Section 3
Function 3: Investment Products, Recommendations & Records
Fundamental, technical, and market analysis
52 min read
· Lesson 16 of 19
About This Lesson
Three lenses for the same security: fundamental analysis reads the financial statements, technical analysis reads the chart, and market analysis reads the crowd. The exam tests vocabulary and direction more than computation; if you know what each ratio measures, which way each indicator points, and which school of thought each tool belongs to, you are most of the way home.
What you'll cover
- economic indicators (leading, coincident, lagging) and the fundamental-versus-technical split
- the balance sheet and income statement, EPS and dilution, liquidity and leverage ratios, growth versus value styles
- technical tools: trendlines, support and resistance, head and shoulders, Dow Theory, and the contrarian sentiment indicators
This is the sixteenth chapter of the products module.
In this chapter
52 min · 13 concept checks
Section 1 of 4
~10 min · 1 concept check
Foundations: Fundamental vs Technical & Economic Indicators
Fundamental vs. Technical Analysis
Fundamental analysis
What is the company worth?
Analyzes financial statements, earnings, revenue growth, balance sheet, competitive position, and management to determine intrinsic value.
P/E ratio — price vs. earnings power
P/B ratio — price vs. book value
EPS growth
Dividend yield and payout ratio
Technical analysis
What is the price doing?
Studies past price and volume data. Assumes all information is reflected in price.
Support and resistance levels
Moving averages (50-day, 200-day)
Head and shoulders reversal pattern
Volume confirmation of price moves
Economic Indicators
Leading (predictive)
Coincident (simultaneous)
Lagging (confirmatory)
Leading indicators
Change before the economy
Building permits
Stock prices
Yield curve shape
Consumer confidence
New orders
Coincident indicators
Change with the economy
GDP
Employment
Personal income
Industrial production
Lagging indicators
Change after the economy
Unemployment rate
Prime rate
CPI
Inventory levels
Leading vs. Lagging vs. Coincident Indicators
Economic indicators get classified by when they move relative to the business cycle, and the exam tests the sorting.
Leading indicators (move before the economy turns): stock prices, building permits, manufacturing orders, unemployment claims (inverted), money supply, consumer confidence, the yield curve's slope.
The mnemonic: the stock market leads; it prices in earnings before they happen.
Coincident indicators (move with the economy): GDP, personal income, industrial production, retail sales.
Lagging indicators (move after the economy turns): the unemployment rate, CPI, the prime rate, outstanding business loans.
The trap: unemployment lags; it peaks after the recession has already ended, because employers wait for a clearly established recovery before rehiring.
Economic indicators get classified by when they move relative to the business cycle, and the exam tests the sorting.
Leading indicators (move before the economy turns): stock prices, building permits, manufacturing orders, unemployment claims (inverted), money supply, consumer confidence, the yield curve's slope.
The mnemonic: the stock market leads; it prices in earnings before they happen.
Coincident indicators (move with the economy): GDP, personal income, industrial production, retail sales.
Lagging indicators (move after the economy turns): the unemployment rate, CPI, the prime rate, outstanding business loans.
The trap: unemployment lags; it peaks after the recession has already ended, because employers wait for a clearly established recovery before rehiring.
Concept Check
Which economic indicator is considered a LEADING indicator of future economic activity?
Building permits are a leading indicator because they signal future construction activity — a permit is issued before construction begins, so rising permits predict future economic growth. Other leading indicators include stock prices, consumer confidence, and new orders for manufactured goods. The unemployment rate is a lagging indicator (it rises after a recession has begun and falls after a recovery is underway). GDP is a coincident indicator. The prime rate is a lagging indicator that follows economic and monetary policy changes.
Section 2 of 4
~12 min · 3 concept checks
Fundamental Analysis: Financial Statements
The Balance Sheet: Assets, Liabilities, and Equity
The balance sheet is the company at a single instant, organized around one equation:
Total Assets = Total Liabilities + Stockholders’ Equity
equivalently: Net Worth = Total Assets − Total Liabilities
equivalently: Net Worth = Total Assets − Total Liabilities
Assets
Current: Cash, accounts receivable, inventory, prepaid expenses (one-year horizon).
