Fin2802: Investments Spring, 2010 Dragon Tang

1. Lecture 15 Financial Statement Analysis March 18, 2010 Readings: Chapter 19 Practice CFA Problem Sets: 6-9,13,14,16 Fin2802: InvestmentsSpring, 2010Dragon Tang Chapter 19: Financial Statement Analysis

2. Everyone gets sick sometime! • Take your stocks to a doctor! • Regular checkups will prevent big problems Chapter 19: Financial Statement Analysis

3. Financial Statement Analysis • Objectives: • Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios. • Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. • Measure a firm’s operating efficiency • Identify likely sources of biases in accounting data. Chapter 19: Financial Statement Analysis

4. Economics Finance Accounting How to interpret reported data? Fundamental Analysis Chapter 19: Financial Statement Analysis

5. The Balance Sheet: Snapshot of Financial Condition Assets – Liabilities = Shareholders’ Equity Current vs long-term Income Statement: Summary of Profitability Revenue – Expenses = Net Income Expenses: raw material; salary; interest; tax EBIT=Earnings – Raw Material – Salary The Statement of Cash Flows: “Actual” Cash More reliable Activities: Operating; Investing; Financing Depreciation is not smoothed Financial Statements Chapter 19: Financial Statement Analysis

6. Economic earnings: Sustainable cash flow that can be paid out without impairing the productive capacity Accounting earnings: “Models” are used Accounting earnings are still useful Accounting vs Economic Earnings Chapter 19: Financial Statement Analysis

7. Return on Equity (ROE) • ROE=Net profit/Equity • Trend in ROE • Watch out financial leverage: ROA: Return on Assets=EBIT/Assets Chapter 19: Financial Statement Analysis

8. EBIT Sales Sales Assets Assets Equity Net Profit Pretax Profit Pretax Profit EBIT ROE = x x x (1) x (2) x (3) x (4) x (5) Tax Burden Interest Burden x x Margin x Turnover x Leverage Du Pont System: Decomposition of ROE x ROA = Margin X Turnover Chapter 19: Financial Statement Analysis

9. An analyst applies the DuPont system of financial analysis to the following data for a company: Leverage ration 2.2 Total asset turnover 2.0 Net profit margin 5.5% Dividend payout ratio 31.8% What is the company’s return on equity? Practice Chapter 19: Financial Statement Analysis

10. Asset utilization ratios: Efficiency Fixed-asset turnover=Sales/Fixed Assets Inventor turnover=cost of goods sold/average inventory Average collection period=(Account receivables/Sales)*365 Liquidity and coverage ratios: Financial health Current ratio=current assets/current liabilities Quick ratio=(cash+receivables)/current liabilities Interest coverage ratio=EBIT/interest expense Market price ratios: Relative Value Market/Book ratio(P/B): “Safeness” Price-earnings ratio (P/E): No easy bargain E/P=ROE/(P/B) Choose a benchmark! Ratio Analysis Chapter 19: Financial Statement Analysis

11. Intel’s Financial Ratios Over Time Chapter 19: Financial Statement Analysis

12. EVA=(ROA-Capitalization Rate)  Capital Invested Growth is not the whole picture! EVA can be positive or negative for firms that have positive earnings Economic Value Added (EVA) Chapter 19: Financial Statement Analysis

13. Key Financial Ratios of Growth Industries Inc. Chapter 19: Financial Statement Analysis

14. Growth Industries Statements of Cash Flow Chapter 19: Financial Statement Analysis

15. GAAP (Generally Accepted Accounting Principles) is not unique Inventory valuation: LIFO vs FIFO Depreciation: Straight line vs Accelerated Real interest payments Quality of earnings affected by: Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities GAAP vs IAS (International Accounting Standards) Comparability Problems Chapter 19: Financial Statement Analysis

16. Allowance for bad debts Non-recurring items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities Quality of Earnings:Areas of Accounting Choices Chapter 19: Financial Statement Analysis

17. Figure 19.2 Comparative Accounting Rules Chapter 19: Financial Statement Analysis

18. Adjusted Versus Reported Price-Earnings Ratios Chapter 19: Financial Statement Analysis

19. Benjamin Graham Pick value stocks (low P/B) Rule: stock price < net current-asset value Information sources: S&P’s Outlook and Value Line Investment Survey Value Investing Chapter 19: Financial Statement Analysis

20. What is the outlook for pricing for products? Can the company sell more? Can the company increase profits on existing sales? Can the company control expenses? How much of the additional sales are net profits? How competitive is the company? Any one-time expenses? Any unprofitable operations? How well does the company meet expectations? Growth over the next five year Excess cash, competition strategies, acquisition value, stock repurchases, insider trading activities Browne: Value Investing Checklist Chapter 19: Financial Statement Analysis

21. Fundamental Analysis Economic earnings vs accounting earnings Financial Statements Du Pont System; ratio analysis Economic Value Added Comparability Next: Macroeconomy and Stock Market Summary Chapter 19: Financial Statement Analysis