Countless books have been written on the subject of picking stocks. 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 of 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 ...