Long-term: Property, plant, equipment, long-term investments.
Intangibles: Goodwill, patents, trademarks, brand value.
Liabilities
Current: Accounts payable, accrued expenses, short-term debt, current portion of long-term debt.
Long-term: Mortgages, bonds outstanding, long-term notes, deferred liabilities.
Stockholders’ Equity
Capital stock at par: Par value of all shares issued.
Capital in excess of par: Amount paid above par at issuance (paid-in surplus).
Retained earnings: Cumulative profits retained rather than paid as dividends.
Capital structure tells the story:
How a company has financed its assets reveals its capital structure —
long-term debt plus stockholders’ equity (preferred and common stock plus
retained earnings). High proportions of long-term debt indicate a leveraged
capital structure with greater financial risk; high equity proportions
indicate conservative financing with lower fixed-cost obligations.
The Income Statement: Revenue Through Net Income
The income statement is the company over a stretch of time, a quarter or a year, marching from revenue down to net income one deduction at a time:
Net Revenues (Sales)
− Cost of Goods Sold (COGS)
= Gross Profit
− Operating Expenses (selling, G&A, depreciation)
= Earnings Before Interest and Taxes (EBIT)
− Interest Expense
= Earnings Before Taxes (EBT)
− Income Tax Expense
= Net Income
− Preferred Dividends
= Earnings Available to Common Shareholders
− Common Dividends
= Increase in Retained Earnings
− Cost of Goods Sold (COGS)
= Gross Profit
− Operating Expenses (selling, G&A, depreciation)
= Earnings Before Interest and Taxes (EBIT)
− Interest Expense
= Earnings Before Taxes (EBT)
− Income Tax Expense
= Net Income
− Preferred Dividends
= Earnings Available to Common Shareholders
− Common Dividends
= Increase in Retained Earnings
EPS and EPS After Dilution
Basic EPS is (net income minus preferred dividends) divided by common shares outstanding. Diluted EPS pretends every convertible, warrant, and option has been exercised, swelling the share count; it is the worst-case figure and always lands at or below basic EPS.
Three-step memorization
framework: The income statement shows (1) what came in (revenue),
(2) what went out (expenses), and (3) what is left (income before and after
taxes). Memorize the order: Revenue, COGS, EBIT, EBT, Net Income.
Other Per-Share Metrics
- Current yield (dividend yield): Annual dividend ÷ Current stock price.
- Dividend payout ratio: Dividends per share ÷ EPS. The percentage of earnings paid as dividends rather than retained.
- Price-to-earnings (P/E): Stock price ÷ EPS. Indicates the market’s willingness to pay for each dollar of earnings.
Concept Check
A corporation reports total assets of $80 million and total liabilities of $50 million on its balance sheet. The corporation’s net worth, or stockholders’ equity, is
Net worth, also called stockholders’ equity, equals total assets minus total liabilities. The fundamental accounting equation — Assets = Liabilities + Equity — rearranges to Equity = Assets − Liabilities. With $80 million in assets and $50 million in liabilities, net worth is $30 million. Adding assets and liabilities together has no analytical meaning. The total asset and total liability figures alone do not represent equity because each ignores half of the equation. The distractors test whether candidates understand the relationship rather than just recognize the individual figures.
Concept Check
An issuer reports basic EPS of $3.00 and diluted EPS of $2.40. The difference between the two figures is best explained by
Diluted EPS calculates earnings per share assuming all convertible securities, warrants, and options are exercised, increasing the share count and reducing earnings per share. Basic EPS uses only common shares actually outstanding. The lower diluted figure ($2.40 versus $3.00 basic) reflects the dilutive impact of those potential conversions and exercises. Stock buybacks would reduce share count and increase EPS, the opposite effect. Preferred dividends affect both basic and diluted EPS equally because they are subtracted from net income before the calculation. Depreciation method changes affect net income but apply to both EPS measures.
