,000 The ratio of 0.74 to 1 means that Trans-Canada Retail has 74 cents of current assets, exclusive of inventories, to meet each $1 of current liabilities. There is no absolute standard for the quick ratio, but 1 to 1 or better suggests a good liquid position. However, companies with a quick ratio of less than 1 to 1 may be in equally good shape if they have a high rate of inventory turnover. Inventory that is turned over quickly is the equivalent of cash. In our example, a quick ratio of 0.74 to 1 is probably satisfactory because the company we are looking at is a retail store chain. This industry is characterized by large inventories and a high turnover rate. © CANADIAN SECURITIES INSTITUTE 14 12 CANADIAN SECURITIES COURSE      VOLUME 2 RISK ANALYSIS RATIOS The analysis of a company’s capital structure enables investors to judge how well the company can meet its financial obligations. Excessive borrowing increases the company’s costs because it must service its debt by paying interest on outstanding bank loans, notes payable, bonds, or debentures. If a company cannot generate enough cash to pay the interest on its outstanding debt, then its creditors could force it into bankruptcy. If the company must sell off its assets to meet its obligations, then investors who have purchased bonds, debentures, or stock in the company could lose some or all of their investment. ASSET COVERAGE The asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied. This ratio typically shows the net tangible assets (NTA) of the company for each $1,000 of total debt outstanding. It enables the debtholder to measure the protection provided by the company’s tangible assets after all liabilities have been met. The asset coverage ratio is calculated as follows: Tangible Assets - (Current Liabilities - Short Term Debt ) Total Debt Outstanding In this ratio, tangible assets are the company’s total assets less goodwill and other intangible assets. Current liabilitie