Chapter 5 - Fundamental Analysis Flashcards
What is Fundamental Analysis?
Fundamental analysis is the study of the variables (including management, sales, regulatory environment, and labour costs) that affect a company’s profitability, its industry, and the economy in which it operates.
At the heart of fundamental analysis is the concept of intrinsic value. The intrinsic value of a security is the estimate or opinion of what the security’s market price should be, either currently or in the future.
Two main proponents:
- Top-Down
- Bottom-Up
What is Economic Analysis?
The goal of economic analysis is to
understand the shifts in the aggregate demand and supply curves.
What is the Aggregate Demand Curve?
The aggregate demand curve is the schedule of the amount of real output that consumers, firms, government, and foreigners will buy at each price level. All things being equal, the lower the price level, the larger the real GDP. A nation’s aggregate demand curve is derived from its total spending on goods and services at different price levels. GDP increases as total spending increases
What is the Aggregate Supply Curve?
The aggregate supply curve is the schedule of real domestic output that businesses would be willing to produce at each price level. Higher price levels are an incentive for businesses to create more output. Each aggregate supply curve assumes a given level of production inputs. If the supply of inputs increases, businesses are able to produce
more at a given price level.
What is Monetary Policy?
Monetary policy is the management of a nation’s money supply to stabilize output, employment, and the general price level. In Canada, monetary policy is the responsibility of the Bank of Canada (BoC), a non-partisan government agency.
What are the three ways the Bank of Canada (BoC) exerts control of the excess reserves.
- The Bank Rate
- The bank rate is the interest rate that the BoC charges to chartered banks for the use of short-term money. - Open Market Operations
- The BoC buys and sells Government of Canada securities.
Example: When buying government securities, the BoC pays cash to chartered banks to settle purchases, thereby increasing excess reserves - Switching Government of Canada Deposits
- The BoC has control over a considerable amount of deposits that belong to the
Government of Canada. Switching these deposits from chartered banks to the BoC can reduce the level of excess reserves.
What is a an Economic Forecast?
An economic forecast is simply an economist’s or economics department’s prediction for the outcome of a particular economic indicator or event, including the release of economic data, the contents of an important policy-maker’s speech, or the results of a planned central bank decision on interest rates.
Two types of methods:
1. Bottom-up
2. Add-up
What is Econometric Analysis?
In the simplest terms, econometrics is the bridge between economic theory and applied economics. Real-world observations, mathematics, and statistical analysis are combined to test a theory and then mathematically represent that theory so that it can be used to predict the future value of an economic variable.
What are Endogenous and Exogenous Variables?
Endogenous Variables
- Not all economic forecasts are generated solely by mathematically deduced results for the underlying components. Some components are themselves forecasts based on available data. These are known as endogenous variables, meaning they depend on variables that are also generated from a forecast.
Exogenous Variables
- Variables that are not determined from within the model are called exogenous variables; for example, the
government spending component in a GDP.
What is the Consensus Forecast?
Simply the average forecast of several economist.
What is a Whisper Estimate?
People on the trading and sales desks will discuss this estimate in the lead-up to the report. Rather than comparing the outcome to the printed consensus, they react to deviations from the whisper estimate instead.
How Can the Yield Curve be used as an Economic Indicator, and what can affect it?
Historically, there is strong relationship between the inversion of the yield curve and its correct prediction of a recession.
While a yield curve inversion generally occurs before a recession, it can also occur for reasons other than declining
economic growth, as follows:
- Low inflation expectations, which flatten the yields of longer-dated securities.
- Large purchases of U.S. Treasuries, notably in the longer maturities, by foreign central banks.
- Pension and hedge fund purchases, as pension funds buy longer-dated bonds to match long-dated liabilities, and hedge funds use long treasuries to execute trading strategies.
What is Industry Analysis?
Understanding the impact of the business cycle on different industries and the factors that determine industry responsiveness to changes in the business cycle is a goal of industry analysis.