Concept Check
A company reports current assets of $12 million (including $3 million of inventory) and current liabilities of $8 million. The company’s working capital is
Working capital is a dollar measure, not a ratio. The formula is Current Assets minus Current Liabilities. With $12 million in current assets and $8 million in current liabilities, working capital is $4 million. The $1.50 distractor reports the current ratio (CA divided by CL), a different metric expressed as a multiple. The $9 million figure reflects (CA minus inventory) and is a numerator component of the quick ratio, not working capital. Adding CA and CL together has no economic meaning. Working capital represents the dollar buffer after meeting near-term obligations; positive working capital indicates short-term solvency.
Section 3 of 4
~10 min · 4 concept checks
Ratios & Investment Styles
Fundamental Analysis: Financial Ratios
Fundamental analysis evaluates a company’s intrinsic value using financial statement data.
P/E ratio
Formula
Market price ÷ EPS
High P/E = growth stock. Low P/E = value stock or earnings concern.
EPS
Formula
Net income ÷ Shares outstanding
Diluted EPS includes convertibles; basic EPS does not.
Current ratio
Formula
Current assets ÷ Current liabilities
>1.0 adequate. <1.0 = liquidity concern.
Quick ratio (acid test)
Formula
(CA − Inventory) ÷ CL
More conservative; excludes inventory. Always < current ratio.
Debt-to-equity
Formula
Total debt ÷ Equity
High D/E = more financial risk. Interest is a fixed obligation.
Book value / share
Formula
Equity ÷ Shares outstanding
P/B < 1.0 may indicate undervaluation.
Inventory accounting: FIFO (rising prices) = higher income, higher taxes. LIFO (rising prices) = lower income, lower taxes.
Liquidity and Leverage Ratios
Ratios turn raw balance-sheet numbers into comparable answers to two questions you will be asked repeatedly: can the company pay its near-term bills (liquidity), and how much of its financing is debt (leverage)?
Liquidity Measures
| Ratio | Formula | Interpretation |
|---|---|---|
| Working Capital | Current Assets − Current Liabilities | Dollar buffer available to fund operations after settling near-term obligations. |
| Current Ratio | Current Assets ÷ Current Liabilities | Multiple coverage of short-term obligations. Above 2.0 generally healthy. |
| Quick Ratio (Acid-Test) | (Current Assets − Inventory) ÷ Current Liabilities | More conservative than current ratio. Excludes inventory because it may not convert quickly to cash. Above 1.0 typically healthy. |
Leverage Measures
Debt-to-Equity Ratio
Long-term debt ÷ Stockholders’ equity
Measures the proportion of long-term financing supplied by creditors versus shareholders. Higher ratios indicate greater leverage and higher fixed-cost obligations.
Book Value per Share
Common equity ÷ Common shares outstanding
The accounting value attributable to each common share. Often differs significantly from market price; useful for comparing valuation across companies in the same industry.
Why liquidity matters more than
leverage: A profitable company can fail if it cannot pay near-term
bills. Liquidity ratios test exactly that capacity. Leverage ratios speak
to long-term financial structure but do not capture the immediate
cash-flow risk that drives most corporate distress.
Growth vs. Value Investment Styles
Equity managers mostly fly one of two flags, and the flags disagree about where above-average returns come from:
Growth Style
Pay up for accelerating earnings
P/E ratio: High — the market pays a premium for expected future growth.
Price-to-book: High — valuation reflects intangibles and expected expansion, not just historical assets.
Dividend yield: Low or zero — earnings reinvested into growth rather than distributed.
Examples: Technology, biotech, emerging consumer brands.
Value Style
Buy underpriced assets and earnings
P/E ratio: Low — the market may be underpricing the earnings stream.
Price-to-book: Low — stock trades close to or below the accounting value of net assets.
Dividend yield: Reasonable to high — mature businesses returning cash to shareholders.
Examples: Utilities, financials, consumer staples, integrated industrials.
Style rotation: Growth
and value styles tend to lead in different market environments. Growth
often outperforms during periods of falling rates and rising risk appetite;
value frequently leads during inflationary or rising-rate periods when
cash flows in the near term are valued more highly than distant ones.
Concept Check
A fundamental analyst calculates a stock's price-to-earnings (P/E) ratio as 22x. The industry average P/E is 15x. Which of the following conclusions is most appropriate?
