2.16.3. Valuing Equity Securities
In addition to valuing fixed-income investments, you are also expected to understand how equity securities are valued. How do analysts determine whether a stock is over- or undervalued? As mentioned in Chapter One, most analysts examine the fundamentals of a company to judge the value of the price of its stock. Analysts who use fundamental analysis examine historical financial statements, looking for future trends. Do the income statements show that earnings are steadily growing? How stable are expenses? Relatively stable expenses with growing income often suggest a rosy outlook for a stock’s price. How do the issuing company’s profit margins compare to those of other companies in the same industry? An analyst will also look at the balance sheet to see how the business is financed. Is the company primarily financed by debt? If so, is this a problem for the future? Here are a few review points to consider when valuing an equity security by using fundamental analysis:
• Do the current ratio and quick ratio suggest that the company can meet its short-term obligations? Numbers below one are worrisome.
• Does the debt-to-equity ratio seem reasonable? Companies with high debt-to- equity ratios are usually businesses that require a lot of capital but have steady cash flow, which enables them to meet high debt service
