Week 3

Week 3 - Assignment: Evaluate Value of Investments with a Fundamental Analysis Investment Pay-Back

Instructions

Create an analysis with examples. The examples should emerge from one common company of your choosing to give the discussion a better flow.

Some important techniques for this assessment include basic financial ratio analysis and models of valuation. The more advanced analysis will make use of discounted cash flow models for developing estimates of intrinsic values.

Evaluate the following:

1. The financial ratios a credit rating agency such as Moody’s or Standard & Poor’s be most interested in, and which ratios would be of most interest to a stock market analyst deciding whether to buy a stock for a diversified portfolio.

2. The value of financial ratio analysis in the context of common stock investing. Provide a discussion of the decomposition of ROE including the deeper evaluation of this decomposition into the common-size income statement.

3. The major difference in approach of international financial reporting standards and U.S. GAAP accounting, and the advantages and disadvantages of each.

Support your paper with minimum of five (5) resources. In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.

Length: 5-7 pages not including title and reference pages

Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.

Fundamental Analysis

The primary focus of the security analyst should be the firm's real economic earnings rather than its reported earnings. Accounting earnings as reported in financial statements can be a biased estimate of real economic earnings, although empirical studies reveal that reported earnings convey considerable information concerning a firm's prospects. A firm's ROE is a key determinant of the growth rate of its earnings. ROE is affected profoundly by the firm's degree of financial leverage. An increase in a firm's debt-to-equity ratio will raise its ROE and hence its growth rate only if the interest rate on the debt is less than the firm's return on assets.

It is often helpful to the analyst to decompose a firm's ROE ratio into the product of several accounting ratios and to analyze their separate behavior over time and across companies within an industry. A useful breakdown is:

Other accounting ratios that have a bearing on a firm's profitability and/or risk are fixed-asset turnover, inventory turnover, days sales in receivables, and the current, quick, and interest coverage ratios. Two ratios that make use of the market price of the firm's common stock in addition to its financial statements are the ratios of market to book value and price to earnings. Analysts sometimes take low values for these ratios as a margin of safety or a sign that the stock is a bargain. Good firms are not necessarily good investments. Stock market prices of successful firms may be bid up to levels that reflect that success. If so, the price of these firms relative to their earnings prospects may not constitute a bargain. A major problem in the use of data obtained from a firm's financial statements is comparability. Firms have a great deal of latitude in how they choose to compute various items of revenue and expense. It is, therefore, necessary for the security analyst to adjust accounting earnings and financial ratios to a uniform standard before attempting to compare financial results across firms.

Review the resources listed in the Books and Resources area below to prepare for this week's assignments.

Book:

Investments

Bodie, Z., Kane, A., & Marcus, A. J. (2013). Investments New York, NY McGraw-Hill-Irwin.

Read Chapters 18 and 19