A P/E ratio above the industry average indicates the market is paying a premium for each dollar of earnings. This premium may be justified if the company has higher expected earnings growth, stronger competitive advantages, better management, or lower risk than peers. It may alternatively indicate overvaluation. Fundamental analysts compare the current P/E to the industry average, historical P/E, and expected growth rate (PEG ratio) to form a view — no single ratio is definitive.
Concept Check
A company reported earnings per share (EPS) of $4.00. The stock is trading at $48. What is the price-to-earnings ratio?
P/E ratio = Market price per share / Earnings per share = $48 / $4.00 = 12.0x. This means investors are paying 12 times the company's annual earnings for each share. P/E is one of the most commonly used valuation metrics in fundamental analysis. The "earnings yield" (inverse of P/E) would be $4/$48 = 8.33%, which represents the return if all earnings were paid out.
Concept Check
The quick ratio (acid-test ratio) differs from the current ratio in that the quick ratio
The quick ratio (also called the acid-test ratio) excludes inventory from current assets in the numerator because inventory may not convert to cash quickly enough to meet pressing obligations. The formula is (Current Assets − Inventory) ÷ Current Liabilities, contrasting with the current ratio of CA ÷ CL. Long-term debt does not appear in either ratio; both focus on short-term solvency. Industry-specific multipliers and intangible asset additions are not part of standard ratio calculations. The inventory exclusion is what makes the quick ratio a more conservative liquidity measure than the current ratio.
Concept Check
A portfolio manager describes a candidate stock as having a high P/E ratio, a high price-to-book ratio, and no dividend payments. This profile matches the characteristics of which investment style?
High P/E, high price-to-book, and absence of dividend payments are the classic indicators of a growth stock. The market pays a premium for expected future earnings expansion; reinvested earnings fund continued growth instead of distribution to shareholders. Value investing targets the opposite profile: low P/E, low price-to-book, and meaningful dividend yields from mature businesses. Income investing requires consistent dividend distributions, which the candidate stock does not provide. Defensive strategies target low-beta consumer staples and utilities, profiles unlike the elevated P/E associated with growth.
Section 4 of 4
~14 min · 5 concept checks
Technical Analysis
Market Indicators (Sentiment)
Indicator
Bullish signal
Bearish signal
Put/Call ratio
High ratio (excessive puts) → contrarian bullish
Low ratio (excessive calls) → contrarian bearish
Short interest
High → potential short squeeze (contrarian bullish)
Rising → bearish sentiment
Advance/Decline
Broad participation — A/D rising with index
Index up but A/D declining = bearish divergence
Bond Buyer Index
Falling index (lower yields) = favorable muni conditions
Rising index (higher yields) = less attractive for issuers
Technical Analysis: Trendlines, Reversals, and Market Theories
Technical analysis ignores the financials and reads price and volume instead. The exam covers the basic charting toolkit plus a few named theories.
Trendlines, Support, and Resistance
- Upward trendline: Connects rising lows. Indicates buyers stepping in at progressively higher prices.
- Downward trendline: Connects falling highs. Indicates sellers active at progressively lower prices.
- Support level: Price floor where buying interest historically prevents further decline.
- Resistance level: Price ceiling where selling pressure historically caps advances.
- Breakout: A move past support or resistance signals a possible new trend.
Reversal Patterns
The head and shoulders top calls the end of an uptrend: left shoulder, higher head, right shoulder back near the first, and a break below the neckline confirms the reversal. The head and shoulders bottom is the same picture upside down, calling the turn out of a downtrend.
Dow Theory
Dow Theory sees three trends running at once:
- Primary trend: The dominant direction lasting months to years.
- Secondary reaction: Counter-trend moves lasting weeks to a few months — typically retracing one-third to two-thirds of the primary move.
- Minor (tertiary) trend: Daily fluctuations of little long-term significance.
Confirmation is the theory's famous requirement: the Industrials and the Transports must reach new highs (or lows) together. When one moves and the other refuses, the divergence is the warning.
