Evaluating Popular
Investments
Lesson 3
Corporate Fundamental Analysis
Fundamental Security Analysis
Aim:
 What we can learn about companies by
doing fundamental security analysis?
Do Now:
 Write a definition for the word
“fundamental”. Alternately, in sports
when the coach says its time to go
back and focus on the fundamentals,
what does he or she mean?
Fundamental Security Analysis
 Do Now answers:
1. Fundamentals are the basics, the
essentials.
2. In sports, it can mean placing oneself
in the right position and having one’s
weight well distributed to react
quickly to the play.
Fundamental Security Analysis
Don’t be scared by the above title. Stocks and
bonds are paper investments that stand something
(ownership or debt), so they’re called securities.
We’re going to learn how to do a basic analysis of
the companies that offer them to see which are
worthy of investment.
Example: A company can have
significant sales, but be having
trouble making a profit. We can
compare profits to sales to get the
insights we need.
Fundamental Security Analysis
• Comparing one number to another produces a
ratio. Ex: Net Profit / Sales = Net Profit Margin.
• A company’s financial ratios are typically
compared to other companies within the same
industry. For example, Walgreen's ratios can be
compared to the ratios of CVS and Rite Aid.
This real life depiction comparing the three
companies is shown at the end of this section.
• Today we’ll look at liquidity,
efficiency and solvency ratios.
1. Liquidity Ratios: Measures a company’s
ability to pay off debts that are due soon.
Liquidity ratios are important to
determining if a company is in a sound
financial position and can recover if
unexpected events occur in the company
or the economy.
Current Ratio: The ratio of Current
Assets / Current Liabilities. It shows a
company’s ability to pay off short term
debt with its short term assets. A large
ratio indicates the company is in a
sound position.
Quick Ratio: A measure of how well a company can pay
off its short term liabilities with its current assets, not
including its inventory. The quick ratio excludes inventory
because inventory tends to be less liquid, thus difficult to
quickly turn into cash even though it is a current asset.
Quick Ratio = Current Assets - Inventory
Current Liabilities
2. Efficiency Ratios: measure how much
profit a company can generate with either its
assets or equity in the business.
Return on Assets: A measurement of how
profitable a company is based on its assets.
It shows how many dollars of net income are
generated per dollar of asset owned.
ROA = Net Income
Total Assets
Return on Equity: A measurement of
how profitable a company is based on
the equity put into the business from
the shareholders. It is the ultimate
measure of profitability from the
shareholders’ perspective.
ROE = Net Income
Total Equity
Price to Earnings (P/E) Ratio: A measure that
shows the company’s current share price compared
to its profits (ie: earnings) per share. A high P/E ratio
means that the investors are expecting the earnings
to increase in the future. A lower P/E means that
investors do not expect the company’s earnings to
increase significantly.
A company made $.50 in profit
per share last year. It’s current
share price is $9. Its P/E ratio is
$9 / $.50 = 18.
3. Solvency Ratios: A measurement that
shows how well a company is able to cover
its long-term liabilities.
Long-Term Debt to Equity: Measures how
much of a company’s long term capital was
raised through debt as compared to equity.
LT Debt to Equity = LT Debt
Total Equity
Times Interest Earned: Measures how easily
the company can pay the annual interest on its
bonds from the annual profit it earns.
Times Interest Earned =
Net Profit
Annual Interest Expense
Example
Refer to the below Income Statement and Balance Sheets from
CVS, Rite Aid & Walgreens. Calculate the companies’ current
ratios, quick ratios, return on assets, return on equity, and price
to earnings ratios. Make a comment on what each ratio says
about the company and compare each ratio denoting which
company has the strongest ratio. (*Note: These Financial
Statements are simplified for the purpose of the example)
CVS Caremark:
Stock Price= $60.32,
Earnings per Share=
$3.86
Rite Aid:
Stock Price= $3.41,
Earnings per
Share=($0.43)
Walgreens:
Stock Price= $50.54,
Earnings per
Share= $2.43
Example
Rite Aid’s Current Ratio is the largest, followed by
CVS and then Walgreens. All of the pharmacies
have current ratios larger than one meaning they
are able to pay off their short term liabilities with
their current assets.
Example
Quick Ratio:
CVS has the largest quick ratio, followed by Rite
Aid and then Walgreens. All of the ratios are less
than one because of the type of business the
companies do. A large portion of their currents
assets is inventory and the quick ratio takes out
inventory from the calculation.
Example
Return on Assets:
All three companies have similar ROAs. In comparison
to each other, Walgreens has the highest ROA meaning
it is more profitable relative to its total assets than CVS
and Rite Aid. *Note that a company’s ROAs are
generally compared with other companies in the same
industry because of the different business structures
within industries.
Example
Return on Equity:
Walgreens and CVS have ROEs of 0.12 and 0.10,
respectively. This means that the companies are
generating about 10-12% return on the shareholders’
equity investments. Rite Aid generated negative net
income and negative shareholders’ equity so it is
unprofitable.
Example
Price to Earnings:
Walgreen’s P/E ratio (20.80) is the largest
followed by CVS (15.63). Rite Aid has a negative
P/E ratio (-7.93). Walgreen’s and CVS’s ratios
indicate the investors expect both company’s
earnings to increase. Rite Aid’s P/E ratio shows
that there is little investor confidence for the
company to increase its earnings.
Lesson Summary
1. What do we call the basic examination of a
corporation’s financial results?
2. What do we get when we divide one number
into another?
3. Which three companies’ financial results did
we compare? Why not throw Home Depot or
Disney in there?
4. What types of ratios did we examine, and
what does each tell us?
5. What we can learn about companies by
doing fundamental security analysis?
Web Challenge #1
Q: Is it possible for a company to be too
strong financially?
•
A: Many argue that it is. Some companies
are so successful and dominant that they
make billions in profit each year. Instead
of doing something with the growing pile
of cash, it just sits there!
•
Challenge: Research three companies that
have enormous cash levels as well as what
analysts and activist investors suggest they
do with it.
Web Challenge #2
After the Great Recession, interest rates were
brought very low by the Federal Reserve.
Wanting to take advantage of these low
borrowing rates, many companies chose to
issue bonds (and not stock) when they needed
to raise money. Let’s see if the numbers prove
this.
 Challenge: Choose three corporations.
Look at their last three annual Balance
Sheets, calculating their Long-Term Debt to
Equity ratios. Have they increased?
Web Challenge #3
Companies that sell software or a service are
often more profitable than companies that sell
actual goods.
 Challenge: Calculate the Net Profit Margin
(Net Profit / Sales) of Hewlett Packard,
Apple, Microsoft and Google using their last
full year Income Statements. Explain the
results.