Countless books have been written on the subject of “picking stocks.”
lang=EN-US style='font-size:10.0pt'>The approaches represented in their pages cover a vast range. Some focus on technical analysis, which seeks to establish the value of a common equity by studying its past price behavior.
Others take as their starting point the Efficient Market Hypothesis, which in its purest form implies that no sort analysis can identify values not already recognized and properly discounted by the market.This chapter does not attempt to summarize or criticize all the methods employed by the legions who “play the market.” Rather, the discussion focuses primarily on the use of financial statements in fundamental analysis. This term refers to the attempt to determine whether a company’s stock is fairly valued, based on its financial characteristics.
Certain elements of fundamental analysis do not use information found in the financial statements. For example, a company may seem like a good candidate for a “bust-up,” or hostile takeover, premised on selling portions of the company to realize value not reflected in its stock price. As discussed later in this chapter, the analyst can estimate the firm’s ostensible breakup value by studying its annual report. The feasibility of a hostile raid, however, may hinge on the pattern of share ownership, the availability of financing for a takeover, or laws applicable to tender offers. All these factors lie outside the realm of financial statement analysis, but may have a major bearing on the valuation process.
A final point regarding the following material is that it should be read in conjunction with Chapter 12 (“Forecasting Financial Statements”). A company’s equity value lies wholly in its future performance, with historical financial statements aiding the analysis only to the extent that they provide a basis for projecting future results. Into the formulas detailed in this chapter, the analyst must plug earnings and cash flow forecasts derived by the techniques described in Chapter 12.