Sentiment Indicators
- Odd-lot theory: Tracks small-investor activity. Treated as a contrarian indicator: heavy odd-lot buying suggests retail enthusiasm at market tops.
- Short interest theory: High short interest is treated as bullish because shorts must eventually cover by buying back, providing upward demand.
Concept Check
A technical analyst observes that a stock has formed a "head and shoulders" pattern on the price chart. This pattern is typically interpreted as a signal of:
The head and shoulders pattern is a classic bearish reversal chart formation. It consists of three peaks: a higher middle peak (the head) flanked by two lower peaks (the shoulders). When the price breaks below the neckline (the support level connecting the troughs between the peaks), technical analysts interpret this as a signal that the uptrend has reversed and the stock is likely to decline. The pattern's price target is often measured as the distance from the head to the neckline, projected downward.
Concept Check
A technical analyst notices that a stock has repeatedly bounced off $45 without falling below it. This price level is called:
A support level is a price at which buying interest is consistently strong enough to prevent the price from falling further. Every time the stock approaches $45, buyers step in and push it back up — creating a floor. Resistance is the opposite: a ceiling where selling pressure consistently prevents the price from rising further. Technical analysts watch for breakouts above resistance or breakdowns below support as significant signals of trend changes.
Concept Check
Technical analysts use the concept of a "breakout" to generate buy or sell signals. Which of the following best describes a bullish breakout?
A bullish breakout occurs when a stock's price rises above a well-established resistance level — a price ceiling that had previously stopped advances. Technical analysts consider breakouts more significant when they occur on above-average volume, which confirms that the move reflects genuine buying demand rather than thin-volume noise. A breakout above resistance suggests the stock may continue higher, as sellers who previously created the ceiling have been overwhelmed.
Concept Check
A technical analyst observes a head and shoulders top pattern forming on the chart of a previously uptrending stock. The pattern most likely signals
A head and shoulders top is the textbook bearish reversal pattern, appearing after a sustained uptrend. The pattern consists of a left shoulder, a higher head, and a right shoulder near the level of the left shoulder. A break below the neckline (the line connecting the two shoulder lows) confirms the reversal and signals a probable change from uptrend to downtrend. Continuation, neutral consolidation, and bullish breakout are not consistent with the pattern’s interpretation. The mirror-image head and shoulders bottom signals a bullish reversal from a downtrend, but the question specifies the top pattern, locking in the bearish read.
Concept Check
Under Dow Theory, a primary uptrend in the broader market is considered confirmed when
Dow Theory holds that a primary trend is confirmed only when both the Dow Jones Industrial Average and the Dow Jones Transportation Average reach new highs (or new lows) together. The two indices represent producers and movers of goods, and their joint movement is taken as evidence of broad-based economic strength or weakness. Divergence between the two indices warns of possible reversal in the primary trend. Odd-lot data, short interest, and head and shoulders patterns are separate technical indicators that operate outside the Dow Theory framework. The cross-confirmation between the two Dow indices is the theory’s defining feature.
Summary
Exam Essentials — high-yield review
Chapter Summary
Ch 23 Exam Essentials — Fundamental, Technical, and Market Analysis
- Fundamental analysis: Determines intrinsic value using financial statements. Key ratios: P/E (price ÷ EPS), P/B (price ÷ book value), dividend yield (annual dividend ÷ price), EPS growth rate. If intrinsic value > market price → buy signal.
- Technical analysis: Studies price and volume patterns to predict future movements. Support = price floor where buyers consistently emerge. Resistance = price ceiling where sellers consistently emerge. Volume confirms breakouts.
- Chart patterns: Head and shoulders = bearish reversal (uptrend ending). Inverse head and shoulders = bullish reversal. Double top = bearish. Double bottom = bullish. High volume on breakout confirms the signal.
- Economic indicator types: Leading (change before economy: stock prices, building permits, consumer confidence, new orders). Coincident (change with economy: GDP, employment). Lagging (change after: unemployment rate, prime rate, CPI).
- Moving averages: When a short-term MA crosses above a long-term MA = "golden cross" → bullish signal. When short-term crosses below long-term = "death cross" → bearish signal. Price above 200-day MA = long-term uptrend.
