A. 3. 1. FUNDAMENTAL STOCK ANALYSIS. CHAPTER SEVEN. Practical Investment Management Robert A. Strong. Outline. Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis
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How to Tell by Looking
securities are priced according to fundamental economic data.
and supply and demand factors play the most important role.
Investors are almost always riskaverse.
Everyone agrees on this basic principle.
Most investment research deals with predicting future corporate earnings.
The tax code is complicated and not all investments are taxed equally.
analysis:
the overall economy(market risk),
most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),
companies within the attractive
industries.
Insert Figure 71 here.
The Value Approach to Investing
should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.
to the mean.
Most of the time a security’s longterm return is consistent with its risk.
Overvalued stock: Sell
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Undervalued stock: Buy
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Cumulative Return
0
Over the long run, a security cannot survive with a cumulative return that is negative.

Time in the Long Term
Regression to the Mean
The Growth Approach to Investing
companies. There are two factions:
believe information differentials in the marketplace can be profitably exploited.
wait, but they share the belief that good investment managers can earn aboveaverage returns for their clients.
value isinextricably intertwined with price.
$ 8
Value vs. Growth Investing
How Price Relates to Value
Great Crash of 1929, price played a minor role: “A stock with good longterm prospects is always a good investment.”
pricetobook
ratio
relative
priceearnings
ratio
+
Value vs. Growth Investing
Value Stocks and Growth Stocks:
How to Tell by Looking
by dividing the current stock price by the firm’s earnings per share.
relative ratios are commonly computed.
Insert Figure 73 here.
Insert Figure 74 here.
Some Analytical Factors: Growth Rates
Some Analytical Factors: Growth Rates
Insert Table 74 here.
Some Analytical Factors: Growth Rates
Choosing a Growth Rate
number of growth rates using different ways to determine a likely range for the statistic.
from the more distant past.
targets may be considered too.
Some Analytical Factors: Growth Rates
Insert Table 75 here.
Some Analytical Factors: Growth Rates
Growth Rate Estimates from Other Analysts
The Dividend Discount Model (DDM)
stream is perpetual and that the long
term growth rate is constant.
The Dividend Discount Model (DDM)
shareholders’ required rate of return.
return is the sum of the expected dividend yield and the expected stock price appreciation.
The Importance of Hitting the Earnings Estimate
sustained.
persist from the third year:
The DDM is at most a useful tool in security analysis  it requires certain assumptions and it has shortcomings.
False growth occurs when a firm acquires another firm with a lower priceearnings ratio  historical data should always be scrutinized carefully when used to determine a growth rate.
Insert Table 77 here.
The statement of cash flows is a useful analytical tool  the cash flow from operations figures are widely used as a check on a firm’s earnings quality.
Another consideration in fundamental stock analysis relates to the size of the firm  for example, the small firm effect.
Some Analytical Factors: Ratio Analysis
interested in the firm’s accounting statements and in the prevailing general economic conditions.
organizations publish comparative statistics for industry groups.
e.g. Dun and Bradstreet’s Industry Norms
& Key Business Ratios, which
includes solvency, efficiency and
profitability ratios.
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Some Analytical Factors: Cooking the Books
must have their financial statements audited to ensure they fairly present the company’s financial position.
accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.
How to Tell by Looking