Series 65: Valuing Equity Securities

Valuing Equity Securities

In addition to valuing fixed-income investments, the exam also wants you to understand how equity securities are valued. How do analysts determine whether a stock is over or undervalued? As we mentioned in Chapter One, most analysts examine the fundamentals of a company to judge the value of the stock price. Fundamental analysts 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. What are the profit margins like compared to other companies in the 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, 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 so that they can meet high debt service payments.
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