Fundamental and Technical Analysis Exam Traps — Consolidated
Twelve analysis traps the exam recycles. One pass before test day; each line settles a recurring question:
1. Net worth = Assets − Liabilities. Stockholders’ equity equals the same thing. The fundamental accounting equation: Assets = Liabilities + Equity.
2. Income statement order: Revenue, COGS, EBIT, EBT, Net Income. Each line subtracts a category of expense to get to a measure of profit. Memorize the sequence.
3. Working capital = Current Assets − Current Liabilities. Dollar measure, not a ratio. Distinct from current ratio (CA/CL) and quick ratio ((CA-Inventory)/CL).
4. Quick ratio excludes inventory; current ratio includes it. Quick ratio is more conservative because inventory may not convert to cash quickly enough to meet near-term obligations.
5. Diluted EPS ≤ Basic EPS. Diluted EPS adds the hypothetical exercise of all convertibles, warrants, and options to the share count, producing a worst-case-scenario EPS.
6. Growth = high P/E, high price-to-book, low or no dividend. Value = low P/E, low price-to-book, reasonable dividend yield. The styles identify different valuation profiles.
7. Dividend payout ratio = Dividends per share ÷ EPS. Percentage of earnings distributed rather than retained. High payout ratios suggest mature businesses; low payouts suggest reinvestment for growth.
8. Head and shoulders top = bearish reversal. Head and shoulders bottom = bullish reversal. The neckline break confirms the pattern.
9. Dow Theory: primary trend confirmed by Industrials AND Transports. Divergence between the two indices warns of a possible reversal in the primary trend.
10. Odd-lot theory is contrarian. Heavy odd-lot buying indicates retail enthusiasm at potentially overheated markets; heavy odd-lot selling at panicked bottoms.
11. High short interest is treated as bullish. Eventual short covering creates buying demand. High short interest also indicates "available fuel" for a potential short squeeze.
12. Round lot = 100 shares; odd lot < 100 shares. A 550- share trade equals five round lots plus one 50-share odd lot, executed at slightly less favorable pricing.
Twelve analysis traps the exam recycles. One pass before test day; each line settles a recurring question:
1. Net worth = Assets − Liabilities. Stockholders’ equity equals the same thing. The fundamental accounting equation: Assets = Liabilities + Equity.
2. Income statement order: Revenue, COGS, EBIT, EBT, Net Income. Each line subtracts a category of expense to get to a measure of profit. Memorize the sequence.
3. Working capital = Current Assets − Current Liabilities. Dollar measure, not a ratio. Distinct from current ratio (CA/CL) and quick ratio ((CA-Inventory)/CL).
4. Quick ratio excludes inventory; current ratio includes it. Quick ratio is more conservative because inventory may not convert to cash quickly enough to meet near-term obligations.
5. Diluted EPS ≤ Basic EPS. Diluted EPS adds the hypothetical exercise of all convertibles, warrants, and options to the share count, producing a worst-case-scenario EPS.
6. Growth = high P/E, high price-to-book, low or no dividend. Value = low P/E, low price-to-book, reasonable dividend yield. The styles identify different valuation profiles.
7. Dividend payout ratio = Dividends per share ÷ EPS. Percentage of earnings distributed rather than retained. High payout ratios suggest mature businesses; low payouts suggest reinvestment for growth.
8. Head and shoulders top = bearish reversal. Head and shoulders bottom = bullish reversal. The neckline break confirms the pattern.
9. Dow Theory: primary trend confirmed by Industrials AND Transports. Divergence between the two indices warns of a possible reversal in the primary trend.
10. Odd-lot theory is contrarian. Heavy odd-lot buying indicates retail enthusiasm at potentially overheated markets; heavy odd-lot selling at panicked bottoms.
11. High short interest is treated as bullish. Eventual short covering creates buying demand. High short interest also indicates "available fuel" for a potential short squeeze.
12. Round lot = 100 shares; odd lot < 100 shares. A 550- share trade equals five round lots plus one 50-share odd lot, executed at slightly less favorable pricing.
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