What are the Four Stages of the Business Cycle?
- Contraction and Recession (the decline)
- A contraction is a decline in real GDP. Recession is defined as a decline in the real GDP that occurs for at least two or more quarters. - Trough (the bottom)
- This is the point in the economic cycle, characterized by high unemployment rates, a decline in annual income overproduction and rising inventory levels. - Recovery and Expansion (the rise)
- At this stage of the business cycle, real GDP grows and there is a recovery from the recession. When business profits begin to improve, firms hire some workers and increase their orders of materials from their suppliers.
- Usually Lasts the longest. - Peak (the top)
- This is the highest point of the business cycle. Real GDP stops increasing and begins declining. At the top, or peak, business expansion ends its upward climb. Employment, consumer spending and production reach their highest levels.
- Danger of inflation
What is Sector Rotation?
Sector rotation involves adjusting the portfolio weights of different economic sectors or industry categories in anticipation of business cycle of economic trends. It can also mean adjusting portfolio weights in stocks according to attributes such as size, dividend policy, or value measures.
What is the difference between IFRS and GAAP?
IFRS
- Used in Canada and throughout most foreign countries.
- IFRS is almost entirely
principles-based.
- The rules are more general leading to more Ambiguity and less complex.
GAAP
- Used by the US
- Rules based.
- More rigid, using specific procedures when preparing financial statements.
What is Company Analysis?
Company analysis is both a quantitative and qualitative evaluation of a company’s business.
There are four major parts of a company’s financial statements:
1. the statement of financial position
- the statement of comprehensive income
- the statement of changes in equity (which provides a link between the statement of comprehensive income and the statement of financial position)
- statement of cash flows.
What is Management’s Discussion & Analysis (MD&A)?
Presents a synopsis of a company’s previous year of operations and a review of its performance. Management will also discuss the upcoming year, outlining goals and future projects.
The MD&A section is very important in regards to studying management and its style. MD&A provides information not found elsewhere in the financial statements, though the quality of this information is at management’s discretion.
What are the four categories of Financial Ratios?
- Liquidity ratios – Measure a company’s ability to meet its short-term obligations.
- Risk analysis ratios – Indicate how well a firm services its debt obligations and its capacity to assume more debt.
- Operating performance ratios – Help determine a firm’s long-run growth prospects. They also measure how
well the company has made use of its resources. - Value ratios – Assess the market’s opinion on the worth of the company’s share price relative to its dividends, earnings, or book value.
What is Earning per Share (EPS)
Earnings per share EPS = Profit / Weighted-average of number of outstanding common shares
What is Return on Equity?
ROE = (Net Profit Margin) x (Total Asset Turnover) x (Financial Leverage)
What is the Sustainable Growth Rate?
SGR = (1 - Dividend Payout Ratio) x ROE
(1 - Dividend Payout Ratio) = The Earnings Retention Rate
All else being equal, the higher a company’s ROE, the higher its sustainable growth rate
What is the Dividend Discount Model?
Dividend discount models assume a stock’s intrinsic value is equal to the present value of its stream of future dividends.
Intrinsic Value = (Dividend x (1 + Growth Rate)) / ( Discount Rate - Growth Rate)
What is the Price to Earnings (P/E)?
P/E = Market price per common share / EPS of the last four quarters
Uninformative when earnings are negative or very small
P/E ratios at cyclical firms may peak at the bottom of a recession and trough at the peak of a boom, rendering them useless for comparison purposes.
What is Price to Book (P/B)?
Price to Book (P/B) = Market Price per Common Share / Book Value per common Share
An overvalued stock would have a low ROE and a high P/B ratio.
The book value itself is a relatively stable measure of value compared to cash flow estimates. Lastly, the ratio
can be used to value firms with negative earnings.
Book value is not relevant for firms with a high debt load or sustained losses. Debt can increase liabilities to the point where they wipe out the value of a company’s tangible assets, creating a high P/B value that may hide the value of productive assets.
